Country Analysis

Understanding Economic and Political Performance

David M. Currie

• Publisher: Routledge
• Year: 2016
• ISBN:
  9781317158882
• Edition: 1
• Topic: Volkswirtschaftslehre
• Subtopic: Makroökonomie

The ability to connect theoretical macroeconomics to the analysis of the economic and political performance of a given country is an essential skill for global investors. In Country Analysis: Understanding Economic and Political Performance, David M. Currie takes a unique analytical approach to the subject, clearly demonstrating the relationship between theory and application in investing practices. This valuable book shows how to interpret country performance and provides the practising investor with sufficient background on economic principles to be able to understand and interpret country summaries that appear in business periodicals and other media. It covers key topics such as the Washington Consensus and the three major categories of economic decisions - fiscal policy, monetary policy and trade policy. It includes an important chapter on the political aspect of government performance, to give the reader an understanding of economic decisions in their true context. Country Analysis explains the reasoning behind the criteria used in evaluating country risk and economic performance, without the need for a sophisticated understanding of economics or mathematics. Each chapter includes a series of text boxes that include real-life examples from business periodicals to reinforce what is discussed and enable readers to practice identifying and interpreting relevant information. Practitioners making investment decisions in global markets, as well as students in MBA and other courses, will find this immensely practical book a valuable aid to critical decision making.

CHAPTER 1
Global Investing

When you have a spare moment to think about globalization, what comes to mind? Do you think of the flood of imports from China, explaining why you see “Made in China” on everything from clothing to toys to housewares? Do you think of outsourcing jobs to Mexico or India, where labor rates are lower than in the US? Or do you think of the money you save as a consumer by purchasing less-expensive imports, or the fact that your company can survive a little longer by lowering labor costs?

These are all aspects of globalization, both the good and the bad. But there is another aspect of globalization that many people overlook: the ability to invest in almost any country around the world. Globalization is breaking down many of the barriers that previously prevented investing, or at least limited it to a few major companies with a global reach. Now even common folks like you and me can invest in another country, sometimes directly, sometimes through a financial intermediary that specializes in the process.

Look at firms catering to average traders, such as eTrade® or Charles Schwab® to see how they make it possible to invest globally. If you prefer to rely on others to do the research and trading, you can still invest globally through mutual funds such as Franklin Templeton Investments® or exchange-traded funds such as Wisdom Tree®, just to pick two whose ads have appeared in periodicals recently. At any of these locations, you will find the ability to either purchase assets (shares, bonds, real estate) in another country directly or invest in a fund that will do it for you. Globalization has made it easier to invest abroad. In fact, many investment advisors encourage investing abroad, as you will read in Box 1.1. Even after the global financial crisis of 2008, financial advisors suggested keeping a portion of an investor’s portfolio in international assets.

The ability to invest abroad doesn’t mean you know what you’re doing. Ability doesn’t equal knowledge. Just because the day is approaching when you can invest anywhere around the world, it doesn’t mean that you know where the right places are to invest. There are myriad issues to consider. Which countries have a climate favorable for foreign investors? Which countries create growing, thriving markets that will enable firms within the country to prosper? Which countries experience economic fundamentals that enhance or at least don’t diminish the return on your investment? Which countries have stable political regimes and policies that help ensure the safety of your investment? Which countries allow you to take your money out when you liquidate your position?

Notice that all the questions focus on a country’s environment for investing. Financial advisers and books about investing usually have plenty of advice about which are the right firms or industries in which to invest. But in a global investing environment, understanding countries and their governments are equally important. Governments create the climate that attracts or repels investment from abroad. This book is about the interplay between economic and political forces and how they determine the climate for investing in a country. It is part of a process called country analysis: the process used by potential investors to analyze the political, economic, and cultural environment of a country.

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Box 1.1 Invest globally

For years, investment advisers and securities managers have encouraged United States investors to look beyond United States borders. In the mid-2000s, when markets were booming domestically and abroad, fund managers recommended investing 10 to 20 percent of a portfolio overseas.

One argument was that overseas securities markets were performing better than United States markets. For example, one index of stocks in developed countries provided a 23.3 percent annual return to United States investors for the five years from 2002 to 2007. A similar index for developing countries returned 46.5 percent. During the same period, an index for the United States market returned 12.8 percent annually.

Another argument was that the United States dollar was depreciating steadily against many foreign currencies. Although it sounds counter-intuitive, a weakening dollar actually increases returns to United States investors. When you cash out your foreign investment, that currency is worth more United States dollars, so you get not only the market return but an additional return due to that currency’s appreciation. Dollar depreciation is one reason why returns on the overseas indexes were so high during the five years.

Even after the financial crisis of 2007 and the recession of 2008 led to declining markets worldwide, market pros continued to recommend foreign securities as part of an investing portfolio. One bond analyst recommends 10 to 40 percent of a portfolio in overseas bonds, which is consistent with the pre-recession weights. Regardless of economic conditions, investing outside the home country is a reality.

Sources: Ian McDonald, “Forget Xenophobia: Go abroad for gains”, Wall Street Journal, Mar 6, 2006, p. R1; Karen Hube, “Going global: How do you get there from here?”, Wall Street Journal, Sep 8, 2008, p. R1; Jennifer Levitz, “Why foreign bonds make sense for incomeoriented investors”, Wall Street Journal, Dec 8, 2009, p. C9.

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Types of Investing

Of course, this idea of investing globally is not new. Big corporations have been doing it for years and continue to do so. In fact, the principles of country analysis were developed decades ago by oil companies and commercial banks as part of their global expansions.

You’re familiar with one type of investing because it frequently makes the news: investing done by large corporations. When Belgium’s InBev purchased Annheuser-Busch, the US’s largest brewery in 2008, it seemed like an American institution was passing. When China National Offshore Oil Company, a firm partially owned by the Chinese Government, wanted to purchase Unocal, one of the US’s largest oil companies in 2005, it set off such a brouhaha that the US Government nixed the sale. The same reaction didn’t occur seven years earlier when BP, a British-Dutch oil company, purchased Amoco, another of the US’s largest oil companies; that sale was allowed. It’s obvious that governments play a role in investing, even in the US.

A variation on this type of investing occurs when a foreign enterprise builds a new facility in a host country. In 2009, Toyota Motor built its eighth North American manufacturing facility, this one near Tupelo, Mississippi. A decade earlier, Mercedes built a manufacturing plant in Alabama. BMW built a plant in South Carolina a few years before that. Of course, US auto manufacturers such as General Motors and Ford have made similar investments in other countries. Now foreign manufacturers are returning the favor.

Economists have a term for these two investments: direct investment. Direct investment occurs when a foreign organization builds a facility in a host country or buys controlling interest in a host company. This is the style of investment that has been occurring for a century or more. Some countries welcome direct investment, while other countries discourage it.

Another kind of investing, portfolio investment, occurs when foreign investors purchase securities such as stocks or bonds. Portfolio investment is a more recent phenomenon that has blossomed in the past two or three decades. In the old days, many countries had what were termed closed capital markets: governments of those countries adopted policies that either limited investment to locals or discouraged foreign investment by limiting inflows or outflows of cash. Or else the countries were not sufficiently developed that they had stock or bond markets. In the past few decades, more countries have developed capital markets and even more countries have relaxed limitations on inflows and outflows of capital, so portfolio investing has increased globally.

At the same time, there were few mechanisms through which investors in one country could purchase securities in other countries. Virtually all of the investment was by large financial institutions rather than by individual investors. But over time, financial institutions developed mutual funds and exchange-traded funds that made it possible for smaller investors to invest abroad. It’s also possible to bypass domestic financial intermediaries and go directly to an intermediary in another country to invest. We can invest directly in some other countries by opening an account at a brokerage firm in that country.

All of these changes – creation of capital markets, removal of restrictions on investing, and enabling small investors to invest in other countries – have created a global market for securities, as you will read in Box 1.2.

The upshot of all this is that smaller investors like you and me are gaining the ability to invest globally, either directly or through financial institutions. And the investments are not simply in securities such as stocks and bonds. We can purchase currencies, real estate, corporate stocks and bonds, government bonds, and even exotic investments such as derivatives.

Thomas Friedman calls this trend the “democratization of finance.” Power is moving toward the individual and away from large institutions. A financial cold anywhere in the world (but particularly in the US) causes sniffles throughout the world. If you doubt that, look at the effect of the US mortgage meltdown in 2007, the subsequent financial crisis in 2008, and the global recession in 2009. As you read Box 1.3, look for evidence that investing has become easier for individuals and that the variety of investments has expanded.

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Box 1.2 Global investing involves risk

Although investing globally makes sense, it is not without risks, and the risks are of a different type from investing domestically. Business Week began an article with this sentence: “Seek profit from strong economies in emerging markets, where demographics and government policies are driving impressive growth.” That sounds simple enough, but how do you identify a strong economy? What demographics drive growth? What government policies promote economic growth and make your investment safer or riskier? Those issues are the topic of this book.

As developed countries become more closely integrated, their markets tend to move together. To increase returns, investors begin to move to less developed countries – known as frontier markets – where markets present both the potential for higher returns but also increased risk.

Here are some of the risks that we will discuss in this book:

• Credit risk: lending to a foreign government exposes you to risk that it won’t pay you back. How do you determine when a government is a good or bad credit risk, or when it has policies that protect your investment? We’ll cover these in Chapters 4, 5, and 7.

• Inflation: high inflation in the foreign country potentially reduces your return because it devalues that currency. How do you tell whether a central bank is credible? We cover this in Chapter 6.

• Currency exposure: the return you earn from investing abroad magnifies when the foreign currency appreciates. What indicators help you forecast whether a currency will appreciate or depreciate, and how do you protect against the currency moving the wrong way? We cover these in Chapters 7, 8, and 9.

Other risks tend to focus more on markets than on the environment for investing, so we don’t go into detail about these risks:

• Volatility: markets in frontier countries are generally more volatile than are markets in developed countries. The investment’s value goes up or down quickly, and sometimes the changes are drastic.

• Liquidity: frontier markets aren’t as liquid as in developed countries, so it’s not as easy to bail out if you need to exit quickly.

• Correlation: returns in frontier markets are not as closely correlated to returns in developed markets, so there is greater advantage in diversification.

Sources: Ben Steverman, “The action stays offshore”, Business Week, Dec 28, 2009, p. 60; Ben Levisohn, Tara Kalwarski, “Cashing in on foreign debt”, Business Week, Jun 29, 2009, p. 56; Jeff D. Opdyke, “The Street’s rush into far frontiers offers big game and bigger risks”, Wall Street Journal, Jun 16, 2008, p. C1.

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Box 1.3 Investing possibilities are endless

If you want to invest overseas, there is no end of ways to do it. Thanks to globalization, you can buy securities directly in many countries. If securities aren’t your bag, you can purchase real estate in a foreign country. To do this kind of investing, you need to have a certain amount of expertise, so this book helps.

If you don’t know anything about the bond market in Moscow, Russia or the stock market in Zagreb, Croatia and choose not to make the decisions yourself, you can invest in Wall Street funds that achieve the same purpose. Mutual funds and exchange-traded funds offer portfolios oriented toward overseas bonds, overseas stocks, securities from developed countries or from developing countries, or combinations of any of the above. If you don’t know anything about real estate abroad, find a Real Estate Investment Trust that does.

Of course, executives in multinational corporations regularly make decisions about expanding into foreign countries. Their access to information is different from what you have, but the process they follow and the factors they consider are similar to the factors discussed in this book. They also contend with the same risks that we discuss. For example, Wal-Mart spent more than $5 billion in 2009 as part of its international diversification strategy. It operates more than 3,700 stores in 14 countries, and it faces the same risks that were covered in Box 1.2. You have more in common with Wal-Mart than you think.

Sources: Jane J. Kim, Aaron Lucchetti, “Jumpy investors gain reasons to look ahead”, Wall Street Journal, Mar 27, 2007, p. D1; Eleanor Laise, “Why venturing abroad still makes sense for fund investors”, Wall Street Journal, Feb 2, 2009, p. R1; Jeff D. Opdyke, “Real-estate investors head overseas”, Wall Street Journal, Jun 21, 2007, p. D1; Miguel Bustillo, “After early errors, Wal-Mart thinks locally to act globally”, Wall Street Journal, Aug 14, 2009, p. A1.

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Country Analysis

When large institutions did the investing, they developed contacts to help them collect economic and political information about the target country and processes for analyzing information once it was collected. Collecting timely, reliable information has always been a formidable task. Big institutions had the resources necessary to obtain information about economic growth, inflation, incomes, trade flows, government policies, and underlying social currents. Once they had the information, institutions had the staff to analyze the risk of investing in the target country. Even so, analyzing risks of investing was “more an art than a science,” according to Ronald Solberg. There was no standardized methodology for evaluating risk.

The world changed with the development of the Internet. Information became available at low cost to anyone with the wherewithal to find it. Governments, who collect and disseminate the information, learned that it was to their advantage to provide information in a timely manner. Suddenly, you and I can find a country’s rate of economic growth or inflation, or get wind of changes in government policy by typing a few keys as part of an Internet search.

One thing that individuals didn’t have was a process for analyzing the information once we had it. Most of us don’t possess the expertise to interpret detailed economic information, and we don’t have a framework to tell us what differentiates good performance from poor performance. That’s where another link in the chain helps.

During the 1980s, at about the same time the Internet was developing, an analyst at a Washington think tank summarized the criteria that institutions such as the International Monetary Fund (IMF), the World Bank, the US Treasury, and several other major lenders used to help them identify good credit risks. John Williamson called these criteria the Washington Consensus. Among the criteria were: whether the government or the free market determined what went on in a nation’s economy, the extent of government control over interest rates, capital flows and exchange rates, the level of corruption in the government, and whether the government adopts sound economic policies.

Over the next decades, investors around the world adopted elements of the Washington Consensus – knowingly or unknowingly – because it provided a framework to use in evaluating the economic and political performance of a country. Maybe everyone didn’t agree on all of the elements of the Washington Consensus, but investors used many if not most of the criteria because they made sound economic and financial sense.

So we have almost the perfect storm that affords everyone the ability to collect and analyze information to help them invest anywhere around the globe. Governments produce information on a more-timely basis, the Internet allows us to collect the information at relatively low cost, and the Washington Consensus provides a framework through which we can analyze the information we obtain. The stage is set for global investing to flower.

The trick is to know what the information means. Statistics become meaningful only when there are guidelines to help us interpret what they mean. The Washington Consensus pr...