The Importance of Emerging Capital Markets

IN A LITTLE UNDER two decades, the spread of market-oriented policies has turned the so-called lesser-developed countries into emerging markets. In 1982 the thirty-two developing-country stock markets surveyed by the International Finance Corporation (IFC) had a market capitalization of $67 billion, representing about 2.5 percent of world market capitalization. By the end of 1999, the IFC had identified eighty-one emerging stock markets with total market capitalization exceeding $3 trillion, or 8.5 percent of world equity market capitalization. In 1999 the value of outstanding domestic debt securities trading in emerging markets exceeded $1.4 trillion, representing 4.7 percent of the global bond market and a several-fold increase over the total twenty years earlier. However, bank lending to emerging markets in 1999 totaled only $783.7 billion (12 percent of consolidated international claims of banks reporting to the Bank for International Settlements), a relatively small increase over the $517.6 billion (37 percent of the total) in claims held by banks in 1980.

Many forces underlie these broad trends. The debt crisis of the early 1980s cooled bankers' appetite for sovereign loans to developing nations. The financial crises in the second half of the 1990s (Mexico in 1995, Asia in 1997, and Russia in 1998, along with other hot spots) brought a fresh reminder of the perils of cross-border lending. In contrast, public financial markets for equity and debt securities were encouraged by marketoriented policies to permit private ownership of economic activities, including ownership to a larger extent by foreigners. Massive privatization programs, corporate restructuring, and financial innovations (such as global offerings and changes to the financial infrastructure) fueled the process.

As dramatic as these changes have been, emerging financial markets still reflect a continuum of market conditions. Some markets are maturing and on course toward converging and integrating into the world of mature, developed financial markets. Markets in other countries are almost nonexistent or deserve the "frontier" label that the IFC gives to markets one step below emerging.

This paper sketches the size and scope of financial markets in emerging nations. The focus is on the markets for foreign exchange, debt securities, equities, and bank lending in emerging nations. I present descriptive information about these markets and analyze some of the important institutional features that have affected their growth and development. Although the paper is largely descriptive, I attempt to analyze the importance of emerging financial markets, not from the standpoint of how they contribute to their own national development, but rather from the standpoint of how they contribute to the opportunities for investors and financial intermediaries in developed nations.

In international economics, the gains from international trade in goods or capital often are proportional to the difference in some measure between the two trading nations. Thus the gains from trade are enhanced when there is a greater difference in relative factor endowments, relative prices, or technology on a pre-trade basis. In many respects, economists have used this concept to assess the impact of bringing emerging financial markets into the picture. The potential gains are greatest as the pre-trade marginal product of capital differs (expected value gains) or as the time pattern of asset returns differs (diversification gains from imperfect correlation in business cycles or financial market conditions).

However, an argument can be made that emerging markets have paid a price for being "too different," meaning laden with idiosyncratic risks, weak institutions, and poor corporate governance. These properties discourage investors and lessen the prospects for reaping the full gains from international trade in capital. If this is the case, then emerging markets may find that their future lies in becoming more integrated into the world financial markets rather than remaining on the fringes, where they risk being marginalized. A related consideration is whether countries should attempt to reform their own institutions and markets to encourage this type...