Monday, August 18, 2008

The Price of Political Connections

To illustrate our approach in action, let’s take a trip to Indonesia and turn the clock back to 1996. Former President Suharto, who by then had ruled the country with an iron fist for nearly 30 years, would be forced to step down a few years later. However, in 1996, Suharto’s government still exercised tight control over the economy: The president decided who could get loans, log for timber, build toll roads, or import rice. In other words, he decided who would make money and how much. If ever there were a time or place where we’d expect the market to place a value on connections, this would be it.

But the aging dictator was in poor health. And because none of his kids or cronies was seen as a capable successor, any leader who followed Suharto would be unlikely to honor (or enforce) the cozy business relationships established under his rule. Any threat to Suharto would translate into a threat to the value of connections, and bets would be placed accordingly.

And indeed, Indonesian investors didn’t disappoint. On July 4, 1996, the Indonesian government announced that Suharto was traveling to Germany for a health checkup. That may not sound like much, but who travels 10 time zones to get his pulse taken? Investors at the stock exchange were inundated with rumors that Suharto had already suffered a stroke or heart attack. The Jakarta composite index, an indicator of Indonesian stocks’ overall performance, much like New York’s Dow Jones Industrial Average, fell 2.3 percent on the day of the news.

What was merely bad for Indonesian stocks turned out to be devastating for well-connected companies. One such firm was Bimantara Citra, a media conglomerate run by Suharto’s son, Bambang Trihatmodjo. In the weeks leading up to the July 4th announcement, both the Jakarta exchange and the price of Bimantara Citra bounced around a bit, not gaining or losing very much value. Then, with the market awash with rumors in the first week of July, Bimantara’s stock price took a nose dive. The prospect of the company without its connections had shareholders dumping their stock and running for the exits, driving its price down more than 10 percent in just a few days, obliterating about $100 million of its value. (As the chart shows, Bimantara starts its steep slide even before the announcement, probably reflecting early selling by those with close ties to the Suharto family or his doctors.)

One can just imagine what would have happened to Bimantara shares if the 75-year-old Suharto had died suddenly. In fact, our estimates, based on stock returns during a number of Suharto health scares, suggest that a complete severing of Suharto connections would have resulted in a 25 percent loss for similarly well-connected companies. How much is 25 percent of a company’s value? When Apple announced its iPhone to great fanfare in 2007, its shares went up 8 percent; when Pfizer was unexpectedly forced to withdraw its bestselling antibiotic Trovan in 1999, its shares fell 10 percent. So, connections in Indonesia were worth a lot more than a blockbuster new drug or the next big technology gadget—or even both of them combined.

Of course, Suharto’s government was considered one of the most corrupt dictatorships of its time, so we should not make generalizations based only on its extreme example. Luckily, researchers have since created market-based measures of political connections in many other countries. Mara Faccio, an economist at Purdue University, has measured the value of political connections for nearly every country with a well-functioning stock market. She has followed the political careers of business tycoons (and the business careers of politicians), traced bloodlines to detect family ties, and read the society columns of local newspapers to track who dines with whom. Her conclusion? Close political-corporate ties exist in nearly every country. In Russia, fully 87 percent of the Moscow stock exchange’s value is in companies with close Kremlin connections. Maybe this isn’t such a shock in the unruly capitalism of post-Soviet Russia. More surprisingly, nearly 40 percent of the London Stock Exchange is politically connected.

-How Economics Can Defeat Corruption by Raymond Fisman, Edward Miguel

No comments: