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Once You Understand Real Risks, Investing Abroad Is Quite
Feb 22, 2005
Publisher: Investor's Business Daily

Investor's Business Daily

Since 9/11, an industry of political risk consultants has grown up to help companies decide in which countries to invest. With $53 billion a year going into China, and billions more going to India and other developing countries, the consultants have their work cut out for them.

For the most part, these firms are staffed with retired Foreign Service officers, academics and ex-intelligence analysts. When they talk risks, they are really talking political risks - revolutions, nationalizations and major acts of terrorism. These are not the risks companies face.

Broadly speaking, there are two types of business risk: High-impact, low-frequency risks and low-impact, high-frequency risks. Revolutions and wars are big and receive media play since they are rare.

Contrast political risks with the ones businesses really face - poor market and banking regulation, corruption and inadequate accounting practices. Add to that bad economic policy, fuzzy rules regarding property rights and laws that are on a country's books but inequitably enforced. These risks may not be dramatic or big, but they are costly, everyday occurrences.

Murky Standards

We have been studying high-frequency, low-impact risks in order to better understand the problems associated with the globalization. We call these risks "opacity," because they are characterized by a lack of clear-cut standards and predictable procedures at the point where government, business and investors meet.

To understand opacity risks, we divided them into five categories: Corruption, the Legal system, Economic policy, Accounting and corporate governance standards and business and financial Regulations. These five factors make up the acronym CLEAR.

To measure opacity, we analyzed about 70 variables per country. These include such small things as the number of procedures it takes to get a grievance heard in court (the fewer the better), whether creditors can participate in bankruptcy proceedings (if they can't, that puts investment money at risk), the number of credit rating agencies operating in the country, whether banks are required to have independent auditors, whether property rights are clearly defined, and so on.

Drawn to Risk

Understanding each CLEAR factor can help companies avoid problem countries or create strategies to protect themselves if they have no choice but to invest in high-opacity areas. In countries with poorly functioning legal systems, for example, companies could still do business there, but enter into contracts that are mediated in nearby countries with better legal scores.

In our research, we found that while a very small handful of the 48 countries we studied are less risky than the United States (Finland, Sweden, Denmark, United Kingdom and the Hong Kong region), there are a large number of countries - 42 - posing risks far greater than anything in the U.S.

After assessing the magnitude of these business risks, we then examined our data to get an appreciation of opacity's cost. What is worrisome is that a number of countries that present businesses with high levels of opacity risks - China, India and Russia - are attracting the lion's share of the world's investment capital. Companies that ignore these risks do so at their own peril. While these countries may be politically stable, they are not financially safe.

High opacity scores correlate with sub-optimal rates of growth. Every increase of 1 point in the Opacity Index is linked to a loss of $986 of GDP income per person per year. Each 1 percent increase correlates with a 4 percent decrease in bank assets as a percentage of GDP. Every 1 percent increase in Opacity correlates with a 57 basis point increase in borrowing costs.

Opacity is sand in the gears of growth, which means that China, India and Russia, which are growing rapidly, could grow more rapidly still if they cleaned up their acts. When President Bush said foreign aid is wasted unless recipient countries attack corruption and bureaucratic inefficiencies, he was speaking about the effect of opacity on growth.

Opacity is not just a problem for businesses; it is a problem for governments. High-frequency, low-impact risks operate as a hidden tax. But unlike most taxes that are designed to provide something of value in return for the money they take, the hidden tax of opacity results in higher costs and less-efficient procedures. If countries were to become less opaque, companies doing business there would receive the economic equivalent of a tax cut without any loss of income to the country's treasury.

Break The Codes

Companies need to understand that to take advantage of global markets and global labor; they need to understand their risks. Whereas most companies are adequately informed about the risks they face that almost never occur, they fall short when it comes to protecting themselves against those small and costly problems that happen everyday. Companies need to spend more time reading legal codes and less time listening to what the political risk consultants say.

Joel Kurtzman is chairman of the Kurtzman Group and senior advisor to PricewaterhouseCoopers. Glenn Yago is director of Capital Studies for the Milken Institute.

To view the Opacity Index, or to read more about it, please read a longer article that appeared in the MIT Sloan Management Review.