Parul Sharma is a PhD candidate at Cornell’s Dyson School.
Two factors—the rate of domestic capital formation and the inflow of external investment capital—are fundamental to releasing capital constraints in emerging markets and unlocking their full potential for economic growth. However, both these factors are impeded by fundamental risks and institutional fragilities inherent to emerging markets.
Armed with this thesis in his forthcoming book, Cracking the Emerging Markets Enigma, Andrew Karolyi, Professor of Finance and Economics at Cornell University, asks: how should foreign investors and corporations evaluate growth opportunities in emerging markets in light of the attendant risks?
Through an ambitious exercise of synthesizing a large volume of data, Andrew Karolyi deconstructs risk for 33 emerging and 24 developed markets into six risk indicators—market capacity constraints, operational inefficiency, foreign accessibility restrictions, corporate opacity, limits to legal protections, and political instability—for the period of 2000-2012. Each risk indicator captures specific constraints to domestic capital formation and the inflow of external investment capital. By using multiple variables drawn from academic research across development economics, international finance, macroeconomics, law and finance, international corporate governance, accounting and political science, the author gives us a comprehensive, theoretically well-grounded framework for understanding fundamental risks in emerging markets.
Which risk indicators most starkly distinguish emerging from advanced markets and which display substantial commonalities across the two groups? How do different risk indicators interact? How fluid and time-varying are they? Why do countries like South Korea, Malaysia, South Africa, Taiwan, and Israel consistently outperform several developed countries on important risk indicators but continue to firmly stay in the “emerging” category? Why do countries like China, Colombia, and Jordan perform extremely well on some indicators while performing extremely poorly on others and what does this mean for their economic outcomes? Why do countries like Egypt, Nigeria, Russia, and Venezuela consistently score extremely poorly across multiple risk indicators, and should investors regard these as permanent basket cases?
The book answers these and several other interesting questions using Karolyi’s scholarly expertise in the study of international financial markets. The author delves into the nuts and bolts of each indicator. He carefully details the choice and definition of explanatory variables, the treatment of missing variables and unbalanced samples, aggregation of firm-level data into country-level data, measurement of qualitative variables such as capital market regulations, and the potential pitfalls of distilling multivariate data into a single index. Karolyi deftly readjusts focus on important disaggregates, presents the reader with different slices of the data, and moves seamlessly between aggregated and disaggregated data analyses to illuminate a sharp understanding of what each risk indicator represents. For the practitioner, the author complements the data-driven treatment of country-level risk with real examples and case studies that contextualize and bring each risk indicator to life.
In the final section the author uses foreign portfolio investment data for 2012 and 2013 to assess how effective his risk indicators are in explaining the investment choices of global investors. Are some indicators more important than others? Do they equally effectively predict economic outcomes across all countries and across all kinds of investors? Do these indicators capture every conceivable facet of risk that affects economic outcomes in emerging markets?
Somewhat surprisingly, the findings show that investors use “softer” aspects of market risk—corporate opacity, limits to legal protections, and political instability—to size up emerging markets rather than the more easily quantifiable and tangible risks emerging from foreign investability restrictions and market capacity constraints. The risk indicators are conspicuously less effective in predicting investment outcomes for China and, to a lesser extent, for Latin American economies like Chile, Colombia and Venezuela. Interestingly, all risk indicators come up short in predicting investment decisions of investors domiciled in emerging markets. Thus investors from emerging economies size up country-level risk in fundamentally different ways compared to investors from advanced economies.
The book is a valuable resource to help further empirical research on international capital markets. It houses up-to-date cross-country data on a broad range of financial market variables sourced from multiple databases and academic studies, each source having a distinctive (and duly highlighted) value-added and comparative advantage. It is dotted with highly readable mini literature surveys on topics such as capital controls, investor protection standards, and portfolio allocation choices that lie at the heart of the international finance literature. Ultimately, the book is an important read for practitioners and researchers in the area of emerging market finance and more broadly for anyone seeking to understand the nexus between financial and economic development and the critical role that global capital flows play in making this nexus operational.
