Domestic Capital Market Reform and Access to Global Finance: Making Markets Work

Contrary to the predictions of standard economic theory, capital market liberalization has been a mixed blessing for many countries. Liberalization of debt inflows exposes economies to the risk of crises stemming from sudden changes in investor sentiment. Equity market liberalizations, on the other hand, have promoted growth in almost every liberalizing country. Yet equity market liberalizations have not had as strong an effect as might be expected. To convince outsiders to invest, countries must put in place laws and supporting institutions to protect the rights of minority shareholders. Countries with such protections tend to have larger, more efficient, and more stable stock markets than those that do not. 1 Henry is Associate Professor of Economics at the Stanford University Graduate School of Business and a faculty research fellow of the National Bureau of Economic Research. Lorentzen is a doctoral student in Economics at the Stanford University Graduate School of Business and a researcher at the Center on Democracy, Development, and Rule of Law at Stanford University's Institute for International Studies. This article will appear in the book The Future of Domestic Capital Markets in Developing Countries, Brookings Institution Press 2003. Henry gratefully acknowledges the financial support of a National Science Foundation CAREER award, the Stanford Institute of Economic Policy Research (SIEPR), and the Center for Research on Economic Development and Policy Reform (CREDPR). Over a decade ago, Robert Lucas asked the following question: Why doesn’t more capital flow from rich to poor countries? His point was simple. Poor countries have lower capital-to-labor ratios than rich ones. Under standard neoclassical assumptions, the rate of return to capital in poor countries should be higher than in the developed world, attracting capital until risk-adjusted rates of return are equalized. In other words, market pressures should lead to a positive net transfer of resources to less-developed countries, thus boosting their growth rates. Lucas encouraged us to think about the obstacles that prevent such flows from occurring. When Lucas asked his question, the prevailing wisdom was that capital flows to developing countries were a good idea. More than ten years later, intellectual opinion has shifted. A heated debate over capital account liberalization has followed in the wake of financial crises in Asia, Russia, and Latin America. Opponents of the process now argue that capital account liberalization invites speculative hot money flows, increases the likelihood of financial crises, and brings no discernible economic benefits. Some economists have gone so far as to assert that open capital markets may be detrimental to economic development. With the debate over the wisdom of free capital flows still raging, it is at least a little presumptuous to write a paper that explains how developing countries can increase their integration with world capital markets without first addressing the underlying assumption that such integration is beneficial. The paper is organized as follows. The first section examines capital market liberalization, establishing that there are indeed substantial benefits to increased capital market integration. The increasingly popular, negative view of capital account liberalization comes about partly from a failure to distinguish between equity market liberalization and debt market liberalization. After equity market liberalization, capital becomes cheaper, investment booms, and economic growth increases. In contrast, liberalization of debt markets has often led to great difficulty, as banks, companies, and governments 1. Bhagwati (1998); Rodrik (1998); Stiglitz (2002). often become vulnerable to changes in financial market perceptions of their ability to pay back loans. The evidence outlined can be distilled into two key lessons. First, the liberalization of dollardenominated debt flows should proceed slowly and cautiously: Countries should refrain from premature liberalization of dollar-denominated foreign borrowing. The second lesson is that countries have thus far derived substantial economic benefits from opening their stock markets to foreign investors; there is no reason to think that future liberalizers will be any different in this respect. The second section turns to liberalization of the stock market. Although the effects of equity market liberalization are positive and substantial, they fall far short of the torrent of capital flow to the developing world implied by the theory of perfect markets. New theories in economics and finance developed over the past three decades have highlighted the inefficiencies that can result when not all parties to a transaction are equally well informed. Such asymmetric information problems can make investors reluctant to put their money in companies for two reasons. First, they may worry about the adverse selection or “lemons” problem, wherein only the worst companies offer their shares. Second, moral hazard or agency problems raise the concern that even money invested in a good company may be misspent on managerial perks or even stolen outright through accounting tricks. Over the past few years, cross-country econometric research on corporate governance, law, and finance has provided empirical support for the importance of such information problems. In addition, some of this research hints at the relative effectiveness of different reform strategies for increasing foreign participation in developing-country equity markets. However, given the relatively small number of countries with stock markets and the large number of plausible alternative explanations for large, prosperous equity markets, the statistical robustness of these conclusions cannot be taken for granted. Thus the findings of this research should be treated as tentative. Nevertheless, stronger laws and regulatory institutions that protect investors (whether domestic or foreign) from colluding insiders are strongly correlated with deeper and more robust equity markets. The third section discusses this literature and its policy implications in detail. A fourth section concludes. Capital Account Liberalizations and Access to Global Finance Capital account liberalization was once seen as an inevitable step along the path to economic development for poor countries. Liberalizing the capital account, it was said, would permit financial resources to flow from capital-abundant countries, where expected returns were low, to capital-scarce countries, where expected returns were high. The flow of resources into the liberalizing countries would reduce their cost of capital, increase investment, and raise output. The principal policy question was not whether to liberalize the capital account, but when—before or after undertaking macroeconomic reforms such as stabilization of inflation and liberalization of trade. Or so the story went. In recent years intellectual opinion has moved against capital account liberalization. Financial crises in Asia, Russia, and Latin America have shifted the focus of the conversation from when countries should liberalize to whether they should do so at all. Opponents of the process argue that capital account liberalization invites speculative hot money flows, increases the likelihood of financial crises, and brings no discernible economic benefits. Some economists have gone so far as to suggest that open capital markets may even be detrimental to economic development. Must developing countries maintain financial self-sufficiency even as they reap the benefits of openness to trade? In reality, the choice is not so stark. Recent research demonstrates that the answer to the question “Is capital account liberalization helpful or harmful?” depends critically on the type of liberalization undertaken. While liberalization of debt flows has gotten many countries in trouble, liberalization of portfolio equity flows has been associated with booming stock markets, greater capital investment, and faster economic growth. In its broadest form, capital account liberalization can be any decision by a country’s government that allows capital to flow more freely in or out of that country. Allowing domestic businesses to obtain loans from foreign commercial banks, allowing foreigners to purchase domestic debt instruments (both 2. See Fischer (1998); Summers (2000). 3. See McKinnon (1991). 4. See Bhagwati (1998); Rodrik (1998); Stiglitz (2002). corporate and sovereign), and allowing foreigners to invest in the domestic stock market are three examples. At a minimum, we need to distinguish between two categories of liberalization: those that involve debt and those that involve equity. Although this is an oversimplification, it is useful for driving home the following point. Debt financing and equity financing are different. This point may seem obvious, but it has gotten lost in the heated debate over whether developing countries should have open capital markets. A debt contract has very different characteristics from an equity contract. A debt contract requires regular payments regardless of the borrower’s economic circumstances, while an equity contract involves risk-sharing—large payouts for shareholders when times are good and little to nothing when times are bad. In other words, unlike debt servicing obligations, which are constant, variations in profits and dividends are procyclical and tend to stabilize the balance of payments. Liberalization of foreign borrowing restrictions typically leads to an over-reliance on debt financing for the liberalizing countries. In the 1970s countries became over-leveraged as governments obtained large quantities of floating-rate commercial bank loans. The 1980s debt crisis then demonstrated that the fixed-payment schedules of debt contracts can induce large inefficiencies when economic conditions turn out to be worse than anticipated at the time the debt contract was signed. Nor, as emphasized by John Williamson, “is it just the flow of payments to service the debt that theory suggests is more likely to vary in a stabilizing way for equity than for debt. The debt crisis was caused not just by high and variable interest rates magnifying the service payments due, and by the reduction in export earnings with which to service the debt, but most immediately and powerfully by the cutoff in new lending without any similar curb on the requirement to pay amortization.” At first glance, it may seem that foreign purchase of equities on the domestic stock market could also be reversed if and when foreign investors become concerned about a country’s prospects. But foreigners cannot simply demand their money back. They have to sell their shares. Prices will drop as 5. See Fischer (1987). soon as other market participants (domestic or foreign) anticipate the sudden increase in supply. Furthermore, as prices fall, expected returns rise so that the incentive to sell equity is no longer as strong. Loans, in contrast, have to be serviced even after adverse information becomes known, so that creditors rush to get their money while they can. In other words, the risk-sharing characteristics of an equity contract provide a kind of built-in stabilization mechanism, which suggests that foreign sales of portfolio equity are not likely to pose a particular threat to the domestic economy. In the 1990s countries turned to bonds instead of bank loans as their principal source of finance, but the outcome was largely the same. A number of economists have documented that excessive shortterm borrowing in dollars by banks, companies, and governments played a central role in the Asian financial crisis. In essence, the mismatch between the term structure of borrowers’ assets, which were typically long term and denominated in local currency, and their liabilities, which were short term and denominated in dollars, placed these countries in an extremely vulnerable position. Any bad news that made their lenders reluctant to extend new loans created an immediate liquidity problem. A bunching of long-term debt maturity profiles creates a similar vulnerability. Beyond the Asian crisis, it appears that excessive short-term borrowing in dollars played a central role in precipitating almost every emergingmarket financial crisis during the 1990s. Thus a key lesson is that once external debt flows have been liberalized, it is of utmost importance that the magnitude and maturity profile of the country’s external debt liabilities be compatible with the magnitude and maturity profile of its assets. That the liberalization of external debt financing can quickly generate liquidity problems for a country is a well-known phenomenon that dates back at least as far as Chile in the late 1970s. The empirical distinction between debt and equity flows is as important as the theoretical ____________________ 6. Williamson (1997, p. 288). 7. Choe, Kho, and Stulz (1999). 8. See Furman and Stiglitz (1998); Radelet and Sachs (1998). 9. See Dornbusch (2000); Feldstein (2002). distinctions, because the composition of capital flows to developing countries has shifted drastically over the past twenty-five years. Table 7-1 breaks the composition of capital flows to developing countries into five major categories: public and publicly guaranteed debt flows, private nonguaranteed debt flows, foreign direct investment (FDI), portfolio equity, and grants. The sum of the first two categories reflects all debt flows to less-developed countries. There are three salient points to be made about table 7-1. First, the lion’s share of capital flows to developing countries from 1970 to 1984 took the form of debt. The five-year averages from 1970 to 1984 show that debt typically accounted for about 80 percent of all capital flows. Second, there were no portfolio equity flows to these countries from 1970 to 1984. The fact that portfolio equity flows were nonexistent is a direct consequence of the fact that these countries did not allow foreigners to own shares in their domestic stock markets (a point we revisit shortly). Third, a dramatic shift in the composition of these flows took place starting in the five-year period from 1985 to 1989. Portfolio equity flows as a fraction of total capital flows rose from less than 0.1 percent in 1980–84 to 18.7 percent in 1990–95, an increase of almost two hundred fold. Debt flows as a fraction of total capital flows fell from 82 percent in 1980–84 to 50 percent in 1990–95. FDI flows as a fraction of total capital flows increased from 13 percent in 1980–84 to 28 percent in 1990–95. One of the principal reasons why countries became so reliant on debt during the 1970s was rather straightforward—foreign shareholding was banned. Countries could not rely on portfolio equity to finance development because their governments did not allow foreign investors to purchase shares in the domestic capital market. The import-substitution development strategy in vogue at the time discouraged integration with the global economy in general, and the writings of academic dependency theorists reinforced concerns about the negative political and economic consequences of widespread foreign ownership in particular. In the late 1980s and early 1990s, perhaps in part as a response to the debt crisis, countries all over the developing world decided to open their stock markets to foreign investment. Liberalizing the ____________________ 10. See Akerlof and Romer (1993, pp. 18–23); Díaz Alejandro (1985). stock market—opening it to foreign investors—is one of the most important domestic capital reforms that developing countries can undertake and a necessary (but not sufficient) condition for increasing their access to global finance. Stock Market Liberalization Although numerous studies have shown that premature liberalization of dollar-denominated debt flows in the capital account has deleterious effects, there has been a relative dearth of evidence on the effects of equity market liberalizations. Recent work has begun to address this deficiency, and a consensus is forming that equity market liberalization reduces developing countries’ cost of capital. Identifying the date of stock market liberalization is the first step in determining whether stock market liberalization has any discernible economic effect. Since markets are forward-looking, the most important question is, when does the market first learn of a credible, impending liberalization? In principle, identifying a liberalization date involves simply finding the date on which the government declares that foreigners may purchase domestic shares. In practice, the liberalization process is not so transparent. In many cases, there is no obvious government declaration or policy decree. When there is no salient liberalization decree, liberalization is taken here to be the date on which a closed-end country fund was established. Closed-end funds are often the impetus for a spate of subsequent market openings, which further increase integration. Table 7-2 presents a list of the eighteen countries in the sample, the date of their first stock market liberalization, and the means by which they liberalized. For example, the table shows that the modal means of liberalization occurred through the establishment of a closed-end country fund. ____________________ 11. See Cardoso and Faletto (1979); Evans (1979). 12. See Bekaert and Harvey (2000); Henry (2000a, 2000b, 2003); Martell and Stulz (2003); Stulz (1999); Tesar and Werner (1998). 13. Bekaert and Harvey (2000); Henry (2000a). 14. While there is broad agreement that liberalization reduces the cost of capital, there is some disagreement about the exact timing of liberalizations. This matters, in principle, because the estimated size of the reduction in the cost The establishment of a country fund in particular—and stock market liberalizations in general— may seem like a narrow way to define capital account liberalization, but it is precisely the narrowness of stock market liberalizations that make them more useful for two specific reasons. First, focusing on stock markets alone helps us to distinguish the consequences of equity market liberalization from those of debt market liberalization. Second, studies that use broad indicators of liberalization focus on cross-sectional data, examining the long-run correlation between average openness and average investment. Examining the correlation between average openness and investment tells us whether investment rates are permanently higher in countries with capital accounts that are more open. The problem with this approach is that economic theory makes no such prediction. What the theory does predict is that capital-poor countries will experience a temporary increase in investment when they liberalize. Hence, the relevant issue is not whether countries with open capital accounts have higher investment rates, but whether investment rates increase in the immediate aftermath of liberalization. The most transparent way of testing this prediction is to compare investment rates during episodes of liberalization with investment rates during periods of no liberalization. Because they constitute a radical shift in the degree of capital account openness, stock market liberalizations provide ideal natural experiments for confronting the theory with data. Stock Market Liberalizations: The Cost of Capital, Investment, and Growth The data indicate that, on average, opening up to foreign shareholders leads to a 38 percent increase in the real dollar value of the stock markets in liberalizing countries. Stock market liberalization does not alter the functioning of these companies in any way; liberalization only changes ____________________ of capital depends on the liberalization date one chooses. However, changing liberalization dates has virtually no effect on the basic conclusion. All of the evidence we have indicates that liberalization reduces the cost of capital and suggests that the effects are economically significant, even if we cannot precisely pin down the magnitudes. 15. See for example, Rodrik (1998). 16. Henry (2000a). This number varies according to the liberalization date. Martell and Stulz (2003) report even larger effects. the ownership of the shares of the companies listed on a country’s stock exchange. Then, is the increase in share prices evidence that liberalization drives domestic stock prices away from the fundamentals and leads to stock market bubbles? Not necessarily. The price of a stock depends on the expected future dividends to be paid by that stock and the discount rate shareholders apply to those expected future dividends. The discount rate has two components: the interest rate and the equity premium. Liberalization reduces interest rates through the inflow of foreign funds from countries with more plentiful capital. Stock market liberalization also reduces the equity premium, because emerging-market stocks provide diversification benefits for investors in countries like the United States. In other words, stock market liberalization leads to a lower cost of equity capital. Thus there are sound fundamental reasons for share prices to rise when the stock market is liberalized, and we seem to observe this in reality. Exactly who benefits from the increase in share prices and the decline in the cost of capital? Clearly, domestic shareholders benefit: Those who sell their shares realize capital gains, and those who continue to hold their shares see the value of their portfolios increase. Some foreign shareholders may reap immediate capital gains if they get in early on the country’s “initial public offering,” but the more important benefit is the long-term reduction in risk they get from diversifying their portfolios. Domestic residents who do not own shares also benefit from liberalization, although for less obvious reasons. When a stock market increases in value, this is equivalent to a fall in the cost of capital through that market. For a given capital-raising requirement, a higher stock price means that fewer shares need to be issued. Figure 7-1 illustrates the fall in the cost of capital that occurs when developing countries liberalize the stock market. The figure plots the average aggregate dividend yield across the liberalizing countries in event time (year 0 is the year of liberalization). The average dividend yield falls roughly 240 basis points—from an average level of 5.0 percent in the five years prior to liberalization to 17. Chari and Henry (forthcoming). 18 an average of 2.6 percent in the five years following liberalization. Although the immediate effect of liberalization is to raise share prices and lower the cost of capital, this is not the end of the story. The lower cost of capital encourages firms to build new factories and install new machines because some investment projects that were not profitable before the stock market liberalization are profitable after liberalization. The increased investment that should result from stock market liberalization is particularly important for emerging economies, because more investment should lead to faster economic growth and higher wages for workers. Thus stock market liberalization should generate substantial economic benefits, even for those individuals who did not own shares before the liberalization and therefore do not reap the capital gains associated with the increase in share prices. It sounds plausible that a lower cost of capital should lead to increased investment, but what is the reality? Figure 7-2 demonstrates that, on average, countries experience an increase in investment when they liberalize the stock market. The growth rate of the capital stock rises 1.1 percentage points in the aftermath of liberalization—from an average of 5.4 percent a year in the period before to an average of 6.5 percent in the period after liberalization. While liberalization leads to a sharp increase in investment on average, it is also important to know whether this is a uniform effect: Do all countries experience higher investment, or do just a select few drive the results? In order to address this question, recent research looks at the results on a country18. Recall that the dividend yield, D / P, is given by the following formula: D / P = r g, where D is the dividend, P is the price, and g is the expected growth rate of D. It is legitimate to interpret a fall in the dividend yield as a decline in the cost of capital, if there is no change in the expected future growth rate of dividends at the time of liberalization. But, as we discuss shortly, stock market liberalizations usually are accompanied by other economic reforms that may increase the expected future growth rate of output and dividends. Economic reforms do have significant effects on the stock market, but the financial effects of liberalization remain statistically and economically significant, after controlling for contemporaneous reforms (Henry 2000a, 2002). 19. The increase in the growth rate of output will only be temporary. Because of diminishing returns to capital, it is impossible for a country to achieve permanently higher growth rates by simply increasing the capital stock. The gains in the level of GDP per capita, however, will be permanent. by-country basis. In one study, only two of the countries in the sample did not experience abnormally high rates of investment in the first year after liberalization. In the second year after liberalization, only one of the countries did not experience abnormally high rates of investment. Theory also tells us that increased investment should raise productivity and economic growth. Figure 7-3 shows that, as predicted, the growth rate of output per worker rises in the aftermath of liberalization—from an average of 1.4 percent a year in the period before to an average of 3.7 percent a year in the period after liberalization. Stock Market Liberalization and Other Economic Reforms Stock market liberalizations are usually accompanied by other economic reforms. Therefore, it is important to ask whether these economic reforms would have caused large increases in stock prices, investment, and growth, even if there had not been any stock market liberalization. While the financial and economic effects of stock market liberalization remain statistically and economically significant after controlling for contemporaneous reforms, the other economic reforms are also important sources of growth. To see the point, consider in greater detail the result illustrated by figure 7-3: per capita gross domestic product (GDP) growth increases following liberalization. On the one hand, there is nothing surprising about figure 7-3. Whereas figures 7-1 and 7-2 document behavioral responses of prices and quantities of capital to liberalization, figure 7-3 simply provides a mechanical check of the standard growth-accounting equation: ( ) ˆ ˆ ˆ 1 Y A K L α α = + + − (7-1) ˆ , where a circumflex over a variable denotes the change in the natural log of that variable. 20. Henry (2000b). 21. In words, this equation says that the growth rate of output equals the growth rate of total factor productivity plus capital’s share in output (α) times the growth rate of the capital stock plus labor’s share in output (1 α) times the The interesting point about figure 7-3 is that the increase in the growth rate of output per worker is too large to be explained by the increase in investment. A few simple calculations illustrate the point. The elasticity of output with respect to capital,α , is typically around 0.33. So, based on figure 7-2, we would expect the growth rate of output per worker after liberalization to be about 0.363 (0.33 times 1.1) percentage points higher. But figure 7-3 displays a 2.3 percentage point increase in the growth rate of output per worker. All else equal, a 1.1 percentage point increase in the growth rate of the capital stock can produce a 2.3 percentage point increase in the growth rate of output per worker only if the elasticity of output with respect to capital is on the order of 2! The increase in growth due to liberalization is slightly larger than 1 percentage point after controlling for a number of variables. Nevertheless, this finding still requires an elasticity of output with respect to capital that is greater than 1. What explains the inconsistency of this finding with standard production theory? The answer, of course, is total factor productivity (TFP) growth. Equation 7-1 shows that any increase in the rate of growth of output that is not accounted for by an increase in the growth rate of capital and labor must be the result of an increase in , the growth rate of TFP. While we typically interpret as the growth rate of the stock of productive ideas or technology, any economic reform that raises the efficiency of a given stock of capital and labor also increases , even in the absence of technological change. Â