33198 INTERNATIONALBANK FOR WORLD BANK R E T C N O E N STRUCTION PM AND DEVELO April 2006 No. 66 A regular series of notes highlighting recent lessons emerging from the operational and analytical program of the World Bank`s Latin America and Caribbean Region WHITHER LATIN AMERICAN CAPITAL MARKETS? Augusto de la Torre and Sergio Schmukler Back in the early 1990s, economists and policymakers had tantly, the study analyzes not just domestic market activity, high expectations about the prospects for domestic capital but also global capital markets trends, the participation of market development in emerging economies and, particularly, developing countries in those markets, and interactions and in Latin America. Unfortunately, they are now faced with feedback loops between local and international markets. disheartening results. Equity and corporate bond markets are illiquid and access to them is segmented in most Latin Evolution and Globalization of Capital Markets American countries. Debt is concentrated in the short end of the maturity spectrum and has tended to be denominated in foreign currency in many The world's financial landscape countries, exposing them to has undergone significant maturity and currency risks. changes during the last three Moreover, government debt is decades. Financial depth and di- crowding out corporate bond versity increased sharply in the markets. The state of domestic largest developed economies, capital markets looks particu- starting in the early 1970s and larly poor when considering booming during the 1990s. Fi- the many efforts already un- nancial intermediation ex- dertaken to improve the mac- panded at a remarkable rate and roeconomic environment and the spectrum of financial ser- to reform the institutions be- vices and instruments reached lieved to foster capital market new dimensions. These devel- development. This disappoint- opments were accompanied by ing performance has left increasing financial integration policymakers without clear across nations. guidance on how to revise the reform agenda and many of While securities markets in them do not envision a bright the developing world also future for domestic capital grew, most of the acceleration markets, particularly in the in capital market development case of smaller countries. and globalization over the past 25 years or so has been concentrated in global financial centers and developed "Whither Latin American Capital Markets?" a study pub- economies. Emerging markets, however, were brought lished by the Latin America and Caribbean Region of the into these global trends, attracting part of the capital that World Bank in June 2004, analyzes the status and prospects became available in international markets and implement- for capital market development in Latin America. It reviews ing reforms to foster their domestic capital markets, albeit the evolution of securities markets in the region and related with mixed success and substantial contrasts across re- reforms and the factors driving their development. Impor- gions. 1 Overall, the 1990s surge in capital flows was characterized by Another feature of stock markets in the region is the high a change in the composition of flows to emerging economies: concentration of both trading and capitalization in a few the share of official flows more than halved and private stocks. Moreover, Latin American stock markets have been capital flows became the major source of capital, especially in affected by a growing number of de-listings, with large the form of foreign direct investment resulting from mergers companies migrating to international stock exchanges. and acquisitions and privatizations. This was accompanied by the internationalization of financial services, as developing In contrast to the relatively poor state of their local capital country issuers and investors began to access international markets, large Latin American firms and governments have financial intermediaries, foreign financial institutions estab- actively participated in international securities markets. This lished physical presences in emerging markets, and investors participation has been significant not only relative to GDP, in developed countries sought higher returns and global but also relative to domestic stock and bond market activity. diversification. In fact, for several countries, trading, equity capital raising, and bond issuance in international markets are much higher Developing countries tried to attract international capital in than in domestic markets. Furthermore, the extent of interna- different ways: by liberalizing their financial systems; priva- tionalization of Latin American securities markets in most tizing state-owned firms; and improving the climate for cases exceeds that of the developed economies and East capital flows through macroeconomic stabilization and better Asian countries. business environments. In particular, they undertook a bar- rage of reforms to foster domestic securities markets develop- In all, the evolution of capital markets in Latin America in the ment, including new legislation, new or refurbished securities last decade shows (see Figure 1) that the high expectations and exchange commissions, enhanced regulatory and super- generated by the reforms have not been met. This is all the visory frameworks; and improved infrastructures for trading, more troubling considering that the effort to reform capital custody, clearing, and settlement of securities. In parallel, markets in Latin America was as broad-based and intense, if many countries implemented comprehensive pension system not more, than in other regions, especially during the 1990s. reforms that were expected to boost the availability of finance Although local securities markets grew appreciably in Latin for the private sector. America, their growth pales in comparison to securities market growth in industrial and East Asian countries. A closer Main Developments in Domestic Capital Markets look reveals an even more disheartening picture. With a few exceptions (notably Chile), Latin American financial markets continue to be dominated by banks--with the added problem As noted, capital markets boomed in the developed world, but that the depth of bank credit to the private sector was, on the picture is more mixed across developing countries, with average, stagnant throughout the 1990s in the region. More- pronounced regional differences. Domestic capital markets in over, local markets for private securities (debt and equity) are East Asia have developed relatively well, but markets in Latin rather illiquid, with private bond markets also tending to be America have lagged behind. highly dollarized and short-term. The contrast between the large number of policy initiatives and reforms and the lack- Domestic bond markets grew significantly since the mid- luster performance of domestic capital markets raises basic 1990s. But whereas in East Asia corporate bonds were a questions, some of which the study tries to answer. central part of this story, in Latin America, public sector bonds dominated. Moreover, the share of dollar denominated, The Effects of Fundamentals and Reforms on floating-rate, and shorter maturities was much higher in Latin Capital Market Development bond markets than in East Asia. Efforts to develop the market for domestic currency denominated corporate bonds in Latin America yielded little success, although Chile, with a rela- The report analyzes the role of macroeconomic and institu- tively large stock of CPI-indexed bonds is an exception, and tional factors (e.g., monetary stability, overall economic recent developments in the corporate bond side (again Chile, development, economic size, rule of law) on the development but also Mexico and Colombia) provide hopeful signs. None- of domestic capital markets and the participation of firms and theless, even where local currency corporate bond markets governments in international financial markets. It also studies have reached a non-trivial size, the issuance is completely how capital markets have responded to the wide array of dominated by a few, large, high-grade companies. reforms that governments undertook during the past two decades. The performance of stock markets in Latin America has also been disappointing. While Latin stock market capitalization The regression analysis of equity markets confirms that better relative to GDP doubled over the last decade, it is still very macroeconomic and institutional fundamentals increase do- modest compared to other regions. Average stock market mestic stock market activity as well as participation in capitalization was 28 percent of GDP in the largest countries international markets (measured by the trading and issuance in Latin America at the end of 2002, compared to 72 percent of emerging market securities in international financial cen- in G-7 countries and 95 percent in East Asia. This lackluster ters). This result, which is mainly based on cross-country performance is matched by low trading and liquidity levels. variations, is confirmed when the effects of reforms are tested 2 Figure 1 - Evolution of Stock Market Capitalization over time, with emphasis on within-country effects. That is, Whither the Reform Agenda? reforms significantly influence local stock market develop- ment and its internationalization in the same direction as economic fundamentals. Perhaps more importantly, the study The shortfall in the development of Latin American local shows that both improved economic fundamentals and re- securities markets relative to initial expectations, despite the forms accelerate the internationalization of stock markets intense reform effort, raises the question of how to proceed proportionately more than the expansion of local stock mar- with the capital market reform agenda. ket activity, and that these outcomes are not independent, as internationalization is found to adversely affect the liquidity There are at least two major views on what might explain the of the local stock market. gap between expectations and outcomes in Latin America, each carrying their own prescriptions for what to do next. Another key and robust finding is that Latin America is One view argues that the needed reforms are basically well different in some important senses. Compared to other known, that there is nothing wrong with them, and that the regions, Latin securities markets not only score poorly but problem is with their implementation. This view ascribes the also are significantly less developed (in terms of com- gap to impatience and imperfect and incomplete reform monly used measures of size and liquidity) than predicted, efforts, recommending that market discipline be given time to controlling for per capita income, economic size, macro- work, while forging ahead with further implementation, economic policies, and legal and institutional fundamen- especially of second generation reforms. The other view tals. In addition, local capital markets in Latin America claims that the problem lies with faulty reform sequencing, have responded much less favorably to reforms than particularly with the fact that financial market liberalization markets in other regions. At the same time, stock market and opening proceeded too soon and too fast. This view internationalization has been much greater than predicted emphasizes the need to achieve a minimum institutional in Latin America, controlling for the mentioned funda- strength and development of local currency debt markets mentals, and much more responsive than expected to the before fully embracing financial globalization. Each view introduction of reforms. In effect, in terms of internation- captures important aspects of the problem, yielding consider- alization of stock trading and issuance, Latin America is able insights, but neither fully addresses some of the ques- an extreme case, but it is not alone, as similar trends can tions posed by the evidence. be observed in Eastern Europe and even in the smaller Western European countries. The contrast with East The report offers a third, complementary view that is much Asia--where local stock market development has been less prescriptive. It contends that there are important deficien- well in excess of its internationalization--is, however, cies with respect to the expectations and design of past striking. The reasons behind these contrasts across re- reforms, related to the failure to take appropriate account of gions is a key subject for future research. the implications of certain basic issues. This third view 3 emphasizes the need to step back and reconsider basic issues with a fresh look, as a prior step to WHITHER LATIN AMERICAN CAPITAL MARKETS? ensure more solid ground for reformulating the reform agenda. The goal of this study is to understand the state of securi- The discussion of the different views and the analy- ties markets in Latin America sis of basic issues invite eclecticism: a savvy re- and discuss issues for the re- former would combine elements from the three form agenda. The study first views, as appropriate to country circumstances. Key describes the evolution of to designing country-specific reforms would be a capital markets and capital determination of whether the country in question can market reforms in Latin realistically meet the size thresholds to sustain a America, over time and rela- liquid domestic secondary market for private sector tive to other countries. Sec- securities. For countries that do, the suitable reform ond, it analyzes the factors package would be easier to formulate, partly because driving the development of developed capital markets experience would be capital markets, with particu- more relevant. Reform expectations would still need lar interest on measuring the to be significantly reshaped, however, particularly to impact of reforms. Third, it accommodate the implications of financial global- discusses the question of ization. Avoiding financial globalization is neither whether and how to recast the capital markets reform agenda going realistic nor desirable in the long run, not least forward. The study consists of a main report, divided into four because integration induces reform. chapters, a series of background papers, and presentations of the work-in-progress in various international forums (see below for all Elaborating suitable reform packages for securities these documents). markets in smaller countries is more daunting. Much more thought and analysis is needed to sketch a This regional study was led by Augusto de la Torre and Sergio suitable "light" version of a domestic securities Schmukler. market for small countries, one that is not "over- engineered", that does not need to rest on substantial Background papers available: liquidity, and that is complementary to international financial integration (rather than focusing on creat- Accessing International Equity Markets, by Claessens, Klingebiel, ing a "mini Wall Street" at home). Related issues and and Schmukler challenges also arise regarding the segmentation of access to capital markets proper, which systemati- Corporate Governance in Latin America, by Capaul cally favors large firms, irrespective of country size. Moreover, the reform agenda for capital markets Government Bonds in Domestic and Foreign Currency, by needs to be couched within a broader vision of Claessens, Klingebiel, and Schmukler financial development for emerging markets. Such a broader vision would emphasize access to high- Migration, Spillovers, and Trade Diversion: The Impact of Inter- quality and diverse financial services, regardless of nationalization on Domestic Stock Market Activity, by Levine whether they are provided at home or abroad, by and Schmukler securities markets or by other financial intermediar- ies. Housekeeping and Plumbing: The Investability of Emerging Mar- kets, by Ladekarl and Zervos About the Authors Stock Market Development and Internationalization: Do Eco- nomic Fundamentals Spur Both Similarly?, Claessens, Klingebiel, Schmukler The source document for this piece (see right) was led by Augusto de la Torre and Sergio Schmukler. The Transaction Costs of Primary Market Issuance: The Case of Norbert Fiess, Juan Carlos Gozzi Valdes, and Ma- Brazil, Chile, and Mexico, by Zervos rina Halac are the leading authors of Chapters 2 and 3. Jurgen Janssens and Laonor Coutinho also partici- Why Do Emerging Economies Borrow Short Term?, by Broner, pated in Chapters 2 and 3. Lorenzoni and Schmukler Many authors participated in writing the background http://www.worldbank.org/laceconomist papers. The peer reviewers of the project were Arturo Galindo (IDB), Thomas Glaessner, and Anjali Kumar. 4