The Future of Domestic Capital Markets in Developing Countries

Chapter 1. Introduction

 Introduction 1 It is now well understood that economic development requires healthy growth of a nation’s financial sector. Initially, nations tend to channel their savings and investment primarily, if not almost exclusively, through banks. But over time, savers in search of higher returns and firms seeking capital provide the foundation for the development of capital markets. Here, too, a sequence is evident: first, the issuance and trading of bills and bonds of national governments, followed by the issuance and trading of bonds and equities of publicly held corporations. Capital markets cannot function effectively, however, unless a number of elements are in place. Exchanges and clearing and settlement systems must exist to enable trading, and money market arrangements are needed to facilitate settlements. A legal system must exist to enforce contracts. Information about the financial soundness and future prospects of companies must be made available on a timely basis to give investors confidence to purchase corporate instruments (both debt and equity). Corporations must be governed in a fashion that also gives investors confidence that their funds will not be wasted or stolen. Events in recent years in both the developed and less developed world have underscored the importance of these straightforward propositions. In the wake of the Asian financial crisis of 1997–98 and follow-on crises in Russia and Latin America, experts from developed countries lectured those  .    .  in the affected countries about the importance of ensuring transparency and avoiding “crony capitalism.” Yet only a few years later, the United States and, to a lesser extent, some European nations suffered their own embarrassing failures in corporate disclosure. Equity investors in each of these domestic capital markets suffered as a consequence. It is appropriate, therefore, that the Fifth Annual Financial Markets and Development conference sponsored by the World Bank, the International Monetary Fund (IMF), and the Brookings Institution, held in Washington on April 14–16, 2003, focused on the future of domestic capital markets in developing countries. As in earlier years, this conference was attended by nearly 200 financial experts and policymakers from around the world. Attendees heard presentations of papers and comments from experts in various panels on aspects of the theme chosen for this year’s conference. In this introduction, we highlight key features of those papers (and invite readers to review the panel summaries at the end of each section of the volume). * * * Gerd Häusler, Donald Mathieson, and Jorge Roldos from the International Monetary Fund open the book with a broad overview of trends in capital markets in developing countries. Several points emerge from this survey. In the aggregate, national bond markets in developing countries have doubled in size since 1993, from 18 to 36 percent of gross domestic product (GDP). This is still well below the average for developed countries, however, at 120 percent of GDP. As one would expect, most of the growth in domestic bond markets has occurred in government bonds, with corporate bonds lagging. Moreover, despite much of the attention given to sovereign indebtedness in various developing countries, domestic bond issues by governments have outpaced foreign currency issues by a factor of thirteen. Equity markets in developing countries emerged as a serious alternative to local financing only in the 1990s, doubling from half of domestic credit in 1990 to an amount roughly equal to domestic credit by 1994. As a result of various financial crises throughout the decade, however, equity as a source of finance also was highly volatile. What policies have been most effective in stimulating domestic capital markets? The authors suggest that there is broad agreement on the importance of sound market infrastructure, transparency, and corporate governance . Although the evidence is less clear-cut on other issues, they offer some conclusions.  , ,   One notion is that, while the existence of indexed instruments and derivatives can help to lengthen the maturities and deepen liquidity in the fixed-income market, these financial innovations require careful monitoring to prevent excessively leveraged positions and undesirable mismatches in the maturities of assets and liabilities. A second conclusion is that, although stock market reforms aimed at improving the conditions under which corporations issue and trade shares are desirable, governments should not protect local exchanges or the domestic brokerage industry from local or foreign competition. Third, foreign investors should be welcomed into domestic capital markets since they can deepen liquidity in those markets, even if they may add volatility in the process. The next two chapters analyze...