Why the West finds it hard to invest in emerging markets

23 Jan

At a time when the West’s economy is being overtaken at every corner by the emerging economies of the world, it would seem sensible for British and Western companies to be tapping into the vast opportunities of Asia, Latin America and Africa. Political leaders seemingly agree with this sentiment, as the hefty flight schedules of David Cameron, Nicolas Sarkozy and Barack Obama would attest.

Yet the vast majority of British – and indeed Western – investment still heads to Europe and North America. In 2010 these two continents accounted for half of global foreign direct investment (FDI), but the figures for Western investment in the other continents are well below this. This is despite academic evidence suggesting that emerging market returns are generally more predictable than developed market returns.

Why don’t companies invest abroad?

Many investors do not expand abroad at all, no matter whether the market is emerging or developed.  This ‘home bias’ in investment decisions is a well-known phenomenon, and its prevalence is perhaps exemplified by a 1997 report that revealed that U.S. corporations had roughly 90% of their investments in US companies.  Although globalization has lessened this figure, it is still the case that emerging markets are underweight in terms of investment – as the FDI numbers above prove.

No one knows for sure the reasons behind home bias. Casual evidence from British companies indicates that they find it difficult to invest in emerging market economies (EMEs) because their managers are often unsure of the risks. Even the Arabian Gulf Region, one of the most rewarding regions for British firms, with a large UK expatriate community and a long history of investment, suffers from the ‘fear of the unknown’.

These risks, which can be both economic and political, may be hard to quantify in EMEs. In most Western nations, a vast library of economic statistics and political analysis is publicly available for review. These countries tend to have well-developed and predictable economies and relatively stable governments. Developing countries offer less transparency and access to accurate economic or industry statistics may not exist at all.

This opacity can significantly increase financial risks of EME investment. One such example is being confident in local corporate governance. Emerging market firms are typically controlled by a large resident shareholder, normally the state or a family, who have power significantly in excess of their voting rights. Although this can be good for the company’s long-term interests, it can also cause economic issues. Some studies seem to suggest that the Asian crisis of 1997-99 was in part caused by poor governance: the close relationship between government, business and finance, typical in these economies, led to high debt-equity ratios in the corporate sector which made it more vulnerable to economic shocks.

Corporate governance aside, there are many other financial risks that act as barriers to emerging market investment. Poor credit ratings, high and variable inflation, and exchange rate controls are but three examples. Yet political risks can be just as important, and at the same time, just as hard to fathom – as Standard Chartered Bank found out in Nigeria when its entire operation there was confiscated by the Government.

Studies have shown that there are good reasons why political risk is worth considering when looking at where to invest. First, political freedom promotes private investment. Second, political instability has a negative effect on private investment. Third, policy uncertainty has a negative effect on investment decisions.

Examples of political risk affecting investment abound. One of the reasons that Zimbabwe suffers from poor FDI is that no one is quite sure about President Mugabe’s nationalisation agenda. Iraq and Afghanistan do not find it easy to attract investors because of the political instability there makes high levels of security necessary, which bumps up costs and significantly impacts on operations.

It is therefore quite easy to see why Western companies can be reticent to invest in emerging economies. Yet investment does sometimes happen. In these cases how do executives evaluate which market to enter?

Making the choice

As might be expected, the two main categories of investment risk that are generally considered are political and economic risk. They are unavoidable factors in international commerce due to the continued differences between the laws, customs and policies of foreign governments. As foreigners entering new markets, companies and individuals often lack the local market knowledge and culture to understand these differences and must depend on outside sources for information and forecasts.

Many companies start with the financial side, using indicators like market GDP, growth rates, and exchange rates. Some also use composite risk indices which look at differing aspects of political and economic risk, like the World Bank’s Country Policy and Institutional Assessment, despite evidence that seems to play down their usefulness.

Other companies will focus on specific issues that come more or less from the personal experience of the Board, perhaps where they have been let down before. Factors examined here will include the absence of contract-enforcing mechanisms and the ease of finding local agents.

There is though one more risk category that needs to be examined, and one that is often overlooked: social risk. This is where cultural factors have an impact on an investment, often at the operational level, which is not easy to spot through traditional financial due diligence.

For example, the joint venture between TNK and BP has been enormously profitable for BP, as the financial analysis predicted. But the relationship has been far from harmonious, and it may in the long-term be a strategic calamity for the British company if it prevents them taking advantage of other opportunities such as the recently blocked deal with Rosneft shows. At the heart of this has been the operational clash between the two companies. Russian managers have found it hard to work under the Western style of management, and in return British executives have not always been attuned to Russian sensibilities. The friction this has caused has exacerbated other issues like the clash on strategic direction that is the core source of disagreement today.

Risk and high return

One final problem for companies wanting to invest in EMEs is a psychological one. British and Western culture has become risk averse over the past decades, with every effort made to eliminate hazards from daily life. Many managers find it difficult to imagine investing outside of their comfort zones: for these, EME risk can never be outweighed by the increased returns expected.

This aversion does not apply to everyone, and with good reason. For emerging markets are the future, and indeed the present – African, South American and Asian GDP growth far outstrips that of the West. The fact that this is likely to be the case for years to come means that it would not be in the interests of shareholders to at least look at the possibility of investing in these emerging markets. True, they will have different risks to investing in the US or France. But the returns will be good if the companies prepare themselves properly. The West should no longer be the be all and end all for Western investment.

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