WhitherWhither LatinLatin AmericanAmerican CapitalCapital Markets?Markets? Regional study led by Augusto de la Torre and Sergio Schmukler October 2004 Office of the Chief Economist Latin America and the Caribbean Region The World Bank Whither Latin American Capital Markets? Augusto de la Torre and Sergio Schmukler With Norbert Fiess, Juan Carlos Gozzi Valdez, and Marina Halac Acknowledgements This LAC regional study was led by Augusto de la Torre and Sergio Schmukler. The main report contains four chapters. Norbert Fiess, Juan Carlos Gozzi Valdez, and Marina Halac are the leading authors of Chapters 2 and 3. Jurgen Janssens and Leonor Coutinho also participated in Chapters 2 and 3. Many authors wrote the background papers, used as input for the chapters and listed in the project’s website, which can be found at www.worldbank.org/laceconomist. We are grateful to Arturo Galindo, Tom Glaessner, and Anjali Kumar (the study’s peer reviewers), who provided detailed and very useful comments, and Guillermo Perry, who has supported this study from the beginning. We would also like to thank Jerry Caprio, Yambeon Kim, Leora Klapper, Jeppe Ladekarl, Danny Leipziger, Giovanni Majnoni, Micheal Pomerleano, Luis Serven, Dimitri Vittas, and Sara Zervos for their useful comments and suggestions. We have also benefited from feedback received at presentations held at the Banco de Mexico (Mexico), the Capital Markets Symposium (Medellin), the GDN Annual Conference (New Delhi), the European Science Foundation Exploratory Workshop (Oxford), Séptimo Congreso de Tesorería (Cartagena de Indias), the UBS Roundtable (Lima), and the World Bank Finance Forum (Washington, DC ). 1 Chapter 1 Summary of the Regional Study 1. Introduction Back in the early 1990s, economists and policymakers had high expectations about the prospects for domestic capital market development in emerging economies and, particularly, in Latin America. Unfortunately, they are now faced with disheartening results. Though many still hope for securities markets to develop, the reality is that equity and corporate bond markets are illiquid and segmented in many countries. Debt is concentrated in the short end of the maturity spectrum and denominated in foreign currency, exposing countries to maturity and currency risk. Moreover, government debt is crowding out corporate bond markets. The state of capital markets looks particularly poor when considering the many efforts already undertaken to improve the macroeconomic environment and to reform the institutions believed to help develop capital markets. In the case of Latin America, the results appear even more discouraging in light of the better evolution of capital markets in East Asia and the rapid growth in developed economies (especially in international financial centers). The disappointing performance has made the conventional recommendations for capital market development questionable, at best. Policymakers are left without clear guidance on how to revise the reform agenda, plus many of them do not envision a bright future for domestic capital markets.1 In this study, we analyze where we stand and where we are heading on capital market development. More specifically, this study has three main goals. First, we take stock of the state and evolution of Latin American capital markets and related reforms, over time and relative to other countries. Second, we analyze the factors driving the development of capital markets, with particular interest on measuring the impact of reforms. Third, in light of this analysis, we discuss the prospects for capital market development in Latin America and emerging economies in general, and the implications for the reform agenda going forward. An analysis of the performance of capital markets would nowadays be incomplete without taking into account the recent trends in financial globalization. Thus, we study 1 This might have important consequences because financial development is linked to economic growth. For more than a century, this link has been emphasized. Historically, the literature focused on the role of banks, beginning with the views of Bagehot (1873) and Schumpeter (1912). More recently, Levine and Zervos (1998), among several others, have documented the positive relation between financial development and growth. 2 WHITHER LATIN AMERICAN CAPITAL MARKETS? not only the domestic market activity, but also the evolution of global capital markets and the participation of developing countries in those markets. Several factors make the inclusion of financial globalization in the analysis valuable. First, most of the studies that analyze the development of local capital markets disregard foreign market activity.2 We believe that this is a major drawback given the significant participation of emerging economies in international markets. Hence, without taking into account this participation, one misses a substantial part of the capital market activity. Second, the papers that analyze the participation in international markets do not study its effects on firms that do not internationalize.3 This is also a relevant weakness since there are contradictory arguments on the impact of globalization on domestic markets. Some claim that participation in international markets would have positive spillover effects on local markets, as going abroad, among other things, sends positive signals to investors, encouraging them to participate in domestic markets. For example, by raising capital in international markets, governments and firms choose to abide by stricter accounting and disclosure standards, making them less likely to expropriate investors.4 On the other hand, others argue that in a context of liquidity agglomeration, migration can shift local liquidity to international markets, generating negative spillover effects on local markets.5 Third, by considering the major developments in financial markets across countries, one can analyze in perspective the trends in capital markets and the degrees of freedom available to authorities to change domestic trends. Fourth, despite possible temporary retrenchments, one can expect that financial globalization will deepen in the years to come, making it essential in any analysis. Our focus on Latin America is interesting in different dimensions. Two stand out. First, countries in Latin America have taken many steps to reform their institutions and to improve their macroeconomic management. Given all these changes, capital markets were expected to develop significantly. Second, many Latin American countries have actively participated in the globalization process. Therefore, one can test the effects of that participation on local markets and derive predictions for countries that have not yet embraced that process to the same extent. To understand the state and future of capital markets in developing countries, the report consists of three additional chapters. Chapter 2 documents the main developments in international financial markets and the increasing globalization process. The chapter also describes the influence of these worldwide trends on Latin America, with particular attention to the effects on the policies and reforms adopted. Furthermore, Chapter 2 2 See Levine (2004) for a review of the literature on the relation between domestic financial market development and macroeconomic variables, financial reform, and other country factors. 3 An extensive literature analyzes the effects of internationalization on those firms that internationalize, focusing on their trading and liquidity (see, for example, Noronha, Sarin, and Saudagaran 1996, Smith and Sofianos 1997, and Pulatkonak and Sofianos 1999), the impact of internationalization on stock prices and the cost of capital (see, for example, Alexander, Eun, and Janakiramanan 1988, Foerster and Karolyi 1999, Miller 1999, and Errunza and Miller 2000), and the effect of internationalization on asset size, growth, financing constraints, and financial structure (see, for example, Schmukler and Vesperoni 2001, Pagano, Roell, and Zechner 2002, and Lins, Strickland, and Zenner 2003). 4 See, for example, Coffee (1999, 2002), Stulz (1999), and Reese and Weisbach (2002). 5 See, for example, Moel (2001) and the background paper for this study, Levine and Schmukler (2004). SUMMARY OF THE REGIONAL STUDY 3 documents the main developments in Latin American capital markets, both in terms of the evolution of different domestic securities markets as well as the participation in international capital markets, and compares them with other regions. Chapter 3 evaluates the factors behind the development (or lack of development) of capital markets. The chapter first studies how different macroeconomic and institutional variables affect the development of domestic stock and bond markets and their internationalization. The second part of Chapter 3 analyzes the effects of reforms on capital markets. The chapter finishes by examining whether the experience of Latin America is similar to that of other regions. Finally, Chapter 4 discusses the future of capital markets in developing countries, the policy implications, and the lessons for the reform agenda. Chapter 1 summarizes some of the main ideas and results from each of the other chapters. The rest of the chapter is organized as follows. Section 2 describes the main developments related to the globalization of capital markets. Section 3 summarizes the main developments in domestic capital markets. Section 4 describes the effects of fundamentals on capital market development. Section 5 presents