So I’m reading The Wall Street Journal one day over my morning glass of fresh Florida orange juice, and find an article about problems in the stock market in India. The article says that until recently, India’s stock market has been able to withstand the financial and economic problems in the US. However, there is evidence that the Sensex (India’s stock market index) is beginning to fall, and a big initial public offering has been withdrawn due to lack of investor interest. Two days later, an article in the Journal says that investors are flocking to foreign bonds. In the past year, US investors have parked an additional $19 billion in foreign-bond funds, bringing the total to $84 billion. The article says that there are different types of foreign government bonds, from ultrasafe bonds in Germany paying 4 percent yields, to riskier bonds in Brazil paying 13 percent or more.
What goes on here? I thought this was the Wall Street Journal, but it contains articles about investing in India, Germany, and Brazil. What this tells me is that investors can put money almost anywhere around the globe these days, thanks to globalization of financial markets. The Journal is forced to take a global perspective because US investors have alternatives beyond Wall Street. Another thing this tells me is that if you’re going to invest globally, you’d better be aware of the risks of doing so. Why is Germany considered ultrasafe while Brazil has to pay three times as much interest in order to attract investors? And if the risk of each country is different, how can I as an investor evaluate the risk and incorporate it into my investing decision?
Back in the 1960s when I studied economics, a course called “Comparative Economic Systems” was common in most economics programs in US colleges and universities. The course attempted a typology of economic systems around the world. At one extreme were the capitalist countries, in particular the US. At the other extreme were the communist countries, in particular the Soviet Union. It was easy to tell the good from the bad because we were taught early on that capitalism was good and communism was bad. I assumed that every country that professed capitalism was good, like the US, and every country that professed any form of communism was bad.
It wasn’t until several years later that I visited some of these countries and interacted with their people. In the process, I learned that there were many shades between market-controlled and government-controlled economies. For example, in France, which most Americans consider a capitalist country, the government owns or owned some of the firms that I took for granted were owned by private investors. In Australia, another capitalist country, there is a high degree of government influence over business behavior, and it has a reputation as one of the world’s highly regulated economies. In Canada and the United Kingdom, government provides many services that are provided by the private sector in the US. Even in the US, government owned some sources of production and protected certain sectors of the economy. It turned out that all of the world’s economies were mixed – a combination of capitalism and government control. If that was the case, how could you tell the good from the bad?
Evaluating risk involves two aspects: assessing and analyzing. Assessing risk means to measure the likelihood of some event affecting the value of an investment, such as when a socialist government threatens to nationalize an industry. Experience, knowledge, and access to information lead to better risk assessment. Analyzing risk means to develop an underlying theory about which factors to consider, how to measure them, and how to develop a system of rating the factors. The theory and practice of analyzing risk have been developed over the past few decades and are still evolving.
In this chapter, we focus on analyzing risk. We discuss a frame of reference that emerged during the 1990s: the Washington Consensus. Countries that meet the criteria of the Washington Consensus are considered safer places to invest than are countries that do not meet the criteria. The Washington Consensus represents a method that investors could use to evaluate the risk of investing globally.
explain modern investing principles in their historical context;
discuss the criteria investors consider when investing in another country;
explain the risk-return tradeoff that faces every investor.
A Brief Historical Background
To put today into its historical context, it is necessary to go back to the Great Depression. The US in the 1930s was gripped by a prolonged economic collapse; millions of workers couldn’t find jobs, factories shut down, and the mechanisms of traditional economics seemed not to function. The unemployment rate reached 25 percent in 1937: one in four workers couldn’t find a job. The economic problems were leading to social unrest; socialism was gaining adherents as a replacement to the capitalist system. It was obvious to some economists and policy makers that the market system no longer worked; people couldn’t rely on a collection of independent decisions by people and businesses to achieve employment, happiness, or social stability. Some alternative way out of the problem had to be found.
A solution that appealed to many was a greater role for government. If the individual actors in the economy – people and businesses – couldn’t generate a level of economic activity sufficient to generate employment, then the government had an obligation to intervene to help stimulate economic activity. In fact, one of the twentieth century’s prominent economists, John Maynard Keynes, developed a theory of when and how a government could intervene and how the economy would behave when it did.
The interpretation of the government as the solution to society’s problems wasn’t shared universally among economists or policy makers, of course. When the government gets involved, the process becomes centralized and people lose a degree of freedom. Decisions previously made by workers or business executives instead are made by government officials. Some economists at the time, such as Friedrich von Hayek, argued that government intervention was worse than leaving the economy to solve its own problems, and that individuals should not be required to cede to the government their freedom about making decisions. In addition, several analysts have examined the period in retrospect and discovered that bad government policy accounted for at least some of the economic ills of the Great Depression, so government was the problem rather than the cure. But none of this was apparent to the majority of policy makers in the 1930s.
Anyway, in 1944, toward the end of the Second World War, representatives of the Allied nations met at a resort in Bretton Woods, New Hampshire, in the US to discuss what the world economic environment would be once the war concluded. The conference featured some of the prominent economic and financial experts of the era, such as John Maynard Keynes of England and Harry Dexter White of the US. Participants remembered the economic collapse that occurred following the First World War and a decade of misery during the Great Depression, and they feared that the world would return to those conditions after the Second World War. To them, government intervention appeared to be the solution.
International Bank for Reconstruction and Development (IBRD). The IBRD’s purpose was to lend to governments to repair a country’s infrastructure – rail systems, roads, port facilities, airports, electricity generation, and distribution systems – damaged during the war. Repairing the infrastructure would enable a nation’s economy to grow, generating revenues for the government to repay the loans. The IBRD still exists as part of the World Bank (WB) group of financial institutions.
International Monetary Fund (IMF). The IMF’s mission was to help a government weather the economic crisis that results when a country loses foreign exchange due to temporary trade imbalances. A nation without foreign exchange would not be able to purchase goods and services from other countries, so the IMF would lend reserves to the country experiencing the crisis. These imbalances sometimes result from bad economic policies on the part of the government, so the loans typically come with conditions designed to rectify the bad economic policies. Once the situation was stabilized, the country would follow the IMF’s guidance and the underlying economic problems would be solved. The improved trade position would generate the funds necessary to repay the IMF.
Notice that both of the organizations resulting from Bretton Woods personified centralization, as if the WB or the IMF could determine what projects or policies were best for an individual country. But the organizations represented economic and political thinking of the time. The people who make public policy do so with the mindset in which they were educated, experienced, or came to power, and the 1930s and 1940s were tumultuous decades. These large, centralized global institutions were the culmination of the idea of government intervention. Not only did the government of a particular nation have the responsibility to intervene, but now the world economic system was structured around intervention by global institutions.
Things continued along this vein for the next 30 years until economic and political thought migrated toward a contradictory view – that government and centralization were not the solutions to national or world problems. During the 1980s, revolutions in economic thought and policy occurred in the United Kingdom when Margaret Thatcher was elected Prime Minister, then in the US when Ronald Reagan was elected President. Both leaders espoused free-market rather than government-intervention approaches to solving economic problems, and the WB and IMF began to follow that guidance. The free-market approach gained credence when the Soviet Union collapsed in 1989, which appeared to prove that a government-directed approach was not a viable solution to economic problems.
The outcome was a group of Washington, DC-based global institutions (the IMF and WB headquarters are in Washington, as are several others) that advocated free-market solutions to the world’s economic problems. Furthermore, the institutions applied the principles to every country under all circumstances. It was centralized control promoting market-based principles.
The Washington Consensus
In 1990, an economist at one of the Washington think tanks summarized the general feeling about desirable economic policies as viewed by official Washington – the US Treasury and Federal Reserve, the WB, the IMF, and other organizations. He called this view the Washington Consensus because it was a summary of the thoughts of the majority of the organizations in Washington DC. In the original article, the principles of the Washington Consensus represented desirable reforms only for Latin American countries, which were undergoing one of their periodic financial crises. However, before long the principles began to be considered the official view of Washington and the global institutions toward all countries.
Fiscal discipline. Governments should practice fiscal discipline, which means that the government should spend no more than it generates through tax revenues.
Public spending priorities. Governments should spend most on purposes that will improve public welfare, such as education, health, and the nation’s infrastructure.
Tax reform. Governments should broaden the tax base and adopt moderate tax rates.
Interest rates. Interest rates should be determined by the market rather than by government edict. Governments should keep inflation low enough that market interest rates exceed the rate of inflation and investors earn a positive return on investment after inflation.
Exchange rate. Exchange rates should be determined by the market rather than by government edict. The exchange rate should be sufficiently competitive that the country’s flow of funds with the rest of the world can be improved through export growth.
Trade policy. Governments should gradually reduce import restrictions such as tariffs and quotas.
Foreign direct investment. Governments should place no restrictions on investment by foreigners for purposes such as building physical facilities or ownership of businesses.
Privatization. Whenever possible, governments should sell off state-owned enterprises so that they are subject to market competition.
Deregulation. Governments should promote competition by removing regulations and reducing protection of industries from market forces.
Property rights. Governments should create a legal environment that encourages and enforces private property rights.
One thing you’ll notice is that the focus in each of these principles is on what the government should (or should not) do. As the ultimate decision maker and enforcer in any nation, government determines the country’s economic environment. It has the power to intervene as it wishes, but the Washington Consensus mentions several places where the government should not intervene. Another thing you’ll notice is the emphasis on free-market principles. The point of the Washington Consensus is that governments have a choice: They can move toward letting the market determine the competitive environment in a country, or they can move toward greater government control over the competitive environment. The Washington Consensus favors less government intervention. If it is a choice between the market or the government determining economic behavior, the Consensus comes down squarely on the side of the market.
Citizens in many European countries have a tradition that the government should play a more active role in society. Nevertheless, many of the governments are moving toward the principles of the Consensus and in the process creating dissatisfaction in some sectors of society. For example, in many European countries, the communication system, the railroad network, and even banks are or have been owned by the government. Because government ownership is contrary to the privatization principle of the Consensus, many governments are privatizing these sectors, endangering the job security and pensions of employees. It’s not surprising that there are public demonstrations such as those that led to the resignation of one French prime minister and greeted a newly-elected president of France.
After collapse of the Soviet Union, representatives from the IMF and the US assisted Russia in setting up economic and political systems that were closer to the Washington Consensus. In other words, they tried to establish free-market principles in a country that had never (even in pre-Soviet times) been free of centralized control. Russian citizens had difficulty becoming accustomed to a different institutional environment, so the transition toward capitalism has not been easy. Of course, there are other reasons for Russia’s hesitancy to move toward the free market, but there is no question that the Russian economy is becoming more open even if its political system is not.
Hugo Chávez, the President of Venezuela, advocates many principles of government that are contrary to the Washington Consensus, and he tries to enlist other Latin American governments to his point of view. One source of conflict between Chávez and officials in Washington is that he flaunts principles such as government ownership of or control over business and opposition to many principles of globalization. When you have an opportunity, research some of the Chávez ideas and compare them to the principles of the Consensus.
We see that the Washington Consensus is a useful way to view political and social changes in the modern world. But it is more than that. As an investor, you have a choice to put your money almost anywhere around the world these days. In fact, if you want to diversify your portfolio, you’ll invest in several different countries so you’re not at the mercy of what happens in only one country. How do you decide where to invest? Wouldn’t you prefer to invest in a country in which the government sets a climate that is most favorable for foreign investors? That’s where the Consensus comes in. It provides a set of criteria that we can use to evaluate whether a country has an economic and political environment favorable for investors.
Major corporations and large financial institutions have been doing this for years. In fact, the concepts of country analysis originated with corporations like the big oil companies. But now even smaller investors have an opportunity to invest in securities around the world, and we don’t want to do it blindly. The Consensus helps us understand whether countries are adopting good or bad policies that establish the environment in which securities markets operate. It’s all part of what Thomas Friedman calls the democratization of finance: the spreading of risks and rewards away from large financial institutions and toward individual investors and borrowers.
As financial markets have grown, as exchange rates have been freed from control, and as countries have liberalized rules about investing, more small players have been able to invest globally. But small investors don’t always understand the way international financial markets operate, so they need to get educated. (It’s like the old adage about a man with experience meeting a man with money. When they parted, the man with experience left with the money and the man with the money left with the experience.) We don’t want to be losers because we choose lousy places to invest. We want to put our money in the places it’s most likely to be safe, and that’s where country analysis helps us. That’s the purpose of this book.
More Detail about the Criteria
Because we will use criteria along the lines of the Washington Consensus throughout the book, let’s spend a little time investigating the criteria in more detail so we understand why they are important and how they influence the investing environment.
Any time you see the word fiscal, think of a budget. A company has a fiscal year that relates to its annual budget. Governments are the same. Governments determine the amount they plan to collect in tax revenue and the amount they plan to spend. Some governments have a habit of spending more than is generated through revenues. In large part, the blame can be placed on politicians, who face more favorable chances for election if they promise to reduce taxes and provide more services. It takes a pretty responsible government to live within its means by spending only what it receives as revenues.
Spending more than revenues means that a government must borrow to finance the difference, and more borrowing increases the national debt. Countries in which the government persistently spends more than its revenues have high deficits and high national debts compared to the size of the country’s economy.
As a global investor, where would you prefer to invest: in a country where the government acts responsibly by balancing its budget, or in a country where the government habitually runs a budgetary deficit because it spends more than its revenues? The Consensus answer is that governments that balance their budgets are more responsible, more courageous, and ultimately, more successful. It’s called fiscal discipline because running a balanced budget requires self-control on the part of government policy makers.
Public Spending Priorities
How governments allocate their spending is a function of the priorities of the people making the decisions. Sometimes those priorities are directed toward what is good for the general population, but other times the priorities are directed toward special constituencies. The special constituency may be a privileged elite that influences or controls the people in the government who make spending decisions. It may be a ministry or a government agency that holds power during the budget process. In these situations, government spending priorities may reflect the priorities of the ruling elite or the powerful ministry rather than what is good for the population in general.
One particular constituency frequently is a government-owned enterprise. Governments throughout the world (even in the US) own some sectors of the economy. In directed economies such as Russia or China, the proportion may be much higher, but even there the trend is toward less government ownership.
The problem arises when the government-owned enterprise doesn’t make a profit, so it becomes a drain on the government’s budget. The government has to subsidize the operation. These kinds of subsidies can have a real impact on government spending, and they force the people who pay the taxes to subsidize the owners and employees of the unprofitable enterprise. And guess who gets stuck with paying taxes in most countries? Working stiffs like you and me, not the wealthy, who frequently are able to avoid taxes.
The Consensus view about public spending priorities is that the government ought to spend on things that are good for the nation as a whole: education, health, roads, and bridges. Having the working class subsidize certain sectors of the economy, particularly unprofitable, state-owned enterprises, doesn’t make sense. And too many countries do just that.
The sole exception to the Consensus view of spending priorities is the military. Defense budgets are virtually untouchable in any country. You and I might argue that they are too high or too low given the possibility of conflict, but military spending is a separate issue that the Consensus doesn’t address.
So the question is, as a global investor, where would you rather invest: in a country that seems to be spending on purposes that are beneficial for the population as a whole, or in a country that is spending to support special interests, particularly state enterprises? The Consensus answer is that you prefer countries in which the government spends to help the nation as a whole, not just a particular class or sector of the population.
One of the lessons of the Thatcher and Reagan eras is the importance of taxes as incentives to behavior on the part of the people or businesses that pay them. Economists had known for ages that taxes and subsidies affect the behavior of those who pay or receive them, but during the years following the Second World War, the incentive effect had become buried relative to the other thing taxes do: raise money for the government.
In the 1970s, several economists gained credibility in political circles by pointing out that tax rates were too high. A tax rate is the proportion of someone’s income, for example, that the government confiscates as tax. When applied to the taxes you pay on additional earnings, the rate is called the marginal tax rate. In the US during the 1950s, the marginal tax rate was as high as 91 percent on incomes above $400,000; in other words, the individual kept only 9 percent of the income he or she earned above $400,000. (The marginal rate was 94 percent during the Second World War.) Imagine the incentive effect of that tax!
Some economists and politicians pointed out that these high tax rates were hurting the economy by discouraging people from doing things that were good for the economy, such as investing, saving, and working. They reasoned that it might be possible for the government to obtain the same amount of revenue by lowering tax rates, provided that doing so had the effect of stimulating people to work more so that taxable incomes went up. The same principle applies to other taxes, of course; the principle isn’t limited to only income taxes.
Another principle of taxation is that a tax system shouldn’t play favorites by allowing some people to avoid taxes while others have to pay them. The figure on which the government collects taxes is called the tax base (for the personal income tax, the tax base is taxable income, after all adjustments, deductions, and exemptions have been made). The Consensus argues that the tax base should be broadened so that everyone shares in the tax burden. Governments in every country have a tendency to allow some people to avoid paying taxes on specific activities. For example, in the US, we are allowed to deduct from income contributions to charitable causes, interest paid on a primary mortgage, and some educational expenses, to name a few. Whether these deductions are legitimate depends on your point of view. They may be beneficial for society, but they allow some people to escape paying taxes while shifting the burden to others. As you read Box 3.1, see whether you can identify the tradeoff between tax rates and the tax base, and the incentive effects of taxes.
Examples of avoiding taxes may be more egregious in other countries. The point of the Washington Consensus is that the government shouldn’t put the entire tax burden on the working people while wealthy families with government connections are exempt from paying their fair share. That sounds like a reasonable idea, doesn’t it?
These two principles – lowering tax rates while broadening the tax base – became pillars of the Washington Consensus. The neat thing is that they appeared to work. When the principles were applied in developed countries such as the UK or the US, the result was a higher rate of growth of the economy. When applied to less developed countries where governments were starving for tax revenues, the result was that people didn’t resist paying taxes as much, and tax revenues increased. The principles were the basis of the monumental US tax reforms that occurred in 1986, which were described in a book about the episode, Showdown at Gucci Gulch. It’s a great lesson on the interplay between economics and politics and I encourage you to read the book.
The interesting aspect is that manipulating tax rates and the tax base doesn’t imply that taxes themselves are inherently bad, or even that government tax revenues should decline. Tax reform means that the burden of taxes should be distributed fairly across society. The appropriate level of tax revenues ultimately is a function of what role individuals expect government to play in society. It therefore depends on how the revenues will be spent, which is the issue discussed in the previous section on public spending priorities. Believe it or not, people in some countries expect a significant level of services from government and are willing to pay for them through taxes. It’s hard for us to believe that in the US, where we traditionally distrust the government, but it’s true.
As a global investor, wouldn’t you prefer to invest in a country where the tax system isn’t used as a political tool and where the burden of paying for government is shared by everyone? That’s the view of the Consensus, anyway.
Countries use corporate tax rates as a tool to attract corporations to invest in the country. Here is a snapshot of the discussion about corporate tax rates around the world in 2007. The discussion also shows the difference between the tax rate and the tax base.
In India, the Government considered a budget that reduced the corporate tax rate to 25 percent from 34 percent. At the same time, the Finance Minister proposed eliminating several exemptions that allowed corporations to escape paying the tax.
In Germany, the Finance Minister proposed a budget that cut corporate tax rates below 30 percent from about 39 percent, the highest in the European Union. He also proposed reducing the amount of interest expenses that could be deducted from tax liability. Business executives in Germany were strongly in favor of the reduction in the tax rate, but strongly opposed limiting tax deductibility of interest expense.
The Government in China enacted a tax law that equalized treatment of foreign and domestic companies. The previous law favored foreign companies by giving them tax breaks and exemptions that allowed them to avoid many taxes. Although foreign and domestic firms were taxed at the same 33 percent rate, the loopholes allowed foreign firms to pay an effective 15 percent tax rate compared to 25 percent for domestic firms. The favorable treatment for foreign investors began when China opened its economy in the 1980s.
The Chancellor of the Exchequer in the UK lowered the corporate tax rate to 28 percent from 30 percent, but reduced capital allowances, a deduction from tax liability for certain investments.
Corporate tax rates at the time in the United States were 40 percent, although most corporations paid a lower effective rate due to tax breaks.
Sources: Amit Mukherjee, “What’s in Chidambaram’s bag?”, Business Today, Mar 11, 2007, p. 96; “German tax changes could damage investment”, International Tax Review, Mar 2007, p. 1; “Levelling the playing field”, Business Asia, Mar 19, 2007, p. 5; “UK corporate tax”, Financial Times, Mar 22, 2007, p. 28; Marcus Walker, “Europe competes for investment with lower corporate tax rates”, Wall Street Journal, Apr 17, 2007, p. A12.
There was a time only a few decades ago when interest rates were controlled to a great extent by government edict. In some countries, they still are. The US got out of the interest rate control business in the 1980s and left responsibility for determining interest rates to the market: the people borrowing and lending money. If interest rates get too high, borrowers won’t borrow as much. If rates get too low, investors aren’t willing to invest. The interplay between these two forces determines the level of interest rates throughout the US economy, from daily rates such as federal funds to long-term rates such as 30-year home mortgages. In fact, perhaps the only rate that is set is the discount rate, the rate at which the central bank lends money to commercial banks that are members of the Federal Reserve System.
The advantage of letting markets determine rates is that the money is allocated according to priorities of borrowers or lenders, which means their need for profit. It gets government out of the business of subsidizing some borrowers by lending to them at lower rates. Interest is the price of money. Economists have long recognized that prices perform important functions in an economy. Prices: 1) transmit information about tastes and resource availability, 2) provide incentives for efficiency in production, and 3) distribute incomes by determining who gets what. Interest rates perform those functions in the money market. Markets are a much more efficient way to make these decisions than governments are, and keeping the government out removes the possibility of favoritism.
A market is a wondrous mechanism, and it is very good at allocating resources according to the priorities of the people trying to buy and sell in the market. Any economist will tell you that when things interfere with the operation of a market, a number of undesirable results can occur. That’s why, when there’s a choice between the market or the government deciding something, the Consensus prefers the market.
When governments control interest rates, they have an incentive to keep rates low because low rates stimulate borrowing and consumption, or because the government wishes to lend to certain sectors of the economy. The trouble is that the government might control rates so they are below the rate of inflation, which means that lenders lose purchasing power when they lend. Pretty soon, lenders decide not to lend under those circumstances, and capital starts to leave the country so it can be invested in more favorable places. Sometimes it’s a hard pill to swallow, but the best solution regarding interest rates is to let the market decide the appropriate level.
As a global investor, you’ll tend to steer clear of countries where interest rates are set by the government rather than by the market. In those countries, governments are apt to use interest rates to achieve purposes other than keeping investors happy. This is the situation in Venezuela, as you’ll read in Box 3.2.
The same choice about how interest rates should be determined – by the government or by the market – applies to the price of a country’s currency. Prior to 1972, currency prices were fixed by government agreements. The only way the price of a country’s currency could change was for governments from several countries to agree on the new price. However, that system of fixed exchange rates broke down in 1972, and since then currency prices have been free to fluctuate according to market forces, although some countries continue to try to set the exchange rate for their currency.
Venezuela’s President Hugo Chávez nationalized several banks in 2008 and began passing legislation and issuing directives dictating operating practices to private banks. Some of the rules required banks to lend 100 percent of the purchase price on home mortgages, a practice that haunted the United States financial system during the financial crisis.
Directives also require banks to lend at lower rates to sectors favored by the government, such as farming and housing, and to increase microlending, the practice of making small loans to poor borrowers. The government sets a cap on rates banks can charge for loans and controls the difference between the bank’s borrowing and lending rates. The government requires banks to increase lending, including purchasing securities issued by the government.
When Venezuela began to experience a financial crisis in 2009, Chávez said he would take over more banks if necessary, and the government closed several small banks. The financial positions of banks have deteriorated to the point that they receive lower ratings from agencies such as Moody’s Investors Services or Standard and Poor’s Corporation.
Sources: “The autocrat of Caracas”, The Economist, Aug 9, 2008, p. 36; Dan Molinski, Darcy Crowe, “Venezuelan leader warns of crackdown”, Wall Street Journal, Dec 8, 2009, p. A12; Brian Caplen, “Venezuela’s banks survive in the face of adversity”, The Banker, Sep 2009.
A number of factors influence the value of a currency, including the country’s trade with other countries, the level of interest rates in each country, and the level of inflation in each country. These forces change so rapidly that only markets unconstrained by government interference have the ability to react by adjusting the price of a country’s currency.
In many cases, government attempts to interfere with the market’s power to determine exchange rates lead to financial crisis in a country. Financial crises in Mexico, Russia, and Southeast Asia in the 1990s were largely the result of economic conditions that were made worse by government exchange rate policies, illustrating the futility of governments trying to dictate an exchange rate. Just as the Consensus favors market-determined interest rates, it also favors market-determined exchange rates. Box 3.3 describes attempts by several governments to fix the value of their currencies.
Governments sometimes try to improve the position of their country relative to trading partners. They do this for a number of reasons, particularly to protect domestic manufacturers from foreign competition. You’re probably familiar with terms such as tariff and quota, two of the common techniques for establishing barriers to trade. There may be justification for trade barriers in a few circumstances, such as when a country is emerging into world competition or when the industry is in its early stages of development. In these situations, it is possible to build a reasonable case for protecting the country or the industry from the nightmare of global competition. The trouble is that once a trade barrier is erected, it is difficult to remove.
When the government of a country tries to maintain the value of its currency against another currency, it is called a currency peg. Currency pegs can be successful, but generally a government finds it difficult go continue the policies necessary to maintain the peg, so it abandons the peg. Here are some examples of recent experiences with currency pegs.
Vietnam began pegging its currency, the dong, against the United States dollar around 1997. Initially, the peg was beneficial at encouraging investment in Vietnam. Over the years, the United States dollar began to depreciate against other currencies, making imports into Vietnam more expensive and driving up Vietnam’s rate of inflation. The Government began to abandon the currency peg in 2008 and allowed the dong to appreciate against the United States dollar.
Bulgaria fixed its currency, the lev, against the euro because it planned to enter the European Monetary Union (EMU). When Bulgaria’s economy slowed in 2008 and 2009, currency markets began to speculate that Bulgaria would allow the lev to depreciate against the euro. The Government had few options if it wanted to maintain the peg: raise interest rates to encourage investors to own leva, or use its foreign currency reserves to purchase leva on the currency market. Both alternatives would further slow the economy, so were not attractive.
Like Bulgaria, the Baltic countries – Estonia, Lithuania, Latvia – pegged their currencies against the euro because they planned to enter the EMU. The Baltic economies were hit especially hard by the economic downturn; their economies were expected to shrink by 10 percent in 2009. The economic situation caused riots in the capitals and led to the downfall of Latvia’s government. The Baltic governments had the same choice that faced Bulgaria: take steps to protect the peg, but fall into further economic decline, or abandon the peg and make it more difficult for the many individuals and companies that had borrowed euros.
Sources: James Hookway, “Vietnam tries to cut loose from falling dollar”, Wall Street Journal, Mar 19, 2008, p. A8; Jens Bastian, “no time to dither over policy options”, Financial Times, Jun 19, 2009, p. 23; Robert Anderson, “Pressure on Lithuania as economy shrinks”, Financial Times, Apr 29, 2009, p. 3; Gideon Rachman, “Latvia’s appalling currency choice”, Financial Times, Oct 9, 2009, p. 12.
A tariff is a tax on an import, so imposing a tariff makes imported goods more expensive relative to domestic goods. This enables the domestic manufacturer to charge higher prices and potentially earn a profit. A quota is a numerical limit on the number of foreign goods that can enter a market. By limiting the number of foreign goods, the quota enables domestic manufacturers to sell more.
These results sound attractive, but they frequently have undesirable consequences. Domestic manufacturers may charge higher prices than warranted. The quality of domestically-produced goods may fall. Employment and wages in protected industries may be higher than they should be. Consumers may not have a choice of products at various prices or of various qualities. We see that restricting trade benefits one sector of the economy at the expense of other sectors, so now we’re back in the political arena. Governments, rather than markets, choose who wins or loses. Such is the case with several tariffs in the US and China, as you see in Box 3.4.
The World Trade Organization (WTO) is the arbiter that decides whether countries can impose trade restrictions such as tariffs and quotas. The WTO issues its rulings after a country brings an official complaint about trade restrictions. In 2009, the WTO heard 27 percent more cases concerning tariffs imposed to counteract dumping (selling at artificially low prices) compared to 2008. The major target of the complaints was China.
The United States has imposed tariffs on several products from China, including steel pipe and tires. In 2009, the United States imposed tariffs ranging from 10 to 16 percent on steel pipe used in drilling for oil and natural gas. Also in 2009, the United States imposed a 35 percent duty on tires manufactured in China. China’s Government called the tariffs “abusive protectionism” and threatened to investigate imports of United States automobiles.
China also has tariffs, of course. Research in Motion (RIM), a Canadian manufacturer of BlackBerry smartphones, faced tariffs trying to sell in China. even though RIM’s products were more technologically advanced, the tariffs prevented it from competing successfully against China Mobile, the largest mobile phone operator. In 2009, RIM signed arrangements with Digital China and with China Mobile to distribute BlackBerry in China.
China also imposed an unusual tariff on exports in 2007. When the world economy was growing in 2006 and 2007, the prices of industrial minerals in China increased drastically. Because China needed the raw materials for its domestic economy, the Government imposed tariffs of up to 95 percent on exports of raw materials from China. The effect of the export tax was to make it more attractive to Chinese raw materials producers to sell to the domestic market. The United States and the EU filed complaints with the WTO against China in 2009 to stop the export tariff.
Sources: Aaron Back, Patricia Jiayi Ho, “Beijing slams US tariffs in growing clash”, Wall Street Journal, Nov 7, 2009, p. A6; James Haggerty, “New tariff on China-produced tires expected to put prices into overdrive”, McClatchy-Tribune Business News, Sep 18, 2009; Kathrin Hille, “BlackBerry maker seals China distribution deals”, Financial Times, Dec 8, 2009, p. 19; John W. Miller, “US and EU file case over China’s tariffs”, Wall Street Journal, Nov 5, 2009, p. A14.
The Consensus opposes most barriers to trade because they interfere with operation of the market. In many cases where trade barriers exist, they have the effect of allowing inefficient enterprises to remain in operation. If they were faced with competition on the open market from more efficient firms, the firms would not be successful, so they seek protection from the government.
Foreign Direct Investment
Besides trading with one another, countries have been investing in one another for hundreds of years. Remember, the US started as colonies of a variety of countries, particularly Britain. Those countries invested in their colonies by establishing manufacturing facilities or trade and distribution channels. More recently, companies have invested in other countries as a means of coping with globalization. Sometimes it is advantageous to manufacture in another country because wages are more favorable or because the company can gain access to resources that aren’t available elsewhere. Other times, it may be advantageous to invest in distribution systems so the company can gain access to a market at lower cost.
When a company invests in physical facilities in another country, it is called foreign direct investment. Guess what position the Consensus takes regarding foreign direct investment? There shouldn’t be any restrictions. That answer shouldn’t be surprising, given that the Consensus favors an environment favorable for global investors. Box 3.5 describes what happened in France when one of its largest banks was the target of takeover offers from other European banks.
Countries have developed a variety of mechanisms for limiting foreign investment. Sometimes a country will put a specific sector off limits to foreign investors, as when the US prohibits foreign ownership of defense companies or Mexico prohibits foreign investment in its oil industry. Other times a country will limit foreign ownership to a minority percentage so domestic investors (or the government) maintain a majority share. Countries also frequently adopt rules about what can be done with the proceeds from an investment by foreigners, such as limiting the amount of profits that can be taken out of the country.
In 2007, at the same time United States banks were failing because of the mortgage meltdown, a financial crisis of a different sort was taking place in France. Executives at Société Générale (SocGen) discovered that a trader in the derivatives division had taken positions that cost the bank more than its capital. The bank was insolvent.
Jérôme Kerviel had not only executed unauthorized trades that lost money, he also had hacked into the bank’s computer system in an effort to hide his losses. When the losses were discovered in January 2008, M. Kerviel had cost SocGen almost €5 billion. When combined with a loss of €2 billion from mortgage losses, SocGen did not have capital sufficient to meet regulatory standards.
The issue became where would SocGen obtain additional capital. Several foreign banks, including others from the European Union (EU), were potential candidates to take over SocGen’s operations. But the Government of France opposed ownership outside of France, so made public statements that it would not allow SocGen to be sold to foreign investors. “The state will not remain just a bystander and leave Société Générale at the mercy of any predator,” said an advisor to French President Sarkozy.
The Government’s position was contrary to the position of the EU. One EU official stated “The rules on free movement of capital mean that potential bidders must be treated in a nondiscriminatory way in the situation of cross-border takeovers.” The EU favored the impartial treatment of potential acquirers, regardless of whether they were foreign or domestic. In addition to French banks, banks from Spain, Italy, and the United Kingdom were thought to be interested in acquiring SocGen.
Sources: David Gauthier-Villars, Carrick Mollenkamp, Alistair MacDonald, “French bank rocked by rogue trader”, Wall Street Journal, Jan 25, 2008, p. A1; Helen Dunne, “SocGen’s independence still hangs in the balance”, The Business, Feb 2, 2008, p. 1; Nicola Clark, James Kanter, “Regulators warn France against protecting bank”, New York Times, Feb 1, 2008, p. C3.
As a global investor, you’d like to put your funds in a country that doesn’t restrict what you can do with the investment or its earnings. That’s the view of the Washington Consensus.
One fact of the modern world is that governments own some enterprises. The countries range from the US, where the government owns Amtrak, the Pension Benefit Guaranty Corporation, and the Tennessee Valley Authority, to China, where government-owned entities constitute a significant portion of the economy. In between are countries such as Mexico, where the government owns the oil industry, and France, where the government owns or has owned the national railway system, the telecommunications system, several major banks, and numerous other sectors.
Beginning with the Thatcher/Reagan revolutions, many of these firms have been privatized, which means that the government is selling some portion of the ownership to private investors. Government ownership doesn’t necessarily lead to bad management, but politicians and economists have found that many times, governments manage firms for purposes other than improving returns to investors. A government might own a firm as a means of providing employment, for example, or to protect a firm from the forces of market competition. These firms frequently became unprofitable, and therefore a drain on the government’s budget. Turning these firms over to the private sector is a way to relieve bloated employment and improve efficiency, while it saves the government treasury the expense of supporting an unprofitable firm.
The trend around the world over the past 20 years has been toward increased privatization. The airline industry presents an interesting example. In the 1950s and 1960s, almost every country had a national airline: Iberia in Spain, Sabena in Belgium, BOAC in the United Kingdom, and many others. In most cases, the national airlines were government-owned. It was a matter of national pride to fly the country’s colors in a growing, glamorous industry. As the airline industry matured, countries found that their airlines couldn’t compete. A national carrier became a drain on the country’s budget and labor issues made it difficult for the airlines to improve efficiency. The national carriers merged with other airlines, were privatized, or left the industry completely. Now there are fewer national carriers than there were 50 years ago.
The Consensus believes that governments ought to get out of the business of ownership. Firms should respond to forces in the market rather than being kept alive through government largesse. In Box 3.6, you’ll read about nationalizations and privatizations in Latin America. Even though the government did not privatize the firm, it has decided to deal with the problems. You also can return to Box 3.2 to see the extent of nationalization in Venezuela. Nationalization is the opposite of privatization: the government, rather than the private sector, owns the firm.
Latin America has gone through waves of privatization (ownership by the private sector) and nationalization (ownership by the Government), depending on the economic philosophy of the party in power. Since the 1990s, Mexico has generally adopted the Washington Consensus of privatizing state-owned enterprises. In 2005, the Government privatized two airlines – Mexicana and AeroMéxico – that accounted for 80 percent of the passenger traffic in Mexico. The airlines had been owned by a Government holding company for more than a decade.
In late 2009, Mexico’s President Calderón sent federal police to take control of the Government-owned power monopoly, Luz y Fuerza del Centro (LyFC). Before the takeover, LyFC employed more than 44,000 workers. Expenses were twice as high as revenues, forcing the Government to subsidize LyFC’s operations by $3.5 billion annually. Following the takeover, the company employs about 8,000, and it has improved the quality of service. Although the monopoly was not privatized, ownership was transferred to a more efficient government-owned utility.
Venezuela has gone in the opposite direction, nationalizing several sectors that previously were in private ownership. President Chávez nationalized part of the oil industry, several commercial banks, and other segments of the economy that he considers of strategic value to the country: cement, telecommunications, dairy, and iron and steel.
Sources: David Field, “Mexican airlines head for private ownership”, Flight International, Jul 12, 2005, p. 8; “Power to the people”, The Economist, Oct 17, 2009, p. 50; José de Córdoba, “Mexico power takeover creates sparks”, Wall Street Journal, Oct 12, 2009, p. A12; Richard Lapper, “Chávez shifts up a gear in his drive for 21st-century socialism”, Financial Times, Jan 10, 2007, p. 15; “The autocrat of Caracas”, The Economist, Aug 9, 2008, p. 36.
Since the days of Adam Smith, the father of economics in the late 1700s, economists have realized that unconstrained markets do not always produce outcomes that are good for society. There are times when the government needs to intervene by providing direction about market outcomes. The intervention frequently takes the form of government regulation. When used properly, regulation can promote outcomes that are more beneficial to society.
Unfortunately, some governments carry the idea of regulation too far. When used to excess, regulations penalize people and businesses by interfering with their ability to transact exchanges. Regulations frequently provide a shield that protects a firm from competition. Regulations also create an environment ripe for corruption. It becomes too tempting to try to circumvent a regulation by offering someone a payment for expediting the process or granting a favor. When this happens, resources are diverted away from the efficient performance of the market.
The US began to realize the inefficiency of regulation during the Carter administration of the 1970s. Several federal agencies responsible for regulating industries were either phased out or had their responsibilities curtailed. Other countries are beginning to realize that regulations sometimes interfere with commerce. For example, India was long known as the “Licensing Raj” due to its complex set of regulations, but through the years the regulations are being reduced.
The Consensus favors reducing regulations that exist primarily to protect firms or industries. The protected firms frequently are unprofitable, poorly managed, or use resources unwisely, creating a drain on society. As an investor, you look for countries where regulations are not as prominent or where the quality of regulation is higher.
A property right gives the owners of a resource the ability to do with it as they please, including allowing someone else to use the resource and require payment for its use. Property rights are one of the fundamental tenets of a market economy. The concept of property rights is so ingrained in most European and American countries that we take the concept for granted. However, the concept is not shared by all nations around the world. When people or firms accustomed to enforceable property rights interact with people or firms accustomed to little or no enforcement of property rights, conflict can result.
An illustration of this point is US or European firms doing business in Asia, where property rights are not always enforced. A US firm introducing a product in many Asian countries may find the product copied and distributed without reimbursement to the owner. In Asia, the tradition has been that a resource was owned by the government, by a collective, or by society as a whole. This cultural tradition of public ownership conflicts with the idea of private ownership, so many western firms encounter unexpected difficulties when dealing with a country such as China, as you see in Box 3.7.
As you might expect, the Consensus, coming from a western-culture line of thought, favors private property rights. You would too, as an investor. Property rights enable you to capture the returns from your investment without having to share them with someone else.
For years, business executives from western countries have complained about the lack of protection of intellectual property in China. Property rights have long been characteristic of Western business practices, but they conflict with Confucian tradition and the Chinese Communist Party’s concept of ownership by the state rather than the individual.
In 2009, a court in China sentenced executives of Chengdu Gongruan network Technology Co. to prison and fined them $1.6 million for copyright infringement. The court ruled that Gongruan had illegally distributed software, including the Windows operating system. The size of the judgment against the executives was the largest in Chinese history, and led outsiders to think that the Government is getting serious about attacking the problem.
In 2007, 82 percent of the software installed on computers in China was counterfeit, so pirating software is not an unusual practice. Although China has laws protecting intellectual property rights, the laws are rarely enforced and fines are usually small. The Gongruan ruling reversed the pattern.
Beginning in 2006, China’s Government declared that protecting intellectual property rights was a “strategic policy.” The Government required all Government offices to use legal copies of software, and ran ads on television explaining the benefits of intellectual property rights.
Perhaps the event precipitating the change in attitudes about property rights occurred in 2005 when Lenovo Group, Ltd. purchased the computer division of IBM Corp., a major United States computer manufacturer. Lenovo has the largest share of the computer market in China and the Government is the largest single shareholder in Lenovo. Only a cynic would argue that there was an unbroken chain between the Government’s announcement of a strategic policy, Lenovo’s purchase of IBM, and the largest judgment in Chinese history.
Sources: “China’s next revolution”, The Economist, Mar 10, 2007, p. 11; Loretta Chao, “China court issues rare piracy penalty to Windows copycats”, Wall Street Journal, Aug 22, 2009, p. A9; Andrew Batson, “As China reins in piracy, some see faster results”, Wall Street Journal, Nov 27, 2006, p. A3; Jay Greene, “A big Windows cleanup”, Business Week, Jun 4, 2007 p. 80.
The Principles in Action
Those are the basic principles of the Washington Consensus. So that you don’t think of the Consensus as an arbitrary set of criteria, let’s look at some examples of how it works in action.
The California Public Employees’ Retirement System (CalPERS) is the largest investment fund in the US. For several years it has been investing in other countries, so has developed a set of criteria to guide where it should invest. Compare these criteria to the ten principles of the Consensus:
Political Stability – Progress toward the development of basic democratic institutions and principles, including such things as: (1) a strong and impartial legal system; and (2) respect and enforcement of property and shareowner rights. Political stabilityen compasses:
Political risk: internal and external conflict; corruption; the military and religion in politics; law and order; ethnic tensions; democratic accountability; bureaucratic quality.
Civil liberties: freedom of expression, association, and organization rights; rule of law and human rights; free trade unions and effective collective bargaining; personal autonomy and economic rights.
Independent judiciary and legal protection: an absence of irregular payments made to the judiciary; the extent to which there is a trusted legal framework that honors contracts, clearly delineates ownership, and protects financial assets.
Freedom of the press: structure of the news delivery system in a country; laws and their promulgation with respect to the influence of the news; the degree of political influence and control; economic influences on the news; the degree to which there are violations against the media with respect to physical violations and censorship.
Monetary and fiscal transparency: the extent to which governmental monetary and fiscal policies and implementation are publicly available in a clear and timely manner, in accordance with international standards.
Stock exchange listing requirements: stringency of stock exchange listing requirements with respect to frequency of financial reporting, the requirement of annual independent audits, and minimal financial viability.
Accounting standards: the extent to which US GAAP or IAS is used in financial reporting; whether the country is a member of the International Accounting Standards Council.
Productive Labor Practices – No harmful labor practices or use of child labor. In compliance, or moving toward compliance, with the International Labor Organization (ILO) Declaration on the Fundamental Principles and Rights at Work. Productive Labor Practices encompasses:
ILO ratification: whether the convention is ratified, not ratified, pending ratification, or denounced.
Quality of enabling legislation: the extent to which the rights described in the ILO convention are protected by law.
Institutional capacity: the extent to which governmental administrative bodies with labor law enforcement responsibility exist at the national, regional, and local level.
Effectiveness of implementation: evidence that enforcement procedures exist and are working effectively; evidence of a clear grievance process that is utilized and provides penalties that have deterrence value.
Corporate Social Responsibility and Long-term Sustainability – Includes Environmental sustainability. In compliance, or moving toward compliance, with the Global Sullivan Principles of Corporate Social Responsibility.
Change in market capitalization.
Average monthly trading volume.
Growth in listed companies.
Market volatility as measured by standard deviation.
Foreign investment: degree to which there are restrictions on foreign ownership of local assets, repatriation restrictions or un-equal treatment of foreigners and locals under the law.
Trade policy: degree to which there are deterrents to free trade such as trade barriers and punitive tariffs.
Banking and finance: degree of government ownership of banks and allocation of credit; freedom financial institutions have to offer all types of financial services; protectionist banking regulations against foreigners.
Trading and settlement proficiency: degree to which a country’s trading and settlement is automated; success of the market in settling transactions in a timely, efficient manner.
Transaction costs: the costs associated with trading in a particular market, including stamp taxes and duties; amount of dividends and income taxes; capital gains taxes.
Appropriate Disclosure – On environmental, social, and corporate governance issues.
These criteria are lifted directly from the CalPERS web site at the URL in the Further Reading at the end of the chapter, and are Copyright © 2007 by CalPERS. You must look at the details of some of the CalPERS criteria, but even after you adjust for social objectives typical of California, you’ll notice the similarities between the CalPERS and Washington Consensus criteria. They focus on whether the government of the country establishes an environment that is favorable for foreign investors.
Here is another illustration. Rating agencies evaluate countries on behalf of clients interested in purchasing currencies or securities issued by governments. In the US, the major rating agencies are Moody’s, Standard and Poor’s, and Fitch Ratings. Table 3.1 shows the criteria used by each of the rating agencies.
The criteria listed are only headings, and within each heading are more details. For example, Moody’s lists 53 indicators that it uses to measure the four criteria in the table. The rating agencies developed their criteria and methodologies independently from the Washington Consensus, but it is interesting that the criteria turn out to be similar.
The point of all this is that the criteria used in the Washington Consensus are used in other forms to evaluate a country’s performance. They are acceptable for use by an investor wishing to evaluate a country as a place to invest because a country that either meets or is moving toward meeting the criteria should be a safer place than a country that is not doing so.
Meeting the criteria of the Consensus doesn’t guarantee investment success, of course. Just think of the risk faced by investors in the US when the real estate market collapsed in 2007, taking with it financial institutions around the globe, or the junior employee in Société Générale in France who was able to make unauthorized trades that cost the bank a loss of €5 billion. Companies succeed or fail, and stock markets rise or fall according to diverse forces, but at least you know the game is fair in a country that conforms to the criteria of the Consensus.
Sources: Moody’s Sovereign Credit Analysis, Standard and Poor’s Sovereign Credit Ratings: A Primer, Fitch Ratings: Foreign Rating Methodology.
Criticisms of the Washington Consensus
Just because the world’s largest pension fund and three rating agencies use criteria similar to the Washington Consensus doesn’t mean that everyone agrees with it. In fact, some people have raised objections almost since the day the criteria were introduced. One notable critic was Joseph Stiglitz, a Vice President at the WB, one of the institutions considered part of the Consensus. Stiglitz pointed out that the criteria of the Consensus also are conditions that lead to a country’s economic development. When they are applied in this manner, the conditions of the Consensus can be imposed at the wrong time, on an ideological basis, or too rigidly.
For example, the Consensus views privatization as a means of improving a country’s economy. But if privatization is imposed simply for ideological reasons, it may not be beneficial. In some situations, a government-owned firm may be performing quite well, and there may not be a need to transfer the firm to the private sector. In other situations, a country may not be at a stage of development that the private sector can assume ownership and responsibility for managing a firm. It could even be deleterious for the country if ownership was transferred to foreign investors, so that domestic people or firms do not participate in the firm’s development.
Another notable economist, Paul Krugman, disagreed with the principles of the Consensus because they were not able to predict whether or when an economic crisis would occur in a country. Krugman says that countries suddenly got “free market religion” when they converted to the principles of the Consensus, and that the Consensus may turn out to be a speculative bubble. One of these countries was Mexico, which had made great strides in adopting free-market principles. Mexico encountered a currency crisis in late 1994, similar to currency crises that other countries had encountered previously. Krugman asked if adopting the principles of the Consensus didn’t help a country avoid crisis, what good were they? Krugman also points out that a country can adopt one or some of the principles of the Consensus without adopting others, and still achieve desirable economic growth.
You’re welcome to read the thoughtful comments by Stiglitz and Krugman in the articles listed at the end of the chapter. As you do, you’ll notice that both criticisms relate to the principles of the Consensus when used as conditions for economic development rather than as criteria for evaluating investment risk. We’re using the Consensus in a slightly different way.
Regardless of whether a country adopts all of the principles of the Consensus, they are being adopted around the world. The principles of the Washington Consensus have become a global trend.
Another set of criticisms of the Consensus come from heads of state that either disagree with the criteria or refuse to abide by them. Perhaps the most prominent of these critics in the early twenty-first century is Hugo Chávez, the President of Venezuela, who advocates a centralized, socialistic approach using government resources to address social inequalities. Chávez calls his approach Bolívarian socialism, named for Latin America’s liberator, Simón Bolívar. Chávez has gained a few adherents from other Latin American countries, but when you read about him in the American press, you’re more likely to see him characterized as a renegade. Box 3.8 explains how the populist movement has attracted some adherents in Latin America, although other countries continue to adopt principles of the Washington Consensus.
Even countries that you might consider bastions of centralized control, such as Russia and China, are adopting principles of the Washington Consensus. Russia has privatized many firms, reduced regulation, allowed the ruble to float, and encourages foreign investment. China has moved further by adopting more free-market economic policies while retaining strict central political control. China still lags in terms of political freedom, but you’ll notice that political freedom is not one of the criteria of the Consensus. If you take a snapshot of either of these countries, you’re likely to miss how much they have moved toward the Washington Consensus. But if you take a video comparing them to the way they were 20 years ago, you would be amazed at the difference.
Even countries that would be considered least likely to adopt the Consensus are in fact adopting some if not many of its principles. Therefore, the Washington Consensus will serve us as our guide for evaluating investment risk.
Since his election as President of Venezuela in 1998, Hugo Chávez has attempted to exert influence in Latin America that would offset that of the United States. Chávez established a television network to offer news with a South American perspective other than CNN’s Latin America network. He also tried to set up a free trade area to compete against the United States-oriented Free Trade Area of the Americas.
In some ways, Chávez’s policies have benefitted countries adopting them. For example, in Venezuela, Chávez adopted programs that benefit the poor, such as hiring teachers and medical personnel from Cuba to raise the levels of education and health. Programs such as these not only help the country, but they make him popular with a class of citizens that previously had been neglected.
Part of what makes Chávez’s programs socialistic is that he advocates Government provision of many goods and services, and in recent years, Government ownership of a country’s resources. In Venezuela, Chávez has nationalized sectors of the economy such as banking, petroleum, telecommunications, and electricity.
A few other countries in Latin America have adopted Chávez’s policies. Bolivia, for example, has become a close ally and has patterned its style of economic development after that of Venezuela. The grease that allows Chávez to accomplish many of his goals is money from Venezuela’s oil industry. Chávez sells oil to other countries at below-market prices.
Chávez is having difficulty managing the economy of Venezuela, however. Inflation is much higher than the level that the Government dictates. The practice of subsidizing some goods and services creates distortions. In 2010, the Government mandated two exchange rates – one rate to make imports more expensive and another to make exports less expensive.
Despite Chávez’s anti-United States rhetoric, Venezuela is tied closely to the United States. The United States is the largest market for Venezuelan petroleum, and Venezuela owns Citgo, a gasoline retailer in the United States. The United States also imports about 13 percent of its petroleum from Venezuela.
Sources: Franklin Foer, “The talented Mr Chávez”, Atlantic Monthly, May 2006, p. 94; Richard Lapper, “Chávez shifts up a gear in his drive for 21st-century socialism”, Financial Times, Jan 10, 2007, p. 15; José de Córdoba, David Luhnow, “New president has Bolivia marching to Chávez’s beat”, Wall Street Journal, May 25, 2006, p. A1; Dan Molinski, “Chávez struggles to tame black-market dollar might”, Wall Street Journal, Jan 22, 2010, p. C2.
How We Use the Criteria
We see that there are ways to evaluate risk when investing in another country. Each of the approaches mentioned in this chapter – Washington Consensus, CalPERS, or rating agencies – attempts to understand the risk of an investment. And that’s the name of the game when investing: to understand the risk associated with the return you anticipate receiving. Investors adjust their expectations by adjusting for risk: they require a higher return to compensate for more risk. That’s why bonds in Brazil pay 13 percent while bonds in Germany pay 4 percent; the risk of investing in each country is different.
The Washington Consensus is one way to evaluate the risk. As we saw, it is not the only way; the rating agencies and CalPERS incorporate other, but similar, criteria. But we use the Washington Consensus throughout the book as a guide to help us understand the various dimensions of risk in global investing.
The introduction to this chapter pointed out that analyzing risk requires an underlying theory about which factors affect risk. That’s what the Washington Consensus gives us – a list of criteria that helps us analyze risk. When we’re finished, we’ll have a process and a set of standards for evaluating the risk of investing in different countries. That’s why this book is called Country Analysis.
The Consensus and the World Financial Crisis
The world financial crisis and the subsequent economic recession that occurred in 2008 and 2009 led governments in many countries to adopt measures to protect their economies. In many cases, the measures violated principles of the Washington Consensus. The measures occurred in developed as well as developing countries, in countries that advocated the principles as well as those that opposed them.
Perhaps the most frequently-violated principle was the Consensus’ preference for balanced government budgets. Keynesian economic theory says that when a government wishes to stimulate the economy, it should increase spending, decrease taxes, or both. The result would be a budget deficit, which is contrary to the first principle of the Washington Consensus. Because of the worldwide recession, governments adopted budget deficits amounting to significant percentages of GDP. In the US, for example, the 2009 budget deficit was $1.4 trillion, or about 10 percent of GDP. Even China, whose economy continued to grow despite the global recession, adopted a stimulus package equal to 7 percent of GDP.
Another frequently-violated principle was privatization. The Consensus argues that firms should be freed from government influence and instead face competition in the market. When the US Government faced the potential collapse of the banking system, the Government intervened massively. The process began with the Government taking control of two large financial institutions responsible for supporting the housing market – Fannie Mae and Freddie Mac. Then the Government provided financing to or took partial ownership of other financial institutions, including commercial banks, investment banks, and insurance companies. As a result, the US Government became the nation’s largest insurer and lender. The US Government also provided financial support to automobile manufacturers such as General Motors and Chrysler, taking an ownership interest in those firms.
It is interesting that these efforts occurred under the presidential administrations of George Bush, a Republican, and Barack Obama, a Democrat. Political ideology appeared to have little to do with the effort to save the country’s economy or with the willingness to abide by the principles of the Washington Consensus.
These violations of the Consensus occurred in other countries, too. In the United Kingdom, a Government minister suggested that the Government reconsider whether it should allow foreign ownership of UK firms. Previously, the Government had taken an approach more consistent with the Consensus, that countries should not adopt policies limiting foreign ownership.
South Korea, which had been liberalizing its financial sector since the Asian crisis of 1997, postponed further efforts. Part of the liberalization was to allow greater foreign ownership of domestic banks. The German Government debated adopting a policy to prevent foreign ownership of one of its automakers, Volkswagen. The Governments of India, China, Russia, and Canada adopted or considered new restrictions on foreign ownership. Because of the financial crisis, countries in the G20 (the world’s major economies) debated new regulations on financial transactions.
In short, the crisis led countries to backtrack on their commitment to free-market principles. It’s still too early to evaluate the extent to which governments went back on principles of the Washington Consensus, but many governments reconsidered the role the Consensus should play in their national economies.
The Washington Consensus was developed in the 1980s to summarize desirable characteristics leading to economic development. Since then, many countries have adopted several of the criteria. Investors use the criteria of the Consensus as a guide to determine in which countries they should invest. Rating agencies and pension funds use criteria comparable to those of the Washington Consensus.
Bolivarian Project, http://www.venezuelanalysis.com/analysis/project, accessed 8/22/08.
Callick, R. (2007) The China model, The American, Nov/Dec, http://www.american.com/archive/2007/november-december-magazine-contents/the-china-model, accessed 8/22/08.
CalPERS (2007) Statement of investment policy, 2007 http://www.calpers.ca.gov/eip-docs/investments/policies/inv-asset-classes/equity/ext-equity/emerging-eqty-market-prinicples.pdf’, 604, 550.