Onus on investors in Asia to get own house in order

Business Asia, April 5, 1999 by Paul Scully

Many investors have been burned by Asia's emerging markets -- viewed as a constant source of opportunity. PAUL SCULLY(*) says investors deserve some of the blame

Risk should always be taken seriously, but especially so in emerging markets and even more especially in the current environment.

Managing risk does not equate with avoiding risk.

In emerging markets the additional risk a participant takes on is in many ways the source of the extra reward the participant derives.

If you wanted to avoid risk, you simply would not participate in emerging markets.

Emerging markets require participants to manage risk pro-actively in all its dimensions. The emphasis on pro-activity means going in with all your senses finely tuned and having thought through responses to possible occurrences.

Most countries in Asia are generally accepted as emerging markets.

Singapore could be regarded as a post-emerging or even developed market. Japan would probably be regarded as a developed market, but government policies, the degree of market openness and the state of development of some of its institutions might belie this.

Of course, different countries under the emerging label are progressing at different rates.

The state of development of Vietnam, for example, obviously lags countries which embraced the market economy far earlier.

This suggests that it is necessary to look at the factors which might cause a country to be labelled as emerging. Relevant factors include:

* the breadth and depth of markets;

* the nature of the institutions which govern markets;

* the type of policies these institutions pursue;

* the policies of governments;

* the degree of market openness;

* the nature of national and business cultures and their impact on the operation of markets; and

* B socio-economic factors such as growth rates, birth rates, the existence of a middle class and wealth dispersion.

Let me now turn to the dimensions of risk.

Risk can be categorised into:

* political risk -- the stability of the political system;

* market risk -- deriving from the structure of the market and occurrences within the market and in other markets which have an effect on that market;

* institutional risk -- associated with the institutions in the market;

* counter-party risk -- associated with the market participants with which you do business and their ability to see out the terms of the ontract;

* Legal risk -- related to institutional risk and counter-party risk but linked to the legal system and the consequences of breaching the law;

* systemic risk -- associated with payment systems, market transaction settlement practices and the inter-connectedness of market participants (sometimes called knock-on risk; there is a form of settlement risk known as Herstatt risk dealing with cross-border transactions);

* operational risk -- aimed at ensuring the appropriate resources are deployed in managing risk, the adequacy of systems, procedures and training, and a proper understanding of the operational environment;

* model risk -- aimed at ensuring any models used in risk management are appropriate to the environment, data is of sufficient quality and model outputs are interpreted intelligently; and

* the risk of hubris.

The section above on understanding why a market is labelled as emerging feeds directly into the different constituent risks -- for example, market risk and institutional risk.

The past 18 months has taught us a lot about institutional risk in Asia and much of the current debate is about structural reform, code for lessening institutional risk. Likewise for political risk.

Other aspects may also be reasonably clear but the linkage more indirect than direct. Accounting practices may affect the availability and quality of data in assessing risk.

Over the past 18 months we have often seen a ricochet effect in that all emerging markets have sometimes been rated down even though the immediate concerns are with particular regions, thus highlighting higher downside correlation across markets; and the keiretsu and chaebol systems of Japan and Korea maximise inter-connectedness.

Still other aspects may not be clear at all. The current vogue risk-management tool, VAR (value at risk), employs a normal distribution (associated with the familiar bell curve which exemplifies the clustering of probabilities around the average) in the quantification of the probability of an event occurring.

The past 18 months has also provided a salutary lesson on the risk of hubris. Many of us had begun to think that the emerging-market good times would go on forever and had begun to ignore the structural factors and market practices which made the Asian markets particularly vulnerable, undertaking transactions and lifting valuations to levels at which the impact of a market correction would be dire.

Many participants also went over-board in their reactions to what happened, effectively getting it wrong on both swings of the see-saw (thereby realising the risk of overshoot).

To me, this reinforces the view that, while risk is in the eye of the beholder, the management of risk is also in the hands of the beholder. You need to get your own house in order before you hand out lessons to others.