MIT Sloan Management Review
Over the years, businesses have evolved a number of innovative ways to manage the risks associated with having global operations. They have developed sophisticated ways to insure their infrastructures and their operations and to hedge their currencies. They have learned how to distribute information resources globally using highly resilient computer networks with geographically dispersed backups. They have put in place sophisticated new internal controls systems to monitor performance and tease out fraud on a global basis. They have developed intricate taxonomies to enable different parts of the company to rate and communicate their risks in a consistent manner around the world. They have created a new global rolei? 1/2 the chief risk officeri? 1/2 to watch over the company as a whole. And many boards of directors have made risk management one of their top priorities. But despite these initiatives, gaps remain.
Global companies face two distinct types of risks: Large-scale, low-frequency risks and small-scale, high-frequency risks. Although the large-scale risks i? 1/2 earthquakes, wars, coup di? 1/2 etats, and major acts of terrorismi? 1/2 are front-page news, the small-scale risksi? 1/2 fraudulent transactions, bribery, legal and regulatory complexity and unenforceable contractsi? 1/2 represent the real costs to business. These risks interfere with commerce, add to costs, slow growth and make the future even more difficult to predict. They also deter investment. i? 1/2 The key to any good investment relationship is clarity'the ability to see and even be in communication with what's really going on. It's the same whether it's a company, a country or a region,i? 1/2 said Matt Feshbach, chief investment officer of MLF investments, a mid-sized hedge fund in Largo, Florida. i? 1/2 If the risk picture is unclear, capital is less likely to go where it's needed.i? 1/2
Annually since 20001, we have been studying a variety of countries, seeking to identify their degree of opacity i? 1/2 that is, the degree to which they lack clear, accurate, easily discernible and widely accepted practices governing the relationships among businesses, investors, and governments, which form the basis of most small scale, high frequency risks. Greater awareness of the risk factors that put the brakes on commerce can enable companies to make better portfolio and direct investment decisions regarding where to develop markets, locate productive resources or find the best outsource partner, and can also help governments understand how to make their countries more attractive locations for investment and to measure their progress.
Toward that end, we developed a methodology for projecting what aspects of a country's economy carry the greatest risk. After talking with companies and financial and economic experts, we discovered that, in any country, small scale, high frequency risks fall into one of five broad causal categories (which form the acronym CLEAR): business and government corruption, an ineffective legal system, deleterious economic policy, inadequate accounting and governance practices, and detrimental regulatory structures.
By assessing and comparing the costs of those risks on a country-by-country basis, we create an overall Opacity Index2, in which higher levels of opacity strongly correlate with slower growth and less foreign direct investment in all markets (except China, where the size of its market and labor force attracts large-scale investment despite what appear to be very high levels of risk).
The Opacity Index
The Opacity Index draws upon 65 objective variables from 41 sources including the World Bank, International Monetary Funds, International Securities Services Association, International Country Risk Guide and individual country's regulators. Considerable effort has been made to ensure that the data are directly comparable across the 48 countries we studied. (Earlier attempts to do survey-based research proved less than optimal because many business leaders did not know enough about business practices in other countries to make meaningful comparisons with their own.) An array of data is compiled and ranked for each of the CLEAR factors.
To understand the how the Index works and what it measures, consider how the research assesses legal systems. We gathered data from a variety of publicly available sources i? 1/2 the Global Competitiveness Report, the International Country Risk Guide and the Index of Economic Freedom i? 1/2 in order to examine a country's overall legal environment and obtain a gauge of how effectively its legal system resolves business disputes and what protections it grants to businesses, investors and to other sources of capital. Factors such as whether bankruptcy procedures allow the continued operation of the business, whether shareholders have preemptive rights that can only be waved by a shareholders' vote, or the degree of judicial independence, strength of property rights or even the level of religious tension are evaluated and compiled to construct an overall score.
Similarly, we drew on a number of sources such as the World Bank doing business database and the global competitiveness report to measure and compare the economic risks that challenge business in various countries, including some traditional and non-traditional economic factors such as the influence of organized crime, the cost of terrorism and costs relating to bureaucratic i? 1/2 red tapei? 1/2 and non-transparent taxation systems. Together, these factors summarize the economic costs of doing business in a country.
Our examination of regulation, particularly as related to the capital markets, measures how safe it is to provide capital to various countries. We sought data to answer two broad questions: Can investors in a given country get a full understanding of the companies in which they invest, and are there mechanisms for settling disputes that arise out of the investment process? In addition to these issues, we were concerned with how well the countries we studied conformed to the robust regulatory practices that are in use in countries like the United Kingdom and the United States, which have very large capital markets that are for the most part well run.
To create our assessment of corruption, we compiled data from existing indices, most notably Transparency International3 and International Country Risk Guide. There is some overlap in the areas of business cost of corruption and that of terrorism which included in the category that focuses on economic factors. This is intentional, because firms often do not, perhaps cannot, clearly discern between these costs as it is often taken as a given to operate in a country. To better assess the opacity cost to businesses in these countries, corruption costs needs to be taken into account individually and collectively with other opacity factors depending on the type of business.
Most of the data we compiled to measure the transparency in countries' accounting practices is binary: Do countries require an independent audit by an external auditor or not? Are there annual banking inspections? Are a country's accounting standards in accord with international standards? Comparing a country's data to various benchmarks and standards established around the world yields an overall understanding of whether the finances of companies in that country can be viewed by with confidence.
Collecting, compiling and linearly rescaling data (from 0 to 100) in all the above-mentioned categories4, we calculated five sub-indicesi? 1/2 one for each CLEAR factori? 1/2 using simple averages. The final score is the simple average of the five sub-indices. (See i? 1/2 The Opacity Indexi? 1/2 in the "charts" link below.) We believe these scores are a reliable reflection of each country's everyday business risks. Further, each individual sub-index score allows companies to assess where they are most likely to get into troublei? 1/2 corruption, the economy, regulation, accounting standardsi? 1/2 and whether they will have a chance for redressi? 1/2 legali? 1/2 should a problem occur.
To put these risks into business terms, each final score is associated with an opacity risk premium/discount5, which is expressed as an interest rate equivalent. (For purposes of this study, the opacity risk premium/discount is calculated by taking the numerical difference in opacity between the subject country and the U.S. multiplied by 0.2213.) In practice this means that if a U.S investor wants to do business in France, he needs to receive a return 3.53% greater than in the U.S. to offset the risk. If he wants to do business in China, he needs to receive a return that is 6.49% greater. If an investor wants to do business in Finland, she could actually receive a smaller rate of return than in the U.S. and still justify the investment.
Correlating Opacity With Other Indicators
To check the efficacy of the Opacity Index, we correlated it various other indicators. For example, because opacity impedes the development and efficient functioning of a financial system - the markets as well as business processes and operations i? 1/2 one would expect to find highly opaque countries among the least developed i? 1/2 and least able to develop - countries. What's more, opaque countries should be among the slower-growing countries in the developed world.
To test these relationships, we looked for consistent differences in the average Opacity Index and individual scores among the four World Bank income groups (See i? 1/2 Average Opacity Index and CLEAR Scores by World Bank Income Groupi? 1/2 in the "charts" link below.) Moving down the income groups, from high to lower, opacity increases in each component, except accounting because most of the lower income countries adapt more uniformly with the international accounting standards, which may be the by-product of high opacity in other components.
Economic Development and Foreign Investment
Our analysis shows that real gross domestic product (GDP) per capita - a common measure of economic development - is lower in countries with higher levels of opacity, whereas for richer countries the reverse is true. (See i? 1/2 Opacity vs. Economic Developmenti? 1/2 in the "charts" link below.) We estimate that for every 1-point increase in Opacity Index6, per capita income is lower by $986 . This suggests a strong association between prosperity and the lessened risk levels that come from transparent processes in each of the five areas we studied. It further suggests that opacity acts as a break on the pace of economic development.
Opacity can also affect economic development indirectly by deterring foreign direct investments (FDI). Since it is the amalgamation of stable investment funds, advanced technology, efficient managerial skills, and easier access to the world market, FDI has a positive impact on economic growth and development. Opacity also has negative and significant impact on FDI a percentage of GDP. (See "Opacity vs. Foreign Direct Investment" in the "charts" link below.) In the majority of cases, most foreign direct investments go to countries with relatively transparent financial and economic systems. In the case of China, which has high levels of opacity and high levels of economic development, the simple lure of China's i? 1/2 bignessi? 1/2 has tended to make it the recipient of greater levels of FDI than would otherwise be warranted. However, the results of this study indicate that if China were to become more transparent, the amount of FDI would likely increase.
Entrepreneurship and Access to Capital
Transparency in countries' financial and economic environments enhances the predictability of business conditions, which in turn promotes increased entrepreneurial activity. Opacity is not only a deterrent to economic development, it also decreases the ability of entrepreneurs to access capital. According to the World Bank Doing Business Database, regulatory and legal transparency is an important indicator of the cost of starting a business and the factor that could enhance or constrain business investment, productivity, and growth.
Opacity can starve a project of funding in many ways. By definition, opaque systems create information asymmetries between lenders and borrowers (that is, information is known to some, but not all, participants) can add complexity and additional burden to lenders' expectations of return on investment. Opacity also increases the ranges of possible projected cash flows from risky projects, resulting in lower risk-adjusted expected present values. This decreasing of expected discounted returns may ultimately result in the rejection of some projects that would be successful yet appear to be poor investments given opaque conditions.
In addition, the Opacity Index would indicate that when fraud occurs in global companies, it begins in business units located in regions with higher levels of opacity. As a case in point, news reports indicate that the scandals surrounding Ahold, a Dutch company, began in high-opacity Argentina, while those of Parmalat, began in high-opacity Italy, but did not necessarily spread to countries with lower levels of opacity which acts as a barrier to contagion of related crises. It becomes difficult for larger companies to impose reporting discipline in high opacity local business environments.
The annually produced Milken Institute Capital Access Index (CAI) ranks countries on the basis of entrepreneurs' access to capital and is based on variables measuring such market features as liquidity, interest rate volatility, and the risk of expropriation. To the extent that opacity adversely affects the development and efficiency of financial markets, one would expect the Opacity Index and Capital Access Index to be significantly and negatively correlated, as they clearly are. (See i? 1/2 Opacity vs. Capital Access Indexi? 1/2 in the "charts" link below.)
Lending and Equity Markets
A country's financial system is, in many ways, its most important intangible asset. The institutional capacity to generate and pool savings and invest them on projects and enterprises that will maximize a country's material well-being is critical. To the extent that the size of a country's financial system is closely related to its entrepreneurs' ability to access capital7, one would further expect to find a significantly negative correlation between opacity and the depth and breadth of the financial system as measured by the number, types, and capitalization of financial institutions, capital markets, and financial instruments and their liquidity. And this clearly is the case.
Our analysis shows that opacity correlates negatively with the size of a country's banking system relative to its GDP. (See i? 1/2 Opacity Index vs. Bank Assetsi? 1/2 in the "charts" link below.) Opacity increases asymmetric information problems for banks, raising agency costs and perhaps the likelihood and costs of debtor defaults. In addition, the Opacity Index has a statistically significant and negative correlation with stock market capitalization and trading volume relative to GDP. (See i? 1/2 Opacity vs. Size of Equity Marketi? 1/2 and i? 1/2 Opacity vs. Trading of Equity Marketi? 1/2 in the "charts" link below.) Opacity can lead to wider bid-offer spreads and hence less liquid and less efficient financial markets. Additionally, it can mask the underlying fundamentals of investments and thereby make investment in an opaque country less attractive. This in turn generates an opacity-related risk premium for that country's for firms when they raise capital.
Since financial institutions and financial markets are critical to the infrastructure of investment flows within countries and their ability to build a broad based business community, these findings strongly suggest that increased transparency of a country's critical financial factors would be a stimulus to its firm creation, industrial expansion, and economic growth. Clearly, countries that ignore their Opacity Index scores could face lagging rates of growth over the long haul. (See i? 1/2 The Negative Impact of Opacityi? 1/2 in the "charts" link below.) One only has to consider the difference between the development of Finland and Russia after the end of the Cold War. Both countries were poor, but had invested heavily in education, and both had abundant natural resources. Russian capitalism developed with a poorly functioning regulatory structure for its businesses, few real legal protections, a vague set of laws governing such things as property rights and very high levels of corruption and crime. Finland, on the other hand, emphasized the creation of strong institutions, regulatory structures and laws and corruption there is almost non-existent. The result? Finland now has one of the most vibrant economies in the world, ranked at the top of the 2003-2004 World Economic Forum's Competitiveness Index. Russia, by contrast, lies at the bottom of the Index, as world's 58th most competitive country.
The Company-Level View
Opacity's correlation with slow growth, lackluster foreign direct investment, flagging equity markets and a host of other woes has obvious implications for global companies. Managers need to make decisions based on more than the size of a country's market and the price of its labour. They need to take into account how its economy works. Businesses that do not pay attention to a country's level of opacity, could find that they are making long-term decisions based on unrealistic estimates of risk and return.
Businesses must understand i? 1/2 in very quantifiable terms i? 1/2 the cost of doing business in high-opacity countries. Doing business in Mexico, for example, which has an opacity score of 44, requires a return of 5.01% above the U.S. rate of return in order to offset a company's risk. Doing business in China, with a score of 51, requires a premium of 6.49% to offset its risk. What this means to managers is that in some instances, China, even with its low wage rates, may be actually be a less attractive place to do business than Mexico when the opacity risks are factored in.
A look at the individual CLEAR factors can inform even finer-grained managerial decisions since, even for countries with the same overall Opacity Index rating, the causes of opacity might be quite different. If managers have a choice of where to locate a regional headquarters, for example, they might choose a country that scores higher on the legal and economic sub-indices. If they are looking for a place to build a plant, they may care more about the corruption sub-index. If they are looking at a joint venture with another company, the legal sub-index will indicate those locales in which the provisions of a joint-venture contract will be best enforced.
This is not to suggest that businesses should avoid high-opacity countries. Indeed, in some areas of commerce such as mineral extraction and oil production, that would be difficult, since many of the largest producers of raw materials and oil have high opacity scores. Instead, businesses can use the Index to prudently measure their risks and to create mechanisms to protect themselves against those risks.
In the final analysis the Opacity Index illustrates why it is in everyone's interest for companies and countries to work together to bring down opacity scores. For businesses, it is critical in order to become fully global in a prudent way. For countries, it is necessary in order to attract their fair share of inbound investment for growth and development.
Joel Kurtzman is chairman of the Kurtzman Group and senior advisor to PricewaterhouseCoopers. Glenn Yago is director of Capital Studies and Triphon Phumiwasana is senior research analyst, both at the Milken Institute.
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