At the beginning of 2002, Enron was the seventh largest company in the United States, with operations extending worldwide. Telecommunications giant Global Crossing operated in 27 countries and 200 cities on five continents. But both fell last year under the weight of financial problems created by the self-dealing of a few corporate insiders and masked by nontransparent accounting. These and other similar corporate failures deprived millions of company employees and shareholders of their lifetime savings and retirement benefits. Stock prices of other U.S. companies also took a beating, partly in response to the revelation of these scandals.
Since January 2002, all major U.S. stock indexes have plummeted. NASDAQ fell almost a third in 2002, and the Dow and S&P 500 tumbled for the third consecutive year, the longest downturn since 1939-41. Foreign markets have also been hit with big losses. Japan's Nikkei 225 closed down 18.6 percent for the year; Britain's FTSE 100, down 24.5 percent.
Of course, the burst of the dot-com bubble, the uncertainty about a war in the Middle East, and a possible rise in oil prices may all have contributed to the stock price decline. It is only natural, however, to suspect that "Enronitis"—opaque self-dealing by a few insiders—has also contributed to this meltdown of the financial markets around the world. In this article, we provide some evidence to substantiate the suspicion.
Roller Coaster Rides
Enronitis has many symptoms. Here we discuss two. One is insider trading—the buying and selling of stock by people who possess nonpublic information relevant to its price. As recent work by Julan Du of the Chinese University and one of the authors (Wei) has shown, insider trading can affect stock prices—and even more important, economic performance—around the world.
Stock markets are volatile. That is not news. But volatility varies greatly from one country to the next. Measured by the standard deviation of the monthly returns of a major market index, stock market volatility is almost twice as high in Italy as it is in the United States. Markets in developing countries are typically even more volatile. The Chinese market is three and a half times more volatile than the U.S. market; the Russian market, six and a half times more volatile.
Excessive volatility matters because it affects people's incentive to save and to invest. In almost any economic model with a representative investor, the more volatile the asset market, holding the average return constant, the less the investor will save and hence invest. A certain degree of market volatility is unavoidable, even desirable. Ideally, changing stock prices signal changing values across economic activities and thereby improve the way resources are allocated. But volatility that is unrelated to market fundamentals results in confusing signals that hamper resource allocation. To the degree that insider trading affects the volatility of a country's stock market, it could thus also affect that country's economic performance.
Some analysts think that because insider trading allows relevant information to be reflected in the stock price faster than it otherwise would be, it should reduce market volatility and improve economic efficiency. That view, however, fails to take into account the ability of insiders to take actions to maximize personal benefits. Access to inside information is most valuable when prices are either rising or falling dramatically. So people in the position to possess inside information love market volatility, and they realize that their actions can increase volatility—through two channels. First, if insiders have a choice of projects or technologies, they may choose the riskier ones. Second, even holding the risk of the technology or project constant, insiders have an incentive to manipulate the timing and content of the information release in a way to maximize volatility.
National laws and enforcement regarding insider trading differ widely around the world. The set of activities defined as illegal can vary, as can the penalties and the diligence with which laws are enforced and lawbreaking punished. In the United States, for example, insider trading is a criminal offense with penalties including jail terms. In Hong Kong insider trading is a civil violation whose maximum penalty is a fine. But Hong Kong compensates for that light penalty with tight antifraud regulation and relatively rigorous and predictable law enforcement. Government regulators are well trained, professional, and relatively incorrupt. Despite the light penalty, corporate insiders in Hong Kong would think twice before releasing misleading information or committing financial fraud.
As insider trading is an opaque practice, difficult to measure and compare across countries in a precise way, few economists have studied it empirically. Recently, a new measure of insider trading was established in a survey of business executives by Harvard University and the World Economic Forum. Using this measure, Du and Wei have shown that more insider trading is related to a higher market volatility. Statistical analysis of the data in table 1 reveals that a rise in insider trading from a relatively low level, such as that in the United States (2.62 on a scale from 1 to 7), to a relatively high level, such as that in China (4.62), would increase the volatility of stock returns by 2.5 percentage points (that is, stock volatility would go up from 4 percent to 6.5 percent)—a sizable increase. In comparison, the difference in the volatility of GDP growth rates for the United States and China increases Chinese stock volatility by only 1 percentage point. In other words, China's higher stock market volatility is explained more by excessive insider trading than by the higher volatility of its economic fundamentals.
Correlation, of course, does not necessarily imply causality. But further statistical analysis by Du and Wei shows that the link between insider trading and market volatility most likely is causal—that is, an increase in insider trading leads to a rise in stock market volatility. And insider trading is associated with a higher market volatility even after other possible causes of market volatility—the volatility of the real output growth, volatility of monetary and fiscal policies, and maturity of the stock market—are taken into account.
The clear lesson here is that to rebuild confidence in their financial markets—and to encourage saving and investment by their citizens—countries with a high degree of insider trading must strengthen their regulation of insider trading and enforce existing regulations more rigorously.
Lack of Transparency
Another symptom of Enronitis is a lack of transparency in corporate and government operations. The recent wave of corporate scandals in the United States has thrown open some corporate curtains to reveal numerous once-secret activities. But many countries the world over have even more serious deficiencies in transparency—not only in their corporations but in their governments—that have retarded their ability to attract international portfolio investment, as research by Gaston Gelos of the International Monetary Fund and one of us (Wei) has shown.
In fact, policymakers often cite lack of transparency as one cause of the financial crises in emerging markets in Asia and Latin America over the past decade. A recent IMF report, for example, noted that a "lack of transparency was a feature of the buildup to the Mexican crisis of 1994-95 and of the emerging market crises of 1997-98." The report concluded that "inadequate economic data, hidden weaknesses in financial systems, and a lack of clarity about government policies and policy formulation contributed to a loss of confidence that ultimately threatened to undermine global stability." The international financial institutions have actively promoted more transparency among their member countries and are also aiming for more transparency in their own operations.
We use the term "transparency" to denote both availability and quality of information at the country level. In government, transparency refers not only to the availability (both timeliness and frequency) of macroeconomic data but also to the conduct of macroeconomic policies. Corporate transparency refers to the availability of financial and other business information about firms.
In principle, for investment across countries, just as for investment across corporations within a country, greater transparency levels the playing field for all investors, increasing their collective confidence and thus encouraging investment. Most technical studies, however, have not demonstrated rigorously this intuitive insight.
To be able to say whether international mutual funds invest less in less transparent countries, one needs to know how much these funds would have invested in various countries had all the countries been the same on the transparency dimension. A useful benchmark is the index produced by Morgan Stanley Capital International, which essentially documents the share of a country's stock market assets in the world stock market.
Table 2 shows measures of opacity—the opposite of transparency—for both government and corporate operations for 15 emerging market countries. (A higher rating is associated with more opacity.) Statistical analysis of the data in the table suggests that a lack of transparency, using any measure, is associated with less investment by international mutual funds. A country like Venezuela, for example, would quadruple its portfolio holdings if it increased its transparency to Singapore's level. The prospect of such an increase in portfolio holdings should strongly encourage countries to undertake reform to improve transparency.
Aside from the level of investment, trading patterns by foreign investors would affect the volatility of the market. At least since the Asian financial crisis, analysts have seen "herding"—international investors' tendency to mimic each other's behavior, sometimes ignoring useful information—as one contributor to market volatility in developing countries. Although in economic theory the relationship between transparency and herding is not clear-cut, our research has uncovered evidence of a positive association between a country's lack of transparency and international investors' tendency to herd when investing in its assets. Thus, if herding by international investors raises volatility or causes more frequent financial crises in emerging markets, it is related to these countries' transparency features.
Another key question is whether capital flight during a time of currency and financial crisis is related to lack of transparency. Do differences in transparency, above and beyond macroeconomic indicators of a country's economic health, explain why some countries suffer greater confidence loss than others during turbulent times?
The Gelos-Wei research suggests that more opaque countries do suffer larger outflows during crises. During the Asian and Russian crises, capital exodus was greater in less transparent countries. So, in a concrete sense, lack of transparency worsens the crises in some countries.
Wanted: Fair Play
It is not easy to restore confidence in financial markets where fraudulent and illegal practices within corporations have run rampant and where a government's operations are not transparently accountable to its citizens. And it will not happen overnight. Even the United States, once the world's unquestioned leader in attracting international funds, cannot bounce back immediately. More than a year after the onset of the 2002 corporate scandals Wall Street is still trying to regain its preeminence in the financial world—and to regain the trust of its many disillusioned investors, both at home and abroad.
In the United States, both individuals and the government have made efforts to restore the credibility of the market and assure the public that the nation is serious about eliminating foul play within corporations. Shortly after the Enron scandal became public, policymakers proposed many initiatives to improve monitoring practices within corporations. Congress has passed legislation designed to eliminate fraudulent behavior in corporations through more careful supervision and the release of greater information to investors. The Securities and Exchange Commission has renewed its efforts to reform existing regulations and create new ones.
The United States is not alone in sensing the need for corporate governance reform. The financial crises of the 1990s spurred such reforms throughout Asia and Latin America. Corporate and government opacity is a major issue in many countries in Latin America, largely owing to the prominence of family-owned companies and the extent of government intervention. Legislation that was passed recently in Chile to increase protection and give more rights to minority shareholders can serve as an example for other countries in the region.
In Asia, a minority shareholders' movement launched in Korea in 1998 has raised awareness of the importance of corporate governance. The shareholders' movement has also created a research center to investigate corporate misbehavior.
China's government has resisted making immediate national reforms, preferring instead to set up a special governance zone (SGZ) in Shenzhen to experiment with anticorruption reforms. A successful reform program in Shenzhen can serve as a model for the rest of the country, but the significance of the experiment goes beyond that. Antireform bureaucrats in China often resist international best practices by claiming to have "a different culture," "a different history," or "a different tradition." Once anticorruption reform succeeds in one SGZ, reform-resistant officials will have fewer excuses for refusing to push for reform. Successful anticorruption reform will also help galvanize popular demand for larger-scale administrative reform in China.
Alongside these individual country efforts, the International Monetary Fund, the World Bank, and other international institutions have become more aggressive in assessing the adequacy of existing standards and codes of financial supervision and the conduct of fiscal and monetary policies in their member countries. They have also become more insistent in advocating the international best practices in these areas.
None of the reforms so far can claim complete success; perhaps they never will. But the revelations of corporate scandal in the United States and the financial crises in the developing countries have persuaded many people around the world that Enronitis, in its various guises, can seriously damage people's confidence in a financial system and slow economic development. If one positive thing has come out of the Enronitis epidemic, it is the reinvigorated reform effort worldwide to reduce the chance of a future economic devastation resulting from poor public and corporate governance.