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A new study suggests that Estonia has the strongest legal system of all EBRD member states, and that investors in the region are overpaying to invest in countries with weak legal infrastructure.
Renaissance Capital has launched a new ranking combining last year’s World Justice Report analysis of legal systems and the World Bank’s Ease of Doing Business surveys, and then correlated the results against market valuation.
Viewed purely on the numbers, the standout names in the region are Estonia, the Czech Republic, Poland, Hungary, Slovenia and Romania, with Egypt and Ukraine the worst. Adjusted for per capita GDP, Poland is the biggest emerging market outperformer, while Turkey and Lebanon lag.
“There are two things about Estonia,” says Charles Robertson, chief economist. “One is that, even in Soviet times, Estonians were a bit exceptional for their lack of corruption, and they have been the most reformist country in Eastern Europe in the 90s. The other is that they are tiny, which helps: it appears that it is easier to make changes in smaller countries.”
Additionally, the report suggests that countries – Estonia included – benefit from joining the European Union “I would argue that legal systems are hauled upwards by the requirement to adopt the body of European legislation that member states have to take on before joining the EU,” he says. “I didn’t think much of that in the late 90s. But now I can measure it, it shows that if a country like Ukraine joined the EU, you might expect a jump in its legal system.”
At the other extreme, he says Egypt is impeded by the scale and complexity of its legal code, adopted from the French model in the Napoleonic era. “And what’s interesting is how difficult it is to change it. If [Egyptian President] Sisi wanted to make a truly big difference, he would have to change the legal system, but that is a very tough project.”
A curious correlation is that, while one might expect markets with respected legal systems to fetch a premium from investors, the reverse appears to be true. South Korea, the best emerging market in the whole survey, trades at about nine times price/earnings; Bangladesh, the worst, at 19. The same pattern is evident in the CEE region. Estonia, the best in the survey (though small and illiquid), trades at nine times. Romania is rated much better than Bulgaria, but Romania’s P/E is 8.5 times, and Bulgaria’s 15. “If you believe that institutions matter and can determine growth over the medium term, you can buy equities at a cheaper price in countries with a good legal system than in those where it is weaker.”
Georgia does relatively well among former CIS nations. “Georgia outperforms in terms of its legal system,” says Robertson. “It demonstrates that even without EU membership, very good legal systems can develop if leaders are determined to push through change.”
Robertson suggests investors look out for the removal of legal protection from political leaders, rising per capita GDP, and improvements in ease of doing business data, as signs of an increasingly credible legal system.
