Category: India

Business Corruption in Emerging Markets

It is obvious to the casual observer that many successful entrepreneurs in the United States and Europe are immigrants from countries known for their corrupt business practices. Turks in Germany, Indians and Nigerians in England and Mexicans and Brazilians in the U.S., to name a few examples, make enormous contributions to the entrepreneurial dynamism of their adopted countries while upholding the highest business ethics.

Why do immigrants change their behavior when they leave their home country? A Nigerian or Indian businessman in his home country might dedicate a significant part of his time and resources to corrupt practices but when in England apply all his efforts to making his business more innovative and efficient. The very recent case of the Batista brothers in Brazil highlights this phenomenon. Joesley and Wesley Batista, over a period of 15 years, grew their company, JBS, from a small regional meat-packing business in Brazil into the largest meat-processing firm in the world, with dominant operations in Brazil, the U.S., Europe and Australia. There is no doubt that the Batista brothers were very astute and visionary businessman, and they ran their operations very efficiently and professionally. However, it has been revealed in recent months that one of the brothers, Joesley, dedicated essentially all of his time to greasing the hands of politicians in Brazil to secure cheap financing from public banks and other favors.  While Joesley acted with total impunity in Brazil and is reported to have paid more than $150 million in bribes to over 1,800 politicians, there is no evidence of any illegal acts by the Batista’s or their employees outside of Brazil where by all accounts they acted as upright corporate citizens.

The case of the Batista brothers illustrates perfectly a theory proposed by the American economist William Baumol. In a seminal 1990 paper, “Entrepreneurship; Productive, Unproductive and Destructive behavior,” Baumol argued that though some societies or cultures may have more entrepreneurial dynamism than others what matters more is how that entrepreneurial spirit is allocated. Business people can apply their entrepreneurial spirit towards productive activities such as innovation or to non-productive activities such as rent-seeking, or, in a worse-case scenario, to destructive activities such as organized crime.  According to Baumol, the actual supply of entrepreneurship does not vary as much as its allocation to productive or non-productive activities. Entrepreneurs react rationally to the different payoffs society offers and will dedicate themselves to non-productive activities if that is where they find the highest returns. As the theory predicts, when in Brazil the Batista’s applied themselves assiduously to rent-seeking behavior because payoffs were high, but outside of Brazil they stuck to a strict legal path and focused on management and innovation.

The case of the Batista’s is not at all unique. Brazilian’s have long quipped that “businessmen work when the government goes to sleep at night.” The CEOs and CFOs of Brazil’s leading companies, even when they espouse the highest ethical standards, are required to spend an inordinate amount of time courting politicians and are expected to travel frequently to Brasilia at a moment’s notice.

Baumal’s theory links well with the argument of the “institutionalists” like Daron Acemoglu (Why Nations Fail) who argue that strong institutions (e.g., the judiciary) underpin development.  Clearly, an efficient bureaucracy and effective judiciary would reduce the opportunities and greatly increase the cost of corruption in Brazil and motivate entrepreneurs to direct their energies to legal activities.

In any case, the implications for policy makers are clear. Countries like Brazil, Argentina, India and Nigeria have huge repressed entrepreneurial spirit that could be unleashed if the business environment was less conducive to corruption.  Reducing bureaucracy, regulations and taxes should be at the top of the list. It is not a coincidence that the countries that rank poorly in the World Bank’s Ease of Doing Business survey tend to be the same where corruption is most prevalent. Straight-forward bureaucratic reforms can make a large difference. For example, in many countries, something very basic like opening or closing a business can require large expenses and months of time, pushing small businesses to take the path of informality. Privatizing state-owned firms also must be pursued, as time and time again we see these entities at the center of political influence-peddling and rent-seeking behavior.

As Baumal concludes, “the overall moral, then, is that we do not have to wait patiently for slow cultural change in order to find measures to redirect the flow of entrepreneurial activity toward more productive goals… It may be possible to change the rules in ways that help to offset undesired institutional influences or that supplement other influences that are taken to work in beneficial directions.”

 

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Notable Quotes:

Opportunity for Growth and Scale in Emerging Markets: In the 1990s, Zell and his team were intrigued by the opportunities in emerging market real estate platforms and other types of emerging market companies and started investing. Even though the potential for strong returns was much higher, Zell’s team wasn’t deluded about the trade-offs. “Investing in emerging markets is a bet on growth,” he said. “But what’s being given up is the rule of law.” That compromise is one he never takes lightly.  Sam Zell (CFA Institute)

Before I begin telling you what I think, I want to establish that I’m a “dumb shit” who doesn’t know much relative to what I need to know. Whatever success I’ve had in life has had more to do with my knowing how to deal with my not knowing than anything I know. The most important thing I learned is an approach to life based on principles that helps me find out what’s true and what to do about it.  Ray Dalio, Bridgewater

 

 

Caution Is Merited For India’s Stock Market

The stock market of India today is probably the most hyped and loved by emerging markets investors. Investor enthusiasm is rooted in the assumption that the country’s high growth rate can be sustained by structural reforms aimed at boosting productivity and modernizing the economy.

As a low-income economy, India has considerable potential for boosting economic growth simply by narrowing the productivity gap that it has with more developed economies. Though India has many world class companies in sectors such as information technology, pharma, manufacturing and banking, much of the economy, particularly small-scale informal manufacturing and farming, suffers from abysmal levels of productivity. Stifling bureaucracy and corruption make operating a business very difficult in India and promote informality. India ranks 130th in The World Bank’s 2017 Ease of Doing Business survey, the worst of any large economy.

Since market-oriented reforms were first introduced in 1991, India has entered into an accelerated catch-up phase, enjoying GDP growth of 6-7%.  For the 2014-2018 period, GDP growth will average about 7% annually, making India the fastest growing large economy in the world. Moreover, in recent years India’s trade accounts and inflation have benefitted from low commodity prices.

In principle, higher GDP growth should justify higher stock market valuations. In many countries, there is a well-established and logical correlation between GDP growth and corporate earnings growth. A generally optimistic view of the potential for long-term growth in earnings has resulted in high multiples for Indian stocks. Moreover, the relatively high valuations in India may be validated by the corporate structure of the Indian market which is dominated by well-managed and profitable private companies operating in industries with stable growth characteristics, in contrast to the much higher concentration of cyclical businesses and mismanaged state-owned firms in the stock markets of Russia, China and Brazil.  We can see this in the chart below, which shows cyclically adjusted, 10-year average price earnings ratios (CAPE) for major emerging markets. India has traded at the highest PE multiples for this group of countries for the past 15 years, as the market has priced in high expected earnings growth and low expectations for future volatility. The market sees India as a “high quality” stock market, with high earnings and low volatility, in contrast to markets like Turkey, Brazil or Russia which are seen as low-growth and high volatility. The only other market currently held in such high esteem by investors is the Philippines.

However, investor enthusiasm for India’s stock market may be misplaced.

India, with its bouts of uncontrolled inflation, high fiscal deficits and elevated public debt levels, recurring balance of payments crises, currency volatility, extreme inequality,  complex democratic politics, and highly inefficient and corrupt bureaucracy, resembles Latin America more than it does East Asia. East Asia has benefited from strong commitments to competitive currencies, a financial system geared to support manufacturing, trade and small-scale farming, and widespread education, none of which are the reality in India or Latin America. Consequently, though India’s GDP growth may be relatively high, it is likely to be volatile, leading to choppy earnings growth for its listed companies.

Furthermore, high GDP growth may be more a curse than a blessing for many of India’s blue chips as it promotes more competition. In recent years, India is seeing many new entrants in sectors like consumer goods and banking. IT powerhouses like TCS and Infosys are threatened by disruption from cloud-based providers. India’s high growth and looser regulations are bringing more foreign competition in many industries (e.g., motor vehicles), potentially disrupting powerful incumbents over time.

In general, stock markets that are very popular with investors because of attractive growth prospects do not tend to perform well in the future. Nevertheless, though expensive relative to other emerging markets, the Indian stock market may continue to do well. It trades today at a CAPE valuation which is below its long-term average and about in the middle of its long-term range, which does not seem prohibitive at a time of very high asset prices around the world.

Still, from a relative performance point of view, there is a high probability that over the next 3-5 years, India will not perform as well as cyclically depressed markets such as Turkey, Russia and Brazil.

One of the ironies of investing in emerging markets is that high GDP growth most often results in excess investment and low future returns. The best stock market returns are often found in depressed cyclical markets which have seen a period of low investment and where companies stand to benefit from operating leverage during powerful cyclical rebounds.

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