Monday, April 30, 2012

Governments and Value III: Bribery, Corruption and other "Dark" Costs

In this last post on the effects of government on valuations, I want to return to the value destructive effects that corruption, bribery and other "illegal" side-payments to government officials can have on value. In many countries, business people know that to keep doing business, they have to grease palms and provide “gratuities” to the gatekeepers of officialdom. A spate of news stories in the last few weeks should alert us all to the reality that the problem is not only still prevalent but that companies everywhere are exposed to its costs.
  1. In a reminder to natural resource companies that the countries where these resources are most abundantly found are often also the ones with the most corrupt government officials, Cobalt International Energy, an energy company backed by Goldman Sachs, saw $900 million of its value wiped out, after revelations that three powerful Angolan officials held concealed interests in the company.
  2. India is the second-largest telecom market in the world, with hundreds of millions of subscribers. The regulatory uncertainty that has always bedeviled companies competing in the sector was augmented to by a tainted telecom auction in 2008, which resulted in the resignation and arrests of a cabinet minister. The saga played out in the Indian Supreme Court's recent ruling taking away licenses awarded to eight companies in that auction; the fact that six of these eight companies were foreign suggested a nativist spin to corruption. Put in blunter terms, the ruling seemed to suggest that bribery of Indians by other Indians was par for the course, but bribery by foreign nationals was an abomination.
  3. Finally, from the other great growth story in Asia, China, came the story of Bo Xilai, a prominent member of the party elite, and his family: his wife, who is accused of murdering a British businessman, and a son, Bo Guagua, who goes to the Harvard's Kennedy School of Government, drives a Ferrari and has the lifestyle of a top notch capitalist. While the story is filled with the kinds of details that tabloid newspapers love, the real story that the Chinese government wants to keep a lid on is that Bo is not alone among government officials, in accumulating wealth out of proportion to his "income" as a government official.
I am not an expert on corruption but here is what I see as the ingredients that allow it to flourish. First, for official gatekeepers to have power, you need gates: the more licenses, permissions or other official approvals you need to operate, the greater the potential for corruption. Second, it is a lot less risky being corrupt if you have political hegemony (whether it be of the dictatorial variety or one party rule), an ineffective legal system (making it impossible to challenge biased official acts) and an apathetic or controlled media (that either cannot or will not view corruption as a good news story). Third, the odds of corruption increase if the system is designed on the premise that corruption is the rule rather than the exception. Thus, setting the salaries of public employees at well below what the market would pay them, given their qualifications, on the assumption that they will augment these salaries with "side payments", will ensure that you will attract the "most corrupt" people into government and a continuation of the system.

Rather than debate the basis of corruption and whether culture and history play a role, I want to first focus on “objective” measures of corruption . Transparency International, an organization that tracks corruption globally, releases an annual listing of corruption across the world. Just to provide a summary, the following is a list of the ten least corrupt and the ten most corrupt countries in the world, based on their ranking.
Least corrupt countries in the worldMost corrupt countries in the world
1. New Zealand1. Somalia
2. Denmark2. North Korea
3. Finland3. Myanmar
4. Sweden4. Afghanistan
5. Singapore5. Uzbekistan
6. Norway6. Turkmenistan
7. Netherlands7. Sudan
8. Australia8. Iraq
9. Switzerland9. Haiti
10. Canada10. Venezuela
Just for information, the United States came in as the 24th least corrupt country out of 182 countries, China was 75th and India was 95th on the list. While I am sure that there are countries where you and I may disagree with the rankings, there are clearly regions of the world where operating a business without "paying off" government officials is close to impossible.

If you are valuing a company that operates in these dens of iniquity, how do you incorporate the costs of corruption into your value? Here are a three alternatives:
  1. Treat bribes as operating expenses: From a valuation perspective, it would be easiest to deal with bribes if they were out in the open and  treated as a separate line item in the expenses. So, in your operating expense breakdown, you could have a line item titled "Bribes and payments to corrupt officials" with the expense associated with it. Perhaps, we can then assess firms on the efficiency of their bribery and treat it as a competitive advantage for companies that are exceptionally good at getting results for their money. Unfortunately, even in countries where corruption is endemic, it remains "under the surface" and unreported.
  2. Treat corruption as an implicit (and unreported) tax: In the more likely scenario, where corruption exists but is not explicitly reported, it may make sense to consider the expenses associated with it as an implicit tax levied by the government. The fact that this tax revenue goes to the government officials and not to the taxpayers is deplorable, but that makes little difference to the company paying it. While this idea may seem farfetched, PWC did exactly this in an "opacity index" that they computed for dozens of countries and converted into tax rates. In 2001, for instance, they estimated the added cost of operating in China was the equivalent of facing an effective tax rate of 46%. Unfortunately, this listing is almost a decade old and while the opacity index itself has been updated by others, the effective tax rates no longer seem to be computed by country.
  3. Increase the cost of capital to cover "government" partners: When corruption occurs at the highest levels, you can argue that as a private business owner, you have "corrupt government officials" as partners who provide no capital but get a share of the income. Consequently, you have to generate a higher return on your capital invested to cover the cash outflows to your implicit partners. You can find interesting attempts to quantify this effect here and here.
There are two complicating factors. The first is that the United States (among other countries) has laws on the books that forbid companies from paying bribes not only to US officials but to officials in other countries . As a consequence, the costs of bribery may be far greater than the actual expenditures incurred and include the penalties that these companies will be face, if the bribery is exposed. The second is that the "right connections in high places" in countries with extensive corruption is a significant competitive advantage in itself. Odious though we may find this proposition, the firms that understand how the system works (or who to pay and how much to pay to make it work) will generate excess returns and higher value than their more virtuous counterparts. 


Tangent Style Storyteller said...

Prof. Damodaran,
I've enjoyed this series, so thank you for that.

Do you think that a valuation that attempts to incorporate corruption costs in one way or another could be taken seriously? I don't mean to question the legitimacy of the idea, only the reception that might await it.

Aswath Damodaran said...

If you are an investor, it is not a question of how others view it or if it passes legal muster, it is one of reasonableness. If you get a better estimate of value by doing this, should you care that others may view your valuation as unseemly?

Gaurav Mehta said...

Just wondering, isn't the cost of capital taking into consideration the corruption and bribery costs?

For example, with the 2G telecom scam the Government has gone into no decision making mood, which has been one of the reasons for ratings downgrade talks by S&P. Also had India been a clean country, wouldn't it have been at a better rating given that Spain ect are still at a higher rating than India? Although i do understand Spain is part of the EU and backed by it.

Aswath Damodaran said...

You are probably right. Corruption is tied to problematic political structures and bad legal systems, all of which feed into country ratings and cost of capital....

Gaurav Mehta said...


Thanks for the confirmation...

Jack Bauer said...

I think this line:
United States came in as the 24th most corrupt country out of 182 countries, China was 75th and India was 95th on the list

Should have the word 'most' exchanged with 'least'. The US is the 24th least corrupt according to your link.

On a sidenote, I really enjoy your blog

Forex Expert Advisor said...

these three are main things which creates much difference in market. crruptiob and bribery effects much.

Aswath Damodaran said...

You are right. Fixed now.

Anonymous said...

prof -

now that The Carlyle Group is going public as a limited partnership instead of a regular corp, can you elaborate on a future post on how valuation is effected because of the structure that a company takes.


Sreekanth.Narayan said...

Hello Professor Damodaran

Thank you for writing this insightful article...

Just wanted to understand your perspective on the discussion held in above comments
Lets even assume that there is value even after considering corruption and bribery costs. How long will this be sustainable? Effectively the money lost in bribery and corruption would be the taxpayer/nation's wealth which in long term would be hitting the nation's GDP... said...

Thanks Prof Damodaran for the series it was insightful. Now India is struggling with its own policies and implications of GAAR.


Aswath Damodaran said...

No economy is ever made better off with an implicit tax system (i.e. bribery and corruption). I agree with you. Taxpayers lose and the least worthy among our businesspeople (those who are good at corrupting others) become the biggest winners...

arsene lupin said...

fascinating! wonder if the dampening effect of corruption on stock valuations can be mitigated by making the corruption a 'fixed & predictable business cost' (as Chandrababu Naidu is purported to have done). Probably a thought for the future author of "Business Strategies for Banana Republic Dictators and other Aspiring Great Panjandrums".


Corruption is a huge problem in developing countries. You know I was sitting at home and I came up with this. If I am a corrupt official in control of a developing country. Its possible to just print paper notes and conceal them some where or create the notes and than deposit them in an account where they can be converted into yen or dollars get the idea. What is really happening is that corrupt officials are stealing from their own people.

Income Protection Insurance Redundancy said...

Corruption is by far the most powerful force that causes poverty.