Cross-border investment in stocks and bonds has been the rage for most of the 1990s. One would have thought the Mexican meltdown would have tempered enthusiasm for these capital flows, but no. Capital is rushing into all kinds of emerging markets, from Mexico again to Russia, the Philippines, and Argentina. At last count, more than 1,200 emerging-market funds managed more than $100 billion in equity. Add to that the additional billions put into dollar-bond and local currency instruments, and the amount is staggering. But do people actually know what they are buying? Do they understand the risk?
A team of scholars from Harvard University--Rafael La Porta, Florencio Lopez De Silanes, and Andrei Shleifer--and Robert W. Vishny from the University of Chicago have written a report, published by the National Bureau of Economic Research, that deals with just this question. Law and Finance asks what institutions are in place to protect stockholders against abuse and appropriation. What happens to holders of corporate bonds when countries or foreign companies default?
The questions are not academic. Investors in Russia have discovered that they can't get into stockholder meetings without getting beaten up. In Brazil, domestic stocks tend to be cheaper than those of multinationals because management often siphons off profits through fully owned subcontractors, leaving little for shareholders. Corporate bondholders in Mexico have discovered that bankruptcy proceedings can take a decade. They wind up renegotiating the debt rather than spending years trying to take possession of collateral. In Japan, T. Boone Pickens Jr. discovered that stockholder meetings are rigged to protect management. Having a significant investment does not translate into meaningful control.
COMMON-LAW PROTECTIONS. The report scrutinizes national legal systems to identify whether investors have effective recourse. It concludes that there are two dominant legal regimes, Anglo-Saxon common law and French civil law, that have been adopted around the world and that provide the basic setting for investing. French law protects investors least. Those countries with common law give investors plenty of ways to safeguard their interests: voting by mail, permitting transfer of shares during stockholder meetings, fewer shares required to call an extraordinary meeting, laws to protect minority holders, etc. This is true for both equity holders and creditors.
In countries operating under French civil law, it's caveat investor. Investors get a poorer deal across the board. All of Latin America is on the French system, while most of Asia uses common law. Japan has adapted German common law, which is somewhere between the two when it comes to protecting investors' rights.
Does all this make a difference to capital flows and the availability of finance around the globe? Absolutely. If investors get poor protection, they will stay away. Outside finance will dry up, and fewer resources will be available for growth. Thus, applying anything other than common law to investors is a poor growth strategy.
A RISING TIDE. There are ways for investors to circumvent weak protections. One way is to simply take a majority equity stake and join the prevailing local team as a business partner, not just as an investor. The downside is that this strategy is not nearly as efficient in broad macroeconomic terms, and there is no guarantee that local partners will protect foreign investors anyhow. Another strategy would be to go into partnership with foreign governments themselves.
Right now, we are living in a world of rising equity and bond markets, and a rising tide raises all ships. The legal environment makes little difference because management and stockholders are on the same side. But when the current atmosphere subsides and markets decline, investors will have to think seriously about how they can recoup their losses when trouble comes.
Emerging countries around the world are reforming their financial systems, opening up to external capital, and reducing the size of government. The question of how to protect investors is central to their performance. Stable macroeconomics and the absence of currency crises is just a starting point.
In the rush to diversify internationally and in the haste to collect capital gains on seemingly underpriced assets, investors have bought foreign securities on an extraordinary scale. It would be surprising if, contrary to the experience of the past century, this atmosphere continued forever.