Comment and Discussion

Comment by Frederic S. Mishkin: Richard Levich's paper provides a very nice overview of developments in emerging capital markets. The good news is that emerging capital markets have increased in importance over the past twenty years. In 1980 around 3 percent of world equity capitalization was found in emerging-market countries, growing to around 9 percent today. The bad news is that capital markets in emerging-market economies are still relatively small. Besides having only a 9 percent share of world equity markets, they also have less than 5 percent of world debt securities markets. Even more important, emerging capital markets also are small relative to gross domestic product (GDP). Equity capitalization averages around a third of GDP in emerging-market economies, compared with more than 100 percent of GDP in mature-market economies.

Their small size indicates that emerging capital markets are not fully developed. They are not providing as many funds as they could to support productive investment opportunities in emerging-market countries. This means not only that there are profit opportunities unavailable to foreign investors but also that the lack of development in these markets is an important impediment to economic growth in these countries. A key policy challenge is to improve the workings of these markets so as to increase their importance.

Levich provides one answer by suggesting that transaction costs for emerging-market securities can be lowered by piggy-backing off existing mature-market institutions and selling emerging-market securities in mature markets. Indeed, innovations such as American depositary receipts (ADRs), closed-end country funds, open-end country index funds, and world equity benchmark shares (WEBS) take advantage of lower trading costs in mature markets and thus make it easier for firms in emerging-market economies to raise funds. However, piggy backing off mature markets' lower trading costs can go only so far in promoting emerging capital markets. The reason is that the more important barrier to selling emerging-market securities is their high risk and the agency problems arising from asymmetric information.

Substantially increasing the importance of emerging capital markets thus requires reducing risk and agency problems in these markets. But how is this to be done? To reduce agency problems in emerging capital markets, we can round up the usual suspects and focus on improving legal and property rights, bankruptcy law, accounting standards, disclosure regulations, and corporate governance. Indeed, the papers in this conference round up these suspects and make useful suggestions on how to improve their performance.

Another usual suspect is prudential regulation and supervision of the banking system. Prudential regulation and supervision that ensure that banks (and other similar financial institutions) do not take on excessive risk clearly are important to the efficient allocation of capital in emerging-market countries. However, good prudential regulation and supervision also are key elements in reducing risk for securities in emerging capital markets. Ensuring that banking institutions are safe and sound is crucial to improving the climate for emerging-market securities because banking crises are a key source of risk in emerging-market economies.

Banking crises directly harm asset returns because when banks are no longer able to extend loans, businesses that are dependent on bank loans do not have alternative sources of financing and so forgo investment projects. However, problems in the banking sector also are a major reason why full-fledged currency and financial crises occur in emerging-market countries, with devastating effects on asset values. When banks get into trouble, a central bank is less likely to take the steps needed to defend its currency because if it raises interest rates, bank balance sheets are likely to deteriorate further. Once investors recognize that a central bank is less likely to take the steps needed to defend its currency, expected profits from selling the currency will rise and so will the incentives to attack the currency. Also recognition that the banking sector may require a bailout and thus produce substantial fiscal deficits in...