The Future of Domestic Capital Markets in Developing Countries

Chapter 7. Domestic Capital Market Reform and Access to Global Finance: Making Markets Work

 Domestic Capital Market Reform and Access to Global Finance: Making Markets Work 7 Over a decade ago, Robert Lucas asked the following question: Why doesn’t capital flow from rich to poor countries? His point was simple. Poor countries have lower capital-to-labor ratios than do rich ones. Under standard neoclassical assumptions, the rate of return to capital in poor countries should be higher than in the developed world, attracting capital until risk-adjusted rates of return are equalized. In other words, market pressures should lead to a positive net transfer of resources to less-developed countries, thus boosting their growth rates. Lucas encouraged us to think about the obstacles that prevent this flow from occurring. (Lucas 1990) At the time Lucas asked his question, the prevailing wisdom was that capital flows to developing countries were a good idea. More than ten years later, intellectual opinion has shifted. A heated debate over capital account liberalization has followed in the wake of financial crises in Asia, Russia, and Latin America. Opponents of the process now argue that capital account liberalization invites speculative hot money flows, increases the likelihood of financial crises, and brings no discernible economic benefits.       Peter Henry gratefully acknowledges the financial support of a National Science Foundation CAREER award and the Stanford Institute of Economic Policy Research (SIEPR), and the Center for Research on Economic Development and Policy Reform (CREDPR). We are grateful to Barry Bosworth and Susan Collins for sharing their growth accounting data. Some economists have gone so far as to assert that open capital markets may be detrimental to economic development.1 With the debate over the wisdom of free capital flows still raging, it is at least a little presumptuous to write a chapter that explains how developing countries can increase their integration with world capital markets without first addressing the underlying assumption that such integration is beneficial. The chapter is organized as follows. The first section examines capital market liberalization, establishing that there are indeed substantial benefits to increased capital market integration. The increasingly popular, negative view of capital account liberalization comes about partly from a failure to distinguish between equity market liberalization and debt market liberalization . After equity market liberalization, capital becomes cheaper, investment booms, and economic growth increases. In contrast, liberalization of debt markets has often led to great difficulty, as banks, companies, and governments often become vulnerable to changes in financial market perceptions of their ability to pay back loans. The evidence outlined here can be distilled into two key lessons. First, the liberalization of dollar-denominated debt flows should proceed slowly and cautiously: Countries should refrain from premature liberalization of dollar-denominated foreign borrowing. The second lesson is that countries have thus far derived substantial economic benefits from opening their stock markets to foreign investors; there is no reason to think that future liberalizers will be any different in this respect. The second section turns to liberalization of the stock market. Although the effects of equity market liberalization are positive and substantial, they fall far short of the torrent of capital flow to the developing world implied by the theory of perfect markets. New theories in economics and finance developed over the past three decades have highlighted the inefficiencies that can result when not all parties to a transaction are equally well informed. Such asymmetric information problems can make investors reluctant to put their money in companies for two reasons. First, they may worry about the adverse selection or “lemons” problem, wherein only the worst companies offer their shares. Second, moral hazard or agency problems raise the concern that even money invested in a good company may be misspent on managerial perks or even stolen outright through accounting tricks. Over the past few years, cross-country econometric research on corporate governance, law, and finance has provided empirical support for the     1. Bhagwati (1998); Rodrik (1998); Stiglitz (2002). importance of such information problems. In addition, some of this research hints at the relative effectiveness of different reform strategies for increasing foreign participation in developing-country equity markets. However, given the relatively small number of countries with stock markets and the large number of plausible alternative explanations for large, prosperous equity markets, the statistical robustness of these conclusions cannot be taken for granted. Thus the findings of this research should be treated as tentative. Nevertheless, stronger laws and regulatory institutions that protect investors (whether domestic or foreign) from colluding...