Emerging Financial Market 6' Measuring Political Risk

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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 (US44 Billion in 1913
  dollars)

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Table 1. The Late 19th Century Trade Boom
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Data Source Albert Kimber, Foreign Government
Securities, 1919, A. W. Kimber Company.
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Table 2. Main Creditor and Debtor Countries,
1913Source United Nations (1949)
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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)

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Figure 2 British Sales of Opium to China
(Thousand Chests)Source Mark Borthwick, Pacific
Century, Westview Press, 1992
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Cultural Clash between the Modern and Ancient
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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.

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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

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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.

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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 years
• a significant difference in market volatility in
  political years
• high correlation between the political dummy and
  financial crisis.
• negatively correlated with changes in currency
  value.

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• 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 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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• 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

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• 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 impact
• why volatility differs across countries and why
  volatility shifts through time
• Implication for Risk Management
• investors and government should increase
  protection against devaluation and crisis
• Political risk premium should adjust according to
  political risk cycles.

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