Investing in Emerging Markets

Eight Commandments

How to Get Your Money Back By

Determining Legal Risk

William Gamble

May, 2005

Economics is not just about capital and technological constraints. It is also about political-legal institutions, such as property rights, an independent judiciary, and timely enforcement of legal rights. In short, an economically efficient legal infrastructure. These institutions are critical determinants of sustainable economic growth and investment opportunities. Without law there cannot be any protection of contracts, protection of intellectual property, corporate governance, transparency, efficient capital markets, protection of foreign investors or sustainable economic growth.

The economic purpose of law is to lower risk. In order to determine that risk, you have to analyze the transaction costs of the law and the legal infrastructure. By legal infrastructure I mean courts, lawyers, registries, regulators, repossessions, bankruptcy procedures etc. In emerging markets, and especially in China, it is paramount to examine the entire infrastructure in order to determine the legal risk, which is a lot more important for any business decisions than concepts like >Rule of Law=.

Legal risk varies between countries and over time. To determine legal risk in China and other countries, you need to look at the following eight factors. By analyzing these factors you will be able to determine the level of a country=s legal risk.

The first factor in determining legal risk, is to analyze the banking and credit system. It is exceptionally important to analyze the level of state ownership or involvement in the credit process. Next, you must review how efficiently the legal system helps loans get repaid. A large state owned banking system tied to an inefficient legal infrastructure is a time bomb.

In China, the Communist Party has always believed that banks and bankers served no useful purpose. Banks have been used simply as a conduit for transferring capital to chosen favored Party members, sectors of the economy, or projects. The Party believes that only its members can decide how to allocate capital. China Construction Bank Chairman, Guo Shuping, pointed this out, when he said that his bank=s Communist Party committee holds Adozens of meetings,@ even debating decisions over small loans. In contrast, the board meets rarely and reported to the party committee.

This policy has been an almost universal disaster. The problem with any government, including China=s, is that they make political decisions. Bankers make economic decisions. In China loans were made without reference to whether they would be paid back. Often they were not. It is one thing to spend taxpayer money, quite another to spend depositors. Unlike taxpayers, depositors expect to get their money back.

China is not alone. Probably the worst example of this type of political profligacy is Japan, whose banks, guided by the Ministry of Finance, managed to lose close to a trillion dollars or around 17% of GDP. China is almost as bad. The four Chinese state owned banks have managed to run up $750 billion in bad debts, probably much more. Indonesia lost only 44 billion, but it represented over 50% of total loans. Thailand was not that much better. In contrast, India=s public sector bad loans are a mere $12 billion or about 12% of loans.

The choice of debtors is not the only problem. Repayment is crucial. Something as simple as repossessing a car can have monumental consequences. If you can't repo a car, the bank cannot get its money back. The bank cannot repossess a car, because, as the mainland's chief justice points out, there is a large problem with local protection.

If the bank cannot get its money back, about a third of car loans default, then the bank has a large hole in its balance sheet. For automobile loans alone the state banks are owed $12 billion. When it became obvious that the car lending business was hurting the state banks= balance sheets, the government ordered the banks to stop lending for cars. When the banks stop lending to buy cars, sales of cars, including General Motors= cars, instead of booming, plummeted. Without Chinese sales, GM's profits weakened along with its credit rating. So a simple problem with >repo-ing= cars helped cause a major corporation=s credit to be reduced to junk.

The second criteria is the bankruptcy system. Bankruptcy systems are important because they represent the plumbing of an economy. You need bankruptcy to flush away the inefficient firms, so that capital can be reallocated to efficient firms. Both Japan and China are examples of counties with inefficient or non existent bankruptcy systems. China does not even have a bankruptcy system. In 1987, it created a bankruptcy law that only applies to state owned industries and is never enforced. Its replacement has been under consideration for at least five years. In Japan the legal system is inadequate to the task of settling economic disputes. So most business failures are settled out of court or by recourse to organized crime. The results in both countries are mountains of bad loans and insolvent banks that starve efficient firms of capital.

The third criteria concern regulators. Before you invest or do business in any country, you should look at the regulators. Are they referees, coaches or players? Ideally, regulators function best when they are referees. A true referee has no conflict of interest. In many emerging markets and some developed ones, regulators are subject to enormous political influence.

Anytime there is a firm owned by the state, the agency regulating that firm will have a conflict, since it is a government agency regulating another branch of government. Such a regulator will be subject to local bias and political pressure. Almost all of China=s listed stocks are owned by a government entity, so the watchdog, the China Securities Regulatory Commission, CSRC, is not totally free to punish or expose the venal or incompetent. Japan does not even have written regulations, just the gyosei shido or administrative guidance that is ignored at one=s peril.

Even worse, some regulators actually become players. Members of the CSRC have been arrested for bribery and at one time, India=s elite tax auditors received bonuses based on the amount that they brought in. It is not surprising that process led to inappropriate actions.

The fourth criteria concern the requirements for good corporate governance. According to agency law and game theory, agents have an economic incentive to cheat their employers or owners. It does not matter whether it is the agents of the Dutch East India Company in the 17^th century or Enron in the 21^st.

Besides their economic incentives, agents have an asymmetry of information. They have it and you don=t. Law and economics provide five economic and legal incentives and disincentives to insure good corporate governance including business failure, corporate control, legal fiduciary duty, corporate governance oversight, and shareholder empowerment. None of these exist for Chinese state owned companies. Russia has a similar problem. There only 10% of the companies disclose executive pay, 49% do not respect shareholder rights, 81% do not document their dividend policy and only 25% disclose their ownership structure.

Markets from stock markets to grocery stores are about choice. To make a good choice, you need accurate and timely information. To get this information you need free speech preferably in the form of an active financial press. China does not have free speech. Russia=s media is subject to intense political pressure and unsympathetic courts. Japan has free speech, but the press is carefully managed. In contrast, India has a very competitive free press, which draws the wrath, sometimes successfully, of corrupt politicians.

The fifth criteria have to do with the courts. Does the country have an independent, unbiased, honest judiciary, who can dispose of cases quickly? In China the judges are overwhelmingly members of the Communist Party and former officers of the People=s Liberation Army, who are not necessarily lawyers. Local Party committees select judges, determine their budgets and possibly their housing, heath services and even schooling for their children. Local Party secretaries review their cases. So it should come as no surprise that local courts will favor local litigants, especially local state owned companies, whatever the merits of the case. Although the Japanese government does not have anywhere near the Chinese level of control, judicial careers are subject to the party in power, which has always meant the Liberal Democrats.

One of the main reasons why investors and businesses put money in emerging markets is to take advantage of cheap labor. Investors must understand that an impoverished population does not automatically translate into low wages. Labor laws are the sixth criteria and must be considered in the investment equation. China has labor laws, but they are rarely or selectively enforced. Without any labor laws, employers have managed to poison, cripple or maim up to one quarter of the Guangdong=s work force resulting in a two million person labor shortage. On the other end of the spectrum, India=s manufacturing growth has been severely limited by labor laws based on European models, which did not take into account local conditions.

The seventh criteria has to do with land. To insure sustainable economic growth, property rights in real property must be protected. This requires that the title to property must be clear and transferable. Information in registries must be accurate and available. In China the registries are open to the well heeled or the well connected. Even good title is not a guarantee. The government has shown scant regard for the lease holders of either oil or land. Russian farm land is owned and parceled out by the collectives and cannot be mortgaged. Under the Chika Koji Hou Land Price Disclosure Law, the Japanese government announces land prices for a given area. Only the Ministry of Finance has a complete record of real estate transactions, which it does not disclose. In contrast, in the Indian state of Karnataka, title information is available online.

The eighth and final criteria has to do with intellectual property. In the age of information, corporate assets are more often ideas rather than land or machines. China is famous for its disregard of protection on intellectual property.

The automobile company, Chery=s QQ model looks exactly like GM=s Chevy Spark. To remedy this situation, GM was advised by the Beijing government to sue Chery. Unfortunately, Chery is partly owned by city government in Wuhu, in the province of Anhui. The city relies for part of its revenue on Chery. It also controls the courts where GM would have to bring its case. Pfizer=s patent for Viagra=s was revoked by the Chinese patent office in Beijing. Microsoft=s Windows is routinely pirated. It is preferred to the Chinese government financed competition.

Things are not much better in Russia. There are 38 plants in Russia that pirate 450 million CDs and DVDs. These plants cannot be closed and nine cannot even be examined because they are on Ministry of Defense property.

Most developing countries are poor in intellectual property, so there is an enormous economic incentive to steal someone else=s. When a country develops a world class homegrown IT industry, the economic incentive tables turn. The locals demand legal protection and they usually get it. This is what has recently occurred in India, where the patent laws were changed to protect burgeoning IT and pharmaceutical sectors.

When you understand the efficiency of a country=s legal infrastructure, you have a vital tool for designing strategy and predicting economic growth. Politicians from all countries are often seduced by economic power and economic incentives. When they use the law or the lack of it to decide how to allocate resources, the result is inefficiency, waste and, ultimately, poverty. It is only when the government=s power is limited by law that the market can operate efficiently and create sustainable economic growth.