emerging equity markets: tapping into global investment flows

Emerging Equity Markets: Tapping into Global Investment FlowsAuthor(s): Ingo WalterSource: ASEAN Economic Bulletin, Vol. 10, No. 1 (JULY 1993), pp. 1-19Published by: Institute of Southeast Asian Studies (ISEAS)Stable URL: http://www.jstor.org/stable/25770456 .

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ASEAN Economic Bulletin Vol. 10, No. 1

Emerging Equity Markets

Tapping into Global Investment Flows

Ingo Walter

In recent years, many developing countries have undertaken important, policy reforms, in

cluding measures intended to stimulate domestic and international investor interest in

locally issued and traded shares, in order to professionalize local equity markets and mobi lize investor capital for future, more complex stages of economic growth. This study assesses

emerging-market characteristics, specifically market capitalization, trading volumes, turn over ratios and cross-border equity flows. It then links these developments to international investor interest, particularly in the light of the low correlations that exist between the return

performance of emerging and developed equity markets and the resulting unusually high value to asset-holders of international portfolio diversification. We then identify the princi pal quantitative and structural factors that appear to explain the differential growth and

development of emerging equity markets, both conceptually and empirically, using straight forward pooled regression methodology. Policy options for improving the functioning of emerging equity markets and their linkage into one of the most rapidly evolving dimensions

of global capital flows are discussed.

The development of efficient domestic capital markets, especially for equities, carries with it

significant potential benefits in terms of both

the quantitative and qualitative dimensions of

economic growth. These are achieved through

improved static and dynamic efficiencies in the

domestic financial market, facilitating privatiza tion of state-owned enterprises and initial public

offerings, improving the process of corporate control, and tapping into global flows of portfolio investments. Further social gains may be achieved

through the spread of public ownership of corpo rate shares, mutual funds, pension funds and other

collective investment structures giving the general public a significant stake in the operation of the

private sector.

Cross-border financial flows were among the most dynamic aspects of the global economy in the 1980s and early 1990s, and are likely to re

main so well into the twenty-first century. They are rooted in differential risk and return profiles across various national debt and equity markets, attributable to such fundamentals as the under

lying productivity of capital, rates of saving and macroeconomic policies

? characteristics that

lend substantial value to cross-border diversifica tion in investors' portfolio decisions and attractive

ASEAN Economic Bulletin 1 July 1993



international securities issuing opportunities for

those seeking capital on favourable terms.

The catalyst in the globalization of securities

markets was dramatic technological and regula tory change. The first made possible important re

ductions in information and transactions costs, as

well as critical new techniques for hedging and

systematic approaches to portfolio allocation. The

second encouraged financial disintermediation and securitization, redirecting international finan

cial flows though the securities markets as against the traditional lending markets ? as well the

elimination of blockages to cross-border transac

tions, notably exchange controls. Certainly, the

catalytic power of these two forces is not yet exhausted as innovation in financial products,

techniques and transactions processes continues to

forge ahead, and especially as emerging financial

markets ? such as those represented by the

members of the Association of Southeast Asian Nations (ASEAN)

? progressively join the

mainstream of international financial flows. And

whereas the principal international markets for

debt instruments have already become somewhat

integrated and relatively "seamless", the same

cannot be said about cross-border equity flows.

Once a topic of heated argument among those

responsible for public policies, the desirability of international equity investment has become con

ventional wisdom in much of the world. Many developing countries have undertaken important policy reforms intended to stimulate international investor interest in locally issued and traded equi ties. Just as liberal international trade enhances

social welfare by allowing free markets to capture the power of comparative advantage, so does the free international flow of investment capital as it is continually redirected from less to more pro ductive applications around the world.

This article assesses the evolution of global

equity flows with reference to the emerging markets, with particular attention to the ASEAN countries. It then suggests a series of factors that

may explain why different national markets have

succeeded more or less well in tapping into global flows of portfolio equity capital, including a

first-cut empirical test. Finally we suggest some

conditions that must be met if ASEAN and other

emerging-market countries are to derive greater benefits from cross-border equity flows.

Basic Characteristics of

Emerging Equity Markets

Table 1 identifies the world's emerging equity markets. All of them are non-OECD countries

with the exception of Greece and Portugal.

Singapore and Hong Kong, which have relatively

well-developed equity markets, are not considered to be emerging markets under the International Finance Corporation (IFC) definition. According to a recent study, the emerging markets as a whole

attracted between US$14 billion and US$15 billion in net cross-border equity investments in

1989, accounting for a 14 per cent share of global cross-border equity flows ? this appears to have been true also in 1990 and 1991 (Howell, Cozzini

and Greenwood, 1992). What are the basic meas ures that can be used to gauge the evolution of

emerging equity markets?

Market Capitalization

Market capitalizations (number of shares out

standing times current share price) for 1991 of

emerging equity markets are provided in Table 1.

Many of these markets developed rapidly during the 1980s, with total capitalization rising from

US$67 billion in 1982 to US$643 billion in 1991 ? a ten-fold increase as against less than a quad rupling of equity market capitalization in the de

veloped countries over the same period.1 Market

capitalization for the ASEAN countries (excluding Singapore) grew from US$17.3 to US$111.46 billion over the same period. This rapid expansion reflects three factors:

1. The role of share price increases. 2. New secondary stock issues by companies which already have shares outstanding. 3. New listings (initial public offerings, or IPOs)

during this period ?

including privatizations.




TABLE 1 Market Capitalization, 1991

(In US$ millions)

Market 1991

Emerging markets

Argentina* 18,509

Bangladesh 269 Brazil (Sao Paulo)* 42,759 Chile* 27,984 Colombia* 4,036 Costa Rica 311 Cote d'lvoire 567

Egypt (Cairo) Greece* 13,118 India (Bombay)* 47,730 Indonesia* 6,823 Jamaica 1,034 Jordan* 2,512

Kenya 638 Korea* 96,373 Kuwait

Malaysia* 58,627 Mexico* 98,178 Morocco 1,528

Nigeria* 1,882 Pakistan* 7,326 Peru 1,135

Philippines* 10,197

Portugal* 9,613 Sri Lanka 1,998 Taiwan, China* 124,864 Thailand* 35,815 Trinidad and Tobago 671

Turkey* 15,703

Uruguay 44 Venezuela* 11,214 Zimbabwe* 1,394

IFC composite* 634,657 All emerging markets 642,852

Total 11,402,880

Emerging markets included in IFC Composite Index. SOURCE: IFC (1992).

Nevertheless, the proportionate share of the

emerging-market countries' market capitalizations (as against the share of these same countries in combined world gross domestic product [GDP]) remains disproportionately low ? 6 per cent for market capitalization as against 13 per cent for GDP. This suggests that there remains plenty of

scope for further dramatic growth in the future.

Comparative international data on equity mar kets seem to suggest that market capitalization rises as a (non-linear) function of per capita GDP. The most likely empirical relationship is an up ward non-linear slope, with the standard error of the fit being higher at successively higher levels of GDP. Figure 1 illustrates a cross-sectional ver sion of this relationship for 1990, based on IFC data. Note the generally positive relationship for the emerging markets (albeit with a number of

outliers, notably Colombia and Malaysia), but a

substantially weaker and more diffuse relationship at the upper end of the per capita income scale. Note also that a substantial number of emerging market countries have higher equity market capi talization to GDP ratios than do several developed countries.

Trading Volume and Market Turnover

A second measure of national equity market de

velopment is trading volume, important because

trading volume drives market liquidity. It appears that equity trading volume does not rise strictly in

proportion to market capitalization, and differs

dramatically across emerging markets ? ranging from under US$10 million in Bangladesh, Costa

Rica, the Ivory Coast, Nigeria and Uruguay to

US$85 billion in Korea and US$365 billion in Taiwan (IFC 1992). Over time, the share of East Asian countries ? Korea, Thailand, Taiwan,

Hong Kong, Malaysia, Singapore, Philippines and Indonesia ? increased from 14 per cent to 46 per cent of total developing-country equity transac tions volume during the 1982-91 period. East

Asian volume, in turn, was disproportionately concentrated in Taiwan and South Korea. Indeed, Taiwan volume exceeded that of the United King dom, France, The Netherlands and Italy in 1991,




FIGURE 1 Equity Markets and GNP, 1990

Emerging markets Developed markets

Malaysia

Brazil

Zimbabwe

Jordan Chile

Thailand

India

Indonesia Philippines

| Argentina

Turkey Venezuela Mexico

Taiwan, China

Korea

UK

Greece

Portugal

Japan USA

France Germany gj Austria

Pakistan

Colombia

Nigeria

1-1?i i 11 11

100

t?r

1,000

I Mill

10,000

20,000

30,000

GNP Per Capita (US$)

SOURCE: IFC (1992).



and Korean volume even surpassed that of Italy and approached that of The Netherlands. More over, several other developing countries ap proached the lower tier of developed countries by this measure of market evolution.2

There are equally wide variations among emerging equity markets' turnover ratios ? de fined as the volume of shares traded divided by average market capitalization

? another measure of market liquidity. For 1991, these are given in

Figure 2. Note the enormous differences in emerg ing market turnover, ranging from 1 in Nigeria to 330 in Taiwan.

Growth in trading volume and equity market

liquidity can be caused by:

1. Increases in the volatility of equity prices. 2. Increases in active traders as opposed to pas sive buy-and-hold investors in the market. 3. Increases in non-local demand for local equi ties (i.e. cross-border investments). 4. Increases in private as opposed to govern ment-linked shareholdings. 5. Changes in the legal, regulatory and transac tions-cost environment that reduce the cost of active trading in equities.3

International Investor Behaviour

It has been estimated that foreign (cross-border plus cross-exchange) trading of equities in 1992 amounted to US$2.15 trillion, up from US$901.5 billion in 1986.4 During that period, foreign inves tors' holdings of equities in national markets in creased from US$460 billion to US$915 billion. From 1979 through 1991, gross cross-border

equity flows increased from US$73.1 million to

US$1,323 trillion, representing an increase in real terms to an index of 447.5 (1970=100) in 1991.

The extent to which a given national equity market is able to access these flows clearly depends on the portfolio behaviour of interna tional investors. The ultimate investors and/or their portfolio managers are continually engaged in asset-deployment optimization. This involves total-return maximization subject to risk con

straints ? an effort to create and maintain so called "efficient portfolios". Internationally, this is undertaken in response to shifting risk-return

expectations that are based on:

1. Individual share price performance. 2. National stock market performance as repre sented, for example, by an appropriate market index.

3. Exchange rate performance. 4. The variances associated with each of the above.

5. Covariances among the above. 6. Transfer conditions and country risk. 7. Equity market "frictions" notably information

costs, transactions costs and liquidity constraints.

The first two of these criteria are self-evident, as is expected exchange rate performance with re

spect to conversion of total returns in emerging markets into the investor's home currency. The fourth criterion defines the unsystematic (diver sifiable) risk associated with individual shares,

market averages and currencies, which focuses attention on the fifth criterion ? covariances in total returns across markets which define the

power of equity portfolio diversification. Interna tional portfolio diversification (IPD) is particu larly important in affecting investor behaviour if net total returns in terms of the investor's refer ence currency are considered to be imperfectly correlated across national equity markets.

That the total returns on equities in emerging markets have in fact not been highly correlated is shown in Table 2, which gives the correlation

matrix for different regional indices and in dividual country performances over a five-year period ending in March 1992. Note the particu larly low correlations with the major market indices for most of the emerging equity markets.5 This adds an important motivation to cross-border

purchases of emerging market equities by global investors. Indeed, the data suggest that the IPD

benefits from investing in emerging markets are

among the most powerful available, and should be highly attractive to international investors ?

provided that problems posed by Criteria 6 and 7, above, can be overcome.




FIGURE 2 Selected Turnover Rates, 1991

SOURCE: IFC (1992).



TABLE 2 Correlation Coefficient Matrix of IFC Total Return Indexes (In US$, five

years

ending March 1992)

USA EAFE FTEP IFCC IFCL IFCA Arg Bra Chi Col Gre

Ind Idn? Jor Kor Mai Mex Nig

Pak Phi

Por Tai Tha Tur Ven Zim

1.00 0.50 0.50 0.41 0.47

0.32 0.08 0.18 0.42 0.09 0.12 -0.08

0.14 0.17 0.26

0.70 0.53 0.03 0.08

0.42 0.20

0.16 0.58 -0.03 -0.10 -0.10

1.00 1.00

0.34 0.28 0.35

-0.11 0.19 0.04 0.06 0.13

-0.15 -0.13 0.21 0.34 0.56 0.26

-0.13 0.05 0.25 0.35

0.26 0.47 0.04

-0.17 0.03

1.00 0.35

0.28 0.36

-0.12 0.19 0.04 0.06 0.11

-0.16 -0.13 0.21 0.35

0.55 0.26

-0.13 0.05

0.25 0.34

0.26 0.47 0.03

-0.17 0.04

1.00 0.62 0.95

-0.04 0.34 0.46 0.13 0.12 0.03

0.27 0.10 0.25 0.56 0.57

-0.13 -0.02 0.26 0.43 0.86 0.55 0.23

-0.37 -0.13

1.00 0.40 -0.03

0.75 0.49 0.08 0.18 0.10 -0.06 -0.15

0.14 0.49 0.64 0.05 -0.01

0.24 0.36 0.30 0.39

0.19 -0.33 -0.09

1.00 -0.07

0.15 0.35

0.07 0.02

-0.11 0.24 0.14 0.28

0.48 0.44

-0.19 -0.02 0.21 0.34 0.94 0.52 0.14

-0.31 -0.07

1.00 -0.21 -0.06 -0.10

0.10 0.23 -0.20 -0.10 -0.16 -0.05

0.13 0.16 0.01 -0.06

0.01 -0.05

0.15 0.13 0.01 -0.22

1.00 0.17 0.16 0.15 0.06

0.01 -0.11

0.02 0.23 0.08 0.07

0.00 0.27 0.15

0.11 0.17

0.14 -0.23

0.00

1.00 -0.06

0.18 0.02 0.01 0.02 -0.01

0.34 0.36 -0.08 -0.15

0.12 0.27 0.32 0.30 0.01 -0.23 -0.12

1.00 0.25

-0.12 0.23 0.11

-0.08

0.10 0,02 0.05 0.47 0.12

0.17 0.12 0.14 0.07

-0.30 -0.14

1.00 0.03 0.29 0.15 -0.21

0.04 0.07 0.13 -0.10

0.09 0.42 0.08 0.31 0.19 0.12 -0.03

1.00 0.08

-0.02

-0.07 0.06 0.05 0.04

-0.13 -0.09 -0.07 -0.14

0.00 0.12

-0.06

-0.36

1.00 0.22

-0.06 0.42 0.21

-0.19

0.07 0.47 0.01 0.23 0.48 0.18

0.00 0.14

1.00 -0.11

0.16 -0.05

0.00 0.01 0.20 -0.04

0.15 0.13 -0.14

0.08 -0.11

1.00 0.29 1.00

0.20 0.47 1.00 0.01 -0.08 -0.07 0.05 -0.02 0.00 0.14 0.46 0.09 0.07 0.25 0.39 0.02 0.29 0.35 0.06 0.61 0.42 -0.02 0.20 0.15 -0.14

-0.14 -0.23 0.01 -0.01 -0.09

1.00

-0.08 0.28

-0.29

-0.28 0.02

0.09

-0.14

1.00 -0.05

0.04 -0.05

0.06 0.04 0.01

-0.26 -0.16

1.00

-0.14

0.07 0.29

-0.03 0.04

-0.10

1.00 0.42 0.43 0.18 -0.24

0.10

1.00 0.45 0.11

-0.15

-0.02

1.00

0.19 1.00

-0.26 -0.20 -0.13

-0.14

0.07 0.11

1.00 1.00

USA EAFE FTEP IFCC IFCL IFCA Arg Bra Chi Col Gro Ind Idn Jor Kor Mai Mox Nig Pak Phi Por Tai Tha Tur Von Zim

Starts December 1982. Source: ifc (1992).



Criterion 6 covers a number of issues, includ

ing investor perceptions of current and possible future changes in foreign exchange regulations (transfer risk). In some instances, this involves

imposition of two-tier exchange rates with a

special rate for capital transactions. The sensitiv

ity of international equity flows to capital controls is illustrated by the estimate that 20 per cent of all

equity transactions in 1991 were cross-border, as

against about 6 per cent in the early 1980s prior to the lifting of many such controls.6 Still, according to the International Monetary Fund the number of developing countries applying either multiple exchange rates or exchange controls on capital transactions actually rose during the 1975-90

period, although the percentage of developing countries doing so had declined.7 In 1992 there were only 21 countries that had no restrictions whatsoever on international capital transactions, a number that was basically unchanged over the

fifteen-year period. Also implicit in the country risk criterion is the probability of favourable or

adverse political measures such as nationaliza

tions, expropriations, price controls and macro economic policy vectors.

Finally, Criterion 7 involves market "frictions" and microstructure issues, most importantly lack of liquidity. Few barriers discourage international

equity investors as much as illiquidity, which in some emerging markets can be severe indeed ?

with individual stocks sometimes not trading for weeks at a time. The investor becomes locked-in, and trades that do get executed produce extraordi

nary price movements. Also of concern are trans

actions costs (including information costs and the

efficiency of the price-discovery process), so that the microstructure that characterizes national stock markets and the efficiency of the local secu rities clearance and settlement systems are critical determinants of international investor interest. Other "frictions" include stamp duties, high fixed commission rates, lack of market transparency, absence of hedging techniques, and lax regulatory enforcement of fair conduct, as discussed earlier.

Ho well, Cozzini and Greenwood (1992) sug gest that an optimum global equity portfolio in 1991 consisted of 92.4 per cent developed market

equities and only 7.6 per cent emerging market

equities. Under the assumption of continued

progress in reducing barriers to international

equity investments, by the year 2000 they suggest that the conditions facing international investors and the power of international portfolio diversifi cation could shift the optimum global portfolio to consist of 54 per cent developed market equities and 46 per cent emerging market stocks. Among these up to 22.5 per cent would cover Asian and

African markets, 3.4 per cent Eastern Europe, and 20.1 per cent Latin America.

Fundamentals Affecting Cross-Border Equity Flows

Given the growing importance of cross-border

portfolio equity investments in emerging markets to the host countries themselves and to inter national investors, it is useful to identify the factors that appear to drive such flows. These

comprise a "checklist" from two perspectives: (1) For developing economies such as the ASEAN

countries, interested in tapping into rapidly in

creasing equity flows, they suggest policies which could significantly facilitate the process; and

(2) For international investors, they distinguish attractive from unattractive markets in their search for efficient portfolios.

Underlying Economic and Political Variables

Level of Macroeconomic Activity All else remaining equal, large economies are

likely to have larger (in terms of market capitali zation) and more liquid (in terms of trading vol

ume) equity markets than small ones (Summers and Heston 1991).

Economic Growth

Theory and empirical evidence suggest a strong positive correlation between real economic

growth and the marginal efficiency of capital (MEC). In competitive markets for productive factors, MEC is equal to the real rate of return on

capital. Consequently, national economies that

experience rapid growth should evidence rapid




rates of capital formation and high returns on

capital, including equity capital, and should attract a significant inflow of cross-border equity invest

ments.

Domestic Savings and Public-Sector Financing Most countries ultimately finance much of their economic growth through internal capital forma tion supported by significant and sustained volumes of domestic savings. Foreign capital, whether debt or equity, usually complements domestic savings. Indeed, large domestic savings flows provide the leveraging effect required to

achieve high returns on equity capital, including that coming from abroad. A high savings rate

should, therefore, be positively associated with the potential attractiveness of a country to inter national equity investors. Beyond this, the size

and trend of the public-sector deficit and capital financing requirements is a possible indicator of

crowding-out of equity issues by sovereign bonds. On the other hand, an active government securi ties market is a possible precursor of corporate fixed-income markets, and the development of a

functioning domestic market for equities.

Economic and Political Stability Like any asset-holder, international investors are

concerned with political and economic stability, or

country risk. Economic instability may be re

flected in high and variable inflation rates, inter est-rate volatility, large public-sector budget deficits that are financed by debt monetization, medium-term exchange rate overshooting (includ

ing currency realignments) that is difficult to

hedge against, and significant balance of pay ments problems that may lead to forced internal or external policy adjustments. Political risk in

volves shifts in the political overlay of domestic

policy targeting including pressure for domestic

income redistribution and social welfare pro

grammes, as well as the more explicit threats

of nationalization, expropriation, application of

price, wage and exchange controls and other

micro-policy expedients. Cossett and Roy (1991), for example, attempted

to replicate the two most often cited country risk

ratings, published by Euromoney and Institutional

Investor, on the basis of a series of economic and

political variables. The first of these is a weighted average of financial market indicators, credit indi cators and analytical indicators. The latter is based on a poll of 75-100 international banks, weighted according to an (unpublished) scoring of bank size and sophistication of the country risk assessment

process. One of these measures is, therefore,

objective and the other subjective, although there is a high degree of rank correlation between the two. However, the authors find that the principal variables related to both measures of country risk are per capita income, propensity to invest, and external debt levels. These three variables alone

replicate both ratings to a significant degree, sug

gesting that neither rating provides market partici pants with much informational value.

International Capital Flows The historical pattern of cross-border lending and

investing may suggest the degree to which a na

tional economy is linked into international real

and financial markets ? i.e. its openness and the

degree to which international lenders and inves tors are already familiar with a particular country. It may also indicate the extent to which flight capital may eventually be repatriated in the form

of cross-border equity investments. Anecdotal evidence and estimates of the amount of flight

capital residing abroad suggests that capital repa triation is an important factor in determining the

emergence of national financial markets due to

information asymmetries between such investors and the rest of the international investor commu

nity ? that is, flight capital reflows may signal to

other (less informed) investors that equity market

conditions have improved significantly.8

Testing for Fundamentals

Having described the size and growth of emerg

ing equity markets and the macroeconomic and

political factors that will help to determine their

development from a cross-border investment

perspective, it is useful to attempt an empirical examination of the cause-and-effect relationships,




insofar as they can be quantified, using some sim

ple statistical tests.9 The objective is to explain the

differential growth rates in cross-border invest ments in emerging market equity shares. Unfor

tunately, no such data exists over a sufficient

time-span. The available data that come closest to

this dependent variable are market capitalization (MCAP) and trading volume (VOL), which were

identified earlier as having a strong theoretical link to cross-border equity flows via emerging

market "attractiveness" to international equity investors. In order to explain the growth in MCAP and VOL, we selected a subset of readily avail able independent variables from among those described above. For each country, these comprise the following:

Level of GDP (SIZE) GDP growth (GRWTH) Country risk index (RISK) The national budget deficit (DEF)

Capital controls (CNTRL) International capital flows (KFLOW) Number of firms listed on the stock market

(#FIRMS)

Model Specification and Data Set

We specify a linear ordinary least squares (OLS) cross-section time-series regression model, which takes the following form:

Y., =

b.X.., + b JC, + b,X4 / + . 5X,., + bJL.t + it 1 1*/ 2 lit 3 Ait b 5it 6 bit

b7X7/, + error

where

/ = the number of emerging market

countries, 1 ... 19

t = time (years) 1982 ... 1989 &. ... b = the coefficients to be estimated / 7

and

Y, = either VOL or MCAP = CNTRL (-ve)

X2 = RISK (-ve)

X3 = DEF (+ve or -ve)

X4 = GRWTH (+ve)

X5 = KFLOW (+ve)

X6 = SIZE (+ve)

X7 = #F1RMS (+ve)

The expected signs ? how each variable is

expected to affect the two dependent variables ?

are shown in parentheses next to the variables. For example, countries that maintain exchange controls and have high country risk indices are

expected to have relatively slower growth in

MCAP and VOL than countries without exchange controls and lower country risk. Countries with

high GDP growth, large economies and a large number of firms listed on the local stock market can be expected to have relatively fast growth of

MCAP and VOL. The impact of a large budget deficit is ambiguous. On the one hand, a large deficit may crowd-out equity investment. On the

other, it may lead to a deepening of financial markets and instruments required to finance the deficit.

Nineteen emerging market countries were

selected for the empirical test covering the years 1982-89: Argentina, Brazil, Chile, Colombia,

Greece, India, Indonesia, Jordan, Korea, Malay sia, Mexico, Nigeria, Pakistan, Philippines, Portu

gal, Thailand, Turkey, Venezuela and Zimbabwe. This provided 152 observations (countries and

years), with missing data reducing the number of observations to 129. All relevant variables

(MCAP, VOL, DEF and SIZE) were normalized to U.S. dollars using 1980-82 average exchange rates.

Fitting the Model

The first set of OLS regression results is shown in

Table 3. Panel A shows the results with MCAP as

the dependent variable, and Panel B the results with VOL as the dependent variable. Both sets of results are very similar. With the exception of

GRWTH, the signs of the coefficients of the

independent variables are as expected. Viewed

individually, the independent variables are not

significant at the 95 per cent confidence level,




TABLE 3 Time-Series Cross Section Results, 1982-89

Panel A All MCAP, No Intercept

Regression Output:

Constant 0 StdErrofYEst 1057562. R Squared 0.968725 No. of Observations 129

Degrees of Freedom 122

X Coefficient(s) Std Err of Coef.

T-statistic

CNTRL RISK DEF GRWTH KFLOW SIZE VFIRMS

-250903. -730.058 0.000033 -64345.1 2728755. 0.079037 56.72642

199295.5 4785.256 0.000147 104300.7 2448699. 0.001521 100.2770

-1.25895 -0.15256 0.228521 -0.61691 1.114369 51.94504 0.565696

Panel B ALL VOLUME, No Intercept

Regression Output:

Constant 0 StdErrofYEst 708892.3 R Squared 0.955099 No. of Observations 129

Degrees of Freedom 122

X Coefficient(s) Std Err of Coef.

CNTRL RISK DEF GRWTH KFLOW SIZE #FIRMS

-170185. -574.661 0.000022 -40669.2 1878463. 0.043949 40.35621

133589.4 3207.595 0.000098 69913.62 1641382. 0.001019 67.21653

T-statistic -1.27394 -0.17915 0.224120 -0.58170 1.144439 43.09093 0.600391




with the notable exception of SIZE. However, viewed collectively the variables performed much better. Indeed, the R2 ? indicating the percentage of the dependent variables that is explained by the independent variables as a group

? is 96 per cent of the growth of MCAP and VOL over the 1981- 89 period. This is attributable to multi

collinearity, the fact that the independent variables are themselves highly correlated, so that the statistical attribution of MCAP or VOL growth to any single variable is problematic. Here this is not a major problem because we are looking for a

collective, not individual, explanation for growth in MCAP and VOL. We next re-ran the model for 1982-89 using

the 1989 model coefficients for the independent variables to predict MCAP and VOL for that year in order to compare the forecast values with the actual values. Let Y. represent the 1989 forecast values for MCAP and VOL estimated from

y.(1989) = V^(1989)

+ ...+V^I<1989)

where the b* terms represent the coefficients of the independent variables estimated over the 1982- 88 period and the Xs represent the actual

independent variables observed for 1989. At the end of 1988 these variables are unknown to the forecaster. Assuming for simplicity perfect fore

sight,10 the forecaster knows the 1989 variables in advance. As a test of robustness we re-ran the

forecasting model using the estimated coefficients with the values for the independent variables observed for 1988 under the implicit assumption of "naive" expectations. That is, the forecaster assumes the 1988 values of the independent variables to be the best predictions of their 1989 values. The perfect foresight assumption should

provide a better set of forecasts than the naive

model, or any other model that assumes incom

plete or imperfect information. Our tests confirmed this, and in Table 4 we

report the forecasting results using the perfect foresight model for the 11 countries for which we have complete data for MCAP and VOL. The linear regression model fits very poorly, and the

differences (DIFF) between the actual and fore cast values of MCAP and VOL are in the major ity of cases negative. That is, the linear-based

regression model tended to overpredict actual

emerging market capitalizations and volumes for

1989, and in most cases this error was very large. This demonstrates a commonly observed regular ity, namely that a model that fits quite well "in

sample" often predicts very poorly "out of sam

ple". There are three possible explanations. First, it may be that a much better forecasting

model might assume that MCAP and VOL grow in non-linear fashion over time. Accordingly, we ran a log-linear model on the same data, convert

ing all except CNTRL, RISK, and #FIRMS to log form, which significantly reduced the differences between actual and forecast values. Still, they were far too large for forecasting purposes, and in some cases underpredicted actual values.

Second, the data covered by the period under

study are highly unstable, since they included the 1987 stock market crash year. Indeed, when the

model was fitted for only 1982-87 the R2 fell to

.64, but when it was fitted for just 1988 the R2 rose to .99. This is consistent with structural

change occurring in emerging markets during the 1982-88 period of turbulence, during which any

model might reasonably be expected to perform poorly out-of-sample.

Third, forecastability would doubtless be im

proved by including omitted independent vari

ables, such as country betas to proxy IPD benefits of any given emerging market.

Financial Market Attributes

In addition to the macroeconomic and political variables that should be related to cross-border

equity flows, there are a number of characteristics of emerging equity markets that will tend to be

important as well. These have less to do with the overall economic and political outlook of the

country concerned, and more with the structure of

enterprise ownership and control, the evolutionary stage attained by local capital markets, and the

regulatory overlay.




TABLE 4 Forecasting Results for 11 Countries

All MCAP, No intercept

Regression Output:

Constant 0

StdErrofYEst 1110624.

R Squared 0.968859

No. of Observations 117 Degrees of Freedom 110 X Coefficient(s)

Std Err of Coef.

T-statistic FORECAST

CNTRL

-281057.

218409.5

RISK

DEF

GRWTH KFLOW

SIZE

-997.305 5337.342

0.000034 0.000221

-58083.5 110125.6

3036574. 2730174.

0.079009 0.001599

Coefficients x Variables

XFIRMS 63.50685 105.9694

-1.28683 -0.18685 0.155744 -0.52743 1.112227 49.40732 0.599293

CNTRL

RISK

DEF

GRWTH KFLOW

SIZE

#FIRMS Constant Forecast

Actual MCAP

Diffas % of Actual

1989 1989 1989 1989 1989 1989 1989 1989 1989 1989 1989

COL IDN JOR KOR MAL MEX PAK PHI POR THA VEN

-281057.

0

-281057. -281057.

0

-281057.

-281057.

-281057.

-281057. -281057. -281057.

-37000.0 -43781.6 -33309.9 -66320.7

-55350.4

-29221.0 -30417.8 -24533.7 -59439.3 -57145.5

-34805.9

180865.0 0.181110 0.014462 -0.01459 0.075207 26.38666 0.186247 0.084509 0.186544 0.086704 0.138119

-16809.3 -10379.5 -8950.67 -6824.81 -6778.35

-14404.7 -8114.27

-8840.31 -11279.8

-10367.9

-40466.8

81076.55 143629.9 113264.2 83809.46 133305.6 85024.09 165796.9 135127.5 300317.2 330683.0 468239.8

21617.94 20675.91 614.1430 16783.73 3528.182 1127532.

5765.265

9156.128 8892.156 6447.040 27342.83

5207.562 3619.890 6731.726 39755.29 15940.22 12891.89 27943.01 9144.987 11558.24 11113.70 3810.411

0 0 0 0 0 0 0 0 0 0 0

234957.7 113764.7 78349.46 67202.87 90645.33 1181849. 160973.3 120054.7 250048.6 280730.3 424120.4

7861.074 6233.525 3773.576 140585.8 47499.67 1603316. 4784.267 32576.77 26249.23 30286.91 11892.93

-2888.88

-1725.05

-1976.27 52.20

-90.83 26.29

-3264.64

-268.53 -852.59

-826.90 -3466.15



State of Market Development

The first set of issues is related to the character of a given national financial market, which in large measure determines whether that market shows up on the "radar screens" of international investors as meriting further consideration.

Equity Market Capitalization, Free Float and Turnover As indicated above, local equity market size in absolute terms is of clear importance to interna tional investors, since it indicates the prospective ability to acquire and dispose of shares held as

part of an international portfolio. The number and

proportion of firms whose shares are publicly listed is important as well, as is the proportion of shares in government hands or closely-held. The

larger the number of listed companies with shares

freely purchasable, the more attractive a particular emerging market will tend to be to international

investors, in part as an indication of the sophisti cation and liquidity of the market and in part by defining the feasibility of adding local stocks to diversified country portfolios. In turn, for a given market capitalization, the more active the market is in terms of trading volume, the greater the

liquidity of equities and the more attractive the market is likely to be from the perspective of the international investor.

A related characteristic is the presence or absence of so-called "noise traders", i.e. retail

investors and mutual funds investors who are in the market continually (as opposed to informed

buy-and-hold institutional investors) and who

provide greater liquidity and consequently narrower bid-asked spreads in the market, with

positive effects on market volume and liquidity (Hasbrouck 1991). Indeed, a significant propor tion of net portfolio equity flows into emerging

market countries was in the form of country funds, of which about US$1 billion were invested in Latin America in 1991, roughly two-thirds of this through multi-market Latin America funds and emerging market funds. At the end of 1991 this included 154 closed-end funds (including 15 new ones formed during that year to raise almost

US$1 billion) reporting total assets of US$15 billion and 169 open-end funds with total assets of US$6.7 billion.

New Issue Volume and Privatizations

During 1991, a total of US$18.2 billion was raised

by over 1,000 companies in the 20 largest emerg

ing markets through new domestic equity issues,

according to IFC data. In addition, US$6 billion was raised in international equity markets by com

panies (including privatizations) located in devel

oping countries.11 The supply of equities to the market ? comprising new issues of seasoned

securities, IPOs, privatization issues and perhaps equity-linked debt issues whose embedded op tions are subject to exercise ? is clearly linked to its interest for international investors. Privatiza tion issues appear to play a particularly important role in countries that have had a significant share of commercial activity conducted under the

auspices of state-owned enterprises (SOEs), and

changing perceptions of what economic activities

properly belong in SOEs as against privately owned companies have been an important struc tural factor in attracting international investor interest.

IPOs and secondary issues by family-owned and closely-held companies that are important in the development of many local equity markets

may be related to privatizations when control

groups are formed to bid for SOEs or find it

necessary to sell shares in the market to finance

privatization bids.

Large Firms The larger the share of the private sector repre sented by large publicly-held companies, the more attractive a given market will tend to be from the

perspective of the international investor. On the other hand, the share of market capitalization and trading accounted for by a small number of domestic companies may also have a negative influence, so that the lower the concentration ratio

among large firms for a given market capitaliza tion, the more attractive a given market will tend to be from the perspective of the international in vestor. A good example of a "top-heavy" market




discouraging liquidity and performance, and with it international investor interest, is Malaysia. Fol

lowing privatization, consolidations and stock market performance that encouraged companies at

go private, about 70 per cent of the Malaysian market's capitalization in mid-1992 was accoun ted for by the ten largest listed companies. This has absorbed an inordinate share of the equity funds of domestic and international investors,

leaving the remainder of the market suffering from lack of interest and liquidity.

International Beta

As suggested earlier, the correlation between a national stock market index and major indices such as the Standard & Poor's (S&P) U.S. stock index ? i.e. its international "beta" ? will give some idea of the international portfolio diversifi cation gains to be had from taking equity posi tions in particular emerging markets. The lower the correlation, the more attractive will be the IPD benefits for the international investor. The poten tial gains have already been indicated above. The

foregoing could be stated as:

where Rt represents the rate of return on a given country-component in an international equity portfolio (e.g. the Stock Exchange of Singapore),

Pt is the SES beta, Rwt is a world equity index and

Of represents a residual reflecting unsystematic risk. In this context, O2 represents country speci fic risk ? i.e. the degree of diversifiable risk.

Equity Market Microstructure and Regulation

In addition to the state of development of an

emerging equity market in a global context, there are a variety of structural issues that influence international investor interest, primarily through their effect on information and transactions costs.

Bid-ask Spreads and Commission Rates The size of bid-ask spreads across various emerg

ing markets is a clear sign of comparative equity

market efficiency. This in turn depends on how the market is structured and the degree of com

petition among local financial intermediaries,

notably broker-dealers. Whether fixed or negoti ated brokerage commissions prevail, and whether

single-capacity or multiple-capacity broker dealers exist, are indicators of the competitive characteristics of the market-place and its impact on transactions costs. Moreover, concentration

requirements on the part of regulators that force transactions on to stock exchanges (and possibly specific exchanges) as opposed to finding the least-cost transactions medium, whether on

exchanges or over-the-counter (OTC), may ulti

mately discourage equity market development. For example, pressure in this direction emanating from the Securities and Exchange Commission in the United States and the Investment Services

Directive in the European Community ?

justified by allegedly improved regulatory oversight

?

may be emulated in particular emerging markets to the detriment of market development and cross-border transactions flows. Recent research

(Tripathy and Peterson 1991) has shown that bid-ask spreads are significantly more affected by order processing and information costs than they are by inventory holding costs and systematic/ unsystematic risk considerations.

Market Transparency and the Process of Price Discovery The nature and extent of information production

and disclosure in order to facilitate the price dis

covery process is central to equity market devel

opment and the ability to attract cross-border flows. This includes an active securities research

capability and the rapid and impartial dissemina tion of news and interpretation of events. The

stronger and more independent the information

infrastructure, the more attractive an emerging market will be to foreign equity investors. This in turn will clearly be influenced by regulatory "transparency" requirements mandating informa tion dissemination. Gaps in transparency and

research in the ASEAN region can be illustrated

by the 1992 restatement of Metro Drug earnings in the Philippines from US$2.2 in the first nine




months of 1991 to a full-year loss of US$5.7 million in 1991 due to "clerical errors" (Poole 1992).

Availability of Equity Derivatives While not a prerequisite for emerging equity market development, the creation of futures and

options contracts on individual shares and on the local market index is looked to by international investors as an important attribute for hedging and

short-selling purposes. Investors increasingly find it cheaper to adjust portfolio profiles using deri vative contracts than by buying or selling the

underlying stocks. On the other hand, the value of IPD lies in maintaining an unhedged local

component in an international equity portfolio, so

that the lack of derivatives is hardly a debilitating shortcoming.

Securities Clearance, Settlement and

Payments Systems A prerequisite for significant cross-border equity flows is an efficient, basic, domestic financial market "infrastructure" that helps to link securi ties intermediaries and the ultimate investor with the ultimate issuer of securities in primary and

secondary market transactions. It centres on the domestic system for clearing and settling securi ties transactions through an efficient central securities depository (CSD). This in turn is a pre requisite for a "value-chain" of services listed in Table 5, which are optimally supplied to market

participants on the basis of quality and price by competing private sector vendors of information

services, analytical services, trading services and information processing, credit services, and secu rities custody and safekeeping. Problems continue to exist in most emerging market countries in such areas as implementing true delivery versus pay ment (DVP), development of centralized trade

comparison systems and message standardization, clarification of specific market practices (such as

trading securities registered in a previous holder's name to avoid the time and cost inefficiencies of

re-registration), as well as such basics as securi ties immobilization via CSDs and facilities for securities lending. By building basic securities

infrastructure that delivers liquidity, transparency,

reliability and hence low transactions and infor mation costs, the interests of both active securi ties traders and buy-and-hold investors ? as well as issuers ? are served, and in turn produce a more efficient allocation of capital (Morgan Guaranty Trust Company 1993). Conversely, the

higher are the information costs, transactions

costs, and risks associated with the basic domestic securities infrastructure, the more retarded will be the development of the national financial market and its ability to link effectively into international

capital flows. Government policies in other areas may be of

great importance in determining the development of national equity markets as well. These include the following:

The character of government micro-policy, including tax incentives to go public, capital gains and dividend taxation, and securities transaction

(stamp) taxes.

Regulation of interest rates on bank deposits, which may influence incentives to invest in equi ties.

The presence of contractual savings institu tions mandated to channel a portion of assets into domestic equity

? e.g. the Singapore Central

Provident Fund (CPF) ? which may foster mar

ket development but ultimately retard it if such in stitutions come to dominate and stifle the market's evolution.

The character of national company law in re

quiring frequent and consistent reporting of com

pany accounts.

The nature of the corporate governance sys tem and government policy regarding merger and

acquisition activity ? in terms of its bearing on

value-maximization on the part of shareholders ?

with greater reliance on market mechanisms in

corporate governance and active investors (i.e. an active takeover market) suggesting greater attrac tiveness for international investors (Walter 1993).

Barriers to market access facing foreign equity investors, such as ownership limitations through voting-stock, share-class and other constraints.




TABLE 5 Key Securities Services

1. Information and analytical services (Bloomberg, Reuters, etc.)

2. Trading systems and services (SEAQ, Globex, etc.)

3. Trade communication information exchange

matching confirmation affirmation

regulatory reporting

4. Securities clearance and netting

5. Settlement: Delivery of good title to securities, whether immobilized or dematerialized, against immediate payment.

6. Cash management services for securities market participants.

7. No-frills cash and securities depository services.

8. Essential custody services ? including coupon collection, redemption, global certificate exchanges, tax reporting and withholding tax relief processing, acting on client instructions on exchange of

rights and shareholder voting.

9. Extended custody services ? including accounting and reporting, foreign exchange, sale of rights, provision of information on redemption payments, interest rate resets, and corporate events.

10. Credit and related services ancillary to settlement ? including money transfer, cash and securities

lending to market participants in order to facilitate failure-free settlement, performance guarantees, and collateralized lending.

11. Securities lending services for trading purposes, most importantly to prevent fails but also to meet the needs of broker-dealers implementing short-selling strategies. This is a critical aspect of the settlement functions, above.

12. Fiduciary services ? including discretionary decisions as a trustee, portfolio management, cash

management, discretionary short-selling and securities-lending services for institutional investors.

13. Analytical services ? performance measurement and comparisons, trend analysis, and on-line access to portfolio valuation and analytics.

14. Corporate events reporting ?

important given the need for issuers and their agents to supply infor

mation to the core custody infrastructure.

15. Services as indenture trustee, registrars, operation of ADR or GDR programmes, as well as pay ment, conversion and warrant rights unique to the security concerned. The question of which issuer

services should be provided by CSDs requires careful consideration.



The nature of the regulatory process with

respect to all of these factors is critical, with

adequate rules governing disclosure, transparency and conduct of business (including insider

trading) providing protection to international as well as domestic equity investors while at the same time avoiding overregulation that raises transactions costs and impairs market liquidity and innovation.

An instructive case of a country that has opened up to cross-border equity investments is Korea. At the beginning of 1992, foreigners were allowed to

purchase up to a cumulative 10 per cent owner

ship ceiling in Korean companies, with foreign investors allowed to hold up to 3 per cent of individual companies' shares each ? bracketing out certain "strategic" sectors. However, market

performance (a 50 per cent drop in the composite stock index in the two years preceding April 1991) and remaining ownership restrictions evi

dently deterred large-scale cross-border inflows, which amounted to less than US$1 billion, ac

cording to the Korea Securities and Investments Board. The market performance issue was ad dressed (to no avail) by government support measures that left US$ 10-15 billion out of a total market capitalization of US$70 billion in the hands of the government and government-influ enced institutions in October 1992. The remaining foreign ownership limits created perceived prob lems with acquiring "reasonable" blocks of stock

? e.g. US$5 million or more ? that would be of

interest to institutional investors and emerging market funds. The initial Korean equity market liberalization was later followed by further easing of ownership restrictions and a raising of the cumulative ownership ceiling from 10 per cent to 25 per cent in July 1992 for any of 50 large companies, provided the company agrees. This occurred quickly in such firms as Pohang Iron and

Steel, the Long-Term Credit Bank and Korea Electric Power. Moreover, domestic investors

appeared to follow the lead of international

investors, so that cross-border trades triggered

significant price movements as local investors acted in a similar way.

Conclusions

This article has attempted to identify the factors that determine the ability of countries to tap into global portfolio equity flows. We began with an overview of the rapid growth of these flows, and the factors that drive international equity investors. The value of international portfolio diversification was identified as a particularly compelling reason why these flows are likely to

grow rapidly in the future, and why emerging equity markets offer investors especially attractive

opportunities in this regard. At the same time,

portfolio equity inflows provide extraordinary

leverage in improving domestic capital market

efficiency and liquidity. A set of preliminary empirical tests suggest that

growth and trading volume in emerging equity markets are strongly linked to a cluster of macro

economic and policy variables, although much more sophisticated structural models are required to create a reliable distinction between successful and unsuccessful countries in this regard.

It seems clear that developing countries hoping to tap into global equity flows as a source of eco nomic growth must first attack the basic structures of their own equity markets. This means investing in a viable equity market infrastructure, including dissemination of information, modern trading systems, regulation that promotes fair and trans

parent markets without inhibiting competition and

innovation, and making the necessary improve ments in securities clearance and settlement, cus

tody, taxation and legal systems. Located in the midst of what is currently a high-growth part of the international economy, the ASEAN countries would do well to place strong emphasis on taking advantage of this window of opportunity to link into dynamic global equity flows as a highly cost effective dimension of national growth policy.




NOTES

1. See International Finance Corporation (1992) for the relevant data.

2. International Finance Corporation (1992). 3. Equity trading volumes appear to be highly sensitive to year-to-year variations, depending mainly on the tran

sitory state of the markets. They are also very sensitive to exchange rate changes. For both reasons, trading volume data must be interpreted with caution.

4. See Howell, Cozzini and Greenwood (1993). 5. As compiled by Morgan Stanley (EAFE), the Financial Times (FTEP) and the IFC (IFCC, IFCL and IFCA)

for all emerging market countries, Latin America and Asia, respectively. 6. Howell, Cozzini and Greenwood (1992). 7. See International Monetary Fund, Annual Report on Exchange Arrangements and Exchange Restrictions

(Washington, D.C.: IMF, various issues) for a summary of the restrictions in force.

8. It is worth noting that international capital flow data are notoriously unreliable, and appear to be getting more

so, with more of the errors and omissions evidently attributable to international portfolio investment that is

inherently less "trackable" than to new issues of securities and international bank lending. 9. Prof. Anthony Saunders of New York University carried out the statistical tests underlying this discussion.

10. In actuality the forecaster would have to construct separate models to predict the one-year-ahead values for

each independent variable by assuming some vector autoregressive process (VAR) or some more complex structural model of the economy.

11. International Finance Corporation (1992).

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Morgan Guaranty Trust Company. Cross-Border Clearance, Settlement and Custody: Beyond the G-30 Recommen

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Pardy, Robert. "Institutional Reform in Emerging Securities Markets". Working Paper, Financial Systems Division,

Country Economics Department. Washington, D.C.: World Bank, 1992.

-. "Securities Market Trading and Settlement Systems: Regulatory and Institutional Aspects of Securities Mar

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ton, D.C.: World Bank, 1992.

Poole, Clair. "The Next Chile". Forbes, 31 August 1992.

Summers, Robert and Alan Heston. "The Penn World Table (Mark V): An Expanded Set of International Compari

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Tripathy, Niranjan and Richard Peterson. "Portfolio Risk, Adjustment Costs and Security Dealers' Bid/Ask Spreads". Journal of Financial Services Research (June 1991).

Walter, Ingo. The Battle of the Systems: Control of Enterprises in the Global Economy. Institut fur Weltwirtschaft, Kieler Studien Nr. 120. Tubingen: J.C.B. Mohr (Paul Siebeck), 1993.

Ingo Walter is the Charles Simon Professor of Applied Financial Economics at the Stem School of Business, New York University, and Director of the New York University Salomon Centre. He holds a joint appointment as the Swiss Bank Corporation Professor of International Management at INSEAD in Fontainebleau, France. At the time

of writing he was Distinguished Fellow in International Banking and Finance at ISEAS.




emerging equity markets: tapping into global investment flows

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