The I in BRIC: Indonesia or India

What do Indian telecom companies have to do with Indonesian coal? The short answer is everything, at least for investors in emerging markets

Every country has numerous types of property. The interests in property are governed by the peculiar laws of any country. Many investors believe that the law will determine the value of the property, but as the Nobel Laureate Ronald Coase pointed out in his famous theorem, the law itself probably does not make much difference because if there are no transaction costs, bargaining will lead to an efficient outcome regardless of the initial allocation of property rights. But in emerging markets there are transaction costs. The most glaring is poorly defined property rights. In India the property right was a license to use parts of the radio spectrum for second generation (2G) mobile telephones. In Indonesia the property right was a license to dig for coal.

In 2008 the corrupt telecom minister, Andimuthu Raja, helped by some well-connected tycoons was able to engineer a rigged auction of licenses to use the 2G spectrum that may have cost the Indian treasury as much as $39 billion. In February 2012, the Indian Supreme Court revoked 122 licenses declaring the sale “arbitrary and unconstitutional”. The court ordered the telecom regulator to reallocate the licenses by an auction to be held in four months.

The court was on solid legal grounds. The common law rule is that fraud cannot convey good title. This is quite logical, because it provides a disincentive to crooks, who may not profit from their acts and an incentive to buyers to investigate ownership before they buy. It is also a very important limit to the pervasive corruption that infects not only India, but all emerging markets.

Despite the validity of the ruling, it will have some far-reaching consequences. Three foreign telecom companies including Norway’s Telenor, Russia’s Sistema and Etisalat of United Arab Emirates made a mistake common for foreign investors in emerging markets. They trusted their sellers or just assumed that it was part of the business culture. Nigerian Internet scammers make a good living on the presumption that corruption is so prevalent that deals, no matter how nefarious, will be respected. Whatever their logic, these three companies stand to lose the billions they invested in networks based on the assumption that their licenses were valid.

The press on the ruling has also been mixed. The Indian muck-raking news magazine Tehelka called the court’s action “judicial over-reach” that resulted from “the abject capitulation of the executive”. One commentator stated that “India has become a banana republic in which the banana is peeled by the Supreme Court. Never has ‘brand India’ been so damaged.” Incredible India has become Undependable India”.

The truth is just the opposite. The Supreme Court’s actions go to the heart of any investment. All investing is a bet on the future. The future is filled with risk. The more investors can limit risk, the more likely they are to invest. Strict adherence to rules and well-defined property rights are the most important criteria for attracting foreign investment.

Contrast India’s license revocation with Indonesia. Gossips lament that the ‘I’ in BRICs now stands for Indonesia and not India. The shareholders of Churchill Mining would disagree.

The Nusantara Group is an Indonesian mining company controlled by Prabowo Subianto, a retired general, once the son-in-law to former president Suharto and future presidential candidate. Nusantara held licenses to mine coal in East Kalimantan on the Indonesian part of the Island of Borneo. These expired in 2006 and 2007.  A small British company called Churchill Mining bought interests in the licenses after the local government declared them available.

In 2008 Churchill discovered a giant coal deposit, estimated to be in 2.73 billion tonnes. It is the second-largest reserve in Indonesia and the seventh-largest in the world. Based on the authority of its license, Churchill invested more than $40 million in the project.

Within months of announcing its discovery, Churchill found that their property rights in the discovery were in question. The same local government that had declared that Nusantara’s license expired backtracked. They extended them which, if upheld, would nullify Churchill’s claims.

Churchill sued in the local courts but predictably lost. A final appeal to the Indonesian Supreme court could take years and a representative of Indonesia’s president Yudhoyono said that the issue was a local matter and denied any knowledge of the case.

It would be easy to dismiss these incidents as isolated cases, but they are not. They are part of the risk of any investment either direct or indirect. Before any emerging market can live up to the BRIC hype, it has to enforce property rights. India has proved that it is the ‘I’. The real problem has to with the C and the R.

(William Gamble is president of Emerging Market Strategies. An international lawyer and economist, he developed his theories beginning with his first hand experience and business dealings in the Russia starting in 1993. Mr Gamble holds two graduate law degrees. He was educated at Institute D'Etudes Politique, Trinity College, University of Miami School of Law, and University of Virginia Darden Graduate School of Business Administration. He was a member of the bar in three states, over four different federal courts and has spoken four languages. Mr Gamble can be contacted at [email protected] or [email protected])

 

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Chinese Roll Over

The great thing about the state-controlled lenders is that they do what they are told. In this case they have been told not to try and collect the loans, just roll them over. If there is no panic and no one actually tries to collect the loans, then there is no reason to believe that their value has declined

All financial crises occur for one reason: Too much debt. We are seeing the endless drama with this issue in regard to Greece. Investors and banks lent Greece a lot of money based on the assumption that it was Germany. This assumption is rather silly in retrospect, but the result is that Greece, not being Germany, can’t pay its creditors back the full amount that it owes. This causes a problem.

In the US we experienced a similar issue. Lenders lent money to home owners based on the assumption that house prices would go one way—up. Worse through the magic of modern finance, the debts multiplied beyond either reason or even sanity and then were sold, not just in the US, but around the world. In retrospect this also turned out to be a bad idea.

Still the issue was not the form of the loans. Whether the debts were sovereign, as in the case of Greece, or collateralized debt obligations (CDOs), as in the case of US mortgages, in the end they made little difference. They are both debts. The point was that an awful lot of lot of money was lent to debtors who could not pay the money back.

What is really interesting about financial crises though is not the cause; it is the trigger. The problems of Greece were not a secret. Perhaps the extent of the problem was, but the issue itself did not become obvious until the world went into recession and creditors decided that they wanted their money back. The same is true with the US housing mess.

The savage lending that led to the bubble could have gone on much longer than it did. If the creditors had never started to doubt the safety of their investments the lending would have certainly continued. If the creditors just assumed that everything was fine and did not try to collect, not much would have happened. Panics start when everyone tries to be the first out the door.

Now let us consider China. The Chinese government required its state-owned banks to flood the country with loans, in excess of $4 trillion since the beginning of 2009. Most of these loans went to either state-owned companies or local governments. It was not only the banks that lent the money. The provinces and cities also created scads of finance vehicles to get around the lending limits. This lending binge was encouraged by the central government in Beijing to the extent that the loans were considered almost a patriotic duty, until now.

It should hardly surprise anyone that many of these loans went bad. When this amount of money goes out the door, much of it will end up in the wrong place. This is especially true of China where loans are made for political and not financial considerations.

But investors need not worry. This particular pile of toxic lending waste will not melt down. Why? Simple, the creditors are not rushing to the door. The great thing about the state-controlled lenders is that they do what they are told. In this case they have been told not to try and collect the loans, just roll them over. If there is no panic and no one actually tries to collect the loans, then there is no reason to believe that their value has declined.

Is this a problem? Many commentators dismiss it. After all unlike Greece, Europe or the US, the Chinese economy is rapidly growing at a projected 8%, so it can easily absorb these bad debts. But one wonders that if the Chinese economy were not flooded with cheap loans whether it would be growing as fast.  

It has also been suggested that the problem is nothing more than a flawed national financial system that needs to be reformed. If the provinces and cities could have issued bonds rather than borrowing from banks, all would be well. The problem is now being resolved because a handful of cities are being allowed to issue bonds.

Exactly why bonds would be better than bank loans is not exactly clear, at least to me. It seems both are debts and both can go bad. But bad loans are not the problem. According to a Chinese investment banker, calling in the loans would be the “surest route to trouble”

But of course this entire assumption is just as absurd as the assumption that Greece is Germany or that housing prices won’t go down. No matter the form, a bad debt is a bad debt. It is money that could have been used more efficiently elsewhere. It prevents further stimulus and stymies growth. So maybe the Chinese have avoided a crash, but don’t expect growth either. Over time quick dramatic pain might have been the better option.

(William Gamble is president of Emerging Market Strategies. An international lawyer and economist, he developed his theories beginning with his first hand experience and business dealings in the Russia starting in 1993. Mr Gamble holds two graduate law degrees. He was educated at Institute D'Etudes Politique, Trinity College, University of Miami School of Law, and University of Virginia Darden Graduate School of Business Administration. He was a member of the bar in three states, over four different federal courts and has spoken four languages. Mr Gamble can be contacted at [email protected] or [email protected])

 

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Concentration in Emerging Markets

Market concentration tends to distort the efficiency of markets, which negates the accuracy of analytic tools. To successfully invest in these markets requires different tools to understand the different rules

Last week I read an article about the IMF’s (International Monetary Fund) latest forecast. Confirming my most recent suspicions, the IMF was forecasting that China’s economic growth in 2012 would slow to 8.25% from the 9% projected in September. Although in most countries a growth rate over 8% would be considered to be highly inflationary, the IMF advised that China could inject additional stimulus into its economy via its weekly open market operations.

Normally a central bank uses open market operations as the primary means of implementing monetary policy. The usual aim of open market operations is to control the short-term interest rate and indirectly control the total money supply. But in China this is not necessarily the case. Interest rates may make little difference in China. Few Chinese use debt to buy homes and fewer still use credit cards. Loans at the controlled interest rates go to state-owned industries and private companies are forced into the huge shadow banking system where interest rates have nothing to do with the money supply.

The IMF’s recommendation tells more about how economists and analysts from developed markets look at China and other emerging markets than about the economic situation in China. The IMF looks at China through the lens of developed markets, where its recommendations would make a lot of sense. In emerging markets things are different. One of the most important differences has to do with market concentration.

Emerging markets are dominated by two types of companies: state-owned firms and family-owned firms. Each emerging market is dominated by one or the other and sometimes both. In either case each market is made up of a few whales and a bunch of minnows. So the diversification that investors expect by investing in emerging markets is often simply an illusion.

For example in Russia about 45% of the market is dominated by five companies. They include three enormous state-owned companies: Gazprom, the world’s largest gas producer, Sberbank, the largest Russian bank, and Rosneft, the company that ‘inherited’ the assets of Yukos. Together these three make up 35% of the market by capitalization. If you include two private companies, Lukoil, and Norilsk, the total market capitalization of just these five makes up over 45% of the Russian market. Gazprom and Sberbank make up over half the turnover. In addition the state also owns large chunks of other large listed companies including Transneft, a pipeline company; Sukhoi, an aircraft-maker; Rosneft; Unified Energy Systems, an electricity giant; and Aeroflot among others. 

 China is a little better. Its top five companies make up a bit less than 30% of the market. They include PetroChina, ICBC, Bank of China, China Construction Bank and the Agricultural Bank of China. It is not only the concentration of a few large companies that dominate emerging stock markets, the companies are overwhelmingly concentrated in either finance or commodities, usually oil. It is not only former communist countries like China and Russia where state-owned companies dominate markets, the 179 listed companies in the Gulf are at least partially owned by 51 government entities. Governments controlled almost 30% of the region’s total market capitalization.

Brazil at least has a mostly private firm, the mining giant Vale, dominating its stock market, but the combination of Vale and the state-owned Petrobras make up 30% of the Bovespa alone. If you add the shares of Vale and Petrobras with the other three in the top five, which include two banks, Itau Unibanco and Bradesco, and, refreshingly, a brewer, Ambev, you end up with the most concentrated stock market in the world at 48%.

In contrast to the other BRICs, India is the model of diversification. The top five companies make up only 23% of the market capitalisation. Still almost three quarters of the economy is in the hands of either state-owned or large family-owned firms like the two Reliance firms controlled by the Ambanis and various bits of the Tata empire. India is hardly unique. Carlos Slim is the richest man in the world. His companies account for more than a third of the Mexican stock market. Even in Israel the market is controlled by a few oligarchs.

Investors around the world are advised of the wisdom of diversification including diversifying internationally and into emerging as well as developed markets. But there is hardly any diversification by investing in markets concentrated in state or family-owned commodities and financial firms. This type of diversification also misses investing in the more dynamic firms that are supposed to make up the emerging market growth story. 

Finally, market concentration tends to distort the efficiency of markets, which negates the accuracy of analytic tools. To successfully invest in these markets requires different tools to understand the different rules.

(William Gamble is president of Emerging Market Strategies. An international lawyer and economist, he developed his theories beginning with his first hand experience and business dealings in the Russia starting in 1993. Mr Gamble holds two graduate law degrees. He was educated at Institute D'Etudes Politique, Trinity College, University of Miami School of Law, and University of Virginia Darden Graduate School of Business Administration. He was a member of the bar in three states, over four different federal courts and has spoken four languages. Mr Gamble can be contacted at [email protected] or [email protected])

 

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