EXAMINING CORPORATE GOVERNANCE REGIMES IN CHINA AND EM

MAY 2015JP SMITH, ECSTRAT

JP@ecstrat.com | Emad@ecstrat.com

2GOVERNANCE REGIMES ARE THE SECULAR DRIVERS OF EQUITY MARKETS

1.Governance regimes are defined by the relationship between minority shareholders, controlling shareholders and

management, the state and society. At one end of the spectrum, the liberal model emphasizes the separation of ownership from

control, whilst under authoritarian and autarkic governance regimes the state dominates both the corporate sector and the allocation of

resources in the broader economy. Most countries are hybrids of different systems, but there is invariably a dominant regime.

2. The analysis of governance regimes can be a valuable lead indicator for future trends at a macro-economic level.

Governance-related factors are a major determinant of corporate investment which is both a key driver and barometer of future trends in

the overall economy. The impact of governance-related factors in driving down returns for companies has consistently been a better lead

indicator for the deterioration in growth across most of the major GEM economies, than macro-based indicators.

3. Governance regimes go through their own cycles of hubris, which can help to time market cycles. All economic systems and

governance regimes are subject to cycles of hubris, on the part of both policy-makers, investors and the broader commentariat.

4. More structural shifts in governance regimes are one of the major secular drivers of equity markets. Most governance regimes

are in a state of constant flux or evolution, which can have a big impact on shareholder returns. Most of the time, these shifts will not be

systemic but on occasion one or more countries will undergo a complete shift to a different governance regime, usually brought about by

political pressures in response to a major internal or external event.

5. The analysis of governance regimes is an indispensable complement to a value-based investment process. A value-based

investment process will not succeed if minority shareholders cannot share in the potential realisation of that value and/or if investment is

at least partly dictated by non-commercial factors which may be related to social/political aims or mere rent-seeking.

6. A country-based equity allocation process using governance regimes as a building block is more credible than the existing

division into developed, emerging and frontier markets. Our analysis shows that there is no systematic process of convergence of

governance regimes towards a more liberal model and that the hierarchical and state-dominated governance regimes, which

characterise most emerging markets, can undermine both shareholder returns and future economic growth prospects. Without systemic

convergence towards DM-type governance regimes and levels of economic development, the case for making allocations towards

emerging and frontier markets as distinct asset classes is severely weakened. We believe that investors should focus on individual

countries as the main building block for equity asset allocation regardless of their current classification.

3GOVERNANCE REGIME CLASSIFICATION METHODOLOGY

1. Equity Markets

Size of equity market relative to overall

economy

Distribution of ownership and control, including analysis of domestic

investor base

Recent or likely shifts in distribution of ownership

and/or control

2. Position of minority

shareholders

Transparency

Track record of corporate transactions and payout

ratio

Extent to which objectives of management and/or controlling shareholders

align with minorities

Is there a market for corporate control at the

right price: if so, how open is it?

3. Relationship between listed companies and

broader economy

Extent to which markets determine the allocation of

resources

Regulatory environment and extent of arbitrary intervention by state

Extent to which controlling shareholders are

accountable to society

Extent of any moral hazard which might impact the corporate

sector

4. Identify potential catalysts

for change

Internal and external economic factors

Commercial and financial factors

Political and geopolitical factors

Demographic shifts

Shifts in prevailing ideological climate

Technological shifts

4A TAXONOMY OF ECONOMIC AND GOVERNANCE SYSTEMS

1. LGR; Liberal Governance Regime; the market plays the dominant role in resource allocation.

US, UK, Australia, Canada, South Africa, Ireland.

2. CGR; Governance Regime; market role limited by social consensus which also prevents state capture by elite families.

Germany, France, Switzerland, Netherlands, Belgium, Denmark, Finland, Norway, Sweden, Israel (elements of HME & LME), Poland.

3. NGR; Network Governance Regime; market and corporate sector dominated by horizontal networks of families or interest groups.

Japan, Taiwan (also elements of HME).

4. HGR; Hierarchical Governance Regime; markets and corporate sector dominated by concentration of elite, mainly family based,

groups which are more politically and socially dominant than in coordinated regimes.

Korea (also elements of CME), Greece (also clientelist CME), Chile, Brazil, India (also elements of LME), Thailand, Philippines,

Indonesia, Italy, Spain (also elements of CME), Mexico (also elements of DME), Turkey, Hong Kong, Portugal.

5. DGR; Dependent Governance Regime; foreign direct investors dominate capital intensive and often the financial sectors.

Czech Republic. Romania, Hungary

6. GGR; Guided Governance Regime Regime; state guides but does not control a high proportion of capital intensive economic activity.

Singapore, UAE, Malaysia.

7. AGR; Authoritarian Governance Regime; the state dominates the listed corporate sector either directly or via intervention

Russia, Argentina, China (also elements of GME), Saudi Arabia, Kazakhstan, Qatar

8. AUGR; Autarkic Governance Regime; mainly closed to passive foreign investment with high level of state control.

Venezuela, Cuba, Iran.

5EM MARKETS GENERALLY MOVING AWAY FROM MORE LIBERAL REGIMES

Brazil; hierarchical/state guided hybrid centred round ISI model has brought Brazil to brink of economic/financial crisis.

India; can Modi and Rajan move India in a more liberal direction away from the hierarchical/guided regime which currently prevails?

China; Beijings rhetoric emphasises liberal shift, but the regime actually appears to be moving in a more authoritarian direction.

Russia; the Kremlin continues to accrue leverage over the corporate sector as the regime becomes even more autarkic/authoritarian.

Korea; definitively hierarchical but under increasing pressure to move in a more coordinated direction; implications for investors unclear.

Mexico; from a hierarchical towards a more coordinated regime as reforms tackle structural rigidities at the cost of corporate margins .

Chile; from hierarchical towards coordinated (neo-liberalism is a myth when it comes to governance).

ASEAN/South East Asia; mostly hierarchical except Malaysia which is state-guided/hierarchical hybrid authoritarian elements increasing in Thailand while Indonesia has element of autarkic regime.

South Africa; liberal corporate governance but politics increasingly authoritarian & social pressures to move in more coordinated way.

Turkey; corporate governance strongly hierarchical but political regime increasingly authoritarian and strong social pressures.

Central Europe; Hungary has moved from dependent toward authoritarian whilst Poland now resembles European coordinated regime.

6STATE-CONTROLLED COMPANIES HAVE UNDERPERFORMED GEM

EM PERFORMANCE BY VARIETY OF CONTROL VALUATIONS BY OWNERSHIP

EM Ex-Financials

Ownership type PE PB ROE FCF/S D/E

Dispersed 16.5 2.9 18% 6% 4%

Dispersed/Private 11.7 1.2 10% 5% -6%

Foreign 20.6 3.5 17% 7% 27%

Private 19.4 1.8 9% 3% 37%

State 13.1 1.1 8% 2% 37%

Grand Total 16.5 1.6 10% 3% 34%

EM Financials

Ownership type PE PB ROE FCF/S D/E

Dispersed 17.4 2.2 13% 2% 117%

Dispersed/Private 12.8 1.5 11% 3% 67%

Foreign 10.9 1.3 11% 24% 48%

Private 10.5 1.3 13% 20% 79%

State 8.8 1.2 14% 15% 13%

Grand Total 9.8 1.3 13% 17% 41%

The governance factor has mainly played out in the underperformance of state-controlled

companies though Chinas bull run has put a floor under this trend over recent months. The premium ratings of companies with dispersed and foreign control show the extent to which investors

prioritise governance-related issues. We can find very little evidence of any serious attempt in the

more state-dominated economies and markets to subordinate political, social and strategic

objectives to more commercial considerations.

7CHINA GROWTH SLOWDOWN DRIVEN BY MASSIVE MISALLOCATION OF CAPITAL.

Authoritarian rather than guided governance regime, designed for the mobilisation phase of economic development, namely massive infrastructure build-out and urbanisation.

Local government has been able to support their enterprises through a network of direct and covert subsidies resulting in growing overcapacity across a wide range of industries.

Central government has also used big strategic holdings to facilitate national development, social and geopolitical objectives.

Very blurred boundaries between private and state sectors and limited transparency, mean conventional distinctions between private and state control are not so applicable.

Soft budget constraint prevalent; despite 2007 bankruptcy law, the number of bankruptcies handled by Chinese courts fell to 1,920 in 2013 from over 10,000 in 2006 (Reuters)

The result has been a steady deterioration in Total Factor Productivity at a macro level and a build up

of debt at both local government and a significant part of the corporate sector.

8COMPARISON OF CHINA WITH OTHER GOVERNANCE REGIMES

NIEs; Joe Studwell, in Japan, Korea and Taiwan, the state did not so much pick winners as weed

out losers. Singapore has been very successful with a state-led guided governance regime, but

within the context of a corporate sector that is

subject to a hard budget constraint and where

listed holdings are managed at arms length via

Temasek. Chinese enterprises benefit from

extensive cost factor subsidies, especially at the

local level, which are more reminiscent of Russia

pre-1998 financial crisis, though the macro

situation is totally different.

Import substitution drive is very similar to ISI

policies pursued by S European and Latin

American countries beginning in the 1950s,

though the theoretical base was laid in the 1930s.

Brazil and the former Soviet Union both had many

years of extremely rapid growth during their

respective mobilisation phases, only to fail to

surmount the so-called middle income transition.

INVESTMENT RATIOS AND GDP GROWTH

Incremental Capital Output ratio (ICOR)

2

3

4

5

6

1973 1978 1983 1988 1993 1998 2003 2008 2013

Source: OECD, Asian Productivity Organisations Productivity Database

Source: Nomura

9CONTRIBUTIONS TO GROWTH

Source: OECD, Asian Productivity Organisations Productivity Database

POOR GOVERNANCE LEADS TO LOWER PRODUCTIVITY

TOTAL FACTOR PRODUCTIVITY (%)

0

2

4

6

8

10

12

14

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

Labour Capital Total factor productivity

0

1

2

3

4

5

6

7

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

10

BLURRED BOUNDARIES CONFOUND PRIVATE SECTOR NARRATIVE

Lenovo (probably a mixed ownership firm given relationship with Legend/China Oceanwide)

Haier (opaque ownership structure supposedly under control of collective/employee ownership)

ZTE (control unclear looks like a genuine hybrid)

Huawei (subsidies, CDB lending, alleged links with security service, opaque ownership structure)

Sany Heavy (recipient of generous local government largesse)

Geely (big recipient of subsidies)

China Mengniu Dairy (COFCO now holds 28% post-milk scandals)

Rongsheng big recipient of state state support, now diversifying into alternative energy

Suntech/LDK Solar (subsidies, SOE support, most likely at behest of local government)

Sinovel (faced with delisting after two years of losses; has effectively been rescued)

China uses the term gaizhi or restructuring as opposed to privatisation. Even where enterprises were

taken out of state control, many retain strong links with local government.

Roughly one third of companies are definitely state controlled, one third private or foreign controlled

and the rest somewhere in between. It is not at all clear that private industry is expanding at the

expense of the state, in fact the opposite appears to be the case in the current stimulus.

The boundaries between the state and private sector are very blurred as shown by the ongoing anti-

corruption drive and the recent Bloomberg/NYT revelations concerning links between leaders families

and private companies. Most private companies are in receipt of subsidies or other aid.

11

CORPORATE SECTOR BEST GAUGE OF PRESSURE POINTS (1)

HANERGY

CHINA NATIONAL BUILDING MATERIALS

NINE DRAGONS PAPER HOLDING

HEBEI IRON & STEEL

Source: Ecstrat, Bloomberg

12

CORPORATE SECTOR BEST GAUGE OF PRESSURE POINTS (2)

CHINA COSCO HOLDINGS

ZOOMLION

YANZHOU COAL MINING

SANY HEAVY

Source: Ecstrat, Bloomberg

13

SOCIAL FINANCING FLOWS (% GDP)

Source: OECD, CEIC and China Trust Association

CHINESE GROWTH BASED ON INCREASE IN CORPORATE DEBT

CHINAS DEBT REACHED 282% OF GDP IN 2014

0

5

10

15

20

25

30

35

40

Bank credits Entrusted loans

Trust loans Corporate bonds

Source: McKinsey Global Institute

14

WHAT IS BEIJING DOING TO AVERT A NEAR CRISIS IN LOCAL GOVERNMENT AND

CORPORATE FINANCES?

The rhetoric stresses SOE and fiscal reform the reality appears very different, namely an effort to shore up the existing growth model within China and also to export it abroad both directly via the

overcapacity industries and also longer term through the One Belt, One Road scheme.

SOE reform?

The combining of SOEs in some of the key industries to form even larger SOEs such as railways, possibly oil and power supposedly from 112 to 40 strategic companies.

Mixed ownership reform purports to give management more autonomy but has involved minority stakes in SOEs businesses, so Beijing or local government retains control. The real objective

appears to be to attract additional external funding into SOEs (Sinopecs petrochemical assets, CITIC, CNBM, Sinopharm, COFCO Land).

Purported consolidation in many industries which should benefit large listed companies but precedents are not always vastly encouraging (CNBM, Nine Dragons, Hebei Iron & Steel).

Transformation of SASAC(s) into Temasek style arms-length relationship with companies appears distant, given widespread bail-outs and prioritisation of political over commercial objectives.

Will there be stealth restructuring via attrition, albeit without big rise in formal bankruptcies?

The central thrust of policy is to attract more dis-intermediated finance into enterprises via the

corporate sector. There have been repeated bailouts of individual companies and of whole industries those industries which are exhibiting some signs of improvement are mainly beneficiaries of additional

state largesse (alternative energy, shipbuilding).

15

IS BULL RUN IN STATE STOCKS LED BY LIQUIDITY OR REFORM?

PRIVATE SHARES OUTPERFORMED OVER 5 YEARS

CSI 300 VALUATIONS BY OWNERSHIP TYPE

LOCAL STATE HAS OUTPERFORMED OVER LAST YEAR

Ex Financials % Index PE PB ROE Net D/E

LS 12.7% 36.4 2.8 7.7% 41.8%

P 16.6% 37.9 5.2 13.8% 21.5%

S 32.0% 26.0 2.3 8.7% 49.3%

All 61.3% 29.4 2.7 9.1% 45.1%

Financials % Index PE PB ROE Net D/E

LS 3.1% 21.6 3.1 14.5% 12.7%

P 3.5% 11.7 2.0 17.2% 187.2%

S 32.1% 10.0 1.5 15.3% -40.0%

All 38.7% 10.3 1.6 15.4% -31.3%Source: Ecstrat

16

BIG OIL SOE SHARE PRICES LOSING TOUCH WITH REALITY

Source: Bloomberg

SOE REFORM BENEFICIARIES CONTRASTING EARNINGS PROFILE

RAILWAY GIANTS BENEFIT FROM INFRASTRUCTURE SPEND

40%

60%

80%

100%

120%

140%

160%

180%

200%

01/14 04/14 07/14 10/14 01/15 04/15

Sinopec Sinopec EPS BF12M

Petrochina Petrochina EPS BF12M

0%

20%

40%

60%

80%

100%

120%

140%

160%

0%

100%

200%

300%

400%

500%

600%

700%

800%

900%

01/14 04/14 07/14 10/14 01/15 04/15

CNR CSR CNR EPS BF12M CSR EPS BF12M

17

CHINA; TO WHAT EXTENT CAN WE TRUST THE CORPORATE FINANCIALS?

Huge growth in total assets and liabilities raises questions over asset quality leading to sometimes mysterious write-offs (Caterpillar Siwei acquisition, Zhangzidao Group scallop/abalone impairment).

Shadow balance sheets (Nanjing Tankers).

Alleged revenue and asset misrepresentation (Sino Forest, Tianhe Chemical)

Growing importance of financial income, which is not always separated out from operating income.

Direct subsidies should they really be taken above the line?

Elongation of depreciation periods to avoid losses and possible delisting (Angang Steel)

Use of accounting reserves to artificially reduce production costs (Yanzhou Coal)

Intra-company transactions and asset injections from parent companies (can obviously be bullish too but its a very untransparent process). Sales to related companies whilst also guaranteeing loans to these companies solar companies appear prone to this behaviour.

Banks NPL provisioning, including quarter-end manipulations to avoid having to write down loans.

Rising receivables with inadequate write-offs

Capitalisation of R&D expenditure and goodwill not always justified - could lead to impairments.

Paul Gillis; accounting fraud in the US is usually from the overly aggressive application of an accounting principle accounting fraud in China has usually been situations where large portions of the business simply do not exist. http://www.chinaaccountingblog.com/

18

INDUSTRIAL/MATERIAL COMPANIES UNDER PRESSURE & EXPENSIVE

Date Capex/S AP/S AR/S D/E Liabilties/E Inventory/S Net Margin PB PE FCF/S ROE

07/05/2015 7.0% 14.0% 13.2% 82.5% 160.3% 17% 1.2% 3.2 142.5 -0.9% 2.3%

31/12/2014 7.1% 12.5% 12.0% 81.4% 158.0% 17% 1.7% 2.1 61.9 -1.9% 3.4%

31/12/2013 8.4% 11.5% 12.4% 82.1% 152.4% 17% 1.4% 1.6 54.7 -5.0% 2.9%

31/12/2012 8.8% 10.8% 12.1% 75.7% 149.0% 18% 1.4% 1.8 60.6 -6.1% 3.0%

31/12/2011 8.0% 10.5% 10.9% 71.4% 147.2% 18% 4.0% 1.9 21.8 -4.9% 8.8%

31/12/2010 8.6% 10.8% 10.5% 72.2% 147.2% 20% 3.1% 3.3 51.9 -5.7% 6.3%

31/12/2009 13.0% 12.6% 10.8% 71.7% 146.9% 20% -1.5% 3.2 (127.5) -3.3% -2.5%

Materials

Date Capex/S AP/S AR/S D/E Liabilties/E Inventory/S Net Margin PB PE FCF/S ROE

07/05/2015 5.5% 24.0% 25.3% 40.2% 179.0% 34% 4.3% 3.8 49.9 -2.8% 7.7%

31/12/2014 5.1% 23.4% 25.8% 43.9% 180.5% 36% 4.4% 2.5 32.4 -3.8% 7.7%

31/12/2013 5.2% 22.5% 24.9% 38.5% 175.9% 34% 4.0% 1.9 26.1 -3.2% 7.3%

31/12/2012 6.2% 19.7% 22.2% 35.4% 176.5% 30% 4.4% 1.8 20.5 -5.7% 8.8%

31/12/2011 6.3% 18.8% 20.6% 29.9% 174.5% 29% 5.6% 2.0 18.3 -7.1% 11.1%

31/12/2010 6.8% 19.9% 21.0% 21.5% 160.6% 28% 5.3% 3.5 38.6 -4.3% 9.1%

31/12/2009 8.4% 18.3% 18.1% 43.5% 186.1% 27% 4.4% 3.8 43.0 -2.0% 8.8%

Industrials

Source: Ecstrat, Bloomberg. Data aggregated on all China-listed stocks

19

CHINA MOST PRONE TO DILUTION (PRICE TO MARKET CAP FOR KEY MARKETS)

Source: Bloomberg, Ecstrat, MSCI

20

POSSIBLE SCENARIOS FOR THE CHINESE MARKET

1. Business as usual - the stimulus combined with lower commodity prices puts a floor under the economy, which begins to show signs of stabilisation. If the pattern of the past five years persists,

sell China on good economic news and buy on bad news, so at the very least the market levels

out and may retrace some of the gains as monetary and fiscal policy becomes more

contractionary.

2. Boom and bust - Beijing looses control over the equity market which behaves in a similar way to 2007-08 and eventually topples over a little like NASDAQ in 2000, simply because of the weight

of supply of stock and in Chinas case the increasingly obvious dichotomy between the fundamentals and the equity market.

3. Stronger for longer or Japan redux - the boom becomes a prolonged bubble like Japan in the mid/late 1980s against the backdrop of a gradually improving economy, as Chinese retail participation continues to grow exponentially and overseas investors are sucked into the market in

greater numbers, especially if Chinese A-shares are admitted into the main global investible

indices. If this happens and company-level governance continues to be very poor, the eventual

result will be wealth destruction on a massive scale, but the denouement could be 2-3 years away.

21

INDIA; NO CHANGE LIKELY TO HIERARCHICAL GOVERNANCE REGIME

1. India was an autarkic and hierarchical regime before the 1991 reforms. The system now is predominantly hierarchical, but with liberal

and state-guided elements; control of the corporate sector is more evenly split between the four main categories than any other market.

2. The most striking characteristic of the governance regime in India is the difference between the way in which the legal framework

around the corporate sector has evolved towards what is regarded as global best practice and the willingness/ability of the authorities to

implement them effectively. This undermines both the liberal common law based elements and also impairs the states ability to mobilisethe resources necessary to increase the pace of infrastructure development, which is one of the major differences between India and the

East Asian NIEs, including China, at a similar stage in their development.

3. The extent of the states domination of the banking system and the tight control of elite families over some of the major companies, has helped blur the boundaries between the state and private sectors to an extent that has give rise to a series of scandals, especially in

the telecoms and infrastructure-related sectors. The state retains a relatively high degree of control over the banking sector which has

resulted in onerous social obligations mainly for the state-controlled banks and also a relatively high level of protectionism from foreign

competition and direct participation in Indian companies through much of the rest of the economy

4. The domestic investment institutions are largely state-controlled, in particular the LIC which tend to behave in a relatively deferential

manner towards controlling shareholders and the state in particular, as has recently been demonstrated by their support of recent partial

sales of government stakes in SOEs. Given that most institutional holdings are not really for sale at the right price, the free float of the

Indian market, like Chile, is probably overstated, partially accounting for the relatively high level of valuations.

5. The hierarchical nature of many of the larger companies has led to the development of conglomerates with the associated succession

issues and also the prevailing low level of dividend payouts at these companies as the controlling shareholders prefer to retain cash in

the businesses. The reluctance of families or other controlling promoters to cede any degree of control in their companies to minority investors makes the task of raising equity very difficult and is currently one of the underlying reasons for the bottlenecks which exist

throughout much of the banking sector.

6. India is a democratic country, but there are concerns that if the Modi-led administration fails to revive growth in time for the next

election, then the BJP may adopt a more overtly nationalistic and authoritarian agenda.

22

INDIA PERFORMANCE BY GOVERNANCE REGIME CATEGORY

STATE LAGS, FOREIGN-CONTROLLED LEADS IN INDIA

Source: Ecstrat, Bloomberg

Valuations PE PB D/E ROE

Dispersed 26.7 5.7 26% 21%

Foreign 46.2 11.3 -36% 25%

Private 23.6 2.7 61% 12%

State 12.6 1.9 44% 15%

23

WILL BRAZIL MOVE TOWARDS A MORE LIBERAL GOVERNANCE REGIME?

1. The Brazilian governance regime was an autarkic/hierarchical hybrid before moving in a more liberal direction in the 1990s after a

number of failed attempts at macro-economic stabilisation. Following the GFC, under the second Lula administration and then under

Dilma, the state intervened more actively in both the listed corporate sector and the broader economy, mainly for ideological/path

dependent reasons, but also to ameliorate the impact of lower growth rates and to promote better quality manufacturing based jobs.

Petrobras local content and project stake/leadership requirements; also controlled downstream prices.

pressure on banks, utilities and telcos to control prices/fees/tariffs.

BNDES promotion of national champions and enhanced role for state-controlled banks.

2. History matters in Brazil where the ISI policies, which have been pursued since 2010 are partly inspired by the perceived success of

the Chinese model, but also by Brazils own policies under the military government 1965-86, including the 1968-73 growth miracle.

3. Form versus substance. Dual-voting share classes have been largely superseded by pyramid structures to preserve family control, so

there are very few truly dispersed ownership companies even on the Novo Mercado. Minority representation on boards now common but

not always of any value (Petrobras). The big domestic investment institutions, led by state-controlled pension funds, have rarely used

their positions to stand up for the rights of minority shareholders.

4. The extent of the blurred boundaries between the state and private sector elites has been highlighted by the Petrobras, OGX and

construction scandals; many prominent politicians across a range of parties have been implicated while the system of party funding has

been an important contributory factor.

5. Weak market regulation by the CVM highlighted in the cases of Oi and OGX.

6. It is clear that the system needs to change, but there is no clear roadmap. The first step is to strip Petrobras of its exclusivity in terms of the pre sal development and to introduce a greater degree of market pricing downstream. The pivotal position of BNDES as a funder

and arbiter of the corporate sector also needs to be addressed. There are however major political obstacles, whilst there are clear risks

to financial stability from Petrobrass debt levels combined with what is likely to be a very weak economy for some time to come, due to the lagged effect of excessive state intervention and weak commodity prices.

24

BRAZIL PERFORMANCE BY GOVERNANCE REGIME CATEGORY

THE FAILURE OF STATE CAPITALISM IN BRAZIL

Source: Ecstrat, Bloomberg

Valuations PE PB D/E ROE

Dispersed 14.1 2.1 9% 15%

Foreign 17.2 1.5 36% 8%

Private 20.4 2.6 57% 13%

State 9.3 0.4 66% 5%

25

ALTHOUGH FALLING COMMODITIES HAVE ALSO PLAYED A MAJOR ROLE

Source: Bloomberg, Ecstrat, MSCI

26

PETROBRAS NET DEBT NOW OVERTAKING MARKET CAP

Source: Bloomberg, Ecstrat

BRAZIL; PETROBRAS IN THE EYE OF THE STORM

27

RUSSIA; GOVERNANCE REGIME AUTARKIC AS WELL AS AUTHORITARIAN

1. Path dependence rules in Russia. Following the dissolution of the Soviet Union in 1991, Russia appeared to be moving towards a

hybrid liberal/hierarchical governance regime, which became disrupted after the 1998 financial crisis. From mid 1998, Russia began to

move towards a more state-guided regime through much needed fiscal and other reforms, a process which accelerated when Putin

became president. Since Autumn 2003, the regime has become increasingly authoritarian, and the Kremlin has taken advantage of both

the financial and the Ukraine crises to extend state control, most recently via the seizure of Bashneft and personnel and organisational

changes in the defence/aerospace industries.

2. The authoritarian governance regime extends throughout much of society. The annexation/reunification of the Crimea is consistent

with the dominant Kremlin-led nationalist and anti-Western narrative, manifested in the clampdown on opposition politicians, NGOs and

print/broadcast/social media. Defence expenditure has been increasing rapidly over recent years and the military industrial complex is

regaining some of the power it held in the Soviet era.

3. There are huge differences between the form and substance of corporate governance, so the apparent improvements in market

infrastructure and rules concerning independent directors have not prevented the interests of minority shareholders from being ignored

(Norilsk Nickel, Uralkali, Surgutneftegas) or overridden (Bashneft, TNK/BP, Pharmastand). There are no major listed companies where

dispersed minority shareholders are able to wield any real influence. The listed state and many private companies prioritise social,

political and sometimes geopolitical objectives ahead of purely commercial considerations.

4. Widespread rent-seeking at many Russian companies can lead to a loss of value due to sales/transfer of assets in non-transparent

deals at below market prices and/or capex to connected parties. The late Boris Nemtsov documented many of the alleged major

instances of corruption in his Putin Itogi report.

5. The biggest risk for investors currently is that the state will use the listed corporate sector to alleviate the massive downward pressure

on living standards caused by high inflation, mainly as a result of the falling rouble as well as sanctions, including the food import ban.

The banks, Gazprom and the utilities are especially vulnerable.

6. Under pressure from sanctions and anti-western ideology, Russia is moving towards a more autarkic governance regime. The risks

are that the system runs out of money in around eighteen months time if oil prices remain low and that there are further episodes of de

facto confiscation of private assets by the state. It is however also possible that more Russian money will be invested in the equity

market and that companies will become more selective about their investment plans, though this does not necessarily imply that it will

become more subject to market disciplines.

28

RUSSIA; OIL DRIVES CURRENCY AND EQUITIES

THE RUBLE HAS BEEN TRACKING 12M BRENT

MSCI RUSSIA DOLLAR DIVIDENDS LOWER (3.98% 15 EST)

SO OIL PRICE IN ROUBLES PROTECTS BUDGET

MSCI RUSSIA PRICE DOWN, VALUATION UP

Source: Bloomberg, Ecstrat, MSCI

29

KOREA SYSTEM UNDER ATTACK BUT REMAINS HIERARCHICAL

1. Korea was a textbook guided regime in the countries development phase as a NIE before the development of vertically

integrated chaebol groupings centred around families, resulted in a more hierarchical regime and corporate sector which had become too big to fail by the mid 1990s. Korea moved closer to a liberal regime in the aftermath of the Asian crisis, initially at the behest of the IMF before President Kim Dae Jungs government began to impose a hard budget constraint on the chaebol forcing a major restructuring and some bankruptcies.

2. Since the early 1990s, Korea has now largely reverted back to a hierarchical regime where the interests of foreign minority

shareholders are clearly subordinated to those of the leading family dynasties. There is a relatively high level of hostility towards foreign

influences in what used to be know as the Hermit Kingdom so none of the major listed Korean companies are under foreign control, with the partial exception of S-Oil, which the Hanjin Group controls together with Saudi Aramco.

3. The political culture in Korea is strongly egalitarian and in some ways the economy should operate under a similar coordinated way to

Continental Europe, but in fact the level of social protection is very low for an OECD country and this and most previous governments

have been dominated by members of the elite political and business class. The chaebol have come under relentless attack from

politicians for supposedly crowding out potential competition, but other than a few well publicised cases against individual family

members, there has been very little action to reduce their dominance over the economy.

4. Is anything likely to change given the much lower growth rates and high levels of household debt? On the political front, there is

certainly evidence of growing unrest among a large part of the middle class, in particular over the cost of education, which is leading to

growing pressure for the chaebol to do more to stimulate the economy and spread wealth. The Korean National Pension Fund is

supposedly the governments tool for overhauling corporate governance, but the senior management appear to have been given a relatively limited mandate for activism. Minority shareholders are hoping for higher payout ratios, but the risk is that they will be squeezed

between higher corporate taxes and continuing high levels of capital expenditure by many of the leading companies.

5. In the meantime, the chaebol are paying lip service to the need to become more accountable both to minority shareholders and to

society, but are still focused on extracting as much value as possible for the controlling families which entails managing succession issues

in the most tax efficient manner. We see little evidence of a durable move to higher payout ratios, which even after recent increases by

some large index constituents are just under historical average levels. There is also little indication of any real improvement in

transparency in terms of intra-group transactions which combined with the cyclicality of many of the leading companies, means that

analysts earnings forecasts are among the most unreliable in the GEM universe.

30

KOSPI DIVIDEND PAYOUT RATIOS

Source: KOSPI, Mark Artherton

KOREA; UNCLEAR IF RECENT PAYOUT INCREASES WILL CONTINUE IN FUTURE

MSCI KOREA GROSS DIVIDEND YIELD

Source: Bloomberg, MSCI

10%

15%

20%

25%

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

31

DISCLAIMER

Analyst and Strategist Certification:

Each of the analysts and strategist identified in this report certifies, with respect to the companies or securities that that individual analyses, that (1) the views expressed in this report

reflect his or her personal views about all of the subject companies and securities; (2) all recommendations are fairly represented, in accordance with Ecstrats Research Policy; and (3) no part of his or her compensation was, is or will be directly or indirectly dependent on the specific recommendations or views expressed in this report.

Analysts and strategists may be remunerated by a combination of base salary and discretionary bonuses, based on the profitabi lity of the company.

Disclaimer:

This document/presentation has been prepared/issued by Ecstrat Ltd.

This document/presentation is issued by an analyst on behalf of Ecstrat to investment professionals and institutional investors only. The information and opinions expressed herein

have been prepared in good faith from sources believed to be reliable, and supplied to Ecstrat. As such, its contents do not necessarily reflect the views of Ecstrat or any of its

directors, officers or employees. Neither Ecstrat nor its associated companies accepts responsibility for the accuracy and completeness of the information herein, nor do they accept

liability from any loss arising from the use hereof or make any representations as to its accuracy and completeness. Any opinions forecasts or estimates herein constitute a judgment

as at the date of this report. The information, recommendations and other materials presented in this document are provided for information purposes only and should not be

considered as an offer or solicitation to buy or sell securities or financial instruments or products. The contents of this document also constitute factual, objective and neutral

research/analysis and, as such, does not amount to advice for purposes of the Financial Advisory and Intermediary Services Act, 2002. Where prices of securities are mentioned, these are mid-market prices as at the close of business on the business day immediately preceding the date of the research. A summary of our policies for managing conflicts and our

research policy is also available from our website at http://www.Ecstrat.com. This document is protected by copyright, is the property of Ecstrat and may contain information that is

confidential and therefore must not be disseminated or reproduced in whole or in part without prior approval from Ecstrat and the relevant research analyst or Strategist. Any use of

graphs, text or other material from this report by the recipient must acknowledge Ecstrat as the source and requires advance authorisation.

Ecstrat, and any of its connected or affiliated companies or their directors or employees, may have a position in any of the securities which may be the subject of this report. Analysts

are prohibited from dealing in the securities that they cover. Our policy governing personal trading is available from our website.

Neither this document, nor any copy of it may be taken or transmitted into any jurisdiction which may constitute a violation of relevant local securities laws.