The Future of Domestic Capital Markets in Developing Countries

Chapter 9. Managing Risks in Financial Market Development: The Role of Sequencing

 Managing Risks in Financial Market Development: The Role of Sequencing 9 Domestic financial markets are a critical pillar of a market-based economy . They can mobilize and intermediate savings, allocate risk, absorb external financial shocks, and foster good governance through market-based incentives. As such, they contribute to more stable investment financing, higher economic growth, lower macroeconomic volatility, and greater financial stability. The development of local financial markets also reduces the risks associated with excessive reliance on foreign capital, including currency and maturity mismatches.1 Key, but heretofore largely unanswered, questions concern the optimal path and sequencing of reforms to develop domestic financial markets and how these reforms should be coordinated with capital account liberalization. Despite a rich literature on capital account issues, no attempt has been made to provide an overarching framework for financial liberalization, with domestic financial market development at its epicenter. Strategies to develop local financial markets must revolve around mitigating risks injected into the financial system as markets develop and   .    1. Prasad and others (2003) note that developing economies have taken measures to “self-insure” against volatile capital flows and asset prices by improving the sovereign management of external asset liability, modifying exchange rate regimes, strengthening banking soundness and the prudential framework , and developing local financial markets. become more sophisticated. The liberalization of financial transactions and capital flows, aimed at deepening capital markets, invariably increases risks that often result in financial distress and crisis. Domestic and external financial reforms thus need to be sequenced so that the central bank and financial institutions (as well as the infrastructure that supports them) develop the capacity to manage the risks associated with a wider range of permissible financial transactions, investible instruments, and loanable funds. The goal of orderly sequencing is to safeguard monetary and financial stability during financial liberalization and market development. Against this background, this chapter presents five theses. First, capital market development–cum–financial stability hinges on establishing the institutional infrastructure for controlling both macroeconomic and financial risks. Macroeconomic risk management requires effective instruments and institutions for the implementation of monetary and exchange policy, including well-functioning money, foreign exchange, and government debt markets.2 Financial risk management depends on high standards of corporate governance, accounting, and disclosure and high standards of prudential regulation and supervision. These institutional reforms are critical to fostering an environment in which capital markets can grow, without undermining financial stability. Second, financial liberalization and market development should revolve around the hierarchy and complementarity of markets and related institutional structures. Markets are hierarchically ordered, starting with money markets, followed by foreign exchange, treasury bill and bond markets, and, ultimately, markets for corporate bonds and equity and for assetbacked securities and derivatives. The hierarchy reflects the degree and complexity of risks created by each market. The hierarchy also incorporates the interaction among markets that links the depth of one market to the depth of other markets. Third, capital market development requires a careful sequencing of measures to mitigate risks, in parallel with reforms to develop markets. Risks evolve into more complex forms and grow in magnitude as markets develop, especially as new instruments and institutions emerge. These risks cannot be managed effectively in the absence of well-functioning markets at earlier stages in the hierarchy. Thus a critical mass of reforms encom-  , ,   2. Ishii and Habermeier (2002); Ingves (2002). passing both market development and risk mitigation at every stage of the market hierarchy is necessary to avoid increases in financial system fragility and macroeconomic vulnerability. Fourth, institutional development is a critical component of building capital markets and financial risk management capacity. Financial institutions —both bank and nonbank—are the key counterparties in financial markets. They often create and transmit risks. As such, establishing good governance structures, including effective internal controls and risk management systems in financial institutions, is among the most critical of market reforms. Fifth, capital account liberalization can play an important role in deepening domestic financial markets. However, foreign capital may complement , but cannot substitute for, a domestic investor base. Before capital from abroad can play a constructive role, critical mass must be reached in terms of the depth of domestic markets, the diversity of local investors, the effective oversight and governance of market institutions, and the length and distribution of instrument maturities. Admittedly, there are trade-offs between having good domestic institutions in place before undertaking capital market liberalization, on the one hand, and opening the capital account to...