Emerging Financial Market 6. Measuring Political Risk

Prof. J.P. Mei

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Emerging markets in the 1900s World Trade accounted for huge part of

GDP in many countries. Equity markets at the turn of the

century flourished, many markets established.

Internet Technology (Railroad) & Worldwide Real Time Communication

Foreign Investment surged (US$44 Billion in 1913 dollars)

Table 1. The Late 19th Century Trade BoomCountry 1870 1890 1913

New World

Australia 44.3 31.3 42.0Canada 33.0 25.6 34.0United States 11.8 13.0 11.1

Old World: Free Trade

United kingdom 50.7 54.6 59.6The Netherlands 87.4 149.9 249.4Sweden 32.0 47.2 42.3Norway 34.0 43.6 50.9Demark 35.7 48.0 61.4Belgium 57.8 81.9 134.9

Old World: Protected

Germany na 31.7 39.8Spain 11.7 25.0 23.9Portugal 11.3 11.1 16.1France 23.7 28.3 30.9Italy 18.3 19.3 28.7

Source: Williamson (NBER)

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Data Source: Albert Kimber, Foreign Government Securities, 1919, A. W. Kimber & Company.

1854 1872 1881 1895 1905 1910 1914$0

$5

$10

$15

$20

$25

1854 1872 1881 1895 1905 1910 1914

Figure1. British Overseas Investment 1854-1914 (US$ billion)

Table 2. Main Creditor and Debtor Countries, 1913Source: United Nations (1949)

Major sources of Political Risk in the past

Two Major Exploitations: within and across Countries (Slavery and Child Labor) Caused Strong Resentment.

Communism and the Risk of Nationalization Colonialism and the Risk of Political Upheaval.

(Then superpower was the largest government supported drug dealer in the world)

World WAR I and the Russian Revolution ended the first wave of globalization.

Long-term Return of Emerging markets (not glamorous due to submerged markets)

Figure 2: British Sales of Opium to China (Thousand Chests)Source: Mark Borthwick, Pacific Century, Westview Press, 1992

0

5

10

15

20

25

1729 1790 1819 1823 1832

Cultural Clash between the Modern and Ancient

Measuring Risks Measurement of political risk

Measuring corruption

Measuring the rule of Law

Political risk measurements can be used

in project financing. (discount rates)

Measuring political risks is still an art

rather than a science.2

Political Risk Insurance Eligibility & Coverage OPIC insurance can cover the following

three political risks: currency inconverti-bility, expropriation, political violence.

OPIC insures Business income and assets.

Election of Coverage & Premium Base Rates

Problem: Lack a systematic approach 3

Political Uncertainty and Elections

Election cycle a) the time leading up to an election and the

time of government transition after the election, and

b) the time after the transition is complete and the next election season starts.

In a democratic system, the election process is a major political event for determining future political course of a country.

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Why Political Risk Matters 1. The "first generation" currency crisis model represented by Krugman

(1979) and Flood and Garber (1984): Strong incentive to engage in inconsistent policies during elections by pursuing expansionary monetary and fiscal policies while holding exchange rates fixed to ensure price stability or other policy objectives.

2. The "second generation" model of Obstfeld (1994). In such a model, the cost of defending the currency increases when people suspect that the government is leaning towards abandoning the fixed rate. (Banking problems)

3. Self-fulfilling exchange rate crises (see, Banerjee (1992)).

4. Contingent investment or "real options": foreign capital flow to Asia from a huge $93 billion inflow in 1996 to a $12 billion net outflow in

1997. 5

Dependent Variables Financial crisis: defined as a sharp shift

from inflow to outflow between year t-1 and t

Turkey and Venezuela in 1994, Argentina and Mexico in 1995; and Indonesia, Korea, Malaysia, the Philippines, and Thailand in 1997.

78 observations (22 x 4 - 10 excluded observations)

equity returns and market volatility: the IFC index.

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Economic and Financial Variables: the ratio of short-term debt to the foreign

exchange reserves total debt outstanding (long and short term) the change in the ratio of the financial claims on

the private sector relative to GDP over the preceding three years.

current account to GDP ratio capital flow to GDP ratio the percentage change in the real exchange rate

(RER) in the previous three years. index of corruption and Regional Market Contagion Dummy

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Table 1: eight out of nine financial crises happened within one year before or after the election.

Table 2 presents some summary financial crisis: 23% in political years vs 2% in

non-political yearsa significant difference in market volatility in

political years high correlation between the political dummy

and financial crisis. negatively correlated with changes in currency

value. 8

Table 1: Summary of Financial Crisis Year, Election Date,Political System, and Election Cycle

Country Crisis Year Election Date Presidential or

Parliamental

System*

Election

Cycle

(Years)

Notes

Argentina 1995 May-95 1 4

Brazil Nov-94 1 4

Chile Dec-93 1 6

Colombia May-94 1 4

Hungary May-94 0 4

India Apr-96 0 5

Indonesia 1997 Mar-98 1 5

Jordan Monarch

Korea 1997 Dec-97 1 5

Malaysia 1997 Apr-95 0 4

Mexico 1995 Aug-94 1 6

Peru Apr-95 1 5

Philippines 1997 May-98 1 6

Poland Nov-95 1 5

Russia Jul-96 1 4

South Africa May-94 1 5

Sri Lanka Nov-94 1 6

Taiwan Mar-96 1 4

Thailand 1997 Nov-96 0 4

Turkey* 1994 93 & 95 0 5

Venezuela 1994 Dec-93 1 5

Zimbabwe Mar-96 1 6

Note: 1=Presidential System. * Turkey has a parliamental system with a strong president.Data Source: Microsoft Encarta Encyclopedia and CIA Factbook (obtained at WEBhttp://www.odci.gov/cia/publications/factbook/country-frame.html)

Table 2: Summary Statistics of Crisis Variables (by Political Dummy)Financial

CrisisCurrentAccountto GDP

CapitalInflow to

GDP

CorruptIndex

3 yearChangein Creditto GDP

3 year %change inReal FX

rate

Short-term debt

to GDP

Totaldebt toreserve

ratio

EquityReturn $

Changein

CurrencyValue

EquityMarket

Volatility

Contagion

PoliticalMean 0.23 -0.03 0.06 3.47 0.07 -17.09 1.15 2.06 0.02 -0.17 0.11 0.34

St. Dev 0.43 0.04 0.09 0.81 0.13 26.74 1.16 2.21 0.53 0.22 0.04 0.48

Non-Political

Mean 0.02 -0.02 0.01 3.63 0.04 -14.95 1.04 2.29 0.12 -0.09 0.08 0.14St. Dev 0.15 0.09 0.21 0.95 0.26 25.13 1.04 3.37 0.73 0.14 0.06 0.35

T-stat. 2.71 -0.97 1.36 -0.78 0.55 -0.36 0.45 -0.36 -0.69 -1.83 2.62 2.09

Correla tionsC. Acc -0.15

Cap. FL 0.07 -0.9Corrupt -0.14 -0.06 0.05Credit 0.20 0.31 -0.33 -0.05

Real FX 0.00 -0.26 0.31 0.31 0.31ST Debt 0.24 0.34 -0.37 -0.03 -0.07 -0.25Debt/Res 0.01 0.38 -0.38 0.07 -0.07 -0.21 0.78Eq. Ret$ -0.31 0.73 -0.73 -0.03 0.3 -0.29 0.13 0.16Devalue -0.53 -0.24 0.29 0.15 -0.34 0.04 -0.26 -0.23 -0.10Volatility 0.31 0.53 -0.54 -0.08 0.29 -0.31 0.27 0.2 0.46 -0.65Political 0.32 -0.10 0.14 -0.09 0.06 -0.04 0.05 -0.04 -0.08 -0.21 0.28

Contagion 0.28 -0.10 0.08 -0.26 0.16 -0.09 -0.12 -0.06 -0.15 -0.24 0.08 0.24

Data Sources: The political dummy variables are based on election information provided inWorld Factbook published by CIA and confirmed by Microsoft's Encarta Encyclopedia.Radelet and Sachs (1998) provided the economic variables and crisis definition.Note: The current account to GDP ratio, the capital Inflow to GDP ratio, 3 year Change inCredit to GDP ratio, 3 year % change in Real FX rate, Short-term debt to GDP ratio, andtotal debt to reserve ratio are measured at the end of last year.

Table 3 presents some summary statistics according to financial crisis.

significantly higher current account deficit, higher capital inflows, larger change in bank credit in the past three years, and higher short-term debt to GDP ratios.

A Probit Analysis of Emerging Market Crises

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Table 3: Summary Statistics of Crisis Variables (by Crisis Countries)CurrentAccountto GDP

CapitalInflowto GDP

CorruptIndex

3 yearChangein Creditto GDP

3 year %changein RealFX rate

Short-term

debt toGDP

Totaldebt toreserve

ratio

EquityReturn

$

Change inCurrency

Value

EquityMarket

Volatility

Political(0 fornon-

politicalyears)

Contagion YearCrisisOccur

Argentina -0.04 0.07 3.00 0.06 -25.66 1.57 2.74 12.7% 0.1% 10.6% 1 1 1995Indonesia -0.04 0.06 2.00 0.07 -8.22 1.70 2.89 -73.7% -46.0% 16.5% 1 1 1997Korea -0.05 0.05 4.00 0.08 -6.65 2.06 3.04 -68.7% -50.1% 14.3% 1 1 1997Malaysia -0.08 0.04 4.00 0.69 -13.78 0.61 1.08 -71.7% -35.1% 11.0% 0 1 1997Mexico -0.08 0.07 3.00 0.20 -30.74 5.28 3.40 -26.0% -36.2% 14.6% 1 0 1995Philippines -0.05 0.10 3.00 0.22 -22.64 0.85 1.44 -61.9% -34.1% 9.6% 1 1 1997Thailand -0.08 0.09 3.00 0.20 -11.24 1.45 2.21 -79.3% -46.6% 13.0% 1 0 1997Turkey -0.04 0.09 4.00 0.01 -11.32 2.06 2.26 -40.2% -62.2% 20.2% 1 0 1994Venezuela -0.03 0.06 3.00 -0.01 -12.09 0.81 1.70 -25.7% -41.5% 14.8% 1 0 1994

CrisisMean -0.05 0.07 3.22 0.17 -15.82 1.82 2.31 -0.48 -0.39 0.14 0.89 0.56 -

St. Dev 0.02 0.02 0.67 0.21 8.42 1.40 0.78 0.31 0.17 0.03 0.33 0.53 -

Non-crisisMean -0.02 0.03 3.60 0.04 -15.92 0.99 2.17 0.15 -0.09 0.09 0.39 0.19 -

St. Dev 0.07 0.18 0.91 0.20 27.21 1.01 3.07 0.64 0.15 0.05 0.49 0.39 -

T-stat. -2.80 1.72 -1.53 1.70 0.02 1.71 0.30 -4.92 -5.01 3.92 3.95 2.02 -

Data Sources: The political dummy variables are based on election information provided in WorldFactbook published by CIA and confirmed by Microsoft's Encarta Encyclopedia. Radelet andSachs (1998) provided the economic variables and crisis definition.Note: The current account to GDP ratio, the capital Inflow to GDP ratio, 3 year Change in Credit toGDP ratio, 3 year % change in Real FX rate, Short-term debt to GDP ratio, and total debt to reserveratio are measured at the end of last year.

Table 4: Probit Analysis the political dummy turns out to be quite significant

even after adjusting pseudo R-square increase from 0.37 with six

independent variables to 0.63 with only four independent variables.

a higher ratio of short-term debt to reserves (liquidity) a rapid buildup in the claims of the banking sector a larger current account deficit or capital flows

(weakly) real exchange rate overvaluation: close to zero corruption not significant contagion appear to be less important than political risk

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Table 4. Probit Results for Financial Crisis__________________________________________________________________________________________________

OutputProbit results I II III IV V VI VII VIII

Independent variable Coefficient (Z stat)

Short term debt/ Reserves 0.543 2.501 0.538 0.590 2.201 0.353 0.639 0.579(2.12)** (1.96)** (2.04)** (2.05)** (1.70)* (1.76)* (2.66)*** (2.23)**

Private credit/GDP 3.774 4.147 4.152 3.967 5.178 2.145 2.610 3.174(2.51)** (2.51)** (2.51)** (2.55)** (2.35)** (2.03)** (1.76)* (2.03)**

Total debt/reserves -1.071 -0.820(-1.55) (-1.08)

Capital inflow/GDP 3.203 1.923 3.653 3.357 -6.108(1.63) (0.55) (1.82)* (1.81)* (-0.98)

Current acct surplus/GDP -26.911(-1.67)*

Real exchange rate -0.008 -0.709(-0.65) (-0.05)

Corruption -0.363 -0.621(-1.06) (-1.27)

Political risk 1.486 1.589 1.506 1.420 2.287 1.574 1.308(2.11)** (2.16)** (2.01)** (2.01)** (1.93)* (2.19)** (1.78)*

Contagion 1.009 0.742(2.08)** (1.41)

Polticalrisk*Parliamentary 0.197(0.34)

Constant -3.483 -3.662 -3.675 -2.302 -3.041 -2.997 -2.809 -3.599(-3.98)*** (-3.68)*** (-3.77)*** (-1.74)* (-1.57) (-3.83)*** (-4.86)*** (-4.02)***

Pseudo Rsquared 0.63 0.86 0.64 0.65 0.88 0.56 0.51 0.62

No. of obs 78 78 78 78 78 78 78 78*** 1% significance** 5% significance* 10% significance__________________________________________________________________________________________________

Data Sources: The political dummy variables are based on information provided in World Factbookpublished by CIA and confirmed by Microsoft's Encarta World Encyclopedia. Radelet and Sachs (1998)provided the economic variables and crisis definition.

1. Changes in the currency value (in dollars):

change in bank credit has a very significant negative impact on currency value.

the political dummy a strong negative impact on currency

foreign capital inflows positive 2. Equity market returns in dollars.

high current account (surplus) high capital flow to GDP ratio (lower) Warning: information lags 11

iiii cDbXaR

iiii cDbXas

3. Volatility of equity market returns in dollars. bank credit has a very significant impact changes in real exchange rates (currency appreciation) political risk has significant impactwhy volatility differs across countries and why

volatility shifts through time

Implication for Risk Management investors and government should increase protection

against devaluation and crisisPolitical risk premium should adjust according to

political risk cycles. 12

iiii cDbXa

Table 5: Regression Analysis of Determinants of CurrencyDevaluation, Equity Returns (in Dollars) and Market Volatility

________________________________________________________________________________

Dependent variable % Change inCurrencyValue ($)

EquityReturn ($)

EquityMarket

Volatility ($)

Constant -0.092 0.134 0.058(-1.06) (0.60) (2.20)**

Current Account to GDP 0.541 3.972 0.177(0.99) (2.94)*** (1.19)

Capital Inflow to GDP 0.364 -1.114 -0.068(1.64) (-1.89)* (-1.16)

Corrupt Index 0.018 0.036 0.005(0.89) (0.56) (0.66)

3 year change in credit to GDP -0.220 0.442 0.049(-3.02)*** (1.01) (2.66)***

3 year %change in real FX rate -0.000 -0.005 -0.000(-0.31) (-2.19)** (-2.04)**

Short-term debt to GDP -0.026 -0.091 0.006(-1.15) (-1.94)* (1.07)

Total debt to reserve ratio -0.007 -0.009 -0.002(-1.22) (-0.77) (-1.33)

Political Dummy -0.064 0.045 0.031(-1.87)* (0.47) (3.74)***

Contagion -0.072 -0.215 0.003(1.38) (-1.91)* (0.33)

Adjusted R-square 0.196 0.571 0.403

No. of obs 78 78 78

*** 1% significance** 5% significance* 10% significance_______________________________________________________________________________

Data Sources: The political dummy variables are based on information provided in WorldFactbook published by CIA and confirmed by Microsoft's Encarta World Encyclopedia.Radelet and Sachs (1998) provided the economic and financial variables. . The t-statistics have been adjusted for heteroscadaticity using the White-matrix.