What Does It Mean To Have a Global Vision? Charles W. Calomiris Henry Kaufman Professor of Financial Institutions, and Academic Director, Chazen Institute of International Business, Columbia Business School August 30, 2004 Globalization has become a buzzword – a term that is used so often that we can become inured to its importance. But at Columbia Business School globalization is not just a buzzword; international business education is central to the identity of Columbia Business School to a degree unparalleled in any other U.S. business school. Realizing Columbia Business School’s ambitious agenda in international business education and research requires resources, commitment, and vision. Our resource base is rich. A majority of faculty and nearly a third of our MBA students were born outside the United States. Furthermore, our American-born students and faculty typically have benefited from extensive work, education, and travel experiences abroad, which add to the international diversity of the School. The diversity of the experiences of faculty and students is a key resource that nurtures the curriculum, research, and classroom experience at CBS. New York City – the world’s preeminent center for global business – is another unique resource of the school. The quality of the faculty and students, their diversity of backgrounds and interests, the New York advantage, and the financial commitments of alumni and other donors all are crucial to achieving Columbia Business School’s goal of being the preeminent location in the world for international business education and research. Our success requires these and more. It also depends upon a vision of how to organize an MBA curriculum with global reach, and how to promote and translate pathbreaking faculty research on international business. What is that vision? The international business program, like the global firm, constantly grapples with a central paradox. On the one hand, global reach implies general objectives and skills that transcend any particular country. Indeed, a firm may enter a country precisely because its clear-headed focus and advanced skill set can make more of that country’s productive resources than local firms. On the other hand, global firms are challenged by their comparative disadvantage in navigating many features of local markets. Success means adapting general knowledge to the particular circumstances of each country. The strategic challenge of the global firm entering a new country is determining which business tactics and practices to import, which to evolve on site, and how to combine them within a working global enterprise. A similar tension between the general and the particular pervades international business education, and the central paradox shows up not just in the most obvious areas of organizational behavior, marketing, and accounting, but even where you would
perhaps least expect to find it – in finance. Let me illustrate my point with some examples. Capital Structure Choice Consider the difficult problem of deciding on your firm’s optimal capital structure (in essence, which sorts of claims to issue to finance your firm). The potential choices include all manners of contracts (bank debt, bonds, and equity with various specific contractual features) and the location of the market (and legal jurisdiction) the firm accesses for its funding (domestic or international). MBA students begin to study optimal capital structure choice in the first-year core finance course, where the focus is often on ways in which differences across firms (particularly, the riskiness of their activities) affect the optimal ratio of debt to equity in their capital structures. It is important to recognize, however, that average differences across countries in capital structure choices are at least as important as industry or size differences of firms within countries for explaining the myriad variation in actual capital structures chosen by firms around the world. When planning your capital structure it is crucial to understand why. A successful capital structure strategy should be formulated with a general costbenefit framework that takes into account the particular circumstances of different countries that affect the costs and benefits of different capital structure choices. Most fundamentally, countries with legal and political traditions that fail to respect the basic rule of law, and that promote crony capitalism and corruption will thereby discourage any form of domestic financial contracting. Local companies in these countries are often constrained to finance with retained earnings, or loans from friends and family. Among countries with sound fundamental legal and political traditions, capital markets can function effectively, but some work better than others. Those that better protect the rights of creditors foster more effective and less expensive bank lending and other debt issuance. Similarly, firms in countries with strong minority shareholder protection laws face a more hospitable environment for public equity flotations, which encourages firms to place more equity publicly. These cross-country differences can be apparent even among relatively developed economies. For example, among the largest public firms in the United States and the United Kingdom, on average only about one percent of stock is owned by insiders. For France and Germany, in contrast, the equity stakes of insiders in the largest public firms average nearly 60 percent. Recent research co-authored by our Dean, Glenn Hubbard, has traced these huge differences in large part to the favorable impact of protections for minority shareholders’ rights in the U.S. and the U.K., and their relative absence in France and Germany. Constructing Local Hurdle Rates When valuing firms, making project choices within firms, or deciding how much of your portfolio to allocate to equity holdings in a particular country, managers have to 2
know what required rate of return (or hurdle rate) to attach to the firm, the project, or the prospective equity offerings. In the Core MBA program, students will learn about the capital asset pricing model (CAPM), a basic tool for pricing risk that is used to derive hurdle rates. According to the CAPM, risk is priced based on knowledge of the aggregate equity risk premium and the “beta” of the investment (its covariance with the aggregate equity portfolio). Is that method for constructing hurdle rates useful for measuring and pricing the risk of investments around the world? Not always. An inclusive portfolio of stocks in emerging market countries tends to have an average beta less than one. According to the CAPM, the hurdle rate required on that portfolio should be lower than that of the S&P 500. But any budding Columbia MBA who would use the CAPM to recommend that his or her firm invest in EM equities with a target rate of return below that of the U.S. equity market would soon be looking for another job, an eventuality that we all want to avoid. The CAPM makes an assumption about the distribution of returns (specifically, the assumption of normality), and that assumption does not work well in emerging market countries (EMs). EMs are more like venture capital investments; they have eventdriven risks. They are perhaps best viewed as institutional reform experiments, and, like venture capital investments, their outcomes have more of a bimodal (eventual success or failure) shape. The general concept of the hurdle rate is useful, but the way one measures the risks of particularly countries depends, as in the capital structure example, on the institutional and political context. Equity Capital Budgeting for Banks Prudent banking requires the budgeting of equity capital (the shock absorber for bank losses) commensurate with the risks undertaken by the bank. Banks whose assets are riskier, all things equal, need larger equity buffers. That principle is codified, albeit crudely, in the minimum regulatory requirements for equity capital set by the Basel Committee (an arm of the Bank for International Settlements), and adopted in whole or in part by the largest industrial countries. Banks typically substantially exceed those minimum requirements, since their desire to survive provides an incentive to measure and manage risk properly, and budget equity capital accordingly, and typically in excess of the minimum regulatory requirement. Recently, a question that has received a great deal of attention in public policy circles is whether the prudential equity capital budgeting standards of the developed countries (e.g., the Basel standards) should be adopted in other countries. Some commentators have objected to that idea, noting, among other things, that there are fundamental institutional differences in the structure of debt markets in EMs which matter for the measurement of bank risk. Most importantly, EM countries’ corporate debts are often denominated in hard currencies (dollars, euros, and yen), rather than in their domestic currencies. This adds a special dimension of risk to those debts that is not present in developed countries. Critics of applying the Basel Standards to EMs argue that this implies a need to construct different measures of loan risk in EMs.
To see why, consider the consequences for bank loan risk of a currency devaluation. Currency devaluations (which are common in EMs) can be dramatic. When a producer of non-tradable goods (goods that are not exported in world markets) raises debt denominated in dollars, it is exposed to a risk of financial distress resulting from devaluation because devaluation raises debt servicing costs relative to domestic currencydenominated revenues. Tradables producers with dollar-denominated debts are insulated from the risk of devaluation, since their revenues remain fixed in dollar value terms. Indeed, tradables producers often benefit from devaluation, since their labor and rental costs fall relative to their revenues. Thus, the risk of lending in EMs depends on the interaction between the likelihood of a devaluation and the borrower’s industry (because different industries vary in their exposure to devaluation risk). Thus, a consideration that is not very relevant to measuring the riskiness of bank loans in the U.S. (exchange rate fluctuations) is central in Latin America, Asia, and Africa. As before, institutional details matter. The basic framework (equity capital budgeting) is transportable, but the specific implementation of the tool differs according to the circumstances. Modeling the Risk of Financial Crisis The last twenty-five years have witnessed an unprecedented propensity for financial crises around the world. The phenomenon is common to both developed countries (e.g., the U.S. S&L crisis, the Scandinavian banking crises of the 1990s, and the ongoing decade-long Japanese banking crisis) and developing countries (e.g., the Mexican crisis of 1994, the Asian crises of 1997, the Russian crisis of 1998, and the Argentine crisis of 2001). Crises not only produce poverty and suffering for workers, they can bankrupt firms and have devastating effects on investors’ returns. Thus, it would be extremely useful for a firm to be able to forecast the likelihood of a crisis in a country where it is investing. Not surprisingly, this is hard to do, but the task must be undertaken nevertheless. One approach to forecasting crises is statistical, relying on signals of trouble that would have been useful in forecasting previous crises that occurred around the world. Many different statistical models have been developed by economists in the private and public sector. Another approach is to rely on local information and opinion about political and economic trends. Both approaches have merit and a smart manager will pay attention to both. No crisis is really quite like another, and so there are limits to the value of signals derived from previous experience, which makes knowledge of the particular circumstances, and local network connections, valuable. At the same time, local market participants can sometimes be blinded by their own limited experience, failing to see important warning signs that are apparent in light of other countries’ experiences.
One famous recent example of excess reliance on local judgment came from the sailing regatta at the Olympics, when competitors from around the world mistakenly followed the native (and 1996 gold medalist) Greek windsurfer as he crossed the finish line without completing the required laps. The overarching lesson is that international business, like international business education, must combine the general with the particular in a way that uses the best aspects of each. Columbia Business School’s vision, and the Chazen Institute’s, is to provide students with the tools, diverse experiences, and background that will help make them flexible problem solvers in the global marketplace. There is no cookbook for successful global business. We will know that we have succeeded as teachers when our graduates display the courage and self-reliance to formulate their own strategies to steer their ships around the global economic course, with as few wrong turns as possible.