INSTITUTIONS

Korea Rapidly Developing Country

1962

1964

1966

1968

1970

1972

1974

1976

1978

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

2006

2008

2010

2012

0.00%

10.00%

20.00%

30.00%

40.00%

50.00%

60.00%

70.00%

Korea GNI (as a percentage of High Income)

0.00%

10.00%

20.00%

30.00%

40.00%

Orientation of Korean Economy% of GDP, 2012

UN National Accounts Database

Technologically Advanced    Patents USPTO

JAPAN   954917

GERMANY   375692

UNITED KINGDOM   152366

FRANCE   140724

KOREA, SOUTH   118443

TAIWAN   116025

CANADA   110164

SWITZERLAND   62929

ITALY   55994

SWEDEN   49087

NETHERLANDS   46949

AUSTRALIA   28519

ISRAEL   27495

Definition of Emerging Markets• Emerging markets are often distinguished from

developing economies by level of income or growth potential.

• Emerging markets also distinguished by degree to which market failures are currently being overcome.

• Market failure: Barriers which prevent people and companies from meeting to exchange goods and services.

Korean economy dominated by Chaebol’s• Why does an electronics company sell insurance?•Why does a car company sell parts to itself and build ships on the side?•Why does a chemical maker sell household appliances?•Why does a telecom company produce electronics and drill for oil?

Neoclassical Economics

• Gains from trade is the source of wealth and foundation of innovation.

• Neoclassical Theory: Competitive markets implement exchanges that create the maximum total value for society (buyers +sellers combined).

S

D

New Institutional Economics• Exchange and markets are the source of wealth and efficiency

But…• Neo-classicals assume

• Costless trade• Full information sharing between buyers and sellers• Buyers and sellers always willing to live up to their bargain• Full internalization of costs and benefits• Clear ownership of goods and means of production• Costless information processing• Free entry into markets

And…

• Basis for efficient markets does not arise in a vacuum.

Institutional Framework• “Institutions are the humanly devised constraints that structure political, economic and social interaction.” Douglas North

Good Institutions Create Incentives for Efficiencies by

Reducing Uncertainty about Property Rights &

Minimizing Transactions Costs

Institutional Economics: Transactions Costs

•As economy develops, products become more diverse and sophisticated.

•Transactions become more complicated.

•Transactions costs become a bigger part of the economy.

Good institutions reduce information asymmetry.

• Transactions costs can arise from asymmetric levels of information. Asymmetric information leads to adverse selection.

• Adverse selection: proliferation of bad products or untrustworthy sellers rives out good products and sellers leading to a worse marketplace and potentially market closure.

• Repeated transactions can reduce effects asymmetric information but limit flexibility. Clientization increases monopoly power.

Lemons Problem• Market consists of good sellers and bad sellers• Buyer cannot distinguish between and good and bad so

pays a discount price. • If price is not sufficient to cover the value of good

products, good sellers drop out of the market worsening the product mix (adverse selection)

• If the likelihood of buying a bad product becomes sufficiently high, buyers may give up and the market disappears

Vietnam Contracts• Transition economy legalized private firms but court

efficiency was poor. Contract enforcement was non-functional for Vietnamese firms through 1990’s.

• Study: Vietnamese entrepreneurs must rely on non-court mechanisms. Preferred mechanisms include long-term (business and social) relationships, personal monitoring and reputational ostracism,

• Lack of arms-length trade limited the ability to scale businesses.

• Written contracts were most likely for long-distance trade and single-customer firms.

Link

Strategies for dealing with Information Asymmetry

Transition Vietnam Problem

Information Gathering

Personal ObservationReputation Sanctions Limited Use

Limit Scale

Repeated Transactions

Personal Relationships Limit ScaleSubject to Market Power

Contracts Long Distance TradeSingle Client Firrm

Costly

• International Finance Corporation uses micro level evidence to assess the ease of doing business along two dimensions

1. Strength of legal institutions relevant to business regulation

2. indicators relating to the complexity and cost of regulatory processes

http://www.doingbusiness.org/

Williamson: Private Orderings over Public Orderings Link• All contracts are necessarily incomplete making

verification of fulfilment of terms difficult for outsiders. Thus all contract enforcement by courts must be costly.

• Transactional contracts will typically be self-enforcing and set up to be mutually beneficial within the technological and cost constraints.

• Advanced countries differ from emerging markets in terms of a) necessary complexity of transactions; b) array of private institutions that can monitor and implement contracts.

Filling Institutional Gaps in Developed Markets

Product Markets Consumer federations, credit card transactions, retail stores, information agencies, logistics firms, shipping, insurance, trade associations.

Labor Markets Educational institutions, personnel agencies

Capital Markets Financial intermediaries, securities exchanges , ratings agencies, accounting standards, independent auditors

Variety of Intermediaries important in reducing information asymmetries and transactions costs

Global Competitiveness Report

Low income Lower middle income

Upper middle income

High income: OECD

High income: nonOECD

2.5

3

3.5

4

4.5

5

Global Competitiveness Report

Efficiency of legal framework in settling disputes, 1-7 (best)

Trade and Institutional Development

Evolution of Transactions Supporting Long Distance Trade

1. Interest paying debt contracts

2. Bills of Exchange

3. Accounting Standards

4. Price lists and manuals of weight standardization

5. Insurance

Evolution of Enforcement

• Development of codes of merchant law in Italy .

• Acceptance by guilds in other European cities.

• Implementation by civil authorities especially in Amsterdam

Mutually Reinforcing

Make rules enforcible

Encourage Innovation

Douglass North: Institutions and Development

• History of successful development is a reinforcing cycle of better institutions leading to richer markets and better markets supporting institutional improvement.

• Catalyst was long-distance trade.• Long distance trade required “complex of institutions, organizations, and instruments” including “the development of standardized weights and measures, units of account, a medium of exchange, notaries, consuls, merchant law courts, and enclaves of foreign merchants protected by foreign princes in return for revenue. “

The Global Competitiveness Index 2012-2013 data platform

Link

Property Rights• Cycle of market development and institutional

improvement requires long-term investment.• Long-term investment requires security of property both

from private actors and from government.

Insecurity & Business Constraints Link

Korea, Rep. India Thailand Cambodia Malaysia Pakistan Indonesia Lao PDR Mongolia Philippines Vietnam0

10

20

30

40

50

60

70

Insecurity

Percent of firms identifying corruption as a major constraint

Percent of firms identifying crime, theft and disorder as a major constraint

Percent of firms identifying business licensing and permits as a major constraint

Tragedy of the Commons, Garret Hardin 1969• The tragedy of the commons develops in this way.. the inherent logic of the

commons remorselessly generates tragedy.

As a rational being, each herdsman seeks to maximize his gain. Explicitly or implicitly, more or less consciously, he asks, "What is the utility to me of adding one more animal to my herd?" This utility has one negative and one positive component.

1. The positive component is a function of the increment of one animal. Since the herdsman receives all the proceeds from the sale of the additional animal, the positive utility is nearly +1.

2. The negative component is a function of the additional overgrazing created by one more animal. Since, however, the effects of overgrazing are shared by all the herdsmen, the negative utility for any particular decision-making herdsman is only a fraction of -1.

Adding together the component partial utilities, the rational herdsman concludes that the only sensible course for him to pursue is to add another animal to his herd. And another; and another... But this is the conclusion reached by each and every rational herdsman sharing a commons. Therein is the tragedy. Each man is locked into a system that compels him to increase his herd without limit--in a world that is limited. Ruin is the destination toward which all men rush, each pursuing his own best interest in a society that believes in the freedom of the commons. Freedom in a commons brings ruin to all.

Coase Theorem: Property Rights and Externalities• Nobel prize winner Ronald Coase argues allocation of

property rights can solve externalities.• Example: Train shoots out sparks that cause damage to

nearby farmer’s fields. If railroads don’t bear the costs of actions they will lay too much track relative to their societal benefit.

• Solution: Farmers own rights to not have their crops burned. They can license the railroads to go through for a fee that covers their costs. Railroads only run if the trip covers all costs.*

• Problem: Only works in situations where transactions costs are sufficiently low and cost of enforcing property rights is low.

Spectrum Rights• Property is not a tangible object, it is a bundle of legal

rights. The legal system allocates those rights; combined with a market system they create.

• Telecom relies on signal frequencies clear of other rivals is a classic commons.

• Spectrum for new (post-Coase) industries like moblie telephony are auctioned to private interests.

• Spectrum for old industries like tv/radio assigned to entities deemed worthy by gov’t.• Terrestrial TV in HK has been limited to two companies, one of

which is operated very poorly. Lack of programming, lack of competition.

• Coase: Allow holders of licenses to sell rights; achieve efficiency

Informality in Developing Economies• Lack of clear titles.• Difficulty in formally registering firms

• Investment in and development of property requires certainty that future benefits will be internalized.

• Rights to the stream of income generated by property are important for incentives to invest.

Land titling in Cambodia Link• Land historically collectivized.• Years of civil war have left land property ownership unclear.• About 15% of land in Cambodia is registered.• Between 20%-40% of rural people are landless typically

through forced eviction of unregistered landowners. 80% of urban lives in slums.

USAID – “Overall, weak enforcement of tenure rights has made it possible for influential individuals (often operating through legal entities) and groups to acquire large landholdings for speculative or unproductive purposes. The large number of illegal land-grabs weakens tenure security.”

Mystery of Capital de Soto• Poor people can use informally owned assets and firms to

make a living.

• But extra-legal assets can never be • used as collateral for capital to extend the business.• reassigned to more efficient uses. • be secure enough to make investment worthwhile.

Land Titling Project Thailand Link• “..(1981−85)…Study found .. only 12 percent of the

agricultural area was covered by title deeds; 49 percent was held under less secure forms of officially recognized land-use-right documents, 18 percent was occupied by people who lacked officially recognized documentation, and a further 21 percent was illegally occupied forest reserve.”

• Government allocated land. People w/ten years of use eligible to register ownership.

• In 2011, more than 90% of non-publically owned agricultural land is held in secure, formal private ownership.

Results AusAID Report• Farmers who have legal title to their land felt more secure in

holding the land and were more likely to invest money, time and effort in developing their land.

• People obtained more favorable credit from lending institutions when they possessed recognized legal title to land.

• Farmers with titled land switched cropping systems to fruit crops, which increased yield, net income and land value.

• Additionally, the following social impacts were observed: People with legal title to their land were gaining equitable access to credit by using their land as collateral

• Poverty in rural areas with land title was reduced• Improved efficiency and equality of taxation• The reduction in land disputes strengthened communities

Good institutions insure property rights.

• Manufacturing technology require investment and continuous production and ultimately efficient product, labor and capital markets.

• “Undergirding such markets are secure property rights, which entail a polity and judicial system to permit low costs contracting, flexible laws permitting a wide latitude of organizational structures, and the creation of complex governance structures to limit the problems of agency in hierarchical organizations.”

Property Rights• Allow owners to internalize externalities and could end the

tragedy of the commons. Property rights include• right to income from property• right to exclude others• right to sell property

• Formal property rights enforcement difficult for poor in developing economies. Formalizing property incentivizes investment.

Measurement drives policy improvement Link

Property Rights & Principal Agent Problem

• Modern production methods will require assembling large quantities of investment & complex organizational forms.

• At advanced level, effective institutions must allow for the exercise of property rights within complex organizations.

• Berle & Means “The Modern Corporation and Private Property”: “Ownership” vs. “Control Rights”. Managers of firm have strong day to day control over allocation of resources though flow of income

• Principal agent problem: How to align behavior of those with control rights to interest of those with ownership rights.

Corporate Governance -“Corporate governance deals with the ways in which suppliers of finance to corporations assure themselves of getting a return on their investment” Link

• Legal: Better rule of law protecting creditors & property rights protecting equity owners creates deeper financial markets, lower credit costs and better allocation of resources.

• Institutions: Varieties of intermediaries: banks vs. centralized markets; institutional investors; insider control vs. diversified shareholders.

The Better Creditor Rights are Defined and Enforced, the more Willing Lenders are to Extend Credit Note: The original rule of law data comes from the International Country Risk Guide.

Claessens S World Bank Res Obs 2006;21:91-122

© The Author 2006. Published by Oxford University Press on behalf of the International Bank for Reconstruction and Development / THE WORLD BANK. All rights reserved. For permissions, please e-mail: journals.permissions@oxfordjournals.org.

Corporate Governance in the Asia/Pacific

Debt markets relatively strong, protection of minority investors somewhat weaker.

East A

sia &

Pac

ific

Europ

e & C

entra

l Asia

Latin

Am

erica

& C

aribb

ean

Midd

le Eas

t & N

orth

Afri

ca

OECD high

inco

me

South

Asia

Sub-S

ahar

an A

frica

2.75

3.25

3.75

4.25

4.75

5.25

5.75

6.25

6.75

7.25

Creditor Rights & Protecting Investors

Strength of legal rights index (0-10) Strength of investor protection index (0-10)

“This index measures the degree to which collateral and bankruptcy laws protect the rights of borrowers and lenders and thus facilitate lending.”

“This index is an average of the Extent of Disclosure index, the Extent of Director Liability index, and

the Ease of Shareholder suit index.”

Expanding Securities MarketsAsian Bond market initiative part of regional governance structure to build

Mar

-95

Jan-

96

Nov-9

6

Sep-9

7

Jul-9

8

May

-99

Mar

-00

Jan-

01

Nov-0

1

Sep-0

2

Jul-0

3

May

-04

Mar

-05

Jan-

06

Nov-0

6

Sep-0

7

Jul-0

8

May

-09

Mar

-10

Jan-

11

Nov-1

1

Sep-1

2

Jul-1

3

May

-14

0

500

1000

1500

2000

2500

3000

3500

Total Asian Local Currency Corporate Bond Market (in USD Billions)

Link

ASEAN Corporate Governance ScorecardLink

Political Institutions

Reflects perceptions of the extent to which agents have confidence in and abide by the rules of society, and in particular the quality of contract enforcement, property rights, the police, and the courts, as well as the likelihood of crime and violence.

Rule of Law

Link

2012 Rule of Law

World Bank Worldwide Governance Indicators

Rules of the Game: Informal vs. formal enforcement

• Live Door: Internet Portal, Grew quickly• Hostile takeovers of Blue Chip corporations.• Founder, Takafumi Horie, prosecuted for securities fraud.

Alleged political prosecution. Link

· A highly insular and consensual business culture that is resistant to hostile mergers and acquisitions (M&A) and prefers to do business, especially M&A transactions, with familiar corporate partners;

2011 Investment Climate Statement - Japan Link

• Business Groups – Large, multi-company associations operating under common control with long-lasting co-operation.• Heavily diversified.• Usually family owned.

Austen, J.E., 1990,

Managing in Development Economies

Link

Chaebols & Business Groups

Link

Philippines Business GroupsRank Company Name Market Capitalization (in billion pesos)

1 Philippine Long Distance Telephone Company (PLDT)P 562.612 SM Investments Corporation P 543.853 SM Prime Holdings, Inc. P 405.054 Ayala Land, Inc. P 363.545 Bank of the Philippine Islands (BPI) (Ayala) P 337.306 Ayala Corporation P 312.307 Aboitiz Equity Ventures, Inc. P 278.858 BDO Unibank, Inc. P 283.969 Manila Electric Company (MERALCO) P 278.39

10 Alliance Global Group, Inc. P 277.2811 Aboitiz Power Corporation P 262.7012 JG Summit Holdings, Inc. P 262.4413 Universal Robina Corporation (JG Summit) P 250.8714 Globe Telecom, Inc. P 222.8715 LT Group, Inc. P 211.0216 Metropolitan Bank & Trust Company (Metrobank) P 207.9217 International Container Terminal Services, Inc. P 195.0518 Emperador, Inc. P 172.5019 DMCI Holdings, Inc. P 161.9920 Jollibee Foods Corporation P 158.92

Theories of Business GroupsCosts

Business Groups ..

-- are the result of government favoritism.

-- exist to exploit minority investors.

-- exist to reduce competition.

Benefits

Business groups …

--Offer economies of scope and diversification in absence of markets.

--Substitute for contracting in vertical organizations.

--Align interests of owners & managers.

Link

54%

81%

Keswick Family

Pyramiding

Link

Markets vs. Hierarchies• Where should the firm end and market begin?• Coase, 1937: Organizing production through markets or

through integration within a firm are alternative modes of governance. Choice depends on which minimizes transactions costs and depending on transactions environment, one or the other might be chosen.

Business Groups fill Institutional Voids

• Missing or malfunction institutions in EM are solved by business groups.

• Product Markets: group reputation substitutes for detailed product reputation,

• Labor Markets: Group can internally develop management talent.

• Capital Markets: Way to Diversify Risk and Increase Access to Capital

Specific Investment and Hold-up problem

• Some transactions may depend on specific investments which only have value within the context of the transaction

• Holdup problem: Asymmetric flexibility may give greater bargaining power to flexible agents leading to reduce incentive to invest in long-run capacity.

• Complete contracts may solve this problem in theory, but this depends on lack of unforeseen circumstance and good contract environment

• Firm hierarchies can avoid transactions costs, mitigate hold-up problems and information asymmetries.

• Example: Park& Shop & Cheung Kong

• Williamson, 1985: Industrial organization occurs to minimize transactions costs. Choices of markets vs. vertical integration depends a] existence of specific investments; b] degree of uncertainty; c] contract enforcement regime.

• Transactions costs are more sensitive to specificity. Worse institutional support for market transactions or greater degree of unforeseen circumstances increases the range over which governing transactions in a firm make sense.

Korea & Competitiveness

• Low ranking of Institutions & Financial Mkt. Development.

Foundation of Quality Institutions• Ease of enforcing contracts• Clarity and strength of property rights• Good governance and regulation.

Measures of Institutional Quality• Subjective: Global Competitiveness Report• Objective: Doing Business

• “Compare Bolivia and Vietnam in the 1990s, both places I experienced firsthand as an economic adviser. Bolivians enjoyed greater political and civil rights than the Vietnamese did, as measured by Freedom House, yet Bolivia's economy grew slowly whereas Vietnam's attracted foreign investment like a magnet. It is easy to see why: Bolivia is a landlocked mountainous country with much of its territory lying higher than 10,000 feet above sea level, whereas Vietnam has a vast coastline with deep-water ports conveniently located near Asia's booming industrial economies. Vietnam, not Bolivia, was the desirable place to assemble television sets and consumer appliances for Japanese and South Korean companies.”

Filling Institutional Gaps in Emerging Markets

Goods Markets•Consumer Credit•Supplier Base and Logistics•Branding

Labor Markets•Managerial Talent•Union Representation

Capital Markets•Debt and Equity Market Depth•Venture Capital•Bankruptcy Resolution•Financial Distress

Macro Context•Openness•Governance•Corruption

• Characterizing Emerging Markets: Lower income levels, higher growth potential.

• EM are characterized by weak institutions in some areas. • Strategies in emerging markets should be organized

around identifying and dealing with institutional gaps.

Private and Public Institutions

Credibility Enhancers Auditors, ISO Certification

Info Analyzers & Advisors CRA, Press, Analysts, Consultants

Aggregators & Distributors Banks, Insurance Companies, Wholesale trading companies

Transaction Facilitators Credit card issuers, On-line marketplaces, exchanges, recruiters

Adjudicators: Arbitrators Regulators

E-Commerce in China

Link

EM Strategies

• REPLICATE OR ADAPT business model to existence of gaps – ex. Dell: Direct sales in developed markets; Local distribution reps in China.

• COMPETE ALONE OR COLLABORATE Joint ventures• CHANGE MARKET CONTEXT fill in gaps. ex. Li & Fung, Big 4

accounting. • EXIT the market. Home Depot, China. No D-I-Y.

Voice, Loyalty, Exit, Albert O. Hirschman.

China Fast Food Market• Developed economy food supply chains will have

advanced logistics network with elaborate tracking systems to identify source (time and company) of food products.

• China had large demand for fast food but lack logistics and safety systems.

KFC & McDonalds• ADAPT –. McDonalds avoids franchising operating

95% of stores but mostly rents. • COMPETE or COLLABORATE – KFC sourced from local

distributors who bought from small farmers. McDonalds brought own distributors to China.

• CHANGE CONTEXT – KFC built own logistic systems. KFC trains thousands of store managers in training program. .

Changing Context• Plus: Can be a source of profits if successful.• Challenges: Markets Institutions specialized. May not be

good organizational fit.• Usually some reason institutions don’t exist. Lack of

political institutions.

Hypermart China• Institutional Gaps: National and international logistics and

Distribution systems weak. Must source goods locally. • Adapt:

• Change Context:

• Exit:

2013 Link

Link

2013 Link