A Panda is not a Bear

Three Types of Investment Risk

• Economic Risk

• Political Risk

• Legal Risk

Economic Risk

• General Economic Conditions

• Indirect Investors– Market Goes up or down

• Direct Investors– Company makes or loses money

Political Risk

• Too much Government- Expropriation: Bolivia - nationalization of gas

sector- Regulatory : Russia - Sakhalin-1 Sakhalin-2

- Too Little Government- Civil Unrest: Pakistan- Failed States: Iraq

Legal Risk

• Economic purpose of law is risk management

• Law can be either economically efficient or inefficient– Law can function in two ways: It can extend power or it can limit

power

– Law is economically efficient when it limits power

– Law is economically inefficient when it extends power

• Legal Infrastructure– Law: Mexico good anti trust law that is not enforced

– Enforcement: India good judges just too few and too many vacations

– Regulators: Players or Referees? China: CSRC

Examples of Legal Infrastructure

• Corporate governance

• Effective Regulators

• Transparency

• Accurate disclosures

• Accurate audits

• Stable regulatory environment

• Stable tax systems

• Enforcement of contracts

• Collection of loans

• Protection of intellectual property

• Efficient bankruptcy system

= Legal Risk

Two Systems

• Relation Based System– Older system based on trust

– small groups or networks connected by family relationships, geographic proximity, ethnic, linguistic, religious ties or even party affiliation

– information can be transmitted quickly and accurately enough to detect and deter deviation

• Rule Based System– Law legal system

Medici Jewish Diamond Merchants of New York

South East Asia Overseas Chinese

Game Theory Models

• Relationship based system less economically efficient

• Break down when larger groups cannot communicate information fast enough to deter cheating

• Resistance to Change– Relation capital

• Interface with Rule based system– Clash of expectations– Susceptible to outbreaks of speculation

Game Theory Models

• Each System is mix of relation based and rule based system

• US one end of spectrum– UK most OECD economies, India more rule based

• Most Emerging Markets at other End– Asian Economies, Japan Korea getting better, China getting worse

• Direct correlation between level of legal risk and level of relationship based system

Effects of Game Theory Model

• Global Investing: Asymmetries favor Relationship based systems– Easier to understand the rules than create relationships

• Relationship systems of Japan, South Korea and Taiwan more successful in exporting than rule systems of US or UK

• European Exporters more successful than US• US tries very hard to export rules

– Easier for relationship based systems to deal with other relation based systems

– Easier for Relationship based savers to buy assets or lend money to rule based system than visa versa

– Rule base investors without relationship capital is asking to be robbed.

Asymmetries and Transparency

• Economic Incentives and Legal disincentives

• Its all about Information– Misinformation: Fraud

– Failure to disclose: No information

– Incomplete or misleading information

• Inefficient markets, greater risk

• Law is the Mechanism in Mechanism Design

• Relationship based systems less transparency

Saudi Stock ExchangePredictable Speculation

Limits of Relationship Systems

A Tale of Two Emerging Markets

True Value

• “only about 30 per cent of the more than 1,300 listed firms on Chinese stock markets had investment value.” Cheng Siwei South China Morning Post March 14, 2007

• “different parts of the government, such as state-owned companies, local government units, the police and the army… have so much money they don’t know what to do with it, so they put it in the stock market.” Financial Times May 17 2007

• “Strip out those gains and, according to Morgan Stanley, the actual price-to-earnings ratio is a bubbly 58 times.” Financial Times, September 7, 2007

China Construction Bank v. ICICI (India)

• Government Owned– Political motivation

• Loans based on relationships and politics

• Embezzlement $1.5 billion• NPLs 3.91 % probably

35% ($911 bn total system)

• Defaults autos loans: 33%• Management appointed by

CCP

• Private held– Profit motivation

• Loans based on risk assessment

• Negligible• NPLs 0.97%

• Defaults autos loans: 3%

• Management appointed by board

Effects of the Chinese Market

• Bank of China’s investment of $9.6 billion in US subprime investments could equal 18% of shareholder’s equity if it is

worthless • According to Yi Xianrong, a finance expert underlying

quality of home loans in China was worse than in the US. Prices are already off 10% since last fall.

• China’s demand for commodities has driven prices since 2000. Problems with Chinese markets and companies will have a dramatic effect on demand.

Sub prime Goes Global

• House price bubbles in Belgium, Britain, Denmark, Spain and Sweden, Bank run in UK, Spanish real estate companies tank

• Brazil’s 2004 change in its mortgage foreclosure law has lead to a 300% increase in housing loans

• Many Russian companies and banks borrowed heavily on international markets are experiencing a credit squeeze.

Asymmetry and Transparency

OldBorrower ↔ Bank

NewBorrower → Bank → Investment Bank →

Hedge fund → Fund of Funds → Consultant → Investor

Risk and Rules

• What you don’t know will hurt you

• What the markets don’t know will hurt everyone

• What markets know depends on the rules

• Without rules, transparency declines, asymmetries increase

• Do not assume that the risks or all markets are the same

• To determine risk, first determine the rules.