Annex II Domestic Capital Markets in Developing Countries

International Monetary Fund
Published Date:
January 1993
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In recent years, governments of many developing countries have become preoccupied with financial sector reform. In a number of developing countries, the authorities have sought not only to liberalize banking regulations but also to introduce sophisticated capital market instruments in an attempt to move more rapidly toward the kinds of markets found in industrial countries. Several developing countries have recently implemented policies intended to allow the spontaneous establishment of securities markets and have often actively promoted their development.133

This annex reviews recent trends in capital markets in developing countries and discusses some of the main institutional preconditions for different segments of a mature financial system to operate efficiently. In the provision and surveillance of these institutional foundations, the role of governments is of paramount importance. The next part discusses some preliminary indicators of the development of financial markets in some developing countries and highlights the diversity of experience and also reviews the recent development of equity and bond markets in developing countries. Discussion of a highly stylized model of the development of capital markets along with the importance of a well-capitalized, competitive banking system for the effective operation of capital markets follows.

Current State of Capital Markets in Developing Countries

Table A21 presents indicators of the development of financial markets in a number of countries. For comparison, data on Japan, the United Kingdom, and the United States are also presented in this table. The data show a great diversity of experience among developing countries with respect to the deepening of their financial systems. Although these differences exist for myriad reasons, the overall macroeconomic environment and the attitudes of the authorities toward financial market development in each of these countries are among the most significant. Naturally, an environment characterized by low output growth or high inflation or one in which capital is taxed relatively heavily or in which resource allocation largely reflects noneconomic considerations is not conducive to the development of financial intermediaries or capital markets.134

The second and third columns of Table A21 show the ratios of narrow money and quasi-money to GDP. Taken together they are indicative of the depth of financial markets, since they suggest the acceptability of money or close money substitutes as means of payment. To a rough approximation these columns suggest that financial markets are deeper in those countries with relatively higher GDP per capita. This relationship is complicated by high inflation rates in some countries—Argentina, for example—which reduce the real demand for money and thereby lower the ratio of nominal broad money—money plus quasi-money—to nominal GDP.135

The ratios of private credit and deposits to GDP are presented in the next two columns. As with the ratio of broad money to GDP, a low value for these ratios is difficult to interpret. It may suggest a relatively immature culture of financial intermediation, controls on interest rates, high inflation, or simply that there are alternative sources of finance to bank credit. This difficulty in interpretation is highlighted by the differences in these ratios among some industrial countries, for example, the United Kingdom and the United States. Among the developing countries it appears generally that those with relatively higher GDP per capita also have relatively higher credit/GDP ratios although there are some important exceptions. It is difficult to identify a clear relationship between the ratio of deposits to GDP and per capita income.

The penultimate column in Table A21 indicates the importance of equity markets as a store of financial wealth. Although the evidence indicates that the ratio of equity capital to GDP rises with per capita income, it is in fact higher for the middle-income countries than for the industrial countries, which suggests that in the most advanced capital markets there are significant alternatives to equity as a source of external finance. The final column shows the ratio of annual stock market turnover to end-year capitalization. It is intended to suggest the relative liquidity of stock markets across countries. These figures show that, with a few exceptions, stock market liquidity rises with income.

Although generalizations are difficult, these indicators taken together can sometimes provide a useful characterization of the financial system. For example, among the countries included in this table, Ghana had the lowest ratio of broad money to GDP at the end of 1991: 13.4 percent. It also had the lowest ratios of bank credit and deposits to GDP, and the smallest (and newest) stock market. These figures suggest that the financial system in that country is relatively underdeveloped, with little use of banking services by creditors or debtors.

Chile, with a per capita GDP of more than five times that of Ghana in 1991, also showed much greater use of close money substitutes, and its ratio of broad money to GDP is over three times greater than that of Ghana. Bank deposits and credit were correspondingly higher in proportion to GDP. However, while market capitalization on the Chilean stock market, Latin America’s most vibrant over the last seven years, is, at end-1991, almost equal to GDP, turnover is very low.

In Korea, while the ratios of broad money, credit, and deposits to GDP are similar to those of Chile, stock market capitalization, while higher in per capita terms, is much lower in relation to GDP. However, the Korean stock market appears to be a much more mature and active one. Turnover there is higher than in any other market included in the table.

Notwithstanding the problems of interpretation indicated above, taken as a whole, some characteristics of financial markets in developing countries do emerge. As per capita incomes rise, demand for the services of financial intermediaries increases. The use of money, and especially close money substitutes, seems to rise with income. Correspondingly, demand for bank deposits rises, which is matched by an increase in bank credit. With few exceptions, equity markets play a relatively insignificant role in the poorer countries. Market capitalization is usually much lower, if a market exists at all, and turnover is generally low.

Recent Experience with Equity Markets

Currently as many as 56 developing countries have stock exchanges, and at least another 9 have announced their intention of creating them in the next few years.136 These countries include many of the economies in transition of Central and Eastern Europe and almost all Latin American and Asian countries.

The recent resurgence of interest in stock markets reflects a belief that they can increase the efficiency with which capital is allocated and perhaps even the supply of capital by providing a new investment vehicle. However, the evidence on the contribution of equity markets to corporate finance is not encouraging. Evidence from industrial countries suggests that stock markets, indeed all securities markets, play only a small role in providing capital for corporate expansion. Looking at flow-of-funds accounts and corporate reports for eight industrial countries over 1970–85, Mayer (1989) found that only a small proportion of corporate finance was generated by stock markets. Moreover, the flow-of-funds accounts for Finland, the United Kingdom, and the United States indicate that firms had bought back more equity than they had issued.

Mayer’s results confirm work by Taggart (1985) in which new stock issues contributed only 3 percent to corporate growth, and internal funds financed 52 percent of expansion in the United States over 1970–79. Interestingly, in the interwar years, U.S. firms had financed as much as 19 percent of their growth through equity issues, and during 1930–39, they had financed 114 percent through retained earnings.

Similar work on recent financing patterns in nine developing countries was carried out by Singh and Hamid (1992). Using company data, they found that firms in developing countries financed a significantly higher proportion of their expansion with external resources than firms in industrial countries appear to have done. The Korean data yielded a median value for the proportion of growth finance by internal retention of only 12.6 percent, whereas the corresponding figure for Indian firms was 36 percent. The highest median value for this ratio that these authors found was 58 percent for Pakistani and Zimbabwean firms. However, the relative importance of external debt and equity varied widely between countries. New equity contributed only 11 percent of new capital for Indian firms, but 60 percent for Turkish firms, and almost 39 percent for Korean firms.

Stock markets in developing countries remain, for the most part, insignificant relative to those in industrial countries. Total capitalization on markets in developing countries was approximately $650 billion at end-1991, or less than 6 percent of the global stock of equity. Table A22 shows the evolution of the dollar value of stock market capitalization between 1985 and 1992 for some developing and industrial countries. It is immediately apparent that some of the developing countries have witnessed phenomenal growth in the dollar value of equity listed on their exchanges. For example, while the value of equity listed in the United States increased by some 73 percent over this period, the dollar values of equity listed in Mexico and Thailand increased by more than 3,000 percent, and those of Korea and Colombia rose by more than 1,000 percent.

The three developing regions represented in this table had different experiences in terms of stock market performance over this period. For example, the Latin American stock markets, after having been rather quiet over 1985–89, surged in the last three years, first in Venezuela in 1990, then in Mexico, Chile, and especially Argentina in 1991. The Mexican market in fact grew impressively through the entire later period, from a capitalization of $14 billion in 1988 to $139 billion in 1992. This burst of vitality is also evident in the turnover ratios in the region.

In the Asian markets, the story is somewhat different. Although the growth in market capitalization and liquidity was just as impressive over the whole period, if not more so, the developments in Asia appear to have been less abrupt—the Indonesian experience notwithstanding—although 1989 was a particularly good year. Moreover, that growth was sustained in 1992, unlike the Latin American countries, which generally saw a decline in market capitalization.

The African markets had a very different experience. Although the South African market recorded a significant increase in capitalization and the Moroccan and Zimbabwean markets grew slowly, the Nigerian market shrank, and the markets of Côte d’Ivoire and Kenya showed little movement in either direction.

The different experiences reflect differences in policies toward capital markets and differences in macroeconomic developments—particularly in exchange rate levels. The bursts of activity in certain markets coincided with major liberalizations of these markets—for example, the provision for access by foreign investors—and improved macro-economic stability. This illustrates quite strongly the potential benefits from the creation of an environment that is supportive of capital market expansion and innovation.

This table also illustrates the variability of returns to potential foreign investors in stock markets in developing countries—which makes it difficult to attract foreign investors. The dollar value of listed equity has fluctuated considerably in some markets, often (but not exclusively) owing to exchange rate developments. For example, while the Korean market’s dollar capitalization leapt from $94 billion in 1988 to $141 billion in 1989, it fell back to $96 billion by end-1991. Although the Argentine market’s capitalization jumped from $3 billion in 1990 to $19 billion in 1991, it fell from $32 billion to $18.6 billion between May and December 1992. Likewise, the dollar value of equity listed on the São Paulo exchange in Brazil, which in 1991 was only slightly greater than that of the Rio de Janeiro exchange, ended 1991 only 6 percent higher than its end-1985 level after having twice fallen below $17 billion in the intervening period.

Just as the history of market capitalization and liquidity differs between developing countries, so too do the returns to investors. In 1991 nine of the ten best-performing stock markets in the world—as measured by the percentage change in the dollar value of price indices—were in developing countries, but so too were the three worst.137 In fact, the International Finance Corporation’s (IFC) Latin America price index outperformed the Asian index, and the indices for the markets in industrial countries over 1984–91. The price indices for markets in developing countries are, however, much more variable relative to markets in industrial countries. For example, while over 1986–91 the annualized standard deviations of price indices of the latter ranged from 18.7 to 28.5, for Asia the standard deviation was 35 and that for Latin America was close to 42.

Bond Markets

Relatively few developing countries have active government or corporate bond markets, in some cases owing to a lack of demand for such a market. For example, the Thai Government has since 1988 run fiscal surpluses and therefore did not have a need to issue debt on the domestic market. In fact, it has been reducing the outstanding stock of its debt since 1989, causing the government bond market to shrink. In other cases loan rates are so low, often because of administrative controls, that firms have no incentive to issue debt securities. However, the absence of a well-functioning bond market is often at least partly the result of government policies that, intentionally or not, prevent such a market from developing.

A corporate debt securities market can contribute significantly to domestic finance. For example, in Korea the stock of corporate debt and debentures more than tripled, from W 22,356 billion at the end of 1987 to W 68,762 billion at the end of October 1992. During that time, the value of new equity raised on the stock market was W 21,437 billion.

Historically, the development of a corporate bond market has generally followed the development of a market for government bonds. Government securities provide a useful low-risk benchmark against which corporate issues can be priced, and the creation of a secondary market for these securities provides the institutional foundation for a secondary market in corporate debt.138 However, most developing countries do not have liquid secondary markets for government debt securities. Instead it has been common practice for governments in many countries to require certain institutions to hold government bonds in fulfillment of liquidity or capital requirements.139 Where secondary trading of government debt is not explicitly forbidden, the terms of sale in the primary market, particularly the low coupon rate, often make a secondary market uneconomical.

The Malaysian experience illustrates the constraints on bond markets in many developing countries and the kinds of policies needed to encourage this market.140 Until the mid-1980s, government debt was sold on a captive primary market because financial institutions were required to invest in these securities.141 Despite partial interest rate liberalization in 1978, the yield on government debt remained lower than yields on other assets. This meant that the Government was able to finance itself at low cost at the expense of the health of the financial institutions.

Reforms of the government debt market began in 1986 with the development of a money market. Shorter maturity debt was issued, deposit interest rates were liberalized, and the statutory liquidity ratio was calculated on the basis of periodic averages rather than daily. The central bank allowed well-capitalized firms to act as dealers in the market, and in 1987 it began issuing government debt with market-related coupon rates.

In 1989 the central bank created the basic structure of a market in long-term government securities by appointing principal dealers to underwrite government debt issues and to act as market makers in the secondary market. In 1990, a paperless book-entry clearing system for public securities was introduced, and in early 1991 commercial banks and finance companies were allowed to set their own base lending rates (BLRs) instead of having to peg them to the BLRs of the two leading banks.

The effect of these innovations was greatly to increase the volume of secondary market trading in government debt. Average monthly turnover of Malaysian Government Securities (MGS) increased from M$667 million in 1989 to M$820 million in 1990.

Until the late 1980s, there was really no private bond market, although loan stocks were issued and traded on the stock exchange.142 In an attempt to promote this sector of the fixed-income securities market, in 1986 the Government set up a national mortgage corporation—the Cagamas Berhad—which would purchase mortgages from their originating financial institutions and issue bonds of its own. Since the mortgages were guaranteed by their original writers, the Cagamas bonds were less risky than the mortgages and therefore more desirable as retail investments.143 By mid-1992 Cagamas had issued bonds worth M$3,865 million. In 1990, secondary market trading of Cagamas bonds amounted to M$l,638 million against a stock of M$2,900 million.

To facilitate the growth of the corporate bond market, in November 1990 the Government created the Rating Agency Malaysia whose function is to rate all issues of corporate bonds and commercial paper. The rating operations began in May 1991 but as of March 1992 only three ratings had been completed. Current regulation requires prior approval for all debt issues from the Capital Issues Committee, which regulates the primary and secondary markets and sets the issue price. In May 1992 the central bank announced that the Committee would only consider applications for debt issues if the issuers were rated by the Rating Agency Malaysia. However, it can only invest in guaranteed or collateralized debt that has been approved by the Capital Issues Committee. In October 1991 commercial banks were allowed to underwrite and invest in private debt securities subject to some conditions.144

The Government’s strategy for promoting a private debt securities market therefore combined three elements: removing regulatory restrictions such as those on interest rate determination and the investment choices of financial institutions; creating the market microstructure by appointing dealers and market makers and establishing an independent rating agency; and finally, providing the market with low-risk government and Cagamas bonds with market-determined coupon rates and a broad range of maturities.

The response to these developments was immediate. Between 1987 and 1991 M$3,639 million in corporate bonds was issued, with M$1,606 million being issued in 1990 alone. In the first half of 1992, corporate issues amounted to M$954.9 million, roughly the same amount that had been issued in all of 1991. Rhee (1993) reports that secondary market trading of corporate bonds in 1991 equaled approximately 11 percent of the outstanding value.

Some Fundamentals of Financial Market Development

The theoretical argument that securities markets can improve the allocation of resources and perhaps increase the total supply of capital has been interpreted to mean that such markets should be established in all countries. However, sound theoretical and institutional reasons suggest a cautionary approach to the development of capital markets. In the description below of how financial markets and instruments might be expected to evolve, the question of how these markets are organized (for example, in an “Anglo-Saxon” or a “universal” banking system) is not addressed. For example, the conditions under which derivatives can be expected to succeed are independent of the structure of the market.

The literature on corporate finance provides insight into the process by which financial markets evolve from self-finance by owner-operated firms toward the complicated systems observed in the major industrial countries in which firms can choose from a wide range of instruments to finance their investments.145 This part of the annex will extract from this literature to show how an individual firm’s demand for different financial instruments changes as the firm grows. Obviously, in an economy with a large number of individual firms and with entry and exit going on continuously, the experience of an individual firm may not be representative of the whole economy. However, the single-firm metaphor proves to be insightful. The role of governments in providing a supportive regulatory environment will be discussed later; the singularly important role of banks in capital markets will be treated in the next part.

Consider therefore, a small-scale owner-operated enterprise. The owner/manager invests his own capital and is the sole claimant on the firm’s profits. New investment is financed out of retained earnings, but as the scale of operations increases, or if a new investment opportunity arises requiring substantially more capital, the owner will seek outside investors. If the new investors are from the same small social group (for example, the same family), whether they invest in equity or through a loan is probably of little consequence. The strong social ties between the original owner and the new investors will probably ensure that the original owner retains effective control over the firm’s operations and also that he/she will not attempt to defraud these investors. In any event, family members, for example, have the opportunity to monitor the manager’s behavior closely and to observe the returns from the investment. In such a case the asymmetry of information between the owner/manager and the external investors is not significant and the investors are in a position to protect their interests.

If it is successful, the firm’s capital needs will eventually exceed its retained earnings or the capital that can be raised by the community of existing equity holders, forcing the original owners to look outside this community for finance. This finance can be obtained either through incurring debt or issuing external equity. There are a number of reasons why the initial outside investment would likely be in the form of short-term bank debt rather than equity or long-term debt. The owner may be reluctant to further dilute ownership of the firm in order to maintain control over managerial decisions. Moreover, an increase in external equity reduces the manager’s marginal return to effort. Perhaps more important, a firm seeking external funds for the first time will not have established a track record on which it can be compared with others. Consequently, investors will want to monitor closely the use of funds and may require a stronger commitment to promised returns than is available in an equity contract. Short-term debt allows investors to earn a fixed return, backed up by a claim on the assets of the firm in case of default, and to monitor the use of their funds through periodic examinations of the firms’ financial records. Although external shareholders and bondholders may be able to demand access to the same information as banks, there is reason to believe that they are in a weaker position to control managerial decisions.

However, the expansion that can be financed only by bank debt is limited. As the ratio of debt to equity (leverage) increases, managers have an increasing incentive to invest in risky projects that have a higher expected return—which enables the firm to service its high debt load—but which may also have greater variability, increasing the probability of default. Thus, firms may be forced to issue equity because banks are unwilling to increase their exposure. However, firms might also decide on their own to issue new shares. Equity spreads the risk from future activities across a wider investor base and represents a longer-term investment in the firm.146

The different payoffs to debt and equity create opportunities for shareholders to increase their expected return at the expense of decreasing the value of the firm’s debt by, for example, taking on additional debt or simply by engaging in riskier activities. One way in which debtors can defend themselves is through the use of covenants that restrict the ability of the firm to borrow from other sources. Alternatively, in many developing countries the conflict of interest between creditors and equity holders is resolved by allowing banks to own shares, either directly or through subsidiaries, in the firms to which they lend. This effectively allows them to create a claim on the firm that combines the characteristics of debt and equity and internalizes the debt-equity conflict.

In more developed capital markets, firms raise capital by issuing debt securities of their own (for example, commercial paper, corporate bonds). These instruments are attractive because, by eliminating (or reducing the role of) the intermediary, they provide cheaper finance. However, access to these markets is restricted to only the most profitable and reputable firms. This restriction exists chiefly because holders of debt securities generally are less able to monitor and influence managers’ behavior than are banks and perhaps even equity holders.147 This informational problem is solved at least partly by requiring that securities must be rated by an independent agency with access to the same confidential financial information provided to banks. However, bond or commercial paper holders are even further removed from the managers than are equity holders and will therefore generally only be prepared to invest in debt securities if an effective alternative control mechanism has been established.

The most recent important development in the more advanced financial markets has been the widespread introduction and use of derivative securities. These instruments allow investors and corporations to hedge against adverse changes in interest rates, securities prices, and commodity prices. However, in general the maintenance of a hedge requires the ability to trade both the derivative security and the underlying instrument at short notice and without causing adverse price movements. Therefore, such derivatives can only be effective if there is a highly liquid market for the underlying instrument. Moreover, the efficient operation of derivatives markets places such considerable demands on the payments system and on commercial bank credit—for example, to supply same-day “good funds” to enable temporarily illiquid market participants to meet margin requirements—that it would be unwise to introduce such markets unless the banking system is sufficiently strong. Finally, regulatory agencies must be prepared before derivatives markets are introduced. The complexity of many of these instruments, as well as the ability to take highly leveraged positions, demands that regulators be fully competent to evaluate financial institutions’ dealings in these markets.

Although the discussion above suggests an evolution of finance from reliance on retained earnings through bank finance to equity finance and ultimately to securitization, this progression can only proceed if the regulatory environment develops appropriately and if macroeconomic conditions support investment. These considerations imply an important role for governments in the development of the financial system through the development of effective commercial and securities legislation and the maintenance of supervisory oversight of the market and its players.

The Legal System

The primary contribution of the legal system to economic development is in providing a framework for the enforcement of contracts. Such enforcement is particularly important for financial markets because of the intertemporal nature of exchange. Debt and equity contracts involve a transfer of means of payment today in return for a claim on the future earnings of the corporation. If these claims cannot be enforced, they will have limited value. Securities are essentially tradable corporate liabilities. Hence, the very existence of securities markets relies on the rules protecting the rights of debtors and shareholders and on the rights of individuals to own and trade these rights.

Where governments do not provide an effective mechanism for enforcing property rights or financial contracts, trade will be limited to those transactions that provide their own automatic enforcement mechanisms. Thus, for example, firms will be limited to unconditional (noncontingent, fixed-income) claims that will include extensive monitoring and collateralization provisions. The informational advantage of existing creditors will lead to a system of “relationship” finance in which firms will maintain an ongoing close relationship with their most important supplier of credit rather than tapping sources of finance, such as the bond or equity markets, that depend on the enforceability of contracts. The internalization of financial obligations through the establishment of large corporations or institutional arrangements in which financial institutions own stakes in the corporations to which they lend is another response to the absence of formal enforcement mechanisms.

Beyond the general protection of property and contracted rights, the legal system can make some specific contribution to the development of capital markets. First, the formalization of claims to private property allows collateral to be posted, and thereby reduces the cost of debt.148 Second, limited liability for equity claims (limited liability is implicit in debt contracts) is an essential precondition to development of an equity market.149 Third, the legal system can define and enforce securities fraud. Effective prosecution of violations of securities laws increases investor confidence in the markets and encourages investor participation. However, excessively strong fraud penalties can discourage legitimate investments.150

Regulatory and Supervisory Systems

The essential role for regulators is to permit the broadest possible scope for market forces to determine prices and the allocation of financial resources while simultaneously ensuring that risk is properly managed by financial institutions and that adequate defenses are prepared against possible specific or systemic weaknesses. Supervision and regulation of banks, for example, is motivated by the need to preserve the public’s confidence in the stability of the credit and payments systems, whereas regulation of nonbank financial institutions is motivated by a desire to monitor important potential sources of systemic risk. The fundamental challenge for the public authorities is to design a framework for financial sector regulation and supervision that will enhance competition in general while ensuring that the ensuing entry and exit of financial activities and institutions proceed in an orderly fashion without triggering a loss of confidence in the overall stability of the financial system.

Special burdens are placed on regulators and supervisors by the transition from a system in which banks dominate the provision of liquidity and credit to a competitive system of intermediation in which securities play an increasingly important role. This transition may result in an increase in macro-economic instability and financial fragility if regulators are weak or out of touch with developments. In particular, regulation during this transition should retain the flexibility to allow spontaneous financial innovation while strengthening supervisory powers to counter increases in systemic risk.

Allowing banks to take equity positions in the firms to which they lend or to engage in investment banking activities—underwriting securities issues, acting as brokers or dealers in the secondary markets—places special burdens on the regulatory authorities to ensure adequate capitalization and the creation of adequate “fire walls” between the different activities of the banks to protect the banks’ vital systemic role as managers of the payments system. The combination of these activities within the same corporate structure may create conflicts of interests that these fire walls are intended to control.151 Whereas investment banking activities may provide valuable sources of income to the banks, they may also increase the variability of bank profits, which may harm public confidence in them. The same is true of bank shareholdings.

As the domestic financial system is integrated into the global financial system, it is important that regulators not impede the international competitiveness of domestic financial institutions. This will require cooperation with foreign regulatory agencies.152 It will also be important to recognize that the structure of regulation and supervision itself must be flexible. For example, it may prove necessary to combine agencies responsible for regulating different segments of the financial system, and it will almost certainly be necessary to expand constantly the range of activities that must be regulated.

Market Structure and the Role of Banks

The discussion above suggested that banks would dominate the provision of finance in economies in the early stages of development and that the establishment of a banking system can therefore be expected to precede significant demands for the creation of an equity market. This part of the annex reinforces this idea by arguing that securities market participants (including banks themselves in many countries) rely heavily on bank credit to ensure liquidity in these markets, and that the creation of securities markets in an economy with a weak banking sector will unduly increase systemic risks.153

Securities markets can be segregated for discussion between the primary markets in which the securities are issued, and the secondary market in which they are traded among investors. It is by means of an issue in the primary market that firms raise capital; however, they are not entirely ambivalent about the development of the secondary market. The greater the liquidity in the secondary market and the greater the information available to participants, the more efficient will be the price discovery process in that market for claims on a firm. Therefore, current prices will be more reliable indicators of how new issues should be priced. Moreover, a liquid secondary market increases the range of potential primary market investors by improving the maturity transformation role of the market. Investors wanting short-term assets will still be prepared to purchase long-term bonds if they are confident that they can sell them on the secondary market when they want to.

Banks’ involvement in the primary markets is both direct and indirect. In the first case, in most developing countries banks are permitted to underwrite security issues either directly or through subsidiaries.154 However, even if it is not permitted, underwriters will often turn to banks for credit. The underwriters’ demand for credit stems from their need to hold securities during issue, to support prices immediately after the initial issue, and to hold undistributed securities.

In the secondary market the same considerations apply. In many countries, banks or their subsidiaries act as brokers and/or dealers. Brokers will, on occasion, need to accumulate large amounts of stock in order to satisfy a block purchase, or sell off large blocks in a piecemeal fashion, for which they may need short-term credit. In addition, large purchases are often made with funds borrowed from the brokerage. The broker itself acquires the funds by drawing on a line of credit with a bank.155 Dealers will demand credit to finance their proprietary positions and to facilitate the buying and selling required of them in their role as market makers. Both groups of intermediaries will need access to bank lines of credit to manage settlement delays or failures.156

The above discussion identifies one of the more important interactions between the banking system and the nonbank securities markets. Clearly, the development of the latter cannot be considered in isolation of the health of the banking sector. To take the extreme case, the introduction of securities markets and the necessary creation of lines of immediate credit with highly variable amounts of credit actually being demanded will greatly increase systemic risks if the banks providing these credit lines are themselves undercapitalized and illiquid.

For example, almost all of the economies in transition of Central and Eastern Europe have opened or announced plans to open stock markets, as have most Latin American and Caribbean countries. In Africa, stock markets have opened recently in Ghana, Namibia, and Swaziland; Uganda plans to introduce a market this year. In China, stock markets opened in Shanghai and Shenzhen in 1990 and 1991, respectively, and in early 1992 a mechanism (B shares) by which foreign investors could participate in these markets was established. Financial derivative securities are a relatively recent innovation in developing countries and are traded in only a few markets. Recently, however, a number of developing countries including Argentina, Malaysia, Mexico, and Thailand have introduced or plan to introduce financial derivative contracts.

The importance of creating a stable macroeconomic environment as a precondition to successful financial market development is discussed at greater length in Developing Country Access to Private Capital Flows (1993).

Moreover, the relationship between the demand for broad money and GDP is likely to be nonlinear in that means of payment and stores of wealth other than those included in the definition of broad money may be well established in the more developed financial systems.

These 56 countries have 66 stock exchanges. However, in some of these exchanges, trading has not yet commenced. The 9 countries that reportedly plan to open stock markets are Bolivia, Dominican Republic, Guatemala, Guyana, Mongolia, Namibia, Uganda, Swaziland, and Viet Nam. Seventeen stock markets in developing countries were created between 1989 and 1992.

International Finance Corporation (1992). The nine leading countries were, in descending order, Argentina, Colombia, Pakistan, Brazil, Mexico, Chile, the Philippines, Hong Kong, and Venezuela. The three worst performing markets in 1991 were, in the same order, Turkey, Indonesia, and Zimbabwe.

The development of a market for government debt securities is also advantageous for the government itself by providing a wider investor base for its debt and perhaps by lowering its financing costs. A liquid secondary market for government debt also makes the domestic money market more efficient by providing a widely acceptable vehicle for managing short-term liquidity imbalances between financial institutions.

For example, in Thailand, commercial banks must keep 7 percent of their funds invested in government securities. In Malaysia, each of the seven discount houses that operates in the secondary market for treasury bills is required to keep 75 percent of the funds arising from its deposits in government debt securities.

The development of bond markets in Malaysia is surveyed in Lin (1992) and Rhee (1993).

For example, the Employees Provident Fund (EPF) was required to keep 70 percent of its investment portfolio in government debt securities. This requirement has since been reduced to 50 percent.

From 1980 to 1985, M$579 million in debentures and loan stocks were issued on the exchanges.

The initial issue of Cagamas bonds also had the distinction of being the first fixed rate debt securities to carry market-determined interest rates.

The conditions are (i) that the security has been approved by the central bank; (ii) that the remaining term to maturity of the debt is not more than seven years; and (iii) that the debt is not convertible into ordinary shares (Rhee, 1993).

The modern theory of corporate finance emerged after the publication of Modigliani and Miller (1958), which proved that in the absence of market imperfections or bankruptcy costs and with a neutral tax regime, the debt-equity choice does not affect the market value of the firm. The literature first investigated departures from these assumptions, but most theories ignored the strategic implications of debt and equity. Subsequent seminal contributions are by Jensen and Meckling (1976), which identified the agency costs of debt and equity; Ross (1977), which investigated the possibility that a firm’s capital structure signals the quality of its management or investments; and Stiglitz and Weiss (1981), which demonstrated that informational asymmetries will generally lead to credit rationing by banks.

Even if the shares are subsequently sold, the initial investment in the firm is generally only reversible if the firm decides to repurchase the share.

The informational advantage that banks have derives from their direct rather than secondhand access to information on the financial condition of the firm. They may also have a control advantage if a withdrawal of credit by a bank that has inside information sends a stronger signal to the market than does the sale of shares by an equity investor whose information may be less detailed or current.

Collateral increases the liquidation value of the firm, thereby improving the terms on which it can borrow. It also enables high-quality firms to at least partially distinguish themselves from low-quality borrowers.

Limited liability protects small investors from fraudulent activity by their agents by limiting their losses to the amount of their investment.

For further discussion, see Greenwald and Stiglitz (1991).

For example, unless prohibited, banks might have an incentive to purchase securities that they are underwriting in order to boost their price or to increase lending to unprofitable firms whose shares are a significant element in the bank’s securities portfolio.

Such cooperation already exists between many countries in the form of international agreements on, for example, capital requirements for banks and securities firms and cross-border supervision. See Section IV for further discussion.

The demand for bank credit by capital market intermediaries in eight Asian developing countries is studied by Scott and Wellons (1992). They found that intermediaries’ demand for bank finance was limited mainly to funding margin loans and managing clearance and settlement. Only in a few countries did brokers and dealers report significant proprietary position-taking or market making activity, which are the principal source of the demand for funds by intermediaries in industrial countries.

The bank may be unwilling to lend directly to the individual investor because the loan would be backed only by the securities purchased whose value may fluctuate significantly. However, a loan of the same amount to the broker would be backed by the broker’s more extensive securities and capital, making default less likely.

In addition to the demand for credit arising from trading activities, members of securities exchanges will need access to credit lines to ensure daily settlement. The exchange clearinghouses themselves will need to maintain borrowing rights to protect the market against defaults by one or more members of the exchange.

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