Emerging markets have always been seen as being risky; but, recently, the nature of that risk has been changing — posing new challenges for clients.

One of the hazards of investing in emerging markets has always been the added element of risk. Companies doing business in less developed countries typically have been perceived as facing greater political risk. They might be operating in regions with unstable governments, navigating capricious bureaucracies or dealing with volatile economies. As a result, greater credit and currency risks were ever-present threats.

Now, however, the gap between developed and emerging markets has narrowed. It was the emerging markets that had weathered the financial crisis and the subsequent global recession better — and they’ve been powering global economic growth since.

Although the macro country risks that used to accompany investing in emerging markets do not appear to be quite as acute as they used to be, there are still dangers. Among them, these countries’ legal systems, respect for property rights and corporate governance practices may not be up to Western standards. These weaknesses may expose clients who invest in emerging markets to greater risk at the individual company level rather than at the country level.

Canadian investors got a taste of this recently with Sino-Forest Corp., whose shares began June trading at more than $20 a share but plunged to less than $2 after short-seller Muddy Waters Research LLC released a report alleging Sino-Forest has substantially overstated its assets and profits, among other things. (The stock has since recovered to about $5.)

In the wake of these revelations, Sino-Forest announced that the Ontario Securities Commission had begun an investigation and that the firm has asked other regulators to look into trading that took place ahead of the damaging report’s release. In the meantime, Sino-Forest has engaged an independent committee to examine the allegations, which is expected to take months.

OSC TO PERFORM REVIEW

Given that this episode involved a Toronto Stock Exchange-listed company, it hit close to home; it also alerted Canadian investors to the rising risks for emerging-markets firms, particularly in China. So, in early July, the OSC announced it is undertaking a targeted review of issuers listed on Canadian markets that do most of their business in emerging markets.

The OSC, which hasn’t given a timeline for its review, says its exercise will closely examine the disclosure made by issuers and the vehicles they use to access the market, and also focus on the role of the auditors and underwriters of these firms. Depending what the OSC review uncovers, it may result in enforcement action for the players involved — and it could also have broader policy implications.

Concerns about firms based in emerging markets that tap international capital markets aren’t limited to the OSC. The U.S. Securities and Exchange Commission recently issued an investor warning concerning companies (particularly, foreign firms) that come to market via a reverse takeover. The SEC also recently suspended trading in more than a dozen such companies, citing a lack of current, accurate information about the firms and their finances.@page_break@In addition, representatives of the SEC and the U.S. Public Company Accounting Oversight Board went to China in mid-July to meet with finance officials and regulators to push for improved audit quality at China-based firms. It remains to be seen if these efforts will amount to anything.

In the meantime, clients who invest in emerging markets are now grappling with a new set of risks: increasing scrutiny of emerging-markets companies, which could uncover previously undetected corporate shenanigans but also make those companies more vulnerable to allegations of corporate wrongdoing, true or not.

For example, in late June, the stock of a China-based meat-processing company took a 31% haircut on mere speculation that Muddy Waters Research was about to release a negative research report on the firm.

Not only does such speculation damage the firm involved, but growing suspicions about the business climate in China can also spill over to the rest of the emerging-markets sector — and to companies in these regions.

In a recent report, New York-based credit-rating agency Fitch Ratings Ltd. notes that since mid-2010, China-based companies that access international capital markets are coming under increased scrutiny. The Fitch report says this intensified attention has gone beyond simply echoing the greater number of China-based firms that are playing in the global markets and is now starting to reflect the “lower level of standards” in China compared with even other emerging markets such as Latin America.

In particular, the Fitch report points to weaknesses in audit and accounting standards, substandard transparency and various corporate-governance weaknesses, such as concentrated ownership, lack of independent oversight and combined chairman and CEO roles.

Another big credit-rating agency, New York-based Moody’s Investors Service Inc. , recently began screening the China-based companies it rates to uncover possible governance or accounting risks. At almost all the firm’s Moody’s looked at, red flags relating to rapid growth, aggressive business strategies, earnings quality and ownership concentration popped up. (See story, below.)

Between the growing sensitivity to these inherent weaknesses and an increase in investor interest in the region, it seems likely that there will be more episodes of emerging-markets firms being accused of fraud and other misdeeds.

Indeed, the Fitch report notes, the agency expects to see more allegations levelled against China-based firms. In fact, the report indicates Fitch is concerned about firms coming under investor suspicion when they are not doing anything wrong.

At the same time, the Fitch report suggests, this increased scrutiny could ultimately prove to be a good thing, forcing higher standards — even if local authorities aren’t demanding them: “Arguably, overseas investors are now undertaking the job that China’s underdeveloped capital market has hitherto struggled to address: challenging Chinese management to adopt higher standards.” IE