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The Role of Economic Freedom in Prosperity

Hong Kong has been ranked tops in the world for economic freedom by the Fraser Institute which publishes the report on Economic Freedom of the World. The annual indices are compiled based on the size of government, legal structure and protection of property rights, access to sound money, free trade, and regulatory environment. It’s the kind of result that government ministers like to proudly cite, but what does it mean for the investment community?

Professor Peter Chen of the Department of Accounting has come up with some answers in his work on the impacts of economic freedom on corporate investment and value creation. In short, economic freedom matters and investments in places with higher economic freedom are better bets.

Peter Chen

Professor Chen employs a real options based valuation model that accounting information informs managerial investments with lack of economic freedom acting as frictions that impede

investments. “Accounting plays two important roles,” he said. “First, it tracks down the shareholders’ wealth or current investment in the company, represented by the book value. Second and most important, if we want to project future cash flow, the accounting system reports the company’s performance in terms of profitability, that is, earnings scaled by capital invested. If a firm does nothing, it will capitalise the current earnings. If it is very profitable, it should attract capital and be able to grow. On the other hand, if the company is losing money, it has to adapt and put resources to alternative use. That is the put option.”

Frictions arise when there are impediments to a firm’s freedom to respond to these situations and invest or divest. For example, Li Ka-shing was able to withdraw investments from China when he perceived clouds on the horizon, but state-owned enterprises may not have the same freedom to do so. “If we have no economic freedom, a firm will keep doing what it is doing now. With greater economic freedom, for the same company, it can achieve great valuation because it grows faster in case of higher profitability, and respond faster to adaptation in case of losing operations because the frictions are minimal.”

To quantify that, Professor Chen applied his model to the growth patterns of firms in 30 countries from 2000 to 2010, resulting in 186,423 firm-year observations. Firms operating in countries or regions with higher level of economic freedom have greater investment sensitivity to accounting profitability, reflecting greater efficiency. The relations of equity value to accounting fundamentals such as earnings and book value were more convex, reflecting managerial flexibility. And for a given change in profitability, shareholder returns were higher for firms in places with greater economic freedom.

For portfolio managers, the implications were clear, he said. Location of managerial decision-making matters, and firms in country or regions with higher economic freedom deserved higher valuation multiples. The economic freedom rating can even vary within a country – Shenzhen is ranked on the top in China among all provinces and major municipalities for economic freedom.

Professor Chen also touched on the implications of Hong Kong’s current high ranking on its future and sounded a strong warning against complacency. “One very key insight of the real options that I am using is that we have to constantly re-assess or adapt to the current situation. People need to always be thinking about and imagining new opportunities so our economic structure reflects the changed reality of Hong Kong.”

Central to creating such opportunities are human capital and the flow of communication and information within society. He cited the example of the HKICPA which still views CPA narrowly as auditing and put great emphasis on examinations which very few takers pass despite years of university training to become accountants. He suggested that the role of accountants be re-imagined like that in North America or Australia, where CPA can serve as a symbol of capability to serve in many managerial positions such as CEO, CFO and regulators in addition to auditing. Rather than emphasising examinations, we should make HKICAP more accessible to our students educated in Hong Kong universities and shift toward emphasizing professional practice and continuing education which will enhance the ability and the value of a CPA. 

“We need to take advantage of our economic freedom and the institutions we have. More importantly, we need to nurture the capability of human capital, especially the younger generation. In addition, Hong Kong’s brand value can be much enhanced through government-assisted communication and co-ordination,” he said.

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