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.

Debt Relief

The G-8 Multilateral Debt Relief Initiative (MDRI) is the next step of the Highly Indebted Poor Countries Initiative (HIPC). There are two reasons why MDRI is unlikely to help poor countries. First, the amount of money at stake is trivial. The roughly $2 billion of annual debt payments to be relieved under MDRI amounts to roughly 0.01 percent of the GDP of the OECD countries%u2014a mere one-seventieth (1/70) of the quantity of official development assistance agreed to by world leaders on at least three separate occasions (1970, 1992, 2002). Second, the existence of debt overhang is a necessary condition for debt relief to generate economic gains. Since the world's poorest countries do not suffer from debt overhang, debt relief is unlikely to stimulate their investment and growth. The principal obstacle to investment and growth in the world%u2019s poorest countries is the fundamental inadequacy in these countries of the basic institutions that provide the foundation for profitable economic activity. In light of these facts, the MDRI may amount to a Pyrrhic victory: A symbolic win for advocates of debt relief that clears the conscience of the rich countries but leaves the real problems of the poor countries unaddressed.

Capital Account Liberalization, Risk Sharing and Asset Prices

In the month that the capital account is liberalized, all publicly traded firms experience a 7 percent stock price revaluation. Firms whose shares become eligible for purchase by foreigners experience and additional revaluation that is directly proportional to their firm specific reduction in aggregate risk -- the covariance of the typical firm's stock return with the local market is on average 30 times larger than its covariance with the world market. The statistical significance of this proportionality persists after controlling for the firm-specific effects of liberalization on expected future profits in this sample of of 411 firms from 11 countries. These findings suggest that capital account liberalization facilitates risk sharing.

Risk Sharing and Asset Prices: Evidence From a Natural Experiment

When countries liberalize their stock markets, firms that become eligible for purchase by foreigners (investible), experience an average stock price revaluation of 10.4 percent. Since the covariance of the median investible firm's stock return with the local market is 30 times larger than its covariance with the world market, liberalization reduces the systematic risk associated with holding investible securities. Consistent with this fact: 1) the average effect of the reduction in systematic risk is 3.4 percentage points, or roughly one third of the total effect; and 2) variation in the firm-specific response is directly proportional to the firm-specific change in systematic risk. The statistical significance of this proportionality persists after controlling for changes in expected future profits and index inclusion criteria such as size and liquidity.

Firm-Specific Information and the Efficiency of Investment

We use a new firm-level dataset to examine the efficiency of investment in emerging economies. In the three-year period following stock market liberalizations, the growth rate of the typical firm's capital stock exceeds its pre-liberalization mean by an average of 5.4 percentage points. Cross-sectional changes in investment are significantly correlated with the signals about fundamentals embedded in the stock price changes that occur upon liberalization. Panel data estimations show that a 1-percentage point increase in a firm's expected future sales growth predicts a 4.1-percentage point increase in its investment; country-specific changes in the cost of capital predict a 2.3-percentage point increase in investment; firm-specific changes in risk premia do not affect investment.

Debt Relief: What Do the Markets Think?

The stock market appreciates by an average of 60 percent in real dollar terms when countries announce debt relief agreements under the Brady Plan. In contrast, there is no significant increase in market value for a control group of countries that do not sign agreements. The results persist after controlling for IMF agreements, trade liberalizations, capital account liberalizations, and privatization programs. The stock market revaluations forecast higher future net resource transfers and GDP growth. While markets respond favorably to debt relief in the Brady countries, there is no evidence to suggest that current debt relief efforts for the Highly-Indebted Poor Countries (HIPCs) will achieve similar results.

Helping the Poor to Help Themselves: Debt Relief or Aid

Debt relief is unlikely to stimulate investment and growth in the world's highly indebted poor countries (HIPCs). This is because the HIPCs do not suffer from debt overhang. The principal obstacle to investment and growth in the world's poorest countries is a lack of basic economic institutions that provide the foundation for profitable economic activity. If the goal is to help poor countries build the institutions that best suit their development needs, then the energy and resources currently devoted to the HIPC initiative could be more effectively employed as direct foreign aid.

Capital Account Liberalization: Allocative Efficiency or Animal Spirits?

In the year that capital-poor countries open their stock markets to foreign investors, the growth rate of their typical firm's capital stock exceeds its pre-liberalization mean by 4.1 percentage points. In each of the next three years the average growth rate of the capital stock for the 369 firms in the sample exceeds its pre-liberalization mean by 6.1 percentage points. However, there is no evidence that differences in the liberalization-induced changes in the cost of capital or investment opportunities drive the cross-sectional variation in the post-liberalization investment increases.