IBM/U2 Topic 6 Liberalization and Unification of World Economics
When a nation becomes liberalized, the economic effects can be profound for the country and for investors. Economic liberalization refers to a country “opening up” to the rest of the world with regards to trade, regulations, taxation and other areas that generally affect business in the country. As a general rule, you can determine to what degree a country is liberalized economically by how easy it is to invest and do business in the country. All developed (first world) countries have already gone through this liberalization process, so the focus in this article is more on the developing and emerging countries.
Removing Barriers to International Investing
Investing in emerging market countries can sometimes be an impossible task if the country you’re investing in has several barriers to entry. These barriers can include tax laws, foreign investment restrictions, legal issues and accounting regulations, all of which make it difficult or impossible to gain access to the country. The economic liberalization process begins by relaxing these barriers and relinquishing some control over the direction of the economy to the private sector. This often involves some form of deregulation and privatization of companies.
Unrestricted Flow of Capital
The primary goals of economic liberalization are the free flow of capital between nations and the efficient allocation of resources and competitive advantages. This is usually done by reducing protectionist policies such as tariffs, trade laws and other trade barriers. One of the main effects of this increased flow of capital into the country is it makes it cheaper for companies to access capital from investors. A lower cost of capital allows companies to undertake profitable projects they may not have been able to with a higher cost of capital pre-liberalization, leading to higher growth rates.
We saw this type of growth scenario unfold in China in the late 1970s as the Chinese government set on a path of significant economic reform. With a massive amount of resources (both human and natural), they believed the country was not growing and prospering to its full potential. Thus, to try to spark faster economic growth, China began major economic reforms that included encouraging private ownership of businesses and property, relaxing international trade and foreign investment restrictions, and relaxing state control over many aspects of the economy. Subsequently, over the next several decades, China averaged a phenomenal real GDP growth rate of over 10%.
Stock Market Performance
In general, when a country becomes liberalized, stock market values also rise. Fund managers and investors are always on the lookout for new opportunities for profit, so a whole country that becomes available to be invested in tends to cause a surge of capital to flow in. The situation is similar in nature to the anticipation and flow of money into an initial public offering (IPO). A private company previously unavailable to investors that suddenly becomes available typically causes a similar valuation and cash flow pattern. However, like an IPO, the initial enthusiasm also eventually dies down and returns become more normal and more in line with fundamentals.
Political Risks Reduced
In addition, liberalization reduces the political risk to investors. For the government to continue to attract more foreign investment, other areas beyond the ones mentioned earlier have to be strengthened as well. These are areas that support and foster a willingness to do business in the country, such as a strong legal foundation to settle disputes, fair and enforceable contract laws, property laws, and others that allow businesses and investors to operate with confidence. Also, government bureaucracy is a common target area to be streamlined and improved in the liberalization process. All these changes together lower the political risk for investors, and this lower level of risk is also part of the reason the stock market in the liberalized country rises once the barriers are gone. (For related reading, see: What risks do organizations face when engaging in international finance activities?)
Diversification for Investors
Investors can also benefit by being able to invest a portion of their portfolio into a diversifying asset class. In general, the correlation between developed countries such as the United States and undeveloped or emerging countries is relatively low. Although the overall risk of the emerging country by itself may be higher than average, adding a low correlation asset to your portfolio can reduce your portfolio’s overall risk profile. (For more, see: Does Investing Internationally Really Offer Diversification?)
However, a distinction should be made that although the correlation may be low, when a country becomes liberalized, the correlation may actually rise over time. This happens because the country becomes more integrated with the rest of the world and becomes more sensitive to events that happen outside the country. A high degree of integration can also lead to increased contagion risk, which is the risk that crises occurring in different countries cause crises in the domestic country.
A prime example of this is the European Union (EU) and its unprecedented economic and political union. The countries in the EU are so integrated with regard to monetary policy and laws that a crisis in one country has a high probability of spreading to other countries. This is exactly what happened in the financial crisis that started in 2008-2009. Weaker countries within the EU (such as Greece) began to develop severe financial problems that quickly spread to other EU members. In this instance, investing in several different EU member countries would not have provided much of a diversification benefit as the high level of economic integration among the EU members had increased correlations and contagion risks for the investor.