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India boasts a pack of dynamic companies selling information-technology services to leading multinationals. More than 1,000 listed companies in China are poised to take advantage of sweeping reforms in one of the world's fastest-growing economies. Russian stocks have roared back, thanks largely to investor faith in the policies of President Vladimir V. Putin's policies. With recovery in sight, bargain hunters have been snapping up the dirt-cheap shares of Southeast Asian companies that vanished from investors' radar screens during the 1997 financial crisis.
Interesting opportunities to some. But not to the California Public Employees' Retirement System (CalPERS). The giant pension fund has adopted a policy of abstinence in all these countries. The reason: tough standards unveiled Feb. 20 for rating emerging markets on governance issues as well as financial fundamentals. Among the criteria are labor standards, press freedom, shareholder protections, and financial transparency. CalPERS picked just 13 markets, including Brazil, Mexico, South Africa, and Poland, as "investable" under its formula (table). Excluded are such huge nations as China, Russia, India, and Indonesia.
It may sound like West Coast political correctness. But to California Treasurer Philip Angelides, who as a CalPERS director instigated the review, it mainly comes down to cold sober business. Soon after taking office in early 1999, Angelides says, he inspected the performance of CalPERS' investments. He was struck by how terribly it was doing in emerging markets. Aren't these supposed to be high-growth markets? he asked. Instead, the five-year average annual returns for Malaysia, the Philippines, and Indonesia as of yearend 2001 were -18.3%, -29.3%, and -31.1%, respectively. CalPERS ordered up a $1 million study. The conclusion: Many developing nations aren't nurturing the political and corporate systems needed to become modern financial markets. And factors such as fair-labor practices, freedom of information, and impartial courts are just as important to sustainable development as economic policies. "This is about getting the best returns for our investors," says Angelides. "The era of blind investment in emerging markets is over." (The complete report commissioned by CalPERS is available on the pension fund's Web site.)
Few professional fund managers are ready to go as far as CalPERS. Most see plenty of sound investments in India, Russia, and China, say. Still, CalPERS' move could prompt other pension systems to rethink foreign investment. And certainly, the action is a sign of the times: Governance now matters in determining where risk-wary Western bankers and investors park their money. "We have never seen investors differentiate between emerging markets to this degree," says Citigroup Senior Vice-Chairman William R. Rhodes.
Just a few years ago, officials in developing countries, inundated with foreign money, could afford to be blase about meeting Western standards. But since the financial crises in East Asia, Russia, Brazil, Turkey, and Argentina, competition for funds has grown fierce. According to the Institute of International Finance Inc. (IIF), a Washington think tank, flows of private capital to emerging markets plunged by nearly a third last year, to $115 billion, the lowest level in a decade. All in all, "2001 was the most challenging in emerging markets since the end of the debt crisis" of the late 1980s, says IIF Managing Director Charles H. Dallara.
The good news is that the markets now seem to be rewarding reform. In 1998, Russia rocked the financial world by defaulting on $20 billion in government debt. Yet last year, the city of Moscow easily raised $260 million in foreign bonds, and Russian corporations are starting to issue shares in the U.S. Mexico and Brazil, both bailed out by the International Monetary Fund in the 1990s, floated billions in bonds even as the Argentina crisis unfolded. And despite South Korea's 1997 meltdown, "there's no problem for us to borrow as much money as we like," says Korea Development Bank Senior Manager Cho Seung Hyun. The KDB's most recent $500 million foreign bond issue was 2.6 times oversubscribed and carried a coupon rate of just 5.25%.
Each of these countries has lured investors back largely due to big strides in financial management and supervision. Disclosure is still poor in Russia, but under Putin the country has restructured its old debts and pushed companies to be more open. Korea has done the best job in Asia of reforming its banks and enacting shareholder protection. After its 1994 peso crisis, Mexico freed its central bank from political control and began releasing daily updates on foreign reserves, budget shortfalls, and foreign stock and bond holdings--the kind of data it used to release three times a year, at most. Top finance officials hold quarterly conference calls with up to 200 global investors.
One of the listeners is Mohamed A. El-Erian, portfolio manager of Newport Beach (Calif.)-based PIMCO Emerging Market Bond Fund. "Mexico understands that the key to fighting contagion is an informed investor base," he says. Countries such as Brazil, South Africa, and even Egypt also are holding regular calls. In addition, El-Erian says he checks a new IMF Web site that rates different countries' performance on disclosure standards--a big change from IMF secrecy of the past. Improved data, he says, have helped his PIMCO fund post a 24% average annual return for the past three years.
Investors also are demanding more of individual companies. "We consider corporate governance to be as important as a company's fundamentals," asserts Alliance Capital Management LP President Edward Baker. "If a company won't meet with us, we won't invest." Investment bank CLSA Emerging Markets now circulates a ranking of each of the 475 companies its analysts track based on 57 criteria, including whether they file timely quarterly reports, follow international accounting norms, and have independent boards. CLSA says its research shows that over time, companies that rate highly in governance far outperform their national stock indexes.
Certainly, governance isn't the only consideration driving fund flows. Take China. Although its banks and companies are notorious for murky finances, corruption, and ill treatment of outside investors, Chinese companies raised $20 billion in offshore stock offerings in 2000. And China pulls in three-fourths of foreign direct investment in Asia. The lure: China's huge, fast-growing market. But Brookings Institution economist Wei Shangjin figures China could draw several times as much investment if it had clean and transparent governance.
Beijing promises to improve. Last year, it required the boards of all 1,160 locally listed companies to have at least one outside director. By 2003, one-third of directors are to be independent. Boards must also set up auditing, compensation, and executive committees and follow governance guidelines recommended by the Organization for Economic Cooperation & Development. What's more, mergers and acquisitions must be vetted at shareholder meetings, where minority owners may raise objections. "Foreign institutional investors have legitimate concerns about governance," says China Securities Regulatory Commission Vice-Director Tong Daochi. "We want to get across the message that we are working to protect shareholder rights."
Such talk is music to the ears of CalPERS' Chief Investment Officer Mark Anson. "Our hope is that countries not on our list adopt practices that will allow them to graduate into our universe of investable countries," he says. With no return of the fast-money days in sight, emerging markets may have little choice but to get on the bandwagon and adopt global standards. By Pete Engardio in New York, with Moon Ihlwan in Seoul, Catherine Belton in Moscow, and Geri Smith in Mexico City