William GAMBLE

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					A Panda is not a Bear
    Three Types of Investment Risk

•   Economic Risk
•   Political Risk
•   Legal Risk
            Economic Risk
• General Economic Conditions
• Indirect Investors
  – Market Goes up or down
• Direct Investors
  – Company makes or loses money
                 Political Risk

• Too much Government
  - Expropriation: Bolivia - nationalization of gas
  - Regulatory : Russia - Sakhalin-1 Sakhalin-2
- Too Little Government
  - Civil Unrest: Pakistan
  - Failed States: Iraq
                          Legal Risk

• Economic purpose of law is risk management
• Law can be either economically efficient or inefficient
   – Law can function in two ways: It can extend power or it can limit
   – Law is economically efficient when it limits power
   – Law is economically inefficient when it extends power
• Legal Infrastructure
   – Law: Mexico good anti trust law that is not enforced
   – Enforcement: India good judges just too few and too many
   – Regulators: Players or Referees? China: CSRC
      Examples of Legal Infrastructure
• Corporate governance
• Effective Regulators
• Transparency
• Accurate disclosures
                                  = Legal Risk
  Accurate audits
• Stable regulatory environment
• Stable tax systems
• Enforcement of contracts
• Collection of loans
• Protection of intellectual
• Efficient bankruptcy system
                     Two Systems
• Relation Based System
  – Older system based on trust
  – small groups or networks connected by family relationships,
    geographic proximity, ethnic, linguistic, religious ties or even party
  – information can be transmitted quickly and accurately enough to
    detect and deter deviation

• Rule Based System
  – Law legal system
         South East Asia
Medici                      Jewish Diamond Merchants
         Overseas Chinese
                                   of New York
        Game Theory Models
• Relationship based system less economically
• Break down when larger groups cannot
  communicate information fast enough to deter
• Resistance to Change
   – Relation capital
• Interface with Rule based system
   – Clash of expectations
   – Susceptible to outbreaks of speculation
          Game Theory Models
• Each System is mix of relation based and
  rule based system
• US one end of spectrum
  – UK most OECD economies, India more rule based

• Most Emerging Markets at other End
  – Asian Economies, Japan Korea getting better, China getting worse

• Direct correlation between level of legal risk
  and level of relationship based system
  Effects of Game Theory Model
• Global Investing: Asymmetries favor Relationship
  based systems
  – Easier to understand the rules than create relationships
     • Relationship systems of Japan, South Korea and Taiwan more
        successful in exporting than rule systems of US or UK
     • European Exporters more successful than US
     • US tries very hard to export rules
  – Easier for relationship based systems to deal with other relation
    based systems
  – Easier for Relationship based savers to buy assets or lend money to
    rule based system than visa versa
  – Rule base investors without relationship capital is asking to be
     Asymmetries and Transparency

• Economic Incentives and Legal disincentives
• Its all about Information
   – Misinformation: Fraud
   – Failure to disclose: No information
   – Incomplete or misleading information
• Inefficient markets, greater risk
• Law is the Mechanism in Mechanism Design
• Relationship based systems less transparency
Saudi Stock Exchange
  Predictable Speculation
Limits of Relationship Systems
A Tale of Two Emerging Markets
                       True Value

• “only about 30 per cent of the more than 1,300 listed firms
  on Chinese stock markets had investment value.” Cheng
  Siwei South China Morning Post March 14, 2007
• “different parts of the government, such as state-owned
  companies, local government units, the police and the
  army… have so much money they don’t know what to do
  with it, so they put it in the stock market.” Financial Times
  May 17 2007
• “Strip out those gains and, according to Morgan Stanley,
  the actual price-to-earnings ratio is a bubbly 58 times.”
  Financial Times, September 7, 2007
China Construction Bank v. ICICI (India)

• Government Owned             • Private held
   – Political motivation         – Profit motivation
• Loans based on               • Loans based on risk
  relationships and politics     assessment
• Embezzlement $1.5 billion    • Negligible
• NPLs 3.91 % probably         • NPLs 0.97%
  35% ($911 bn total
• Defaults autos loans: 33%
                               • Defaults autos loans:
• Management appointed by
  CCP                          • Management
                                 appointed by board
    Effects of the Chinese Market
• Bank of China’s investment of $9.6 billion in US subprime
  investments could equal 18% of shareholder’s equity if it is
• According to Yi Xianrong, a finance expert underlying
  quality of home loans in China was worse than in the US.
  Prices are already off 10% since last fall.
•    China’s demand for commodities has driven prices since
    2000. Problems with Chinese markets and companies will
    have a dramatic effect on demand.
       Sub prime Goes Global
• House price bubbles in Belgium, Britain,
  Denmark, Spain and Sweden, Bank run in
  UK, Spanish real estate companies tank
• Brazil’s 2004 change in its mortgage
  foreclosure law has lead to a 300% increase
  in housing loans
• Many Russian companies and banks
  borrowed heavily on international markets
  are experiencing a credit squeeze.
Asymmetry and Transparency

Borrower ↔ Bank

Borrower → Bank → Investment Bank →
 Hedge fund → Fund of Funds → Consultant
 → Investor
               Risk and Rules
• What you don’t know will hurt you
• What the markets don’t know will hurt everyone
• What markets know depends on the rules
• Without rules, transparency declines, asymmetries
• Do not assume that the risks or all markets are the
• To determine risk, first determine the rules.

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