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
Risk Spread and War on Terrorism Basis Points 1200 1000 Congress authorized use of force in Iraq. 800 600 400 200 Sep.11, 2001 2001 Bush s Speech at the UN about Iraq 2002 Saddam statue toppled. 2003
1.30 Decline of the Dollar and War on Dollar Per Euro Terrorism 1.20 1.10 1.00 Sep.11, 2001 Bush s Speech at the UN about Iraq Congress authorized use of force in Iraq. 0.90 0.80 2001 2002 Saddam statue toppled. 2003
135 130 125 120 Decline of the Dollar and War on Yen Per Dollar Terrorism Congress authorized use of force in Iraq. 115 110 Sep.11, 2001 105 100 2001 Bush s Speech at the UN about Iraq 2002 Saddam statue toppled. 2003
Index 2003=100 250 200 150 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
US$/Troy Ounce 450 Gold Prices Spot Price 400 350 300 250 200 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003
US$/bbl 40 Oil Prices West Texas Intermediate Crude Oil Price 35 30 25 20 15 10 5 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003
US Inflation Percent Change, Year Ago 16 14 12 Recession 10 8 6 4 2 0 71 73 75 77 79 81 83 85 87 89 91 93 95 97 99 01 03
Relative Growth Rates Real GDP Growth 1980 1985 1990 1995 2000 2003 China 7.9 13.5 3.8 10.5 8.0 7.5 Japan 9.6 4.6 5.2 1.8 2.8 2.0 United States -0.2 3.8 1.8 2.7 3.8 2.6 European Union 1.4 2.5 3.1 2.5 3.6 0.8 Latin America 6.3 3.1 0.6 1.8 4.0 1.1
Relative Unemployment Rates 1985 1990 1995 2000 2003 China 1.8 2.5 2.9 3.1 N/A Japan 2.6 2.1 3.2 4.7 5.3 United States 7.2 5.6 5.6 4.0 6.0 European Union N/A 8.9 10.1 7.8 8.0 Latin America N/A 5.2 7.2 7.1 7.0
U.S. Total Debt Outstanding Percent of GDP 70 60 50 40 30 1960 1965 1970 1975 1980 1985 1990 1995 2000
U.S. Total Debt Outstanding Percent of GDP 140 120 100 Projections 80 60 40 20 1940 1950 1960 1970 1980 1990 2000
Is the World Threatened by U.S. Budget Percent of GDP -35-30 -25-20 -15-10 -5 0 Deficits? Projections 5 1930 1940 1950 1960 1970 1980 1990 2000
Percent Change, Year Ago 20 15 10 5 0-5 National Defense Expenditures and Gross investment -10 70 75 80 85 90 95 00
Dow Jones Industrial Average Index 2000=100 120 100 80 60 9/11 event 40 20 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003
US Corporate Profits Percent Change, Year Ago (SAAR) 30 20 10 0-10 -20 92 93 94 95 96 97 98 99 00 01 02 03
World Crude Oil Price Index 1977=100 280 260 240 220 200 180 160 140 120 84 86 88 90 92 94 96 98 00 02
Rising U.S. Retail Gasoline Prices US$/Gallon 3.0 2.5 2.0 Real (2004 dollars) Projections 1.5 1.0 Nominal 0.5 80 82 84 86 88 90 92 94 96 98 00 02 04
Percent 10 8 Interest Rates Fed Funds Rate and 10-year Government Bond Fed Funds Rate 10-Year Government Bond 6 4 2 0 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003
Relative Growth Rate Comparisons Percent Change in GDP, Year Ago 25 20 Japan 15 Germany 10 5 United States 0-5 60 65 70 75 80 85 90 95 00
China Two Decades of Growth Percent Change in RGDP, Year Ago 20 10 2001 Member of WTO 0-10 -20 1966-76 Cultural Revolution 1990 Shanghai and Shenzhen Stock Exchanges established -30 1960 1965 1970 1975 1980 1985 1990 1995 2000
Percent Change, Year Ago (SAAR) 10 8 6 4 2 0-2 United States Real GDP Growth -4 92 93 94 95 96 97 98 99 00 01 02 03
Corporate Profits Percent Change, Year Ago (SAAR) 30 20 10 0-10 -20 92 93 94 95 96 97 98 99 00 01 02 03
Consumer Confidence Index Conference Board Percent Change, Year Ago 160 140 120 100 80 60 40 92 93 94 95 96 97 98 99 00 01 02 03
Aaa Corporate Spread Percent 2.5 2.0 1.5 1.0 0.5 93 94 95 96 97 98 99 00 01 02 03
Declining U.S. Labor Costs Unit Labor Costs Percent Change, Year Ago 6 4 2 0-2 -4 92 93 94 95 96 97 98 99 00 01 02 03
U.S. Consumer Prices and Wages Percent Change, Year Ago 4.5 4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 93 Core CPI Average Hourly Earnings 95 97 99 01 03
U.S. Consumer Price Index Food and Energy Percent Change, Year Ago 20 10 Food Energy 0-10 -20-30 85 87 89 91 93 95 97 99 01 03
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
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
US$ Trillions 14 12 Global Futures Market Notional Amounts Interest Rate (L) US$ Billions 700 600 10 8 6 4 Equity Index (R) 500 400 300 200 2 Currency (R) 100 0 1986 1988 1990 1992 1994 1996 1998 2000 2002 0
US$ Trillions 25 20 Global Options Market Notional Amounts Interest Rate (L) US$ Billions 150 120 15 Currency (R) 90 10 60 5 30 Equity Index (L) 0 1986 1988 1990 1992 1994 1996 1998 2000 2002 0
Global Credit Derivatives Market US$ Trillions 5 4 3 2 1 0 1997 1998 1999 2000 2001 2002 2003 2004
Financial System Risks Lack of Capital Access Banking System Vulnerability Undiversified Financial System Opacity
5.8 2004 Capital Access Index Mature Market 5.6 5.4 5.2 5 4.8 4.6 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
2004 Capital Access Index Frontier Markets 5 4.5 4 3.5 3 2.5 Bahrain Barbados Tunisia Panama Slovak Republic Mauritius Croatia Vietnam Jamaica Nigeria Costa Rica Honduras Dominican Republic Uganda Bolivia Ukraine Ecuador Paraguay Malawi
Capital Access and Income Per Capita GDP Per Capita, US$ Thousands 60 50 40 30 20 10 0-10 3 3.5 4 4.5 5 5.5 6 Capital Access Index
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.
Increasing Capital Access Would Accelerate Emerging Market Growth Mexico Russia Argentina Pakistan India Foregone GDP Growth % 2.63 2.50 1.97 1.70 1.66
Increasing Capital Access Would Add Billions to Emerging Market Economies Mexico India Czech Republic Russia Phillippines Foregone GDP US$ Billions 15.7 5.7 4.5 2.4 1.7
Increasing Capital Access Would Accelerate Emerging Market Growth Percent 2.8 2.6 2.4 2.2 2.0 1.8 1.6 Mexico Russia Argentina Pakistan India
16 14 12 10 8 6 4 2 Increasing Capital Access Would Add Billions to Emerging Market Economies US$ Billions 0 Mexico India Czech Rep. Russia Philippines
Banking Crises Since Late 1970s 117 Systemic in 93 Countries 51 Nonsystemic in 45 Countries Information not Available
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.
Estimated Cost of Resolving Bank Problems Can be Enormous Senegal (1988-1991) Norway (1987-1993) Spain (1977-1985) Paraguay (1995-ongoing) Colombia (1982-1987) Sri Lanka (1989-1993) Malaysia (1985-1988) Sweden (1991-1994) Indonesia (1992-1994) Poland (1992-1995) United States (1984-1991) Ghana (1982-1989) Turkey (1982-1985) Thailand (1983-1987) Australia (1989-1992) Turkey (1994) New Zealand (1987-1990) France (1994-1995) Argentina (1995) Egypt (1991-1995) Philippines (1998-ongoing) Chile (1981-1983) Thailand (1997-ongoing) Uruguay (1981-1984) South Korea (1997-ongoing) Côte d'ivoire (1988-1991) Venezuela (1994-1997) Japan (1992-ongoing) Mexico (1994-ongoing) Malaysia (1997-ongoing) Slovenia (1992-1994) Brazil (1994-1996) Philippines (1983-1987) Bulgaria (1996-1997) Ecuador (1996-ongoing) Czech Republic (1991-present) Finland (1991-1994) Hungary (1991-1995) United States 3% S. Korea 27% Thailand 33% Argentina (1980-1982) Indonesia (1997-ongoing) Indonesia 50% 0 10 20 30 40 50 60 Percent of GDP
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
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
Distribution of the World s Financial Assets Percent Accounted for By High Income Middle Income Low Income Population 6.1 billion 15.1 43.7 41.1 Bank Assets $36.9 trillion 86.6 11.9 1.5 Equity Market Capitalization $27.8 trillion 92.9 6.6 0.6 Bond Market Capitalization $31.6 trillion 96.9 2.6 0.6
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% $13.2T Equity 7.4% 0% 20% 40% 60% 80% 100%
Banks Still Dominate World s Financial Sector Percent of World GDP 140 120 Bank Assets 100 80 60 Bonds Outstanding Equity Market Capitalization 40 1990 1992 1994 1996 1998 2000 2002
Undiversified Financial System Equity 34% High Income Countries Bond 35% Bank 57% Middle Income Countries Equity 31% Low Income Countries Bank 31% Bank 56% Equity 22% Bond 12% Bond 22%
Benefits of Diversified Financial System Enhance economic stability Decrease the depth of recession Increase speed of recovery from business cycle
Opacity is Costly Rise the cost of capital Reduce foreign direct investments Reduce GDP growth
Opacity Raises Governments Capital Costs Percent 18 16 Higher than Median Opacity Lower than Median Opacity 14 12 10 8 6 Loans Bonds Equity
US$, Billions 45 40 35 30 25 20 15 10 Forgone FDI Due to Opacity 5 Brazil Argentina Korea Hong Kong Thailand Poland Russia
Percent of FDI 270 260 250 240 230 220 210 200 Forgone FDI Due to Opacity 190 Russia Indonesia Turkey Korea Romania Czech Republic
Opacity Raises Governments Capital 15 Costs Government Bond Yield Spread 10 5 0-15 -10-5 5 10 15 20 25 30 Opacity Index Spread
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%
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%
Opacity Decreases FDI 160 140 FDI (log) 120 100 80 60 40 20 0 10 20 30 40 50 60 Less Opacity Opacity Index More Opacity
Dependents - Developed Countries Percent of Working Age (15-64) 80 60 Forecast Dependency Ratio Aged 0-14 Aged 65+ 40 20 0 1950 1960 1970 1980 1990 2000 2010 2020 2030 2040 2050
Dependents - Developing Countries Percent of Working Age (15-64) 80 60 Forecast Dependency Ratio Aged 0-14 Aged 65+ 40 20 0 1950 1960 1970 1980 1990 2000 2010 2020 2030 2040 2050
Percent of Working Age (15-64) 85 80 Dependency Burden Forecast Dependency Ratio 75 70 65 60 55 50 Developing Countries Developed Countries 45 1950 1960 1970 1980 1990 2000 2010 2020 2030 2040 2050
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.
Large Banks Provide Lesser SME Credit Percent of Total Assets 10 8 8.1 6 4 2 2.3 2.1 0 Community Banks Large Banks Top 20 Large Banks
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
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
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
CLEAR From these elements emerges the acronym, CLEAR. A means of keeping in mind the multiple aspects of opacity/transparency in capital markets
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.
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
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
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
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
Scores for O-Factor and Components (higher numbers indicate more opacity) A Key Chart Country C L E A R O-Factor Argentina 56 63 68 49 67 61 Brazil 53 59 68 63 62 61 Chile 30 32 52 28 36 36 China 62 100 87 86 100 87 Colombia 48 66 77 55 55 60 Czech 57 97 62 77 62 71 Ecuador 60 72 78 68 62 68 Egypt 33 52 73 68 64 58 Greece 49 51 76 49 62 57 Guatemala 59 49 80 71 66 65 Hong Kong 25 55 49 53 42 45 Hungary 37 48 53 65 47 50 India 55 68 59 79 58 64 Indonesia 70 86 82 68 69 75 Israel 18 61 70 62 51 53 Italy 28 57 73 26 56 48 Japan 22 72 72 81 53 60 Country C L E A R O-Factor Kenya 60 72 78 72 63 69 Lithuania 46 50 71 59 66 58 Mexico 42 58 57 29 52 48 Pakistan 48 66 81 62 54 62 Peru 46 58 65 61 57 58 Poland 56 61 77 55 72 64 Romania 61 68 77 78 73 71 Russia 78 84 90 81 84 84 Singapore 13 32 42 38 23 29 South Africa 45 53 68 82 50 60 South Korea 48 79 76 90 73 73 Taiwan 45 70 71 56 61 61 Thailand 55 65 70 78 66 67 Turkey 51 72 87 80 81 74 UK 15 40 53 45 38 38 Uruguay 44 56 61 56 49 53 USA 25 37 42 25 48 36 Venezuela 53 68 80 50 67 63
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
The Second Key Chart Economic Cost of Opacity: Tax-Equivalent Estimates (Singapore is the benchmark) Country O-Factor Tax-Equivalent (%) Argentina 61 25 Brazil 62 25 Chile 36 5 China 87 46 Colombia 60 25 Czech Republic 71 33 Ecuador 68 31 Egypt 58 23 Greece 57 22 Guatemala 65 28 Hong Kong 45 12 Hungary 50 17 India 64 28 Indonesia 75 37 Israel 53 19 Italy 48 15 Japan 60 25 Country O-Factor Tax-Equivalent (%) Kenya 69 32 Lithuania 58 23 Mexico 48 15 Pakistan 62 26 Peru 58 23 Poland 64 28 Romania 71 34 Russia 84 43 Singapore 29 (benchmark) South Africa 60 24 South Korea 73 35 Taiwan 61 25 Thailand 67 30 Turkey 74 36 United Kingdom 38 7 United States 36 5 Uruguay 53 19 Venezuela 63 27
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!
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.
The Third Key Chart Risk Premium Due to Opacity (Singapore and USA serve as benchmark) Country O-Factor Opacity Risk Prem. (Basis Points) Argentina 61 639 Brazil 61 645 Chile 36 3 China 87 1,316 Colombia 60 632 Czech 71 899 Ecuador 68 826 Egypt 58 572 Greece 57 557 Guatemala 65 749 Hong Kong 45 233 Hungary 50 370 India 64 719 Indonesia 75 1,010 Israel 53 438 Italy 48 312 Japan 60 629 Country O-Factor Opacity Risk Prem. (Basis Points) Kenya 69 848 Lithuania 58 584 Mexico 48 308 Pakistan 62 674 Peru 58 563 Poland 64 724 Romania 71 915 Russia 84 1,225 Singapore 29 0 South Africa 60 612 South Korea 73 967 Taiwan 61 640 Thailand 67 801 Turkey 74 982 UK 38 63 Uruguay 53 452 USA 36 0 Venezuela 63 712
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.
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 0 0 36 United Kingdom 0 0 38 United States 0 0 36 Singapore 0 0 29 Other Countries Argentina 139 18,732 60 Brazil 141 40,261 61 Colombia 138 4,593 60 Czech 194 5,964 71 Ecuador 179 1,295 68 Egypt 125 1,287 58 Greece 122 1,340 57 Guatemala 162 502 65 Hong Kong 54 10,305 45 Hungary 83 1,738 50 India 156 4,458 64 Indonesia 218 1,268 75 Country Deterred FDI (%) point estimate Other Countries (Cont d.) Deterred FDI (in millions of US dollars) point estimate Survey O-Factor Israel 97 1,890 53 Italy 71 3,151 48 Japan 137 8,662 60 Kenya 183 28 69 Lithuania 128 768 58 Mexico 70 8,554 48 Pakistan 147 1,094 62 Peru 123 2,363 58 Poland 157 9,874 64 Romania 197 2,874 71 Russia 263 9,802 84 South Africa 134 2,632 60 South Korea 208 12,347 73 Taiwan 140 2,560 61 Thailand 173 10,224 67 Turkey 212 1,822 74 Uruguay 100 176 53 Venezuela 155 6,988 63 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 1997-1999. See the report for more details.
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!