Weak controls and corruption in cross-border capital raising

Credit Suisse is the latest to join the company of the likes of McKinsey and Goldman Sachs in being accused of abetting corrupt practices in developing countries. 

Recall the case of $850 m Tuna Bonds, whereby Mozambique's state-owned fishing company Ematum issued Eurobonds to finance shipping fleet expansion so as to increase the country's fishing exports. Much of that money was siphoned off. It was part of the surge in foreign bond issuances by African countries which gained much praise in the financial media. 

In a case with strong parallels with the Malaysian 1MDB scandal involving Goldman Sachs, Bloomberg reports that US prosecutors have charged three former Credit Suisse employees and Mozambique's former Finance Minister with defrauding investors over $2 billion of state-backed loans for the country which generated at least $200 m in bribes and kickbacks. 

The charge sheets in the two cases set out the lengths to which information was hidden internally: In Credit Suisse’s case, prosecutors argue that much due diligence — from company directors to competitive tender processes — was faked. But the common thread is also one of boom-time activity, when red flags might be more likely to be missed. The backdrop to these alleged frauds was a time, around 2012 and 2013, when banks were desperate for new sources of profit after the financial crisis. Between 2008 and 2012, annual emerging-market bond issuance rose from $487.3 billion to $1.6 trillion. Amid that boom, risk controls appeared to take a back seat.

The lucrative fees added an incentive. The $600 million Goldman netted from 1MDB’s fundraising amounted to a stunning 10 percent of the $6.5 billion raised. A report by Kroll, disputed by Credit Suisse, alleges the Swiss bank received about $160 million in fees for arranging $2 billion of loans in Mozambique. This included $141 million of “contractor fees,” which were, however, passed on to other banks. The cost of these transactions may now become more apparent: As the orchestrators of the Mozambique deal lined their pockets, according to prosecutors, the government found itself sinking deeper into costly debt.

Sample this snippet on currency volatility which underlines the risk about foreign currency loans, especially when backed against local currency revenues,

Analysis by TCX and Carnegie Consult, an investment advisory service, of 95 currencies since the end of the Bretton Woods system of fixed exchange rates in 1971 suggests that, on average, one-in-eight developing world currencies fall 20 per cent or more against the dollar in any given year, and one-in-20 crash by 50 per cent.

This blog had then urged caution, here, here, and here, about such African bond bubbles. Don't be surprised if similar stories tumble out from Zambia, Kenya and others who hired western investment banks to raise large amounts of foreign capital in the 2011-13 African Eurobond boom. 

There are three issues here.

1. Original sin and all means that foreign credit market access comes at a prohibitive cost for developing countries. Weak state capacity and macroeconomic instability merely exacerbate the problems. In 2016 Mozambique was accused by the IMF of hiding $1 bn in debt and turned off its funding, whereupon the country defaulted and underwent debt restructuring. Last year the country grew at its slowest pace in 18 years!

2. In boom times, when capital inflows into developing countries surge, internal control on both the lending and borrowing sides weaken and distortions invariably creep in. Further, capital costs decline steeply, far out of proportion to the risks being assumed, thereby lulling everyone into a false sense of comfort with such borrowings. In a financialized global economy, the surges itself are generally the result of spillovers of monetary policy and other actions in developed economies. This makes the RBI's self-restraint in keeping out foreign capital all the more remarkable. 

3. Finally, such capital raising and other related assistance is never far away from corruption. This, while always suspected, though never raised prominently, is now fast becoming evident in the series of scandals that have been surfacing in recent times. None of the leading US and European financial institutions and consultancies appear to have been averse from indulging in corrupt practices. In fact, it is fair to say that when faced with high-stakes engagement in less than transparent countries, their dealings appear to generally raise questions. 

It is very likely that the ongoing bromance of western financial institutions and consultancies with Saudi Arabia will reveal a lot of muck once the tide comes down in a few years and new information surfaces.