MASOOD AHMED AND SUDARSHAN GOOPTU
The past three years have witnessed an unprecedented increase in private portfolio investment flows to developing countries, increasing from $7.6 billion in 1989 to $20.3 billion in 1991, and are estimated to have reached over $27 billion in 1992. According to data in the World Bank’s World Debt Tables 1992-93:
Portfolio equity investment (comprising external stock offerings in the form of depository receipts, country funds, and direct equity purchases by foreign investors) increased 15-fold, from $0.4 billion in 1989 to over $6.0 billion in 1991, and are estimated to have reached $5.2 billion in 1992.
International bond financing by developing countries, which started from a stronger base in the late 1980s, also showed remarkable growth in 1991-92, accounting for nearly $20 billion of gross inflows in 1992 (see charts).
Aggregate net resource flows to developing countries
Aggregate net resource flows to developing countries increased by 17 percent in 1992 over the previous year and the pattern of external finance changed significantly. Of the $134 billion in real aggregate net resource flows that took place in 1992, foreign direct investment (FDI) and portfolio investment accounted for the bulk of the increase over previous years. Most of these flows were directed to the middle-income countries ($89 billion), with flows to low-income countries remaining broadly unchanged ($44 billion) in 1992 The large increase in flows to middle-income countries (130 percent over the previous year) stemmed mainly from the upturn in private flows. In addition, within these flows there has been a shift from debt to equity financing, comprising FDI and portfolio investment, and from bank to nonbank sources. Most low-income countries, especially those severely indebted, remain heavily dependent on official financing.
Thus, while there are legitimate concerns about the volatility and sustainability of some portfolio flows, developing countries that are receiving these flows can maximize their benefits by taking a variety of steps. These include: (1) listing at least a few stocks internationally; (2) strengthening supervisory and regulatory policies; (3) conforming to generally accepted accounting and disclosure standards; (4) ensuring investor protection; and (5) improving the efficiency of settlement and clearing procedures. Regulatory changes in industrial countries that ease entry restrictions into their securities markets (such as the US SEC Ruling 144A) without jeopardizing prudential standards are encouraged.
Real aggregate net resource flows to developing countries
Source: World Bank Debt Tables 7991-92.
Note: All flows are deflated by the import unit value index (IMF: WEO) at constant 1992 dollars, 1992 deflator is a World Bank staff estimate; data for portfolio equity investment are World Bank estimates, available since 1959 only.
Gross portfolio investment flows by region
Source: World Bank Debt Tables 1991-92.
The recent surge in portfolio flows is of interest to developing country policymakers for a variety of reasons. First, as part of a broader resumption of private market financing, these flows signal the return to market access after the decade of the debt crisis for a number of mainly middle-income developing countries. Second, the very different nature of these flows—compared with the syndicated bank lending of the 1970s and the early 1980s—reflects important structural changes that have taken place on both the borrowing and lending sides over the past decade. These changes include the growing importance of institutional investors as the source of long-term finance, even as commercial banks have cut back their activities in this area. And in the developing countries themselves, there has been a parallel movement away from public sector dominated borrowing to a more balanced mix of access to foreign capital by private corporations and sovereign borrower alike. Portfolio equity flows also help to reduce the cost of capital for companies in emerging markets and introduce an important element of risk sharing between international investor and host country.
The short three-year history makes it difficult to extrapolate the future magnitude and behavior of portfolio investment flows. But the observed rapid increase in these flows to developing countries has given rise to some legitimate concerns on the part of policymakers in the recipient countries as well as those in other developing countries who wish to benefit from this experience in an endeavor to attract and deal with similar portfolio investment inflows from abroad without jeopardizing their adjustment efforts and domestic policy agenda.
The portfolio investment flows have, however, been concentrated in a few countries, primarily in Latin America. Five countries—Argentina, Brazil, Mexico, South Korea, and Turkey—accounted for over two thirds of the cumulative total gross portfolio investment flows between 1989 and 1992. Mexico, which led the process of restoring access to voluntary financing by previously debt-distressed countries, was the largest recipient of both portfolio equity and bond financing flows. Moreover, most of the increase in the supply of private funds went to private borrowers, especially “blue chip” companies that have a good credit rating in their own right in international capital markets.
Portfolio investment, as distinct from foreign direct investment (FDI), comprises financial instruments that can be acquired by foreign investors either in the international securities exchanges, the US private placement market, or through direct purchases in the developing country’s stock market. These instruments can be classified in two groups: equity and debt instruments (see box for details). Country Funds accounted for the bulk of the portfolio equity flows in 1989 and 1990, partly because in several developing countries, they were the only permitted instrument for foreign investors. Their importance has declined more recently as many countries have relaxed restrictions of foreign equity investment and as investors themselves have become more interested in picking individual stocks rather than a slice of the overall market. At less than $200 million, the value of new emerging market funds launched in 1992 represents less than one tenth of the corresponding figure two years earlier.
American Depository Receipts (ADRs) have grown in popularity for many of the same reasons that led to a declining interest in country funds. There are currently more than 800 ADR programs in the United States and capital raising through ADR issues accounted for some $10 billion in 1992. The growth in ADRs was greatly facilitated by rule 144A of the US Securities Exchange Commission (SEC), which has enabled this instrument to be used by a number of smaller, first-time foreign issuers in the US equity market.
In terms of debt instruments, Mexico became the first debt-distressed country to raise voluntary financing from abroad since the debt crisis, with an unsecured international bond issue of $100 million in June 1989. Since then, Argentina, Brazil, and South Korea have also tapped the international bond market extensively and bond issues now account for the largest share (about two thirds) of portfolio investment flows to developing countries.
Commercial Paper (CP) issues have also increased drastically in the 1990s as more and more firms that are unable to raise longer-term financing turn to this vehicle. Maturities are generally of 3, 6, and 12 months, although note issuances of shorter maturities of a few days are not out of the ordinary. About $1.4 billion of CP issues were made by entities in developing countries in 1991, of which $1.2 billion was issued by those in Latin America alone.
Much of the initial growth in portfolio investment was financed by returning flight capital. Domestic nationals with substantial overseas holdings also continue to be a major investor category, particularly for portfolio flows to Latin America. But these individual investors have been joined by a more diverse—and potentially much bigger—group of institutional investors. These institutional investors, which include pension funds and life insurance companies, are motivated primarily by the portfolio diversification benefits that accrue from investing a small part of their large overall holdings in developing country obligations. They generally have a longer-term investment horizon and look for stability and long-term growth prospects in the market in which they invest. Recent research has shown that even though developing country stock markets are more volatile than developed markets, they have not been found to be correlated with one another or with developed markets. Global institutional investors will, therefore, lower their portfolio risk by diversifying their portfolios into these emerging markets.
To date, institutional investors have allocated only a small fraction of their investible portfolio to these markets, especially in countries such as Chile and Mexico, which have a favorable track record of domestic policy reforms. These institutions have typically invested less than 5 percent of their foreign equity holdings in developing country equities (which is less than 0.2 percent of their total asset portfolios). There is considerable variation across institutional investors, with some investing as much as 6 percent of their portfolio in emerging markets and others not investing in them at all.
As of the end of 1991, pension funds and insurance companies had an estimated $12-15 billion invested in emerging market stocks (which was about 3 percent of the market capitalization of all emerging stock markets combined at the time). US institutional investors appear to favor Latin American securities, UK institutions seem to favor portfolio investments in the Far East, while Japanese institutional investors appear to favor Southeast Asian securities.
Other actors in the market include:
managed investment funds (closed-end country funds and mutual funds—see box), whose portfolio managers buy and sell high-yield instruments in one or more emerging markets for trading activity geared toward achieving a portfolio yield that is better than some benchmark (the Standard & Poor’s 500 index, for example);
foreign banks and brokerage houses, who allocate their own portfolios for inventory and trading purposes; and
retail clients of Eurobond houses, who are involved in emerging securities markets for portfolio diversification motives.
Why the rapid increase?
The reasons behind the sharp growth in portfolio investment flows have been the subject of vigorous debate among academic economists and policymakers. Some explain the increase primarily in terms of the “push” effect of the unusually low interest rates prevailing in the United States, arguing that the boom in flows coincided with a sharp decline in US interest rates and the drying up of the so-called junk bond market, which offered investors a domestic alternative in the high risk/high return arena.
Other analysts emphasize the “pull” of investment opportunities in the emerging markets themselves. They point to the wide ranging economic reforms that a number of Latin American countries have undertaken in the aftermath of the debt crisis; these reforms, coupled in several countries with commercial debt-reduction agreements, have generated greater investor confidence in the growth and creditworthiness prospects for these countries. They also cite the steady access of East Asian economies to bond financing in the period before international interest rates declined in the late 1980s.
As is often the case, the true explanation lies in a combination of the two. The decline in interest rates in home markets certainly provided an added impetus to investors searching for high-return instruments to look at the very attractive yields available in both fixed-return and equity investments in emerging markets. Lower interest rates in the United States also improved the short-term creditworthiness indicators of developing countries by reducing their debt-service obligations. But lower interest rates or other supply side factors do not explain why portfolio flows have not been dispersed randomly to all emerging markets, or why countries such as Mexico, with an established track record of sound economic management, are able to issue bonds at 300 basis points below the rate required by investors of comparable bond issues in other developing countries.
The instruments through which portfolio investment takes place can be classified in two groups: Equity instruments and debt instruments. Equity instruments include:
Country Funds, which allow foreign investors to pool resources and invest in the emerging stock markets in, for example, Brazil, Chile, India, South Korea, Mexico, and Thailand. Funds can be invested in all emerging markets (through global funds), in specific regions (Regional funds), or in specific countries (country funds). Closed-end funds make an initial share offering for public trading on organized exchanges but are not redeemable unless the fund is liquidated or changed (with stockholders’ consent) to an open-ended fund (or mutual fund), which can issue and redeem shares to meet investor demand.
American Depository Receipts (ADRs), which are negotiable equity-based instruments, issued by a non-US corporation, publicly traded in the US securities markets and backed by a trust containing shares of the corporation. ADR holders have the same rights, including voting rights, as if they held the underlying shares.
Global Depository Receipts (GDRs), which are similar to ADRs but can be simultaneously issued in securities exchanges all over the world.
Direct purchase of shares by foreign investors, which, where permitted by developing country governments, is increasingly important in attracting resources from abroad.
Debt instruments include:
International bond issues, which have been a steady feature of developing country financing for many decades, but which were displaced by the growth in syndicated bank loans in the 1970s and early 1980s.
Commercial Paper (CPs), which are short-term instruments that have been issued by entities in developing countries in the Euromarkets and in the United States,
Certificates of Deposit (CDs), which have also been used by developing countries to raise resources in the international markets.
In the case of equity flows, the recent growth has also been facilitated by institutional changes in developing and developed countries that have taken place in light of the widespread efforts toward global integration of securities markets and increasing financial deregulation measures. In the industrial countries, developments such as US SEC Rule 144A, which allow foreign issuers easier access into the US securities markets largely by easing restrictions on the resale of privately placed securities, have simplified trading in foreign equities by eliminating costly settlement delays, registration difficulties, and dividend payment problems. The recent raising of ceilings on foreign investment imposed by the New York State regulator of insurance companies has also helped increase cross-border trading with some emerging stock markets. (Other countries—notably Germany—have much more binding ceilings on the fraction of assets that pension funds and insurance companies can invest abroad.)
Developing countries, too, are doing more to encourage foreigners through fewer regulatory restrictions, better settlement and clearance, and reduced taxes and fees on transactions. For example, in South Korea, the Securities Supervisory Board relaxed the registration procedures for foreign institutional investors, individuals, and corporations in March 1992. In India, the government has announced plans to abolish the Office of the Controller of Capital Issues and firms will be able to determine the pricing and timing of new issues, including share issues abroad, and to arrange joint ventures. In some markets, such as Chile, Hong Kong, Singapore, and Taiwan Province of China, domestic institutional investors (pension funds and social security administrations) have played an important role in developing capital markets.
While policymakers in recipient countries have generally welcomed the substantial inflows of portfolio investment, they have also come to recognize that these flows pose significant issues of both macroeconomic and financial sector management. At the macroeconomic level, the main concern is how to deal with the effects of sudden large capital inflows and the possibility of equally sudden outflows in terms of real exchange rate fluctuations or the monetary implications of substantial changes in reserve levels. Some economists have argued for a tax to discourage speculative short-term inflows or other measures to offset the expansionary impact on the money supply; others caution against any action that might also discourage genuine investors and would be difficult to apply in practice. Preliminary evidence on the major Latin American recipients of portfolio flows shows that although country responses to these large portfolio investment flows have been varied, the general tendency of policymakers has been to regard these inflows as temporary. As a result, these countries have tried to limit the extent of real appreciation by intervening in the foreign exchange market or by sterilizing part of these inflows by issuing domestic debt.
|1989||1990||1991||1992 (est.)||Total 1989-92|
|Portfolio equity investment||3.5||3.8||7.6||3.2||23.0|
|Direct equity investment||1.3||0.8||1.5||1.9||5.4|
|Bonds, CPs, and CDs||4.1||5.6||12.7||19.1||41.5|
At the financial sector level, one important issue is whether allowing foreign investors into small equity markets might exacerbate volatility or “overheating” (artificial increases in market capitalization as a result of sharp increases in the prices of the shares of a few companies that are traded internationally on the developing country stock markets). Financial policymakers are also worried about the potential dislocation that might be caused by a subsequent precipitous withdrawal by foreign investors for reasons beyond the host country’s control.
These concerns reflect the nascent state of many emerging markets and weaknesses in the regulatory framework under which they operate. Despite their rapid growth, emerging markets—with a capitalized value of near $650 billion—account for only about 6 percent of industrial country stock markets. A result of a limited supply of stocks of corporations with large market capitalizations, most emerging equity markets also remain relatively illiquid and have a high concentration (the ten largest stocks account for over 30 percent of market capitalization in most of these markets; the comparable figure for the United States is 15 percent). Moreover, these markets have been quite volatile, with plus or minus 50 percent annual changes in market indexes in a number of markets during a given year. Some of these factors can only be addressed as these markets mature, but steps can be taken to address some issues now. For example, the recent stock market riots in China and irregularities in India’s stock market have shown that there must be better regulation, registration, and monitoring of stock market transactions. Accounting practices and disclosure requirements must also be raised in many cases and insider trading remains an issue of serious concern to both foreign and “outsider” domestic investors. To contain the disruptive effects on the domestic financial system of any sudden withdrawal of foreign investors, consideration should also be given to limiting the role that banks are allowed to play in equity markets, or the extent to which equity assets can be used as collateral for bank lending. Finally, it would be useful to assess ways to increase the involvement of large institutional investors, who typically have longer-term investment objectives in the financing of portfolio flows. The way to achieve this lies in a sustained and demonstrated commitment to sound economic management and financial sector regulation at the national level.