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The Brookings InstitutionPOLICY BRIEFPolicy Brief #118April 2003Related BrookingsResources Following the Money: TheEnron Failure and the State ofCorporate DisclosureGeorge Benston, MichaelBromwich, Robert E. Litan,and Alfred WagenhoferAEI-Brookings Joint Centerfor Regulatory Studies(2003) “Cooking the Books: The Costto the Economy”Policy Brief #106Carol Graham, Robert Litan,and Sandip Sukhtankar(July 2002) “The Enron Failure and theState of Corporate Disclosure”Policy Brief #97Robert E. Litan(April 2002) “Does Insider Trading RaiseMarket Volatility?”Shang-Jin Wei and Julan Du(February 9.htmTheBrookingsInstitution1775 Massachusetts Ave., N.W.Washington, DC 20036A Case of “Enronitis”?Opaque Self-Dealing and the Global Financial EffectSHANG-JIN WEI AND HEATHER MILKIEWICZt the beginning of 2002, Enron was the seventh largest companyin the United States, with operations extending worldwide.Telecommunications giantGlobal Crossing operated in twentyseven countries and two hundredcities on five continents. But bothcompanies collapsed last year underthe weight of financial problemscreated by the self-dealing of a fewcorporate insiders and masked byChinese investors check the stock prices at anontransparent accounting.share market in Shanghai.These and other similar corporatefailures deprived millions of company employees and shareholders oftheir lifetime savings and retirement benefits. Stock prices of other U.S.companies also took a beating, partly in response to the revelation ofthese scandals, and foreign markets have suffered enormous losses.The practice of opaque self-dealing by a few insiders—as evidenced byinsider trading and a lack of transparency in corporate and governmentoperation—has contributed to the meltdown of the financial marketsaround the world. A crucial, invigorated reform effort is under wayworldwide to stem the problem, which, if left unchecked, could lead toglobal financial ruin.AROLLER COASTER RIDESSince January 2002, all major U.S. stockindexes have plummeted. NASDAQ fellalmost a third in 2002, and the DowJones industrial average and S&P 500tumbled for the third consecutive year,the longest downturn since 1939-41.Overseas, Japan’s Nikkei 225 closeddown 18.6 percent for the year; Britain’sFTSE 100 was down 24.5 percent. Ofcourse, the burst of the dot-com bubble,the uncertainty about a war in theMiddle East, and a possible rise in oilprices may have all contributed to thestock price decline. However, it is onlynatural to suspect that “Enronitis”—All Policy Briefs are available on the Brookings website at www.brookings.edu.
POLICY BRIEFopaque self-dealing by a few insiders—hascontributed to the financial meltdown.Insider trading—the buying and selling ofstock by people who possess nonpublicinformation relevant for its price—is one ofthe primary indicators of self-dealingamong an elite few within a corporation.Recent work by Julan Du of the ChineseUniversity and Shang-Jin Wei has shownthat insider trading can affect stock pricevolatility—and even more important,economic performance—around the world.Stock markets are volatile. That is notnews. But volatility varies significantly fromone country to the next. Measured by thestandard deviation of the monthly returnsof a major market index, stock marketvolatility is almost twice as high in Italy asit is in the United States. Markets in developing countries are typically even morevolatile. The Chinese market, for example,is three and a half times more volatile thanthe U.S. market; the Russian market, sixand a half times more volatile.Shang-Jin Wei is a seniorfellow in EconomicStudies at the BrookingsInstitution.Heather Milkiewicz is aresearch assistant inEconomic Studies at theBrookings Institution.Excessive volatility matters because itaffects people’s incentives to save and toinvest. A certain degree of marketvolatility is unavoidable, even desirable.Ideally, changing stock prices signalchanging values across economic activities and thereby improve the wayresources are allocated. But volatility thatis unrelated to market fundamentalsresults in confusing signals that hamperresource allocation. To the degree thatinsider trading affects the volatility of acountry’s stock market, it could also affectthat country’s economic performance.Some think that because insider tradingallows relevant information to be quickly2Policy Brief #118reflected in the stock price, it shouldreduce market volatility and improveeconomic efficiency. However, this viewfails to take into account the rationalactions that a few insiders would take tomaximize personal benefits. Access toinside information is most valuable whenprices are either rising or falling dramatically, so people who are positioned topossess inside information love marketvolatility. They realize that the actual extentof volatility could be partly a consequenceof their actions.There are two channels through whichinsiders may generate increased volatility.First, they may choose riskier projects orriskier technology than they normallywould. Second, insiders have an incentiveto manipulate the timing and content ofthe information release in such a way as toincrease the price volatility.Laws and enforcement regarding insidertrading differ widely around the world. Theset of activities defined as illegal can vary,as can the diligence with which laws areenforced. In the United States, forexample, insider trading is a criminaloffense with penalties including jail terms.In Hong Kong, insider trading isconsidered a civil violation with amaximum penalty of a fine.But Hong Kong compensates for that lightpenalty with tight antifraud regulation andrigorous and predictable law enforcement.Government regulators are well trained,professional, and relatively incorrupt.Corporate insiders in Hong Kong wouldthink twice before releasing misleadinginformation or committing financial fraud.Because insider trading is an opaqueApril 2003
POLICY BRIEFpractice, it is difficult to preciselymeasure and compare among countries.Consequently, few empirical studies havebeen done on the subject. But a recentsurvey conducted by Harvard Universityand the World Economic Forum for theirannual Global Competitiveness Report(GCR) polled business executives inapproximately 3000 firms in 53countries and resulted in a new measureof the extent of insider trading. Asmentioned, both the differences in thedefinition of insider trading along withthe fact that it is illegal in manycountries make it difficult to assess.However, business executives who aresavvy about financial markets shouldhave a sense of the extent of insidertrading. Therefore, although the GCRinsider trading index is derived fromsubjective responses, these responsesshould reflect the practices within firmsas accurately as possible.Policy Brief #118The executives were asked: “Do you agreethat insider trading is not common in[your country’s] domestic stock market?”The measure was adjusted by Du and Weiso that on a scale from 1 to 7, a highernumber corresponds to more insidertrading. The average of the answers for aparticular country is used as a measure ofthat country’s extent of insider trading.Using this formula empirically, insidertrading is shown to correlate with highermarket volatility (figure 1).“To the degree thatinsider tradingaffects the volatilityof a country’s stockmarket, it couldalso affect thatcountry’s economicTo illustrate this comparatively, we look atwhat would happen to the market volatilityif the extent of insider trading rises from arelatively low level, such as the U.S. ratingof 2.62, to that of China, with a relativelyhigh rating of 4.62 (see table 1, p. 4). Thestatistical analysis shows that this rise ininsider trading would increase thevolatility of stock returns by 2.5percentage points (e.g., stock volatility willApril 2003”performance.3
POLICY BRIEFTable 1. Market Volatility andInsider Trading Index, by Country“China’s higher stockmarket volatility isexplained more byexcessive insidertrading than by thevolatility of itseconomic”fundamentals.Country Name Stock Market GCR InsiderVolatilityTrading 54.63Turkey0.1834.08United Kingdom0.0562.26United States0.0432.62Zimbabwe0.1094.14Source: Du and Wei, 2002. The insider trading index isderived from the “Global Competitiveness Report” in1997 and 1998. The insider trading index equals 8, or theaverage of the original index. A higher number implies ahigher degree of insider trading. Market volatility is thestandard deviation of the monthly returns in U.S. dollarsbetween 1984 and 1998.account the impact from the volatility ofthe real output growth, volatility ofmacropolicies, and market liquidity andmaturity on stock market volatility. To sumup, an economy where insider trading isrampant is likely to have a very volatilestock market, resulting in less savings andlower investment than otherwise.OPACITYAnother symptom of “Enronitis” is a lackof transparency in corporate andgovernment operation. The recent waveof corporate scandals in the UnitedStates has thrown open some corporatecurtains to reveal practices that wereroutine but secret until now. Othercountries, however, have even morego up from 5 percent to 7.5 percent). Thisis a substantial increase, considering thatthe average volatility of the entire sampleof 56 countries is 9.8 percent.serious deficiencies in transparency thatexist not only in the private sector but inthe government as well. These practiceshave caused countries like China,Russia, and Venezuela to lag behind theIn contrast, using the difference in thevolatility of GDP growth rate for the twocountries yields an increase of only onepercentage point. In other words,China’s higher stock market volatility isexplained more by excessive insidertrading than by the volatility of itseconomic fundamentals.Correlation does not necessarily implycausality, but the research by Du and Weiemploys a statistical approach designed toaddress the issue. Using these additionalstatistical methods, their findings showthat the positive correlation betweeninsider trading and market volatility likelyimplies a causal relationship where anincrease in insider trading leads to a rise instock market volatility. Furthermore,insider trading is associated with a highermarket volatility even after one takes into4Policy Brief #118rest of the world in the financial realm,as research by Gaston Gelos of theInternational Monetary Fund (IMF) andShang-Jin Wei demonstrates (see“Additional Reading,” p. 5).Policymakers often cite lack of transparency as one cause of the financialcrises in emerging markets over the pastdecade. A recent IMF report, for example,noted that a “lack of transparency was afeature of the buildup to the Mexicancrisis of 1994–95 and of the emergingmarket crises of 1997–98.”The report concluded that “inadequateeconomic data, hidden weaknesses infinancial systems, and a lack of clarityabout government policies and policyformulation contributed to a loss of confi-April 2003
POLICY BRIEFFigure 2:DIFFERENCE BETWEEN ACTUAL INTERNATIONAL MUTUAL FUNDINVESTMENT AND THE MSCI BENCHMARK: TRANSPARENT VERSUS OPAQUE COUNTRIESActual investment benchmarkActual investment benchmarkMacropolicy ata Internationalinvestment fundsOpaqueSource: Authors’ calculations based on the data from eMergingPortfolio.com and the Morgan Stanley CapitalInternational Emerging Markets Free (EMF) Index, and the statistical analysis in Gelos and Wei (2002).dence that ultimately threatened toundermine global stability.”The international financial institutionsconduct of macroeconomic policies.Corporate transparency refers to the availability of financial and other businessinformation about firms.and are aiming for more transparency intheir own operations. The emphasis ongreater transparency presupposes thatdestabilizing behavior by individualinvestors can be avoided or attenuated bymaking better information available. Forexample, international investment fundsmay be more likely to engage in herding—that is, to make investment decisions onlybecause other funds are making them—inless transparent countries. As a result,investors may rush in and out of thosecountries even in the absence ofsubstantial news about fundamentals.Greater transparency could discouragesuch behavior.The term transparency denotes both theavailability and the quality of informationmeasured at the country level. Ingovernment, transparency refers to theavailability of macroeconomic data (bothtimeliness and frequency) as well as to thePolicy Brief #118to engage inherding—that is, tomake investmentdecisions onlybecause other fundshave actively promoted increased transparency among their member countriesmay be more likelyIn principle, for investment acrosscountries, just as for investment acrosscorporations within a country, greatertransparency levels the playing field forall investors and increases the confidence of the investors collectively, and asa result, can encourage investment.While this is intuitive, it has not beendemonstrated rigorously.Advances have been made by Gelos andWei, whose research tests this theoryempirically. Before it can be concludedthat international mutual funds invest lessin less transparent countries, there mustbe a benchmark on how much international funds would have invested invarious countries if they had the samedegree of transparency. A naturalbenchmark is the index produced byMorgan Stanley Capital International(MSCI), which essentially documents theweight of a country’s stock market assetsin the global market. Finance theorypredicts that the allocation of investmentApril 2003are making them—in less transparent”countries.ADDITIONAL READING“Transparency andInternational InvestorBehavior”R. Gaston Gelos andShang-Jin WeiNBER Working PaperNo. w9260(National Bureau ofEconomic Research,October 2002)http://www.nber.org/papers/w92605
POLICY BRIEFacross different countries should beproportional to the importance of thesecountries in the world stock market.It is common for asset managers to reporttheir positions relative to this index andfor investment banks to issue recommendations relative to it (e.g., “over-weightSingapore” means “advisable to investmore than Singapore’s weight in the MSCIEmerging Markets Free index”).“A country likeVenezuela wouldquadruple itsportfolio holdingsif it increased itstransparency to”Singapore’s level.Looking at the difference between theactual share in the world market portfolioand the MSCI weight for opaque andtransparent countries, we see that themore transparent countries actually attracta greater amount of foreign investmentthan predicted by MSCI, whereas themore opaque countries obtain less thanpredicted (see figure 2, p. 5).In this research by Gelos and Wei, transparency is measured for both governmentTable 2. Opacity zuelaZimbabweO-Factor(composite)MacroeconomicData oeconomic 3.17Notes and Sources: O-Factor is derived from a 2000 PriceWaterhouseCoopers survey of banks,firms, equity analysts and in-country staff; Macropolicy is based on measures developed byOxford Analytica for Wilshire Associates. These ratings for transparency of fiscal and monetarypolicies are on a scale of 1-10, where a higher number is associated with less transparency.Macrodata is based on indices on the frequency and timeliness of national authorities’ macroeconomic data dissemination averaged over 1996, 1997, and 2000. Corporate Opacity iscreated using results from 1999 and 2000 surveys about the level of financial disclosure andavailability of information about companies from the World Economic Forum and HarvardUniversity’s “Global Competitiveness Report.”6Policy Brief #118and corporate operations, independentlyand collectively. The variables used arereferred to as opacity measures, as ahigher rating is associated with a lack oftransparency. The research examines twoaspects of government transparency: thetransparency and predictability of agovernment’s monetary and fiscal policies(Macro policy opacity) and the frequencyand timeliness of the official release of theimportant macroeconomic data (Macrodata opacity).In addition, the lack of transparency atthe corporate level is gauged from asurvey of firms worldwide on executives’own perception of the degree ofmandatory disclosure requirement(corporate opacity).The statistical analysis suggests that a lackof transparency on all levels is associatedwith a lower share of emerging marketfunds. For example, a country likeVenezuela would quadruple its portfolioholdings if it increased its transparency toSingapore’s level (see opacity measures,table 2).This increase in portfolio holdings shouldbe an important incentive for countries toincrease their transparency levels. Inaddition, greater transparency couldmoderate the herding tendency of outsideinvestors, which might reduce thecountry’s vulnerability to financialcontagion and crisis.At least since the 1997-98 Asian financialcrisis, herding behavior by internationalinvestors has been said to havecontributed to the market volatility in thedeveloping countries. Although ineconomic theory the relationship betweenApril 2003
POLICY BRIEFtransparency and herding is not clear, ourresearch uncovers some evidence of apositive association between a country’sopacity and the tendency for internationalinvestors to herd when investing in itsassets (see figure 3). Thus, if herding byinternational investors contributes to ahigher volatility or more frequent financialcrises in emerging markets, it is related tothese countries’ transparency features.Beyond herding, another importantquestion is whether capital flight during atime of currency and financial crisis isrelated to a lack of transparency. Dodifferences in transparency, above andbeyond macroeconomic indicators of acountry’s economic health, explain whysome countries suffer greater confidenceloss than others during turbulent times?Our research suggests that more opaquecountries do suffer larger outflows duringcrises. For example, during the Asian andRussian financial crises, we observed thatcapital exodus was greater in less transparent countries.In the United States, efforts have beenmade by both the government and itscitizens to restore the credibility of themarket and assure the public that thenation is serious about eliminating foulplay within corporations. Shortly after theEnron scandal became public, severalinitiatives were put forth to improve themonitoring practices within corporations.Congress passed legislation to eliminatecorporate fraud by requiring more carefulgovernmental supervision from bothoutside and within a corporation andstrengthening requirements on whatcompanies must disclose to investors. Inaddition, the Securities and ExchangeCommission has been more diligent in itsefforts by adopting new regulations, suchas one outlining the standard of conductthat must be followed by all attorneysrepresenting corporate clients.Policy Brief wasCorporate governance reform has gainedmomentum in other countries as well. The1997 economic crisis played a major role inprompting corporate governance reformsthroughout Asia and Latin America.financial markets where fraudulent andillegal practices within corporations haverun rampant, and where governmentoperation is not transparently accountableto its citizens. Greater transparency andinvestor confidence will not happenovernight. Even the United States, oncethe world’s unquestioned l
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