Trends in Developing Country Capital Markets
Around the World
by Gerd Häusler
Director, International Capital Markets Department
International Monetary Fund
Paper prepared for
The World Bank, International Monetary Fund, and
Brookings Institution Conference on the
Future of Domestic Capital Markets in Developing Countries
Washington, D.C.
April 14-16, 2003
Trends in Developing Country Capital
Markets Around the World
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One of the key structural changes in a growing number of emerging markets
has been the rapid development of local securities markets since the mid1990s.
The recent interest in developing local securities and derivatives markets
reflects the experience of many emerging markets with volatile international
capital flows and asset prices and systemic banking crises.
“Sudden stops” (or even reversals) of capital flows were often key features
of many of the most severe balance of payments crises and systemic
banking crises since 1995 (particularly the Mexican and Asian crises).
This volatility of capital flows has raised the issues of both how to achieve
more stable access to international capital markets for emerging markets
and how these economies can cope with whatever volatility occurs.
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While establishing sound and sustainable macroeconomic policies has been
one obvious element in strengthening domestic economic fundamentals and
perceived creditworthiness, many emerging markets have taken additional
measures to “self-insure” against volatile capital flows and asset prices.
These measures include:
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Changes in external asset and liability management policies
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Holdings of foreign exchange reserves by emerging markets nearly doubled
between the end of 1995 and the end of 2001, with notable accumulation by
some countries that experienced sudden stops of capital flows (such as
Korea, Taiwan Province of China, and Mexico).
Emerging markets borrowers have also shown deftness in adapting to the
volatile nature of capital flows by employing staff in debt management
agencies with extensive market experience, exploiting “windows of
opportunity” to prefund their yearly financing requirement, and extending
maturities of external debt whenever possible.
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Adapting exchange rate arrangements to the degree of
openness—countries have generally moved away from pegged by
adjustable exchange rate arrangements since the mid-1990s,
especially those with access to international capital markets.
Strengthening domestic financial institutions (particularly in the
banking system) and enhancing prudential supervision and
regulation in order to increase resilience to volatility.
Developing local securities and derivatives markets to provide an
alternative source of funding for public and corporate sectors and
to facilitate the management of the financial risks associated with
periods of high asset price volatility.
• The efforts to develop local securities markets have been
motivated by a number of considerations:
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• a desire to stimulate domestic savings by offering savers new
financial instruments which broaden the set of investment
opportunities and allow for better portfolio diversification;
• to improve the intermediation of domestic savings and attract
foreign investors. This has become particularly important as a
greater number of emerging markets have privatized their
pension systems;
• to develop alternative sources of funding for both the public and
corporate sectors to either domestic bank lending or international
capital markets. In addition, local derivative markets have been
seen as providing a vehicle for managing financial risks,
especially those related to exchange rates and interest rates.
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Recent Trends in Local Securities
Markets
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Emerging local bond markets have grown considerably over the last
decade, but they are still much smaller than bond markets in the G-7
countries. Emerging local bond markets are roughly 36 percent of GDP
(see Table 1). Mature markets average 120 percent of GDP, although this is
influenced by the large 150 percent of the United States—with Euroland
showing a lower figure of around 90 percent of GDP
There are regional differences in how rapidly the markets have developed.
In Asia, the growth of local bond issuance has been driven by the need to
recapitalize banking systems and more recently to finance expansionary
fiscal policies. The lack of bank credit has also contributed to some
increase in corporate bond issuance, not just in Asia but also in Latin
America. In the latter region, the rapid growth of local institutional investors
has driven the growth of local bond markets, together with large refinancing
needs of the corporate sector in a difficult external environment.
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There has been substantial progress in the development of government
bond markets, but progress has been somewhat slower in corporate bond
markets
The use of the equity market as a serious alternative source of financing for
emerging market corporates really began in earnest in the early to mid1990s. This period coincides both with significant financial market
liberalization in many emerging market countries, and also with a marked
increase in the interest of international money managers in emerging market
equities.
However, the importance of the stock market as a source of funding for
corporates in emerging markets has become more volatile as a result of a
string of financial crises, starting with Mexico in 1995, Asia during 1997–98,
Russia in 1998, Brazil in 1999, and in more recent years, Turkey and
Argentina.
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To what extent have these markets begun to provide an alternative source of
funding to either domestic bank lending or international capital flows for both
the private sector and the public sector? (see Figure 1).
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A surge of local corporate bond issuance, particularly in Asia and Latin America.
Local corporate bond issues grew by a factor of 10 between 1997–99 and
2000-01.
Local bond markets have been the dominant source of funding for the public
sector in all regions. Although this primarily reflects the heavy reliance of the
public sector on bond issuance, domestic corporate bond issuance
nonetheless rose from 5 percent of total corporate domestic and
international funding in 1997–99 to 31 percent in 2000-01; whereas
domestic bank credit fell from 52 percent of total corporate funding in 1997–
99 to 40 percent in 2000–01.
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Common Practices in Emerging Local
Capital Markets
There is general agreement between market participants and the authorities
in emerging markets that certain policies have proven most effective in
stimulating the development of local securities markets
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A growing number of countries have adopted measures to improve transparency
and corporate governance, as they see these as critical for local capital markets
development.
Although the provision of a robust financial infrastructure for trading, clearing,
and settlement of transactions is generally considered to be a public good, many
authorities have felt that the establishment of a liquid government securities
benchmark yield curve in order to facilitate the pricing of corporate securities is
also a desirable policy objective.
Many emerging markets have realized the importance of developing a local
institutional investor base (particularly pension funds) to support local securities
markets.
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Other Selected Policy Issues
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While the development of market infrastructure, institutional investors, and
transparency are uncontroversial steps, countries’ experience and the
arguments behind some other aspects of the development of local securities
markets (the “grey areas”) are less clear cut.
Indexed Bonds
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The development of indexed bonds, in particular inflation indexed (or
inflation linked, IL) bonds, has contributed to the development of local
bond markets—especially in high inflation emerging markets.
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Although indexation to inflation could help deepen and lengthen both
private and public bond markets, indexation to the exchange rate is more
controversial. While dollar-linked debt provides a foreign currency hedge
for investors, it can lead to financial instability if the excessive use of this
instrument results in sizable currency mismatches that create solvency
concerns about the issuers—like the sovereign and/or non-exporters
whose tax revenues or receipts are mostly denominated in local
currency. The higher volatility of the exchange rate vis-à-vis the price
level, especially during capital flow reversals, can cause a deterioration
in these issuers’ balance sheet positions that is likely to magnify the
initial problem of lost access to international capital markets and capital
outflows.
The issuance of dollar-linked debt in local markets compounds the
problem that most emerging markets cannot issue international bonds
denominated in their own currencies, the so-called “original sin problem.”
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Credit Risk Pricing
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Market participants regard the lack of sophistication in pricing credit
risk as a major constraint to the growth of emerging corporate bond
markets. Development of a credit culture takes time.
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The Role of Foreign Investors in Local Markets
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Foreign investors are an important source of demand for local
securities, and several emerging markets have opened their local
markets to foreign investors in an attempt to widen and diversify the
investor base.
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Some argue that foreign investors seeking diversification benefits may
not have an incentive to invest in the necessary information required
to understand local markets and may be more prone to herding
behavior; while others state that because foreign investors tend to be
quite sensitive to risk and to manage actively their portfolios, they may
make local markets more volatile and prone to crises. These
hypotheses are difficult to test empirically and only a couple of
experiences may shed light on the issue.
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Sequencing
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Broadly speaking, a comparison of different types of financial systems,
and their evolution over time, is a complex issue and there are no
simple answers to what would be an optimal development strategy.
Some analysts suggest that it may be optimal to develop first a deep
local debt market before opening up the capital account. An example is
Australia. The potential benefits of developing local markets in isolation
from international markets have to be weighed against traditional
arguments against capital controls (such as misallocation of resources,
increased costs of funding, and evasion)
The development of well-functioning money markets appears to be a
critical first step in developing corporate bond markets as well as
derivatives markets.
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Although local securities markets can provide an alternative source of
funding to the banking sector, especially during banking crises
(Greenspan “spare tire”), a sound and well-regulated banking system
can be a necessary complement to the development of local securities
markets. Banks can play a number of supporting roles for securities
markets: they can be large holders of securities, underwriters and market
makers, issuers, guarantors, as well as arrangers of securitizations.
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Local securities markets remain highly segmented in most regions, and
a number of measures would have to be undertaken to develop fully
integrated, regional markets. In Asia, for example, analysts note that,
besides the removal of controls and harmonization of taxes, several
institutional aspects of bond markets—such as contracts, underwriting,
and settlement conditions—would have to be standardized to some
extent before a pan-Asian market could be created. A recent proposal
by the Asian Cooperation Dialogue (ACD) would involve a set of Asian
governments launching a regional bond fund, financed by Asian central
banks, that would “catalyze” larger investments from institutional
investors and would invest initially in U.S. dollars, euro, and other
nonregional currency bonds, later diversifying into local currency bonds
from government and corporate issuers.
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Concluding Remarks
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Despite the rapid expansion of local markets—in particular, local bond
markets—they have not yet developed enough to provide full insurance
against the closure of banking or international markets. Nonetheless,
continued efforts to develop these markets could eventually provide a
significant cushion against future closures. In particular, these efforts
should focus on continuing to adopt measures geared toward
strengthening market infrastructure, developing benchmarks and local
institutional investors, and improving corporate governance and
transparency.
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