Crony Capitalism in Emerging Markets

Mexico's Carlos Slim is emblematic of an emerging market tycoon who’s contributing to a top-heavy economy. Brendan Smialowski / Getty Images

Worth more than $60 billion, magnate Carlos Slim Helú is the richest man in the world, which makes him a titan in Mexico. His vast network of companies constitutes 42 percent of the country's benchmark stock index. América Móvil, his cellular-phone empire, controls more than 70 percent of the domestic market. And while Mexico has made one of the most remarkable recoveries from the financial crisis—the International Monetary Fund just revised its growth forecast up to 4.5 percent this year, a third higher than its superpower neighbor to the north, and exports are booming, up 44 percent in May—economists argue that Slim's success actually comes at the cost of Mexico's growth.

Nobody's suggesting anything illegal is afoot, but the concentration of business wealth and power among just a few makes economists "talk about Mexico as if it has given up a few percentage points of GDP growth," says Raghuram Rajan, a former chief economist of the IMF.

President Felipe Calderón says that monopolies are forcing a 40 percent premium on Mexicans for everyday goods and services. Likewise, credit for consumers and small businesses is abysmally low, stunting enterprise. Meanwhile, Slim's firms, along with those run by a handful of other modern-day tycoons in the country—like retailer and banker Ricardo Salinas's Grupo Salinas or the Azcárraga family's media empire—deliver eye-popping gains. In other words, Slim may be great, but if he's all that Mexico's got, that's no good.

Surveying the landscape of emerging markets today, the "Slim syndrome" is one of the foremost dangers developing economies face. In the same way the technology boom fueled the 1990s, emerging markets (averaging 6 percent growth) have been the relentless drivers of the global economy over the last decade. However, without a sea change in the way these countries do business, the spectacular ride could soon come to a stunted end. Fifteen years ago the backroom privilege of big-time industrialists was known as crony capitalism, and its insidious grip brought down several of the so-called Asian tigers. Today, the situation is different. Interviews with some two dozen economists, bankers, and consultants working in emerging markets paint a portrait that would better be called "crooked capitalism." Emerging markets may be the most promising global investments, but many are lopsided and some even corrupt.

Monopolies, graft, and massive infusions of state spending are resulting in low competition and unsustainable gains, and the heavier hand of government is carrying these problems into the future. For countries like Mexico, India, China, Russia, Indonesia, and several other developing economies, "this is the fork in the road," says Ruchir Sharma, head of emerging markets at Morgan Stanley. The export-led growth strategies that fueled the boom were, "in large part facilitated by the fact that the cost of capital was very cheap across the globe." Investors poured money into manufacturing sectors that boomed off the back of cheap labor, and a new class of oligarchs like Slim rose by snapping up state assets on the cheap. But now the cost of capital is rising, wages are going up, and the once hungry consumer stalwarts like the U.S. and Europe are facing anemic growth, likely for years to come. To prepare for the long haul, emerging-market economies need to become more competitive domestically and crack down on corruption. The problem is that, as Sharma argues, instead of an appetite for reform, success has often sparked a turn toward complacency.

Crony capitalism involved an incestuous relationship between industrialists, politicians, and banks. By the late 1990s family-run firms in South Korea, Indonesia, Thailand, and Malaysia had grown into far-flung global enterprises, often fueled by sweetheart loans from well-rewarded friends in government and banks that were part of the family empire, too. The debts rung up under this system were massive, often uncountable and untraceable, and the whole system came crashing down in the Asian financial crisis of 1997–98. Economies and currencies collapsed. The International Monetary Fund intervened with more than $100 billion in bailouts, broke up many of the corrupt banks, and pressed many of the stricken conglomerates to reform their ways. In fact, many firms have. "During the recent global financial crisis, many emerging markets faced something of a stress test of their cronyism," says Simon Johnson, former chief economist of the IMF. Many bounced back quickly because they've improved their macroeconomic policies, and Johnson says "there are better governance structures, but these problems are still very real."

The Greediest People of All Time Aaron Favilla / AP

Today many of the largest family conglomerates are free of debt and less likely to tolerate playboy uncles or wayward second sons in top management, but they are also growing ever-more powerful, often in large part because of strong ties to government. Crooked capitalism is crony capitalism run by financial pros, which may be even more dangerous. The result is a continuing trend toward consolidation, creating increasingly top-heavy economies. In India the personal worth of the 10 richest billionaires constitutes a 10th of the $1.2 trillion economy. University of Alberta finance professor Randall Morck estimates that the pyramids of companies owned by the Tata and Birla families alone in a typical year are worth about half of the entire market capitalization of the Indian stock market. Export-led growth strategies in many emerging markets has led to increased consolidation, which offers big firms more power abroad but squashes rivals at home. Harvard economics professor and former IMF chief economist Kenneth Rogoff says that these monopolies thrive on the global market, "but as they turn inward, they have every incentive to restrict innovation, entry, competition, and it's hard because these corporations are often very rich and very politically powerful." Transparency International's most recent Global Corruption Report, which focused exclusively on corruption in the private sector, warns that in developing economies, corruption is "a growing and complex problem," and "politicians and government officials receive bribes believed to total between $20 billion and $40 billion annually." In Russia, some 80 percent of listed firms are politically connected.

The China case is telling. In response to the financial meltdown in 2008, China launched an $800 billion spending plan. By some estimates, as much as 60 percent of the stimulus money was recycled back into the stock and property markets, in large part because of the tight ties between state officials handing out money and the businesspeople receiving it. (A recent study reported that more than 90 percent of the 3,220 Chinese worth more than 100 million yuan—that's about $14.6 million—are the children of high-level Communist Party officials.) These property and stock bubbles now threaten economic stability.

Family firms tend to become particularly entrenched, according to Sharma, in sectors like real estate, construction, and energy, which rely on government contracts. This is opening up new opportunities for crooked dealings. Emerging markets are spending trillions—Merrill Lynch figures as much as $6.6 trillion over three years—on infrastructure. Much of that will go to industries controlled by large family-owned conglomerates. Transparency International says there's "compelling evidence that a new and potent wave of globalized cartel activity" has hit developing countries, corrupting big infrastructure projects. In India, Prime Minister Monmohan Singh has said that his country needs to spend some $1 trillion over the next five years on infrastructure. As Johnson puts it, "in part, government money is feeding into these very unequal structures that can give them growth for a time, but then have historically led to busts."

Right now, there's not much pressure to reform. Global investors keep pouring money into emerging markets, drawn by high growth rates. Analysts have long hoped that activist investors would clean up the system, but they are in short supply. Meanwhile, the new middle classes in these countries tend to be more nationalistic than their Western peers and quicker to embrace state capitalism and big family firms, and they've got money in their pockets—so why complain?

The obvious answer to monopolies is to bust them up or regulate them into submission. Analysts often point out that America was still a developing economy when, in the early 20th century, the government broke up the Gilded Age's commercial empires. But today there is precious little momentum behind monopoly reform. There may be a simpler solution, says Charles Ormiston, head of Asia strategy at Bain & Co.: "Allow more foreign competition," particularly in sectors dominated by the large export firms, creating a more dynamic and fluid market to spur innovation and growth.

There are some positive signs. Suvojoy Sengupta, a partner with Booz & Co., says that often "a good relationship with the government is still an important one," but reforms in India have introduced remarkable competition, especially in the automobile and insurance sectors. He says "it's forced the erstwhile crony capitalists to get their acts together." And obviously, with competition, prices drop, which is good for consumers. Brazil's antitrust regulator is considered by many to be one of the world's most lackluster, but its current head, Arthur Badin, is fighting for legislation to add muscle to the office and is targeting the construction industry, where infrastructure dollars are pouring in and big firms hold significant control.

The real question is, will these economies take up reform before the corrosive effects of monopolies begin to slow them down in the coming decade? After all, the massive investment in infrastructure today is, at least in theory, supposed to build a platform for a thriving and dynamic economy for decades to come. But if that process ends up expanding the power of the monopolists, the Slim syndrome will only become more acute.