Stock markets in developing countries(l): terminology

This is the first in a series of posts about the characteristics of stock markets in developing countries.  The term “emerging markets” is used very often in casual talk on this topic, but can mean any of several things, referring either to the characteristics of the economies, or of the securities markets in these countries, or of the companies whose stocks are traded in these markets.  These are all different things.

Where the terms come from


During the Cold War conflict between the US and the Soviet Union, commentators began to speak of the First World (the US and its allies), the Second World (the USSR and its allies) and the Third World (unallied nations, many of which were developing countries).

At around the same time, the UN began using a four-part terminology that divided the world’s countries according to wealth/income levels.  For the UN, the First World ends up being the US and its Cold War allies, the Second World is the USSR and its allies, the Third World was everyone else who did not belong to the Fourth World, that is, countries with annual per capita incomes of US$100 or less.  Still, the UN division corresponds very closely to the political division that was the more popular way of speaking during that time.


After the fall of the Berlin Wall, the terms shifted to ones with a more economic, less political, basis:  developed and developing.  The term emerging also came into vogue, meaning countries with rapidly growing economies that are quickly bridging the gap between the developing and developed world.

The term developing quickly became a controversial one, for two reasons.  Many of the countries so designated found the term to be condescending.  Multi-national economic and political agencies pointed out that since this was a catch-all term, it also was also used to describe countries that were stagnating or declining economically and which therefore were in no sense developing.  As a result, these organizations have begun to refer to this set of countries as either less developed countries (LDCs) or least economically developed countries (LEDCs).  They generally correspond to the Fourth World countries mentioned above, but the income threshhold has been raised to around $1000.

Stock markets

Investors have generally taken the political or economic terminology to use for talking about various stock markets outside the developed world.  Today the two terms most popular are emerging, which refer to the largest and longest-standing stock markets and frontier, which refers to the markets in LEDCs.

These distinctions aren’t completely adequate, however.  Emerging or frontier countries can have markets that vary considerably in liquidity conditions, rules of operation and attitude toward foreigners.

This will be one of the topics in later posts in this series.

EU Problems with Greece

The wider problem in the EU


The West German constitution of 1948 gave anyone who can establish German heritage the absolute right to claim German citizenship.  When the Berlin Wall came down in 1989, the Federal Republic was faced with the prospect of making good on that promise for millions of Germans who had been trapped behind the wall.

Thus the merger between the former BRD and DDR.  The terms were more political than economic, and were designed to minimize migration from east to west:  massive financial aid from west to east, and exchange of Öst-marks into D-marks at the rate of one to one (the real exchange rate would have been more like seven or eight to one).

The economic result of the reunion of east and west into one Germany was stagnation for the next ten years.  Since Germany is the largest economy in the EU, money policy was set  to lend support to the struggling giant.

This policy stance had a downside:  it sent massive stimulus into faster-growing countries on the periphery, like Ireland and Spain.  Overabundant money not only spurred overall economic activity and raised wage levels, but it also funneled energy disproportionately into domestic demand activities like residential construction and commercial property development.  In many ways, the peripheral countries experienced a variation of the “Dutch disease,”  with the difference that it was money policy and not a natural resource development that spurred the one-sided development.

The financial crisis

The financial crisis popped the speculative property bubbles that had grown up over years in Ireland and Spain.  It has also focused attention on the way Italy has been abusing its EU membership to fund excessive government borrowing.  So the EU had three problem cases.

Recovery of all three economies will likely be drawn-out affairs.  For Italy the question is one of political will.  For Spain and Ireland, the short-term issue is that export-oriented manufacturing has been supplanted by domestic demand-related businesses, especially those linked directly to housing and commercial construction.     Given that housing and construction aren’t going to be such hot businesses in the next year or two, growth will have to depend on export-oriented activities.

The outlook there?  Looking within the EU, Germany has a labor cost advantage and is a net exporter, in any event.  Outside the EU, the competition is China.  Spain and Ireland will gradually return to health, but the emphasis in that thought should probably be on gradually.

And then there’s Greece

Greece is the weakest link in the EU.  As best we know, the country has debt equal to 110% of GDP and a budget deficit of 12.7% of GDP.  These are really bad numbers.  Why the “as best we know” qualification?  Greece had an election late last year that produced a change in the ruling party. The new government discovered and announced that the prior administration had been falsifying the national accounts for years. Who knows whether the accounts we now have are correct or complete?

We know, qualitatively at least, that Greece is the Ireland/Spain problem on steroids, but with a gigantic government sector (over half of GDP) and rigid product and labor markets thrown in.  There’s also a bit of the Italy question mixed in–does a country that cooks the government books so it can act imprudently a while longer have the political will to do the heavy restructuring needed to restore fiscal and trade balance?

Recent developments

Rating services have downgraded Greece to a level below which the country would effectively be barred from issuing euro-denominated debt.

The euro has dropped several percent against other currencies on the worry that Greece will not be able to fix its own problems and will have to be rescued by the rest of the EU.

Speculation has also begun that Greece will seek to leave the EU instead, so that it can devalue its currency and thereby get some quick relief from its economic woes.

Finally, some have extended the thought that Greece will flee the EU to wonder if, say, Italy might not be next on the list of defectors.

My thoughts

None of the “easy” solutions for Greece are likely to bring any resolution to the crisis.  The EU is unlikely to bail Greece out, for fear this would send a signal to, say, Italy that its borrowing can go on unchecked and will ultimately be repaid by more responsible EU members.  Bailout also couldn’t occur, I think, before the EU welded itself into a more cohesive political/economic whole, something member countries and their citizens have shown themselves, in voting on the proposed EU charter, loathe to do.

Leaving the EU would not come without difficult consequences.  Would Greece accept responsibility for its euro-denominated government debt, even though a presumably immediate and large depreciation of the currency would make the burden that much heavier?  or would it default on its obligations and lose access to world credit markets?

“Muddle through,” the current watchword for the US and the UK, will likely become the EU strategy for Greece.  There may be some covert help from stronger EU members or from the EU as a whole.  But the key question will be the level of Greek resolve to set out on the difficult road to economic healing.  We won’t know the answer for several years, I suspect.

Another problem the world didn’t need.

The Mets and the 4Bs–Beltran, Bay, Bengie (Molina) and Bernie (Madoff)

The analyst’s disease is that you can’t stop analyzing, whether it has to do with the stock market or not.

I’ve been struck by what I think is peculiar behavior by the Mets over recent months.

1.  All-Star centerfielder Carlos Beltran just had arthroscopic knee surgery that will likely keep him from playing during the first month of the upcoming season.  The Mets are reportedly upset enough about this, even though Beltran says the Mets gave permission for the operation, to have sent him a letter that would be the first step toward voiding his contract.

Yes, not having Beltran in center field on opening day lessens the chance that the Mets will get off to a good start–and thereby help to fill the (very expensive) seats in their new home, Citi Field.  But Carlos is a superb outfielder.  He plays hard and has played hurt.  What good does it do the Mets to make their displeasure public, other than to embarrass Beltran?  Is the fast start really so important to the Mets that they’ll risk alienating one of their best players?

2. During this offseason, the Mets signed a strong-hitting free agent outfielder, Jason Bay.  Yes, this is great–especially so if the Peter Gammons report that the Red Sox, his former employer, were worried about his long-term health proves incorrect.  But where’s the pitching?

3.  Bengie Molina has just reportedly turned down the Mets offer that had $1 million more in guaranteed money than the one he signed to play for San Francisco this season.

4.  This brings us to the fourth B, Bernie Madoff, a long-time friend of the Mets’ owners, the Wilpon family, and–until his Ponzi scheme was uncovered–holder of season tickets right behind home plate.  Madoff added insult to injury for his victims by commenting after his arrest that he only accepted as clients people he considered not financially astute enough to recognize the implausibility of achieving the financial results he claimed.

There’s no evidence to connect a suddenly more frugal Mets organization to losses they may have suffered from investing with Madoff.  What we do know is this:

1.  The list of 10,000 or so Madoff victims contains over 400 entries for the Wilpon family and about a dozen for the Mets.

2.  Financial journalist Erin Arvedlund, author of a recent book about Madoff, claims the Wilpon family lost as much as $700 million in the Madoff Ponzi scheme, an assertion the Wilpon family strongly denies.

3.  CNBC has reported that the Wilpon/Mets loss could be as high as $300 million.

4.  The court-appointed trustee tasked with recovering Madoff investors’ assets says that two Mets accounts withdrew $47.8 million more than they originally invested.  This isn’t necessarily as good as it sounds, since the trustee may seek to force the Mets to give back the money, since it isn’t investing profit but rather money others deposited with Madoff.

Let’s try to take a rough guess at the Mets’ revenue and expenses (I’ve read or heard some of the numbers.  Others I’m making what I consider reasonable guesses, but they need to be refined with more research.  But I think they’re at least directionally correct.)

Ticket sales for 2009 were reported to be about $115 million.   The club has cut ticket prices by about 10% and season two at Citi Field may draw fewer fans coming just to see the new stadium.  So let’s put 2010 ticket sales at $100 million.  Add $20 million from Citigroup for naming rights and $15 million for profit from food, parking and team merchandise, net of related expenses and stadium operating costs.  Figure that SNY cable TV generates $40 million.   Total:  $175 million.

Let’s take the Mets bill for players’ salary for 2009 as being $150 million.  Add to that $40 million for what amounts to stadium debt service expense and another $10 million for coaching, the minor league system plus administration.   Total:  $200 million.

If these numbers are roughly correct, a $150 million player payroll seems to imply a $25 million loss for the Mets this year, even figuring in cable revenue.  Without that, the loss would be $60 million.

I may be missing some important source of revenue, but if I’m not, the Mets would be in trouble whether it incurred Madoff losses or not.  Madoff losses would only make the problem more pressing, by removing–from either the Madoffs personally or the Mets corporately, or both–a savings cushion that could postpone dealing with the cash shortfall.

In addition, if any money the Mets put aside for deferred payments to players was lost to Madoff, the team’s immediate problem may not be worsened but its long-term financial situation would be.

Transfer pricing–what you need to know about it

What it is

In all but the simplest companies, it often happens that one unit of the firm provides a good or service to another unit, which uses it in a product it sells to the outside world.  In some cases, unit #1 has no customer other than unit #2; likewise, unite #2 may have no other source than the internal one, unit #1.

For management control purposes–figuring out whether the units are earning money or doing a good job in other ways, as well as for other reasons I’ll write about below, companies want to decide a notional price at which unit #1 “sells” its output to unit #1.  That selling price is called the transfer price. The process of figuring out what the price is is transfer pricing.

Three ways companies use transfer pricing–

Management control:

There are lots of ways of figuring out the transfer price, all with their plusses and minuses.

The process can be complicated.  Unit #1, for example, may have external customers as well as internal ones.  Unit #2 may have external sources of supply in addition to the internal one.  However, internal and external customers may have somewhat different requirements, so products available on the open market may not be strictly comparable to the internally produced ones.  So market price may be hard to use.  The competitive situation within an industry may also argue against selling to or buying from certain external parties.  In addition, cost-plus, another common method, may just institutionalize inefficiency.

The process can also be intensely office-political.  This stands to reason, since a dollar of notional profit that goes into the bonus pool of unit #1 is a dollar that stays out of the bonus pool of unit #2, and vice versa.  In well-managed companies, everyone is slightly unhappy and things work out for the best.  In poorly-run firms, internal pricing may reflect the delusions of the chairman or testifies to the infighting skills of the most “profitable” units–an creates horrible distortions that end in ruin.

Tax planning:

Except for the smallest and simplest companies, there’s no reason that different units in the firm have to be in the same tax jurisdiction.  In fact, there may be very good reasons to have them located in different states or different countries.

When I began investing in the Japanese stock market, I soon came across lists of the financial results of foreign brokers located in Tokyo.  Virtually every one was making huge losses.  As I asked around to try to figure out why this should be, I found out that many trading transactions were legally structured to occur in Hong Kong instead of Japan.  Why?  The total tax on profits for a transaction done in Tokyo would be over 50%.  In Hong Kong, the tax would be zero. So Tokyo had the costs of maintaining research, sales, a trading desk and investment banking–and the trades were farmed out to Hong Kong.

At one time, many computer manufacturing operations were set up in Ireland, which offered tax incentives, had a low income tax rate and was inside the EU.  Let’s say you make a PC in Ireland and ship it to the UK (a high tax-rate regime) for sale to a consumer electronics store.  Should you set the transfer price from manufacturing subsidiary to distribution subsidiary high or low?  Obviously, high–unless you had tax loss carryforwards in the UK that you wanted to use up.

You can see the effects of this sort of activity in the low tax rate reported by publicly traded companies with extensive foreign operations.

Twenty years or more ago, investors didn’t like low tax rates.  Theorizing that the phenomenon was only temporary, the custom in the UK was for analysts in their reports to explicitly correct or “normalize” the tax rate to whatever the (higher) norm was for a purely domestic company.  In the US, investors mostly made a mental adjustment and paid a correspondingly low p/e for the stocks of low tax-rate companies.

Today as far as I can see, no one makes this distinction.

There is one hitch to the low tax rate strategy.  For the US, and also typically elsewhere, if the profits held in a low tax-rate regime are repatriated to the home country, they are subject to tax at the full home-country corporate rate.  And unless repatriated, the funds can’t be used to pay dividends.

Foreign exchange controls:

Some countries, developing nations in particular, may regard their holdings of hard foreign currency as a scarce national resource.  So they restrict companies’ ability to convert local currency profits into foreign currency and send them out of the country.

The most straightforward of the ways creative companies try to get around such policies is through transfer pricing.  A foreign company with a subsidiary in a developing economy will typically act as the sole agent for purchases of foreign materials and equipment for its sub, as well as being the distributor of its finished goods abroad.  The parent can aggressively mark up the foreign currency price of the materials supplied to the domestic company.  And the local sub will sell finished goods at very low prices to the parent, so that the lion’s share of profits will be realized in hard currency and outside the developing nation.