For more than a decade stock markets have boomed in just about every country. From 1984 to 1994 the capitalization of world stock exchanges grew fivefold to a combined $18 trillion. Most of this money is still invested in industrial nations, but the dramatic growth has been in the emerging countries. Foreign investors have increased their annual net investment in emerging markets from $13 billion in 1990 to $61 billion in 1993.
"Push" and "pull" are behind the sharp increase in the interest of private equity investors in the developing world. The push is for better profits and more diversification. Even with adjustments for risk, returns are generally higher in the developing markets. At the same time the investment community has increasingly recognized that developing country exchanges have a low, even negative correlation with the stock markets in industrial nations. Negatively correlated stock markets move in opposite directions: when one is heading up, the other is going down. Investing in the developing world is a means to reduce overall portfolio risk. Recent Bank research confirms that cross-country portfolio diversification is more important than diversifying across sectors.
The "pull" for international private equity is the beneficial impact of wide-ranging structural reforms, legislative as well as economic, in many developing countries. As governments have liberalized or eliminated capital restrictions, improved the flow of financial information, and strengthened investor protection, they have earned the attention of the investment community. Put simply, investors have seen a chance to make more money and been given assurances that they will be able to take their profits home.
Last year the rush to invest in the developing world slowed considerably. Private capital flows to some Latin American countries dropped, culminating in the year-end Mexican crisis---a crisis brought about in part by an overdependence on foreign capital. The Mexican difficulties and a reviving U.S. equity market are causing an even greater slowing of private investment abroad in 1995. Portfolio flows almost certainly will stagnate for a time. But the "push" factors remain. Despite increased integration, the international market will remain imperfect for many years. Economic turbulence, investor conservatism, and variances in national growth rates will all contribute to differences in returns and market conditions. Bigger profits and better diversification cannot fail to entice investors.
One measure of the amount of funds that could be shifted to developing country stock markets is the still minuscule investment in such markets by institutional investors in the industrial countries. U.S. pension funds generally are more adventurous than their counterparts elsewhere in the industrial world. Yet the typical U.S. fund holds no more than 1 to 2 percent of its portfolio in equity securities from emerging countries. Studies indicate that a fund could raise its expected annualized return by 2 percentage points with no increase in risk if it increased its holdings of emerging market stocks to 20 percent of its portfolio. An increase of that size wont come quickly. But fund managers will gradually increase their market position in developing countries, trickling vast sums of capital into the developing world.
The money will not be divvied up equally. Investors will discriminate carefully between markets. So far, Asian and Latin American countries have absorbed most of the equity flow. Africa, the Middle East, and other areas remain largely ignored. The emerging markets of Asia have attracted almost all the private equity investment from Japan and half the equity dollars invested in developing countries by the United States in 1993. Within regions there also are big differences. Hong Kong attracted more U.S. equity investment than other Asian emerging countries combined. In Latin America most of the funds have gone to Argentina, Brazil, and Mexico. As the events in Mexico show, investors do not always make the best choice, but they do choose countries that have a sound institutional and regulatory framework for the capital market. And they avoid the rest.
No emerging countries can afford to be overlooked. Almost by definition, all require outside capital to sustain economic growth. But many are at their borrowing limit---liabilities can grow only as fast as export earnings. And all are in danger of being the indirect victims of the increasing political pressure on the aid budgets of industrial nations. Encouraging international private equity investors is a sound alternative to more debt and increasingly uncertain help.
Most important, encouraging and sustaining a vital stock exchange does more for a national economy than simply bring in new capital. A developed stock market is as important to national economic growth as banks. While the importance of the financial sector has long been recognized, the contribution of the stock exchange has been less obvious. Each provides a different bundle of crucial services, but both stimulate the accumulation of capital and contribute to improvements in productivity.
Credit markets are not, as is sometimes contended, a close substitute for equity markets. Banks and stock markets have complementary and shifting roles in a developing economy. Both sectors help fund the development of private enterprise, exchanging roles back and forth as the economy and its enterprises mature. Simple debt financing with instruments that are rarely traded comes first. Equity financing of larger firms comes next as the economy attains a critical level of real development. As growth continues, both large and small firms start to swap short- and long-term debt for equity investments. Finally, as the financial markets begin functioning with increased efficiency, equity funding becomes available for a range of ventures. At that point the larger firms begin to take on more debt, in part because they now have acceptable debt-equity ratios and in part because the stock market aggregates the information needed by lenders and investors alike.
The importance of a healthy and vibrant national stock market is underlined by a recent study showing that a developed banking system and a robust stock exchange not only promote economic growth, but predict it. A countrys stock market can be measured by capitalization, liquidity, or turnover. Each measure appears to reveal something about where a national economy is headed. Researchers have found a robust correlation between stock market indicators in 1976 and economic growth averaged over 197693. This correlation does not appear to be simply the result of stock market traders' and investors' anticipating growth. Indicators of liquidity, for example, are closely associated with growth prediction, but these liquidity indicators are a measure of trading volume, not simply prices. The conclusion: stock market development does not merely follow economic development, but provides the means to predict future rates of growth in capital, productivity, and per capita GDP.
If nothing else, the potentially large economic benefits of a vital stock market highlight the cost of government efforts to impede market development by policy or law. Conversely, a national program that encourages both markets and banks to thrive can have dramatic effects. One hypothetical example tests the effect of a one standard deviation increase in a measure of banking development combined with the same deviation in a measure of stock market development. The result is an increase in real per capita growth of 1.6 percent a year over the following 18 years---a 33 percent accumulated increase in GDP over the period.
A large inflow of private equity money is not without drawbacks. As Mexico and other Latin American nations recently observed, private capital flows can be volatile. If the international investment community spots weak exports, an overvalued currency, a rise in consumption relative to savings, or an overreliance on short-term capital inflows, money will go out faster than it came in. A government that seeks to attract international equity capital is, knowingly or not, committing itself to sounder, more agile economic management. Equity dollars and export earnings end up on the same side of the account, but neither is a substitute for the other. The mix of policies needed to sustain inflows of private capital varies from country to country. But there is no substitute for fiscal restraint, an emphasis on exports over consumption, and sound regulation of the banking system and the capital markets.
Floods (and ebbs) of private equity
Where it's coming from . . . and going to
The way to better markets: Information and Liberalization
Vouchers and governance: The Czech and Slovak experiment
The articles on stock markets are based on a series of papers presented at Stock Markets, Corporate Finance, and Economic Growth, a World Bank conference held February 16-17, 1995, and organized by Asli Demirg-Kunt and Ross Levine. To obtain copies of the papers listed below, please contact Paulina Sintim-Aboagye at 202-473-7644.
