The Role of American Depositary Receipts in the Development of Emerging Markets

ADRs bring to emerging markets the advantages of liquidity, transparency, and ease of trade that characterize the U.S. markets. When foreign and local investors choose ADRs over local share issues, it places pressure on local exchanges, brokers, and regulatory authorities to modernize operations, enhance disclosure standards, and strengthen enforcement in order to make the local market more liquid, transparent, and efficient. Because these activities help develop the local market, ADR programs might be expected not only to increase participation by local companies and investors, but also to eventually lead the more sophisticated U.S. investors to buy and sell foreign shares in the firms' home markets rather than through ADRs. Thus many foreign companies would use the U.S. markets as a temporary mechanism to access U.S. funds and gain international investor credibility and visibility. The development of the ADR market would then result in the further development of the local market, as more local investors and firms enter this increasingly efficient market.

This dynamic product-development interaction between intermediaries and markets can be interpreted as part of a financial innovation spiral pushing the financial system toward an idealized target of full efficiency.¹ As products such as ADRs become commonplace, the proliferation of new trading markets in these instruments makes feasible the introduction of competing products by local intermediaries. Trade and volume in these new products expand, driving down marginal transactions costs. This makes possible further implementation of additional new products and trading strategies by intermediaries, which in turn leads to still more volume. The success of these trading markets encourages investment in creating additional markets and products, thus spiraling toward the theoretically limiting case of zero marginal transactions costs.

Under this model, the migration of local companies to the ADR market represents the first step in the competitive dynamic between a deep market, namely, the U.S. market, and the local financial intermediaries, including the local stock and bond markets. Local firms, which are used to dealing with opaque financial intermediaries (such as banks or private equity investors) as their sources of capital and which have previously bypassed or neglected the local stock market, will now turn to the ADR market for capital. As firms are able to access foreign equity capital, they might also be able to exploit foreign debt capital, putting the foreign debt markets in direct competition with both the local debt market and local financial intermediaries.

The second step in the innovation spiral predicts that the ADR market will serve as a catalyst for the local intermediaries to develop in order to compete effectively with the ADR market. This would lead to growth in both the ADR and local markets, as well as to continued financial innovation by local intermediaries

An alternate hypothesis, however, is that the diversion of activity away from the local market might lead to the opposite effect. As local firms look abroad to the U.S. market, local market participants become less appealing to investors and, hence, their trading volume, liquidity, and incentive to innovate are all reduced, leading to a downward spiral for local market development. The end result is that the local market contracts and becomes less relevant.

Such market atrophy has negative implications for the real economy. As summarized by Beck, Levine, and Loayza, financial development can accelerate economic growth through enhanced savings and the efficient channeling of these savings into real investment and the accumulation of capital.² Wurgler finds that financially developed countries allocate investment across industries more in line with growth opportunities in these industries than do the financially undeveloped countries.³ This research suggests that financial development improves resource allocation in the real economy. Additional evidence shows that stock market development is robustly correlated with future economic growth, that capital flow liberalizations encourage stock market development, and that stock market integration is correlated with economic growth.⁴ Thus a reduction in stock market activity could have a negative impact on a country's level of economic development. This effect is likely to be particularly serious if the stock market's ability...