EQUITY MARKETS are emerging in developing countries and economies in transition around the world the governments of these economies institute macroeconomic and institutional reforms, international investors are gaining confidence in and directing capital flows toward the new markets.
In the year ending June 1993, the world’s top-performing stock markets were not those of the United States, Japan, or Germany. They were Turkey’s (up 111 percent in US dollar terms), Brazil’s (up 83 percent), and Indonesia’s (up 29 percent). Markets in Hong Kong, Singapore, and the Philippines have also delivered high-return performances in US dollar terms recently.
These equity markets, most of which evolved in the late 1970s and early 1980s, have emerged as part of the development process of many countries and have only just begun to be accepted in the global marketplace. The early markets, which were characterized by low liquidity, high volatility, and reduced efficiency, have become increasingly active due to increases in the types and volume of securities they offer; more stable, government-mandated macroeconomic policies; and decreased regulation that allows easy access to investment information.
Embryonic equity markets with the same characteristics are emerging throughout the developing world—in Viet Nam, Ghana, and Guyana, for example—and in the former centrally planned economies of Eastern Europe and the Soviet Union (most notably in Bulgaria, the Czech Republic, Russia, Ukraine, and the Baltic states). As financial reforms take root in many countries and market institutions appear in the economies in transition, equity market activity is expected to grow, resulting in surges in trading volumes and stock price movements similar to those in Mexico in 1991 and Korea in 1992–93.
These equity markets are the products not only of domestic capital demand but also of the willingness of investors to place their funds in less developed countries. The reform process in both the developing countries and transitional economies has allowed the markets to develop as alternate sources of capital for entrepreneurs and government-owned companies attempting to privatize. In particular, capital demand has been generated by fast-growing, export-oriented companies operating with low-cost resources and technology transfers. The combination of these two factors often produces large profit margins for corporations, resulting in higher equity returns than those in the more established markets, as well as greater opportunities to diversify international portfolios.
The stages of development
Though each emerging market has its own idiosyncracies, it is possible to offer a broad description of several phases common to all equity markets. It should be noted here that the duration of these phases may vary according to the country and time frame within which an emerging market’s evolution occurs. Periods of global economic expansion tend to accelerate the development of capital markets—emerging equity markets in particular.
Equity markets tend to develop only after a country has achieved a degree of economic and political stability and begun implementing growth-oriented policies. In the initial phase, equity prices tend to rise. As they do, the market gains the confidence of domestic investors and becomes more widely accepted as an investment alternative to traditional bank deposits and often to short-term government bonds. Equity markets in this stage of development currently exist in Belarus, Kazakhstan, Ukraine, and some of the other independent states of the former Soviet Union.
In the second phase, because the equity market now has some degree of credibility, pressure abroad for greater accessibility and at home for cheaper capital funding leads to a loosening of regulations in the domestic capital market. As market liquidity increases and risk-adjusted returns rise, international investors begin to realize the diversification benefits of investing in such markets. The equity markets in Brazil, China, Colombia, India, Pakistan, Peru, the Philippines, and Poland have all entered this phase.
In the third, or expansion, phase, the market offers the prospect of higher, less volatile returns, and investors easily absorb new issues of stocks and corporate bonds. The volume of issuance increases rapidly as firms strive to pay down debt and private or newly privatized companies make their initial public offerings. Trading activity increases, producing more effective intermediation, while the growing need for a risk transfer mechanism spurs the development of equity and currency-hedging instruments such as derivatives and index products. Such activity can be found in the markets of Argentina, Hungary, Indonesia, Malaysia, Thailand, and Turkey.
In the final, or mature, phase, as equity risk premiums fall to internationally competitive levels relative to government treasury bill rates or equivalent short-term money market rates, the equity market begins to achieve the stable growth that marks a mature or developed state. Greece, Hong Kong, Korea, Mexico, Portugal, Singapore, and Taiwan Province of China all have such markets.
Problems and risks
Despite their potential benefits, emerging equity markets carry as much risk as—and sometimes more than—more developed markets. In addition to the dangers of economic and political instability, other obstacles facing investors in developing countries and economies in transition include sharp equity price fluctuations, limited availability of trading instruments, and inadequate monitoring of insider trading activity. Institutional investors also face bureaucratic restrictions that can limit market access, hinder the settlement of payments, and make the clearing system unwieldy. In the last two or three years, a number of countries—especially Mexico and Korea—have initiated serious efforts to eliminate or reduce many of these obstacles.
Frequently, emerging markets must deal with unique macroeconomic and political risk factors associated with unsettled macroeconomic policy choices and volatile political situations. The most endemic of the macroeconomic risks are monetary instability, inconsistencies in monetary and fiscal policy mixtures, large budget deficits, and an overvalued exchange rate. Developmental and institutional obstacles are also common, including small capitalization in relation to a country’s GNP, limited liquidity of traded instruments, and an outdated and often over-regulated financial system.
Macroeconomic policy. Monetary and fiscal policies constitute a major source of risk in equity markets, because monetary instability and fiscal imprudence create financial uncertainty that may seriously impair market functioning and performance. For example, unanticipated inflation transfers wealth and income from lenders to borrowers, driving investors out of securities and into the real assets (such as gold and real estate) that are traditionally believed to offer protection against purchasing power risk.
In their attempt to accelerate the growth of their investment sectors, governments may be tempted to compromise fiscal and monetary discipline by financing certain public or private sector projects through the government budget or preferential credit rates. However, such policy deviations create macroeconomic instability, most often manifested by higher inflation and excessive exchange rate volatility. Russia is currently a classic, if extreme, example of this.
During the implementation of adjustment programs, in particular, countries may be faced with inappropriate mixes of monetary and fiscal policies. For example, strict monetary policy that is not accompanied by serious curtailment of large budget deficits may lead not only to continuing public sector expansion at the expense of the private sector but also to high real interest rates and an overvalued currency. Such a policy mix may aid temporarily in the fight against inflationary pressures. However, it can also hurt exports—and therefore growth potential—as well as capital inflows, since an overvalued exchange rate often inhibits direct and portfolio investment by raising expectations that a currency depreciation will follow.
Economies in transition are faced with other specific problems, among them incomplete or not widely accepted economic reform programs (including liberalization, privatization, and corporate restructuring) and an underdeveloped financial infrastructure that lacks technical managers and is burdened with bureaucratic processes. In such an environment, newly emerging markets must deal with inadequate macroeconomic policies, limited equity exchange listings, and institutions unable to regulate insider trading or protect the property rights of borrowers (companies issuing equity) and lenders (shareholders).
Political risks. Other real-world risks include the possibility that a developing nation’s government will nationalize firms, institute high withholding taxes, or restrict the repatriation of dividends and capital. Although such risks can be partly diversified away, they cannot be ignored.
Developmental and institutional barriers. Small capitalization is often regarded as a major barrier for international investors because it limits the available investment choices and may be a factor in the sharp equity price fluctuations of a highly volatile market. Many transitional and developing economies have small domestic markets and less than buoyant business climates characterized by numerous small firms engaged solely in domestic production. Domestic demand may be weak due to low income levels or a small population, while an overly stringent regulatory system and lack of infrastructure may contribute to the unfavorable business climate. In such an environment, only a few firms will be eligible to meet the minimum asset requirements of local equity market listings, and market capitalization relative to GDP will tend to be small.
Lack of liquidity and variety of trading instruments is a major obstacle to international investment in many emerging markets. Small trading volumes effectively shut out large institutional investors, since even what these investors consider small trades would amount to huge transactions for the markets and could lead to dangerously high volatility. In general, the lack of liquidity and depth depresses financial transactions and reduces market efficiency. Liquidity may depend to some extent on governmental initiative in providing an appropriate legal and accounting system to ensure the transparency of financial transactions.
Regulations are among the most common institutional barriers that limit foreign investment. International investors face constraints of one kind or another in most of the world’s capital markets, but the limitations are most severe in emerging markets. Restrictions and controls on capital flows and exchange transactions, barriers on market entry and exit, inadequate information on securities transactions, a small number of market makers and brokers, and high transaction costs and brokerage fees sharply restrict international investment in many developing countries.
Financial intermediaries, in particular dealers and brokers, must be able to operate under specific legislation that guarantees compliance with agreements and contracts. Emerging equities markets develop and function well only if participants have confidence in the efficient workings of the financial market system, trust that the rules of honest trading prevail, and accept specialized government institutions as arbiters in disputes.
Furthermore, differences in accounting rules and settlement standards between developing and developed countries often complicate investment decisions. For example, the absence of an adequate settlements system in Poland means that investors must make a down payment of about one third of any equity purchase before placing their order. Also, international investors may be constrained by internal company-specific or country-wide provisions on the proportion of foreign assets they can hold in their portfolios. However, these constraints have been relaxed in countries around the world as the trend toward deregulation accelerates.
Promoting emerging markets
Many governments of countries with emerging markets have adopted macroeconomic and structural adjustment policies, as well as other institutional changes, in order to ensure a sustainable, noninflationary growth path and promote portfolio investment. Most often, emerging market economies have followed relatively strict macroeconomic policies in a growth-oriented framework and have implemented numerous financial system reforms; these are the policies that have begun to win acceptance for the emerging markets in global financial markets.
Stabilization policies. It is important to note that many of these governments—for example, in Portugal and Indonesia—have succeeded in instituting growth policies without adversely affecting fiscal balances or monetary discipline, bringing inflation and exchange rates under control and minimizing public sector spending. As a result, private investment and overall domestic demand have grown and the number of larger firms operating in such economies has increased, raising the ratio of market capitalization to GDP.
As part of their structural adjustment efforts, many emerging market economies have succeeded in cutting budget deficits. In addition, they have reduced the economic role of the state through privatization by liberalizing internal and external trade, easing controls on capital flows, and passing legislation encouraging market liquidity and the development of larger firms.
Institutional reforms. In addition to following prudent macroeconomic policies, many governments in countries with emerging equity markets have paid close attention to institutional factors that inhibit portfolio investment by holding down the size of corporations and keeping market liquidity low. These factors include the tax and accounting systems, the legal framework, the financial infrastructure, and often cumbersome bureaucratic procedures.
Many of these governments have also instituted accounting systems that are perceived as fair and accurate and, in doing so, have gained investors’ confidence. Laws have been passed ensuring that private contracts are honored and enforced and that appropriate dispute resolution mechanisms exist. Special committees have been instituted to oversee laws and regulations dealing with the transparency of financial transactions. Thailand, for example, has recently implemented measures enforcing fair equity trading and tightening certain disclosure rules.
Governments have attempted to improve financial infrastructures by allowing the computerization of equity market dealings, simplifying procedures for listing firms in the equity markets, and relaxing antiquated standards for accepting brokers and brokerage houses in equity transactions, significantly reducing transaction costs and management fees. Malaysia and Singapore have both championed such changes.
The Far East Asian countries, most notably Korea, are prime examples of the success of such measures during the past decade. These markets have been able to attract large inflows of foreign capital as international investors gain confidence in the improved climate the reforms have brought about. Korea’s capital inflows, in the form of portfolio investment, rose from $811 million in 1990 to $3,116 million in 1991 and $5,742 million in 1992. The result has been sharp prices rises in these equity markets.
Liberalizing the regulatory structure. In order to remain competitive in today’s global marketplace, governments with emerging equity markets are, to a large degree, following the general trend of relaxing excessive controls and regulations on financial systems. In the 1980s, financial liberalization included the relaxation of restrictions on international capital flows and a shift toward more flexible exchange rate arrangements.
The pace of financial liberalization has varied widely across economies, with a small number—such as that of Singapore—moving quickly and the majority (Korea, Mexico, and Turkey, for example) following a more gradual process. In Korea, liberalized interest rates resulted in positive real interest rates that contributed to significant financial deepening. The ratio of broad money supply (including nonbank financial assets, particularly corporate bonds and commercial paper) to GDP rose sharply in 1980s, reaching over 100 percent in 1989. This increase reflected the relaxed regulatory environment of the nonbank financial institutions and their ability to offer higher yields on financial instruments than banks. However, Korea suffered setbacks in its financial liberalization efforts and, toward the end of the 1980s, resorted to some informal direct controls to help offset the monetary impact of the large balance of payments surpluses.
Foreign exchange controls in particular have been eased gradually, in line with improvements in government finances, overall macroeconomic policies, and the development of a legal and institutional framework for financial markets. In most countries, such controls have eventually been eliminated—for example, in Greece, Mexico, and the Philippines. Without sufficient limits on international capital flows, however, and with liquidity increasing in domestic secondary markets, countries with undeveloped equity markets could face capital flight problems and find their foreign exchange reserves endangered if the international financial community questions their macroeconomic policies.
Finally, many governments have moved away from both direct and indirect intervention in capital markets that could interfere with the process of disseminating equity market information. Financial markets produce and distribute information on returns and risks efficiently through interest rates and securities prices, permitting savers, investors, and borrowers to make rational choices among competing investment options. Government intervention restricts access to this process, which is the primary source of information for investors comparing the risk and return characteristics of alternative capital investments and for entrepreneurs trying to determine the best means of acquiring capital.
Other measures. In addition to pursuing prudent macroeconomic policies and abolishing credit and exchange restrictions, governments in countries with emerging equity markets have tried to encourage portfolio investment by offering investors a sufficient level of liquidity, along with a variety of securities in different sectors and industries, in the process enhancing diversification within and among markets themselves. Many of these governments have offered their securities in more established stock markets as a way of improving liquidity. The US Securities and Exchange Commission, for example, allows American Depository Receipts to be used as vehicles to trade foreign stocks on the New York Stock Exchange.
Many equity markets in developing countries have had attractive relative valuations during the past decade. Individual issues have often been underpriced, as is evidenced by the faster growth of their economies, on average, in relation to those of more developed countries. If history is any guide for the future, the equity markets in these countries will eventually catch up in relative size and valuation to those of developed countries. When this happens, the opportunities these markets offered in their early stages will gradually evaporate.
In the coming years, well-established emerging equity markets are also expected to play an important role in helping to fulfill the financial requirements of developing countries and the economies in transition through effective mobilization of domestic and foreign capital resources. As a result, these countries have the potential to rely much less on official and private debt to finance their development, as compared with developing countries of the last generation. The only requirement for the successful functioning of these emerging equity markets is that their governments follow prudent macroeconomic policies and institute decisive capital market reform programs. Well-functioning emerging equity markets will lead to the most efficient allocation of available capital resources, in turn spreading efficiency to other sectors of their economies.
An extended version of this paper was presented at an international seminar in Shenzen, the People’s Republic of China, in 1992 and is forthcoming in the Journal of Investing, as “Accessing Emerging Stock Markets: Prerequisites for International Investors.”
Edited by Dean T. Jamison and W. Henry Mosley, with José-Luis Bobadilla and Anthony R. Measham
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