Current Issues In Global Risk

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2 Current Issues In Global Risk US Economic Recovery Terrorism Iraq and Middle East Conflicts Exchange Rate Volatility China s Exchange Rate Policy Corporate Governance World s Health Epidemics Real Estate Prices Opacity

3 Risk Spread and War on Terrorism Basis Points Congress authorized use of force in Iraq Sep.11, Bush s Speech at the UN about Iraq 2002 Saddam statue toppled. 2003

4 1.30 Decline of the Dollar and War on Dollar Per Euro Terrorism Sep.11, 2001 Bush s Speech at the UN about Iraq Congress authorized use of force in Iraq Saddam statue toppled. 2003

5 Decline of the Dollar and War on Yen Per Dollar Terrorism Congress authorized use of force in Iraq Sep.11, Bush s Speech at the UN about Iraq 2002 Saddam statue toppled. 2003

6 Index 2003= Rising Middle East Markets Since Fall of Baghdad Iraq War Qatar Kuwait Saudi Arabia Egypt Israel Jordan Oman U.A.E Bahrain 100 Lebanon 50 JAN 2003 JAN 2004

7 US$/Troy Ounce 450 Gold Prices Spot Price

8 US$/bbl 40 Oil Prices West Texas Intermediate Crude Oil Price

9 US Inflation Percent Change, Year Ago Recession

10 Relative Growth Rates Real GDP Growth China Japan United States European Union Latin America

11 Relative Unemployment Rates China N/A Japan United States European Union N/A Latin America N/A

12 U.S. Total Debt Outstanding Percent of GDP

13 U.S. Total Debt Outstanding Percent of GDP Projections

14 Is the World Threatened by U.S. Budget Percent of GDP Deficits? Projections

15 Percent Change, Year Ago National Defense Expenditures and Gross investment

16 Dow Jones Industrial Average Index 2000= /11 event

17 US Corporate Profits Percent Change, Year Ago (SAAR)

18 World Crude Oil Price Index 1977=

19 Rising U.S. Retail Gasoline Prices US$/Gallon Real (2004 dollars) Projections Nominal

20 Percent 10 8 Interest Rates Fed Funds Rate and 10-year Government Bond Fed Funds Rate 10-Year Government Bond

21 Relative Growth Rate Comparisons Percent Change in GDP, Year Ago Japan 15 Germany 10 5 United States

22 China Two Decades of Growth Percent Change in RGDP, Year Ago Member of WTO Cultural Revolution 1990 Shanghai and Shenzhen Stock Exchanges established

23 Percent Change, Year Ago (SAAR) United States Real GDP Growth

24 Corporate Profits Percent Change, Year Ago (SAAR)

25 Consumer Confidence Index Conference Board Percent Change, Year Ago

26 Aaa Corporate Spread Percent

27 Declining U.S. Labor Costs Unit Labor Costs Percent Change, Year Ago

28 U.S. Consumer Prices and Wages Percent Change, Year Ago Core CPI Average Hourly Earnings

29 U.S. Consumer Price Index Food and Energy Percent Change, Year Ago Food Energy

30 Risk Management: Passing the Grenades We view them as time bombs both for the parties that deal in them and the economic system... derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal. Warren Buffett February 2003

31 Risk Management: Building the Bunker [T]o continue to foster expanding living standards, risk must be managed ever more effectively as the century unfolds... [Derivative] instruments appear to have effectively spread losses from defaults in recent months. Alan Greenspan September 2002

32 US$ Trillions Global Futures Market Notional Amounts Interest Rate (L) US$ Billions Equity Index (R) Currency (R)

33 US$ Trillions Global Options Market Notional Amounts Interest Rate (L) US$ Billions Currency (R) Equity Index (L)

34 Global Credit Derivatives Market US$ Trillions

35 Financial System Risks Lack of Capital Access Banking System Vulnerability Undiversified Financial System Opacity

36 Capital Access Index Mature Market Hong Kong Netherlands U.K. Singapore Switzerland U.S. Australia Finland Germany Denmark New Zealand Ireland Canada Sweden Taiwan Spain France Iceland Japan Austria Belgium Portugal Israel South Korea Norway

37 2004 Capital Access Index Frontier Markets Bahrain Barbados Tunisia Panama Slovak Republic Mauritius Croatia Vietnam Jamaica Nigeria Costa Rica Honduras Dominican Republic Uganda Bolivia Ukraine Ecuador Paraguay Malawi

38 Capital Access and Income Per Capita GDP Per Capita, US$ Thousands Capital Access Index

39 Forgone Finance, Forgone Growth Recent empirical estimates suggest that doubling banks credit to the private sectors as percent of GDP in emerging markets could increase annual GDP growth by almost 3 percent. doubling trading volume of stock market in emerging markets could increase annual GDP growth by almost 2 percent.

40 Increasing Capital Access Would Accelerate Emerging Market Growth Mexico Russia Argentina Pakistan India Foregone GDP Growth %

41 Increasing Capital Access Would Add Billions to Emerging Market Economies Mexico India Czech Republic Russia Phillippines Foregone GDP US$ Billions

42 Increasing Capital Access Would Accelerate Emerging Market Growth Percent Mexico Russia Argentina Pakistan India

43 Increasing Capital Access Would Add Billions to Emerging Market Economies US$ Billions 0 Mexico India Czech Rep. Russia Philippines

44 Banking Crises Since Late 1970s 117 Systemic in 93 Countries 51 Nonsystemic in 45 Countries Information not Available

45 Costs of Banking System Instability High and often run-on resolution cost Accumulative output losses are large, and even larger when there is a twincrisis. On average, a systemic banking crises reduce GDP by 8% or 4.3% on an annual basis.

46 Estimated Cost of Resolving Bank Problems Can be Enormous Senegal ( ) Norway ( ) Spain ( ) Paraguay (1995-ongoing) Colombia ( ) Sri Lanka ( ) Malaysia ( ) Sweden ( ) Indonesia ( ) Poland ( ) United States ( ) Ghana ( ) Turkey ( ) Thailand ( ) Australia ( ) Turkey (1994) New Zealand ( ) France ( ) Argentina (1995) Egypt ( ) Philippines (1998-ongoing) Chile ( ) Thailand (1997-ongoing) Uruguay ( ) South Korea (1997-ongoing) Côte d'ivoire ( ) Venezuela ( ) Japan (1992-ongoing) Mexico (1994-ongoing) Malaysia (1997-ongoing) Slovenia ( ) Brazil ( ) Philippines ( ) Bulgaria ( ) Ecuador (1996-ongoing) Czech Republic (1991-present) Finland ( ) Hungary ( ) United States 3% S. Korea 27% Thailand 33% Argentina ( ) Indonesia (1997-ongoing) Indonesia 50% Percent of GDP

47 Banking Stability Risk in Emerging Markets Determinants of Stability Macroeconomics Capital Adequacy Asset Quality Management Quality Earnings Liquidity Sensitivity to Risk Riskiest Countries 1. Ecuador 2. Argentina 3. China 4. Pakistan 5. Indonesia 6. Poland

48 Banking Environment Risk in Emerging Markets Category of Determinants Legal Environment Supervision and Regulation Competition Business Environment Riskiest Countries 1. Ecuador 2. China 3. Russia 4. Indonesia 5. Venezuela 6. Egypt

49 Distribution of the World s Financial Assets Percent Accounted for By High Income Middle Income Low Income Population 6.1 billion Bank Assets $36.9 trillion Equity Market Capitalization $27.8 trillion Bond Market Capitalization $31.6 trillion

50 Cross-Country Differences in Household Financial Holdings (March 2003) Bond 9.7% Others 15.5 % US Equity 32.4% Insurance and Pension 28.0% $34.3 T Bond 2.5 % Banks 12.4% Others 6.2% Japan Banks 55.9% Insurance and Pension 30.0% $13.2T Equity 7.4% 0% 20% 40% 60% 80% 100%

51 Banks Still Dominate World s Financial Sector Percent of World GDP Bank Assets Bonds Outstanding Equity Market Capitalization

52 Undiversified Financial System Equity 34% High Income Countries Bond 35% Bank 57% Middle Income Countries Equity 31% Low Income Countries Bank 31% Bank 56% Equity 22% Bond 12% Bond 22%

53 Benefits of Diversified Financial System Enhance economic stability Decrease the depth of recession Increase speed of recovery from business cycle

54 Opacity is Costly Rise the cost of capital Reduce foreign direct investments Reduce GDP growth

55 Opacity Raises Governments Capital Costs Percent Higher than Median Opacity Lower than Median Opacity Loans Bonds Equity

56 US$, Billions Forgone FDI Due to Opacity 5 Brazil Argentina Korea Hong Kong Thailand Poland Russia

57 Percent of FDI Forgone FDI Due to Opacity 190 Russia Indonesia Turkey Korea Romania Czech Republic

58 Opacity Raises Governments Capital 15 Costs Government Bond Yield Spread Opacity Index Spread

59 Opacity is Equivalent to a FDI Tax of up to 17% in Developed Markets Spain France Japan Germany Italy Tax Equivalence % 3% 9% 9% 11% 17%

60 Opacity is Equivalent to a FDI Tax of up to 71% in Emerging Markets South Korea Venezuela Poland China Russia Tax Equivalence % 34% 34% 40% 60% 71%

61 Opacity Decreases FDI FDI (log) Less Opacity Opacity Index More Opacity

62 Dependents - Developed Countries Percent of Working Age (15-64) Forecast Dependency Ratio Aged 0-14 Aged

63 Dependents - Developing Countries Percent of Working Age (15-64) Forecast Dependency Ratio Aged 0-14 Aged

64 Percent of Working Age (15-64) Dependency Burden Forecast Dependency Ratio Developing Countries Developed Countries

65 Basel II and SME Credit Market Implementation of Basel II would allow banks that use advance internal risk rating to hold capital ratio according to perceived risks of instruments. Banks that adapt advance internal risk rating may reduce marginal cost of SME loan by 16 basis points.

66 Large Banks Provide Lesser SME Credit Percent of Total Assets Community Banks Large Banks Top 20 Large Banks

67 Transparency and Opacity Global commerce and heightened world-wide cooperation have revealed how much one country can differ from another in their capital markets and business environment. Some countries offer relatively transparent economic environments: Corruption on a broad scale is rare The rule of law is well developed and enforced Government economic and fiscal policies are openly debated and decided Accounting and corporate reporting standards are comprehensive and prudent Regulatory authorities operate by clear and publicly debated criteria

68 Opacity is the lack of: Defining Opacity Clear, accurate, formal, easily discernible, and widely accepted practices in the world s capital markets. These practices are shaped in the broad arena where business, government, and regulatory authorities interact The practices are domestic, but subject to global influence and pressure

69 The Causes of Opacity Until now, opacity caused by corruption has been the main focus of international concern. The new Opacity Index integrates five related measures to create a more balanced, comprehensive view: Corruption Legal system opacity Economic and fiscal policy opacity Accounting standards opacity Regulatory opacity

70 CLEAR From these elements emerges the acronym, CLEAR. A means of keeping in mind the multiple aspects of opacity/transparency in capital markets

71 Are There Any Heroes? A high degree of opacity in any of the CLEAR dimensions will raise the cost of doing business and curtail the availability of investment capital. Yes, some countries are more transparent overall than others. But no country is likely to earn a perfect score.

72 The Opacity Index is Not a Ranking Among Countries The Opacity Index is not yet a ranking (although the media often treat it that way, and rankings are likely to emerge as more countries are included) Some countries score well in one or more of the five CLEAR dimensions, less well in other dimensions The Index correlates with other indices, but it is a genuinely new measure, raising new questions and giving new results

73 How Will the Opacity Index Help? Businesses can make better informed investment decisions Governments can more clearly assess strengths and weaknesses, and track change over time Governments will better see where to revise their legal, regulatory and policy frameworks to achieve greater economic progress The Index helps to estimate the costs of certain behaviours. As such, it can help all concerned parties without imposing political or ethical judgements The value of transparency in world-wide capital markets will be reinforced

74 Four Data Streams This overall exercise created four streams of related data: 1. O-Factor scores 2. Measurements of the risk premium due to opacity when countries borrow through sovereign bonds 3. Calculation of the effects of opacity as if it imposes a hidden surtax on FDI 4. Estimates of the extent to which opacity deters FDI

75 For Those Who Think Mathematically The composite O-Factor is calculated by averaging (on an equally weighted basis) the various components of opacity for each country: O i = 1/5 * [C i + L i + E i + A i + R i ], Where i indexes the countries and: O refers to the composite O-Factor (the final score) C refers to the impact of corrupt practices L refers to the effect of legal and judicial opacity (including shareholder rights) E refers to economic/policy opacity A refers to accounting/corporate governance opacity R refers to the impact of regulatory opacity and uncertainty/arbitrariness

76 Scores for O-Factor and Components (higher numbers indicate more opacity) A Key Chart Country C L E A R O-Factor Argentina Brazil Chile China Colombia Czech Ecuador Egypt Greece Guatemala Hong Kong Hungary India Indonesia Israel Italy Japan Country C L E A R O-Factor Kenya Lithuania Mexico Pakistan Peru Poland Romania Russia Singapore South Africa South Korea Taiwan Thailand Turkey UK Uruguay USA Venezuela

77 The Tax-Equivalent View The next table shows the effect of opacity as if it were a surtax imposed on foreign direct investment (FDI) through an increase in the corporate tax rate The number 30 would indicate opacity in that country equivalent to levying an additional 30-percent corporate income tax Singapore is the benchmark

78 The Second Key Chart Economic Cost of Opacity: Tax-Equivalent Estimates (Singapore is the benchmark) Country O-Factor Tax-Equivalent (%) Argentina Brazil Chile 36 5 China Colombia Czech Republic Ecuador Egypt Greece Guatemala Hong Kong Hungary India Indonesia Israel Italy Japan Country O-Factor Tax-Equivalent (%) Kenya Lithuania Mexico Pakistan Peru Poland Romania Russia Singapore 29 (benchmark) South Africa South Korea Taiwan Thailand Turkey United Kingdom 38 7 United States 36 5 Uruguay Venezuela 63 27

79 Why the Tax-Equivalent View Matters Many countries are eager to cut tax rates in order to boost investment, often by offering tax concessions to attract foreign investment. These numbers argue that a reduction in opacity can essentially substitute for a tax cut. Domestic reforms that reduce opacity may be as effective as a tax cut without sacrificing tax revenues. Governments take notice!

80 Three Caveats Some governments have deep pockets in terms of accumulated foreign currency reserves (the calculations allowed for this). Domestic and global bond markets differ. Countries issuing dollar-denominated bonds may enjoy lower risk premiums than estimated, but pay higher rates on bonds denominated in local currency. When actual rates in domestic markets are lower than estimated opacity-based risk premiums, this may be a symptom of what economists term financial repression. The end cost of such policies is borne by individuals who save money.

81 The Third Key Chart Risk Premium Due to Opacity (Singapore and USA serve as benchmark) Country O-Factor Opacity Risk Prem. (Basis Points) Argentina Brazil Chile 36 3 China 87 1,316 Colombia Czech Ecuador Egypt Greece Guatemala Hong Kong Hungary India Indonesia 75 1,010 Israel Italy Japan Country O-Factor Opacity Risk Prem. (Basis Points) Kenya Lithuania Mexico Pakistan Peru Poland Romania Russia 84 1,225 Singapore 29 0 South Africa South Korea Taiwan Thailand Turkey UK Uruguay USA 36 0 Venezuela

82 Opacity Risk Premium - Example Were Poland to issue 4 billion zloty (approximately US $1 billion in government bonds, the Opacity Risk Premium implies an interest expense of approximately 280 million zloty (or approximately US $ 70 million) per year, which could be avoided through the reduction of opacity to the benchmark level.

83 Opacity: Its Economic Cost in terms of Country Benchmark Deterred FDI (%) point estimate Deterred Annual FDI Deterred FDI (in millions of US dollars) point estimate Survey O-Factor Chile United Kingdom United States Singapore Other Countries Argentina , Brazil , Colombia 138 4, Czech 194 5, Ecuador 179 1, Egypt 125 1, Greece 122 1, Guatemala Hong Kong 54 10, Hungary 83 1, India 156 4, Indonesia 218 1, Country Deterred FDI (%) point estimate Other Countries (Cont d.) Deterred FDI (in millions of US dollars) point estimate Survey O-Factor Israel 97 1, Italy 71 3, Japan 137 8, Kenya Lithuania Mexico 70 8, Pakistan 147 1, Peru 123 2, Poland 157 9, Romania 197 2, Russia 263 9, South Africa 134 2, South Korea , Taiwan 140 2, Thailand , Turkey 212 1, Uruguay Venezuela 155 6, Note: The percentage loss in FDI is calculated based on the point estimate from the last regression in Exhibit 8 in the report. The dollar amount of deterred FDI is estimated as the product of this percentage loss and the country's average FDI inflow over See the report for more details.

84 Drawing Some Conclusions The Opacity Index charts structural elements in each nation s economic make-up which, if made more efficient, can help countries grow more quickly and soundly. The mathematics and methods underlying the Index are neutral but the results argue for greater transparency as a means of accelerating growth. The Index has further applications. Our calculation of FDI deterred provides an important view of how opacity reduces foreign direct investment. Look also for the next release of the Opacity Index, with many additional countries included. Some have asked us to include them!