Decision Making for Global Investors Becomes Clearer

Is it a safer investment for an American company to build a new plant in Mexico - or in China?

How much riskier is it to do business in France than it is in Finland?

What’s the biggest obstacle to making a profit in Russia: the high level of corruption, or the low quality of accounting and governance?

Where are you most likely to encounter the most corruption: South Korea, Russia, or Nigeria?

How much more of a return on your investment will you need to justify an investment in Saudi Arabia to offset the risk versus investing in the United States?

Historically, there has been no objective way to answer questions like these. But now, a new tool designed to support the globalization mega-trend provides global executives and investors a way to measure the relative costs of doing business in countries around the world. And, it promises to revolutionize the way business decisions are made and outcomes are measured.

Before we explore this new tool, here are the answers to the questions we presented:

It’s safer to build a new plant in Mexico than it is in China.

It is three times riskier to do business in France than it is Finland.

The biggest obstacle to making a profit in Russia is corruption, followed by a poor legal system, and then by inadequate accounting and governance practices.

However, companies are more likely to encounter corruption in Nigeria than they are in Russia or in South Korea.

To justify an investment in Saudi Arabia, you would need to receive annual returns that are 5.52 percent greater than what you would receive on a comparable investment in the U.S. to offset the risk.

How can we provide such precise answers, and so confidently? Because, for the first time, businesses can rely on the Global Opacity Index to peer into the murky business climate of 48 nations. Opacity refers to the degree to which there is a lack of clear, accurate, easily discernible, and widely accepted practices among businesses, investors, and governments.

The Opacity Index is based on 65 objective variables from 41 sources. These sources include the World Bank, the International Monetary Fund, the International Securities Services Association, the International Country Risk Guide, and the regulators of individual countries.

For example, to answer questions about each country’s accounting practices, questions such as these were explored:

- Does the country require an independent audit by an external auditor?
- Are there annual banking inspections?
- Do the country’s accounting standards comply with international standards?
Comparing a country’s data to various benchmarks and standards around the world suggests whether the finances of companies in that country can be viewed with confidence.

The researchers used these variables to give each country a score on five components of opacity that can be remembered by the acronym CLEAR:

C stands for Corruption in business and government.

L stands for a Legal system that is ineffective.

E is for an Economic policy that isdeleterious.

A is short for Accounting and governance practices that are inadequate.

R stands for Regulatory structures that discourage businesses.

The researchers assigned a score on each of these five components, as well as an overall Opacity Rating, for each of the 48 countries. This allows executives to make comparisons between nations on the level of corruption, for example, or to identify the biggest obstacle to business success in an individual country.

The complete analysis is detailed in “The Global Costs of Opacity,” which appeared in the Fall 2004 Sloan Management Review,1 by Joel Kurtzman, Glenn Yago and Triphon Phumiwasana.

As they explain, these scores allow companies to assess where risks are most prevalent - in the country’s legal system, its economy, its accounting standards, its regulatory policies, or its vulnerability to corruption.

They also compared each country’s Opacity Rating to that of the United States to calculate an Opacity Premium or Discount for doing business in each country as compared to doing business in the U.S.

For decision-making purposes, an opacity risk premium or discount is calculated by taking the numerical difference in the opacity index between the subject country and the United States and multiplying it by 0.2213.

For example, doing business in Japan, which has an Opacity Rating of 28, requires companies to get a return 1.51 percent above the U.S. rate of return in order to offset the risk. Similarly, doing business in Indonesia, which has an Opacity Rating of 59, requires a premium of 8.54 percent to offset the risk. And, if a U.S. investor wants to do business in France, he needs to receive a return 3.53 percent greater than he would earn in the United States to offset the risk.

Among the 48 countries evaluated, the five riskiest to do business in are:

- Indonesia, at a premium of 8.54 %
- Lebanon, at 8.47 %
- Venezuela, at 6.56 %
- The Philippines, at 6.51 %
- China, at 6.49 %

By contrast, if an investor wants to do business in Finland, he could actually receive a smaller rate of return than in the United States and still justify the investment. That’s because Finland is among the five countries that rate higher overall than the U.S. on the Opacity Index. In descending order of attractiveness, these five countries are:

- Finland, at a discount of -1.83 %
- The United Kingdom, at -0.44 %
- Denmark, also at -0.44 %
- Sweden, at -0.31 %
- Hong Kong, at -0.21 %

To test its reliability, the authors also correlated the Opacity Index with various other indicators. Not surprisingly, they found that opacity can discourage foreign direct investment, or FDI, in a country. This, in turn, limits economic growth and development. Similarly, opacity also has a negative and significant impact on FDI as a percentage of GDP. Most foreign direct investments go to countries with relatively transparent financial and economic systems.

According to the World Bank Group’s Doing Business Database, transparency is an important indicator of the cost of starting a business and is the main factor that could enhance or constrain business investment, productivity, and growth.2

For executives at the helm of global companies, as well as investment managers, it will become increasingly essential to take opacity into consideration when making foreign investments. As many companies are finding, there’s no guarantee that a company will make a profit in a country simply because it offers large markets and cheap labor. In those nations where the five “CLEAR factors” point to problems, the risks of doing business may exceed the rewards, and anyone investing there should demand an expected return that includes the appropriate risk premium.

Based on this analysis, we offer the following four forecasts:

First, the countries that increase the transparency of their financial policies and practices will stimulate the creation of new businesses, investments by foreign companies and individuals, and the growth of their economies. This forecast is supported by the research data assembled by Kurtzman and his colleagues. Using regression analysis, they found that opacity is correlated to a high degree with poor financial performance. Specifically, for every one-point increase in the Opacity Index a country can expect a decline of $986 in its gross domestic product per capita; a 1 percent decrease in its net foreign direct investment as a percentage of GDP; a 0.06 percent decrease in its Capital Access Index; and a 57-basis point increase in its average borrowing interest rate. That’s why you can safely expect countries like Russia and Indonesia to continue lagging unless they take extraordinary steps to reduce their opacity.

Second, when this knowledge is factored into companies’ strategic plans, we will see investments in some countries increase, while others will decrease. For example, many U.S. corporations have found the low wages and enormous population of consumers irresistible when considering opportunities for foreign direct investment in China. However, the Opacity Premium for doing business in China is 6.49 percent, meaning that a company has to receive a return six and a half percent greater than it would earn from making the same investment in the U.S. By contrast, Taiwan’s Opacity Premium is only 2.83 percent because there is less corruption, the accounting practices are more reliable, and the regulations are more favorable for foreign-owned businesses. Sobered by poor returns, the Trends editors expect companies to increasingly take off the “rose-colored glasses” when it comes to investing in China. Armed with the Global Opacity Index, they will begin to start redirecting much of the investment that’s been flowing to China. Since China is so heavily dependent on FDI, it will suffer a substantial slowing of growth, unless it remodels itself to emulate the opacity of Hong Kong, which it reclaimed from the British in the mid-‘90s.

Third, global companies will take advantage of the granular insights built into the Opacity Index to make more well-informed decisions benefiting their shareholders. Drilling down further into the Index, senior managers can analyze potential moves with more precision. A country that scores poorly in one factor may be a risky partner for one type of venture, but if it rates highly in another area, it may be a perfect choice for another type of deal. For instance, if managers have a choice of where to locate a regional headquarters, they should choose a country that earns higher legal and economic scores. If they want to build a new plant, they may care more about the corruption subindex. And if they are considering a joint venture with another company, they should look at the legal subindex to find which countries will strictly enforce the joint venture contract.

Fourth, in some cases, companies will not be able to avoid doing business with countries with high Opacity Ratings. Consider Saudi Arabia, with an overall Opacity Premium of 5.52 percent, based on particularly unappealing scores for corruption and regulations. Despite this, Saudi Arabia is “the indispensable nation of oil,” according to a recent analysis in The Economist.3 As that journal reported, “The Saudis not only export more oil than anyone else, but they also have more reserves than anyone else - by a long shot. Fully one-quarter of the world’s proven reserves lie in Saudi Arabia . . . [and] Russia, Nigeria and Alaska put together do not match Saudi reserves.” Thus, when a country controls a large supply of a limited resource, companies and governments have little choice but to pay the Opacity Premium and factor it into the cost of doing business with that country.

References List :
1. MIT Sloan Management Review, Fall 2004, “The Global Costs of Opacity,” by Joel Kurtzman, Glenn Yago, and Triphon Phumiwasana. ⓒ Copyright 2004 by the Massachusetts Institute of Technology. All rights reserved. o The complete article is available from MIT Sloan Management Review. Ask for reprint #46107.2. For information about the “Doing Business Database,” visit the World Bank Groups website at: www.worldbank.org/DoingBusiness3. The Economist, May 27, 2004, “Terrorists Are Now Targeting Saudi Arabias Oil Infrastructure. How Bad Could Things Get?” ⓒ Copyright 2004 by The Economist Group. All rights reserved.