If you can profit from the distortions in certain emerging markets, but protect yourself, then the potential of the market can be yours. If not, it is far better to simply stay home

How do you make money in Africa? The African business environment has been very difficult. According to the World Bank's Doing Business Report 55% of the countries in Africa are in the lowest quartile of its 'Ease of Doing' business ranking.

The most notable exception is South Africa, which ranks a respectable 34 just below the UAE and a few notches below France at 31. The World Bank's Report is based on one thing: law. Laws are just ink on paper. One would think that these laws could be changed easily. Just enact or pass the most economically efficient laws and then wait for the foreign investment to roll in. Sadly it is not that simple.

Laws exist because someone put them there. They remain on the books because someone wants them there. Countries are plagued with inefficiencies and corruption, because government officials realise that a given law or regulation can be a source of income. Once government officials understand that these laws can be a profit centre, the corruption tends to feed on itself. They also have a strong incentive to keep the regulation in place. Bureaucrats become rent-seekers and continue to increase the charges. A reform that gets rid of the law will end their little enterprise, so they will fight tooth and nail to keep the existing system in place. It may kill economic growth, but it helps them. The members of the group profit at the expense of the general economy.

Generally businessmen do not like this type of red tape and corruption. Business is about one thing, investing. All investments are a bet on the future. Since no one knows what the future will bring, businessmen and investors use their past experience to judge risk. When a rent-seeking bureaucrat can either up the bribe or use his discretion to change or not enforce the rules, the risk increases. As the risk increases the returns must as well. If they don't the investment is not competitive with other potential investments and the project will be cancelled.

It is not only the uncertainly that increases risk. Corruption's main impact is more insidious. It lowers the quality of information. It is difficult to know what to pay to whom; to know who will perform or which official has the power to perform. If everyone knew this information, then corruption might be efficient. But since this information is not generally available it distorts the market.

Market distortions though are also an opportunity. If you have access to information that is not available to other players in the market, if you know who to bribe, how much to bribe and whether the official will actually perform, then you can take advantage of this information to get a competitive edge. You can charge higher margins and make fatter profits, often shared with government officials.

Knowing the right person to call is important in any business environment. It is especially important in Africa and other frontier and emerging markets. In game theory these markets are called relationship-based systems in contrast to rule-based systems in more developed markets. In relationship-based systems the trust inherent in a relationship substitutes for the trust inherent in the law and the courts. Relationship-based systems are less efficient than rule-based systems because information, all information, is not available to all of the market players. In essence the relationships are networks, but networks on steroids. There are no alternative methods of conducting business. Of course in corrupt business environments, the relationships are everything.

But how can other investors take advantage of this? Just find the right person with the right contacts and you are all set. In fact many Western firms have done just that. In China for example, Western firms have made a habit of hiring the scions of important Chinese leaders to be sure they have the right contacts.

There is one drawback. You have to be extremely careful in emerging markets to understand that just because someone is making tonnes of money in the country does not mean that a foreign investor will make money. Many foreign investors, especially investors from rule-based or developed countries assume that the corruption and relationships are local issues and that they are somehow protected. Wrong. In relationship business environments the only protection is the strength of the relationship, not law.

The best way to invest is to find a bridge. An excellent bridge in Africa is South Africa. South Africa has sufficient rules to protect foreign investors investing in South Africa, but South African businesses have sufficient connections and relationships to do business in other African countries. To a certain extent Hong Kong and Taiwan offer the same service in China. If you can profit from the distortions, but protect yourself, then the potential of the market can be yours. If not, it is far better to simply stay home.

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