Table Of ContentCracking the Emerging Markets Enigma
FINANCIAL MANAGEMENT ASSOCIATION
Survey and Synthesis Series
Asset Management: A Systematic Approach to Factor Investing
Andrew Ang
Asset Pricing and Portfolio Choice Theory
Kerry E. Back
Beyond Greed and Fear: Understanding Behavioral Finance and the Psychology of Investing
Hersh Shefrin
Beyond the Random Walk: A Guide to Stock Market Anomalies and Low-Risk Investing
Vijay Singal
Consumer Credit and the American Economy
Thomas A. Durkin, Gregory Elliehausen, Michael E. Staten, and Todd J. Zywicki
Debt Management: A Practitioner’s Guide
John D. Finnerty and Douglas R. Emery
Dividend Policy: Its Impact on Firm Value
Ronald C. Lease, Kose John, Avner Kalay, Uri Loewenstein, and Oded H. Sarig
Efficient Asset Management: A Practical Guide to Stock Portfolio Optimization and
Asset Allocation, 2nd Edition
Richard O. Michaud and Robert O. Michaud
Last Rights: Liquidating a Company
Dr. Ben S. Branch, Hugh M. Ray, and Robin Russell
Managing Pension and Retirement Plans: A Guide for Employers, Administrators,
and Other Fiduciaries
August J. Baker, Dennis E. Logue, and Jack S. Rader
Managing Pension Plans: A Comprehensive Guide to Improving Plan Performance
Dennis E. Logue and Jack S. Rader
Mortgage Valuation Models: Embedded Options, Risk, and Uncertainty
Andrew Davidson and Alex Levin
Real Estate Investment Trusts: Structure, Performance, and Investment Opportunities
Su Han Chan, John Erickson, and Ko Wang
Real Options: Managing Strategic Investment in an Uncertain World
Martha Amram and Nalin Kulatilaka
Real Options in Theory and Practice
Graeme Guthrie
Slapped by the Invisible Hand: The Panic of 2007
Gary B. Gorton
Survey Research in Corporate Finance: Bridging the Gap between Theory and Practice
H. Kent Baker, J. Clay Singleton, and E. Theodore Veit
The Financial Crisis of Our Time
Robert W. Kolb
The Search for Value: Measuring the Company’s Cost of Capital
Michael C. Ehrhardt
Too Much Is Not Enough: Incentives in Executive Compensation
Robert W. Kolb
Trading and Exchanges: Market Microstructure for Practitioners
Larry Harris
Truth in Lending: Theory, History, and a Way Forward
Thomas A. Durkin and Gregory Elliehausen
Value Based Management with Corporate Social Responsibility, 2nd Edition
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Valuing the Closely Held Firm
Michael S. Long and Thomas A. Bryant
Working Capital Management
Lorenzo Preve and Virginia Sarria-Allende
Cracking the Emerging
Markets Enigma
G. Andrew Karolyi
1
1
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Library of Congress Cataloging-in-Publication Data
Karolyi, G. Andrew.
Cracking the emerging markets enigma / G. Andrew Karolyi.
pages cm.—
(Financial Management Association survey and synthesis series)
Includes bibliographical references and index.
ISBN 978–0–19–933662–3 (alk. paper)
1. Investments, Foreign—Developing countries. 2. Investments—Developing countries.
I. Title.
HG5993.K37 2015
332.67′3091724—dc23
2014046283
1 3 5 7 9 8 6 4 2
Printed in the United States of America
on acid-free paper
{ CONTENTS }
Preface vii
Acknowledgments xi
PART I Understanding the Risks in Emerging Markets
1. Accepting the Challenge 3
2. The Emerging Market Landscape 21
3. A Primer on Empirical Methodology 36
PART II Building the Emerging Markets Risk Indicators
4. Market Capacity Constraints 47
5. Operational Inefficiencies 64
6. Foreign Accessibility Restrictions 85
7. Corporate Opacity 107
8. Limits on Legal Protections 127
9. Political Instability 150
PART III Validating the Risk Indicators
10. Do the Emerging Market Risk Indicators Work? 173
11. Making Sense of the Emerging Market Swoon of 2013 195
PART IV The Emerging Markets Enigma Cracked?
12. Final Remarks and a Few Cautions 209
Data Appendices 215
Notes 241
Bibliography 271
Index 285
{ PREFACE }
During World War II, the British Government Code and Cypher School at
Bletchley Park built up an extensive cryptanalysis team designed to read sub-
stantial amounts of secret Morse-coded radio communications of the Axis
powers that had been enciphered using so-called Enigma machines. This mas-
sive effort over a five-year period yielded military intelligence that was con-
sidered by western Supreme Allied Commander Dwight Eisenhower to have
been decisive to the Allied victory. The Enigma machines were portable, plug
board-equipped cipher machines with rotor scramblers, which made the ciphers
virtually unbreakable as long as good operating and proper enforcement pro-
cedures were followed. Alan Turing, a Cambridge University mathematician
and widely considered the father of computer science and artificial science,
provided much of the analytical thinking that led to the design of the Bombe
machines—precursors of the modern-day computer—that eventually broke the
Enigma code.
Much has been written and told about Bletchley Park, Turing, and the Enigma
codebreaking, including a serious treatise by Frederick William Winterbotham
published in 1974 by Orion Books titled The Ultra Secret: The Inside Story of
Operation Ultra, Bletchley Park, and Enigma. The “Ultra” in Winterbotham’s
title was the designation adopted by British military intelligence for the wartime
signals intelligence obtained by breaking encrypted enemy communications.
This serious book inspired, in turn, the 1986 London play by Hugh Whitemore,
Breaking the Code, which focused on Alan Turing himself; another wonderful
fictional thriller by Robert Harris titled Enigma (1995, Arrow Books), and the
2001 film by the same name starring Kate Winslet and Dougray Scott (Jagged
Films). The 2014 Black Bear Pictures release of The Imitation Game, the new-
est installment, will undoubtedly draw even more attention. Bletchley Park is
today a heritage site where visitors can see the original code-breaking huts and
blocks.
While I would love to envision myself as a modern-day Enigma code-breaker
tasked with devising an understanding of the risks associated with investing in
emerging markets, I know I am not worthy of the comparison. But this is the
goal of my book. And I would be remiss in failing to give due credit to the
men and women of Bletchley Park who inspired my title for the project. I am
fascinated by their story and feel lucky to have visited the site, seen the actual
German Navy 4-rotor Enigma machines, and even pulled the start levers of one
of Turing’s rebuilt Bombes that cracked the code.
viii Preface
What Is This Book About?
This book develops a rigorous, comprehensive, and practical framework in
which to evaluate the opportunities—and, more importantly, the risks—of
investing in emerging markets. It is rigorous in that it is built on a foundation
of sound academic research on foreign direct and portfolio capital flows and
the principles underlying international finance and economics. The framework
is comprehensive in that it incorporates in an empirically coherent framework
multiple dimensions of the potential risks that a prospective corporation or
investor faces walking into those markets. These dimensions of risk reflect the
uneven quality and fragility of the various institutions designed to assure integ-
rity in the functioning of the country’s capital markets. Finally, the framework
is practical, as it distills these various dimensions of risk into an internally con-
sistent scoring system that ranks emerging markets by each dimension of risk
and overall across all dimensions.
Philosophically, this book posits that what fundamentally characterizes
emerging markets are not the high rates of actual economic growth, but the
even higher rates of potential economic growth that are hampered by the
underdeveloped capital markets needed to finance them. The limited capac-
ity of the financial markets in those countries, mandates active engagement of
multinational corporations and foreign investors to help fund the shortfall. But
these capital flows are stunted in turn by operational inefficiencies, restrictions
on foreign participation, problems of poor governance and transparency rules,
weak legal protections for investors, and political instability. These are the six
dimensions of risk that comprise the scoring system around which the book is
built and that will constitute its main chapters.
To enable its practical use, the book will also feature recent case studies
of corporations and investors that have done deals in many of the emerging
markets that embody my risk scoring system. The case studies focus on recent
financial decisions involving corporations from emerging markets issuing secu-
rities to fund their businesses, global corporations seeking acquisition opportu-
nities in emerging markets, cross-border asset sales, joint public-private project
financing of infrastructure investments, and many other situations. They are
relatively recent events, and have been used as teaching cases in my course on
emerging markets at Cornell University. A case study will be seamlessly inte-
grated into the chapter associated with the dimension of risk it is designed to
showcase.
The primary force behind this book project was my consulting engagement
with Dimensional Fund Advisors, a major US-based asset management firm
with over $325 billion in assets under management (as of early 2014). In 2005,
they hired me for a multiyear project to help determine objective criteria by
which they should judge the countries into which they were deploying their
Preface ix
investment strategies and client monies—and, more importantly, those into
which they did not. Like so many managers with global mandates, and especially
in emerging markets, the firm was concerned with market capacity constraints,
operational inefficiencies, foreign investability restrictions, and the quality of
legal protections for minority investors, corporate governance, and disclosure
issues. For Dimensional, it was important that these criteria be well grounded
in sound academic research on international markets. Fortunately, much of my
own research program during the preceding 20 years had been focused on one
or the other of these various dimensions of risk toward understanding their
consequences for investors or corporations. I am glad that Dimensional gave
me the green light to build on, extend, and update the core elements of the
original consultative white paper from 2006 for this book today.
How Is the Book Organized?
The book has four parts. The first part, which involves three separate chap-
ters, sets the stage. The opening chapter is called “Accepting the Challenge”
(which is how I responded to Dimensional in 2005), and gives a complete over-
view of the book. It gives the reader a taste of the six different indicators, how
they are built, what the overall findings are across the countries that consti-
tute my emerging market set, and how I try to validate their usefulness. This
is my one-stop-shopping chapter; if you read only one, then this is the one to
pick. The other two chapters justify the set of emerging market countries I will
study (“The Emerging Market Landscape,” Chapter 2) and describe in detail
the multivariate statistical methodology I used to distill the data into a single
index for each risk indicator. Some readers may want to skip “A Primer on
Methodology” (Chapter 3) to get straight to the results, but I strongly recom-
mend that they do not. The methods define the outcomes and I make strategic
choices that deserve scrutiny.
Part II builds the emerging market risk indicators one by one, with chapters
corresponding to each of the six risk indicators. They follow the same methodi-
cal structure of defining the category, highlighting the extensive research that
lies at its core, describing the data sources that I integrate into the statistical
analysis, and exhibiting the resulting scores. I always wrap the analysis in each
chapter around one of the case studies to bring the key concepts alive.
In order to validate the risk indicators I turn to the penultimate Part III of
the book, in which I put some tough tests before them. Specifically, I obtain
data on foreign portfolio holdings and net foreign portfolio flows by global
investors into emerging markets, to see if one can reconcile how they might
choose to do so with the risk indicators that I built. Chapter 10 offers up evi-
dence that they work quite well.
