Chinese Walls in Emerging Markets

Analysts in the investment banking industry are once again feeling the heat.

An August 2007 study by a group of American academics, widely reported in the press from the Economist to the Financial Times, concluded that about two-thirds of Wall Street analysts receive professional favors from corporate executives to ensure benign outlooks on their companies.

The study, from James Westphal from the University of Michigan and Michael Clement from the University of Texas, is not the first of its kind experiencing such conflicts of interest. Information asymmetries and other market failures have always plagued financial markets — be they equity or fixed income.

The study, as those before it, is based on a wealth of empirical data: In this case a survey of 1,800 financial analysts and hundreds of chief executives between 2001 and 2003.

The results show 63% of analysts receives favors from CEOs, CFOs and other corporate leaders. The average is of three favors per person over periods stretching from a month to a year.

The particular relevance of this study lies in the fact that it was conducted after Wall Street took measures to curb conflicts of interest between analysts and bankers in investment banks — supposed to strengthen the (in)famous Chinese walls.

Such investigations are not infrequent in developed financial markets, particularly in U.S. equity and fixed-income markets. Curiously, however, they are much less common in emerging markets, where one would expect such conflicts of interests and market failures to be perhaps even rifer — as market competition is also narrower and information more scarce.

Granted, we are a long way from those days in the 19th century when speculators could simply dream up a country lost in the heart of the Americas, a financial El Dorado such as that imagined by the Scots adventurer and prankster Gregor MacGregor.

This "discoverer" of the imaginary Republic of Poyais, upon discovery of his deception, precipitated the first modern emerging markets crisis in the City of London during the 1820s. The bonds he had issued on behalf of his imaginary land crashed to earth — bringing down with them the financial markets of the time.

The repeat of such a story is hardly imaginable nowadays. However, lack of information is not remote history in emerging markets. A Harvard Business School study, from 2000, showed on average 13 analysts covering a same company, against up to 30 in OECD countries like the United States or Germany.

Mexico and Brazil — with 18 and 16 analysts respectively — were the Latin American countries with the most extensive equity analyst coverage. Other emerging markets found themselves with much more restricted coverage.

Colombia, for instance, only had on average three analysts covering the same company, Peru eight, Chile five — and Venezuela a paltry two. Furthermore, most of the remaining countries of the region didn't have a single analyst to cover their companies.

Error dispersion is also much higher in emerging markets, reaching on average between 40% and 60% in countries such as China, Mexico or Argentina, far higher than the total (19%) or U.S. (2%) average.

In a more recent study at the OECD Development Centre, we underlined the considerable variance in the coverage of sovereign fixed-income markets by investment bank analysts.

In fact, we found that the main Wall Street and City (London-based) investment banks extend full regular coverage to a meager thirty-five emerging countries of the developing world. Basically, they are the ones that appeared in the dominant index of sovereign fixed income markets, the Emerging Bond Market Index of JP Morgan.

That is to say that 120 countries in the developing world quite simply do not exist for financial analysts or have hardly any coverage.

In Latin America, just ten emerging countries benefit from systematic and regular coverage from all investment banks — among them Argentina, Brazil, Mexico, Columbia, Peru and Venezuela.

A legacy of the very active debt markets of the region, Latin America is the emerging region with the most extensive coverage. Other regions and countries fare less well, finding themselves covered by barely half of investment banks in the survey.

Of all developing regions, Africa is by far the least covered, with only six countries occasionally cropping up in research publications. And entire regions, such as Central Asia or Central America, practically do not register on the analyst's investment banks radar.

The outcomes of country coverage are even more revealing, including for those emerging countries enjoying intensive analyst attention.

Drawing on 3,500 analyst recommendations from the ten principal investment banks in Latin American fixed-income markets between 1997 and 2007, we found a surprisingly strong correlation was uncovered between sovereign recommendations and the extent of the banks' business in a country.

Ninety percent of banks emitted buy or hold recommendations when the bonds being issued were from countries in which they held strong business interests.

This held particularly true in cases where the bank making the recommendation was also responsible for launching (i.e., underwriting) those same bonds on international markets — and placing them with investment funds.

Even though the Chinese walls may still be standing, independent research has shown that their ramparts are not the sturdiest, nor their defenders the hardiest.

In this respect, emerging markets are following the dubious lead of their more developed brethren — where transparency and lack of information is also an issue, as painfully underscored by the recent U.S. subprime crisis and its collateral damages.