Stocks
A cautionary tale

The quality of information in emerging markets has not matched their economic growth. This will not only distort the numbers, but global markets as well

Economists, financial analysts and accountants might want to think about a problem in the natural sciences. We like to think that numbers don’t lie and that they are accurate evidence of reality, but that might not be so. Professor John Ioannidis of Stanford University illustrated the issue in his recent paper published in a scientific journal titled, “Why Most Published Research Findings Are False”. The paper traced the tendency of scientific findings to distort information.

In today’s world we are showered with a massive amount of information. It is a conceit of professionals that they are well informed by credible information. This is not the case and the problem is getting worse. Not only is the information often wrong, it gets published, repeated, and spun around the web in ways that catch even the most discerning.
 
For example, recently, an Indian research firm, Ambit Research, published a study stating that over the past four years the accounting quality in India had deteriorated most often in large-cap companies.
 
Questionable accounting is not limited to India. In Hong Kong the independent branch of the international accounting firm Grant Thornton was involved in a scandal when its former boss went missing. To repair the damage, Grant Thornton International—the governing body—decided to reorganise the firm by merging the Hong Kong branch of Grant Thornton with its mainland China affiliate Jingdu Tianhua.

Rather than subject themselves to the jurisdiction of the Chinese company, the 600+ partners and staff of the Hong Kong branch jumped ship to work for a rival accounting firm BDO, which was independent. Although it wasn’t stated, it would be reasonable to assume that the accountants were concerned over the potential interference from the mainland Chinese.

It is not just professionals who distort information. Governments often do so as well. Sometimes it might be due to a mistake or incompetence. For example, India has claimed to be the world’s fastest-growing telecom market. However, a recent release of data showed that 30% of the claimed subscribers were actually inactive.

Another incident, with perhaps a greater impact, concerns the Chinese government’s response to the growing problem of inflation in China. In economics, the concept of signaling is a method of dealing with the problem of asymmetric information. This problem is central to every market. Some people have information and others don’t. In the case of China, it has to do with the problem of inflation and government’s efforts to control it.

Inflation in China has been rising. From 3% during the summer it rose to 4.4% in October and 5.1% in November. Inflation is not new to any economy. The last time the Chinese had a problem with inflation was in 2007. At that time, the Chinese government announced very specific steps to deal with the problem. The result was a disaster. The real estate market alone fell 30% in six months.

Part of the problem has to do with the nature of China’s economy. In an economy dominated by the state, there is really only one signal that matters and that is the one coming from the government. Other signals are either less important or have been intentionally muted through the control of information. For example, when the Chinese announced last month that they were raising interest rates, markets tumbled.

So as not to unsettle the markets, the Chinese government has resorted to a different policy. Rather than a direct statement, the government provides different and often contradictory statements about its intentions. In early December, the Politburo said that it would move from a relatively loose monetary policy to a “prudent policy”. To avoid the impression that this would mean a dramatic tightening, it was reported by Bloomberg that lending for 2011 would remain essentially the same as in 2010, which is almost double the amount of 2008. The story was attributed to “two people briefed on the matter”.

The Financial Times in turn attributed the statement to “a leading Chinese official newspaper”. The same article also quoted “officials close to the process” that a final lending decision had in fact not been made, but that it was being discussed “every day”.
 
The problem with this type of signal is the problem with any type of distorted information. It gives the wrong signal. The Financial Times analysis was that “Chinese leaders are still relatively sanguine about the country’s inflation prospects”. No doubt many people in China came to the same conclusion. So instead of limiting inflation expectations, the Chinese government has increased them. When they do finally decide to act, the result will be worse.
 
Emerging markets are no longer a rounding error in the global economy. They are the global economy. The danger is that since the quality of their information has not matched their economic growth, it won’t be just the numbers that will be distorted, but global markets as well.

(The writer is president of Emerging Market Strategies and can be contacted at [email protected] or [email protected])

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