risks and rewards in emerging market investments

Journal of Applied Corporate Finance F A L L 1 9 9 7 V O L U M E 1 0 . 3

Risks and Rewards in Emerging Market Investments by Roy C. Smith and Ingo Walter,

New York University

8JOURNAL OF APPLIED CORPORATE FINANCE

RISKS AND REWARDSIN EMERGING MARKETINVESTMENTS

by Roy C. Smith andIngo Walter,New York University

8BANK OF AMERICA JOURNAL OF APPLIED CORPORATE FINANCE

1. For a useful analysis of the investment cycles and quantities in the 19thcentury, see D.C.M. Platt, Foreign Finance in Continental Europe and the USA,1815-1870 (London: George Allen & Unwin, 1984).

2. A term coined by John Williamson, of the Institute for InternationalEconomics, to represent the conventional wisdom among opinion leaders that free

markets and macroeconomic (notably price) stability are preconditions for viableeconomic development.

or the better part of two centuries, coun-tries with shortages of internally gener-ated capital have relied on foreign in-vestment to augment their growth and

rescheduling exercises, the results of which arewell known.

In the early 1990s, following a number ofimportant economic policy changes in developingcountries that encouraged the creation of relativelyfree markets, a new wave of capital flows to emerg-ing markets unfolded. The set of principles used tojustify such policy shifts has come to constitute anew model of economic development, looselyknown as the “Washington Consensus.”2 This time,the wave was accompanied by a surge ofprivatizations that made available to the investingpublic shares of large-capitalization companies thatpromised to be actively traded. Between 1991 and1994, with the stimulus of the new free-marketpolicies, foreign portfolio investment into emergingmarket countries soared, and so did foreign directinvestment (see Figure 1).

The collapse of the Mexican peso in late 1994and early 1995 brought an abrupt end to theeuphoria. Emerging market equity securities crashedin a simultaneous pattern all over the world. The IFCEmerging Markets Investible Composite Index mea-sured in U.S. dollars dropped by 12% in calendar1994 (having risen by 79.6% in 1993, 3.3% in 1992,and 39.5% in 1991). By the end of January 1995, thedamage had become far greater. Measured against itslevel as of January 1, 1994, the stock market in Turkeywas down 57%, Mexico 56%, China 54%, Poland50%, and Hong Kong 41%, with plunges of 20% to30% common in most countries. (The principalexceptions were Chile, where the market was up42%, Brazil 39%, South Africa 10%, and South Korea9% over the same period.)

development. Such investments principally took theform of bank loans and corporate bonds and stocksissued to overseas investors by local companies, aswell as direct investments by foreign corporations. Inthe 19th century, the capital flows originated mainlyin Britain, Germany, and France and were directedto the then-emerging markets of the United Statesand Latin America.1 In the 20th century, the UnitedStates became a major capital exporter and joined theEuropeans in lending and investing in the develop-ing countries of the Americas and Asia.

The financing usually came in waves. Periods ofcautious optimism that attracted capital at relativelyhigh rates of return were followed by periods of“irrational exuberance” in which others sought toduplicate the seemingly easy successes of the earlyinvestors only to see—as money rushed in—returnsfall off dramatically. Next came periods of financialdistress, defaults, reschedulings, and other eventsthat bred an attitude of pessimism, which in turncaused the inflows to cease and even reverse. Timewould pass, and another cycle would begin.

In this century, there have been two majorperiods of difficulty for emerging market debt in-struments. The 1930s saw the default of large num-bers of bonds issued by Latin American govern-ments and others—many of which were solicited,underwritten, and sold by the securities affiliates ofAmerican banks. And in the 1980s, a host of devel-oping countries entered into massive bank debt

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9VOLUME 10 NUMBER 3 FALL 1997

The aftermath revealed that large foreign insti-tutional investors, especially dedicated country-fundmanagers, were shocked to discover politicallymotivated, deceptive, and misleading reports ofquestionable financial practices in Mexico—andthey decided en masse it was time to get out. Thesefund managers had rushed into emerging markets allover the world on behalf of their investor clients, andthey suddenly appeared to lose confidence in all ofthem at once (again, with only a few exceptions suchas Chile and Brazil), regardless of important differ-ences in country fundamentals. Mutual fund share-holders began to demand redemptions, and mul-tiple-country liquidations were often necessary toretain portfolio balancing.

Panic sales by both foreign and local investorsoverwhelmed the relatively illiquid markets in mostparts of Latin American, Eastern Europe, and Asia.

These markets, which were seen to offer low corre-lations in investment returns (and were thereforeattractive in the perspective of modern portfoliotheory), turned out to be highly correlated after all.They all had the same large and volatile investors—the big American and European fund managers.

This lesson was learned, too. Emerging marketinvestors became more cautious, and market re-turns reflected it. Figure 2 shows the effects onaggregate returns on a portfolio of emerging mar-ket securities during this period. The IFC Compos-ite lost 8.4% in 1995 and gained 9.4% in 1996, butthese returns were meager indeed compared toreturns of 37.5% in 1995 on the S&P 500 Index and23% in 1996. The relatively low returns came inspite of the recovery of aggregate emerging marketequity portfolio inflows in 1996 to the $45 billionlevel achieved in 1993.3

3. In 1993 the total equity inflow to emerging market countries was $45 billion,but it fell sharply to $32.7 billion in 1994 and $32.1 billion in 1995 before recoveringto $45.7 billion in 1996. Of the 1996 total, $34 billion were secondary market flowsinto outstanding shares traded on domestic markets, mainly in Latin America and

Eastern Europe. The volume of new issues of equity securities in 1996, however,was well below the peak year of 1994, though higher than 1995. Data: World BankDebtor Reporting System, April 1997.

FIGURE 1TOTAL PRIVATE CAPITALFLOWS TO DEVELOPINGCOUNTRIES

FIGURE 2COMPARATIVE EMERGINGMARKET EQUITYPERFORMANCE(1/91-2/96)

Source: World Bank Debtor Reporting System.

Source: Merrill Lynch.


Still, there is now some evidence to suggestanother turn in the foreign investment patterns ofemerging markets. Banks and bond market inves-tors have taken up where the equity investors leftoff. JP Morgan’s Emerging Market Bond Index rose39.3% in 1996, having nearly doubled from its lowpoint in early 1995 (see Figure 3). Emerging marketborrowers issued $74 billion of investment gradebonds (now called “zunks”) in 1996, and $20 bil-lion more were sold by over 50 different issuers inthe first quarter of 1997.4 A record $3 billionuncollateralized 30-year Brazilian sovereign Euro-bond was issued in June 1997 at 395 basis pointsover U.S. Treasuries. Three-quarters of the bondsin this Brazilian issue were exchanged for higher-yielding Brady bonds issued by the debtor govern-ments as part of their debt restructuring programs.Indeed, during the preceding year, more than $9billion of similar exchanges to retire outstandingBrady bonds were made by Latin American govern-ments—and more followed in 1997. However, theBrazil issue, rated B1 and BB–, was perhaps themost aggressively priced.5 Bond market rallies alsooccurred in other emerging market countries, par-ticularly in Eastern Europe, where Russian bondsreceived much support in the market.

The renewing enthusiasm for Third World debtwas not limited to bond investors; banks werejumping in again as well. In 1996, syndicated bankloans to Latin American borrowers exceeded $250billion, an increase of nearly 50% over 1995. MajorAmerican banks doubled or tripled their Latin Ameri-can exposures during this time, during which lend-

ing spreads over LIBOR were, on average, 50% lessthan those of the preceding year.6 Emerging marketbond prices collapsed with the East Asian financialcrisis in 1997, while banks saw some of their cross-border loan exposures threatened yet again.

EMERGING MARKET INVESTMENT CYCLES

These patterns suggest that the basic cycle ofemerging market loans and securities investments hasbeen compressed, and its amplitude accentuated, byfactors related not to the conditions in the emergingmarket countries but rather to the behavior of theinvestors themselves. These investors have their ownpreoccupations and problems. Most important, theymust compete to attract and retain funds under man-agement by demonstrating outstanding results in totalreturns. They are competing with hundreds if notthousands of other fund managers—indeed, in theU.S. and Britain there are more investment funds thanthere are individual stocks to invest in. All are trying tobeat their benchmarks, and yet the vast majority fail todo so. All attempt to increase returns for the samedegree of risk by shifting into new and different assetclasses. The record shows that adding a modestamount of high-risk/high-return investment to a well-diversified portfolio will, up to a point, serve toenhance risk-adjusted portfolio returns. Emergingmarket securities are thought to be good examples ofhigh-risk/high-return investments that exhibit lowcorrelations with more conventional asset classes; andso portfolio managers seek to include them in theirportfolios in modest quantities.

4. “Can’t Get Enough of That Zunk,” The Economist, April 19, 1997.5. Thomas Vogel, “Brazil’s Offering of Dollar Denominated Bonds Totaling $3

Billion Is Snapped Up by Investors,” The Wall Street Journal, June 5, 1997.

6. Thomas Vogel, “Ecuador Woes Rattle Foreign Lenders,” The Wall StreetJournal, February 11, 1997, and Samuel Iskander, “Banks Agree $275 Million BrazilLoan,” The Financial Times, April 23, 1997.

FIGURE 3TOTAL RETURNS ONEMERGING MARKETBONDS

Source: JP Morgan.


Invariably, however, investors move in herds.Globally, there were more than $35 trillion (marketvalue) in stocks and bonds outstanding at the end of1995, of which in excess of $22 trillion were fundsunder management by institutional investors aroundthe world.7 Given the pressure to perform against theirmarket indices, such investors must move into which-ever asset class seems to be the most promising at thetime. As their investments in the chosen class accumu-late and prices are bid up, expected returns fall. Then,as the sector loses its appeal, investors begin towithdraw in search of the next fashionable sector. Thisis not the irrational behavior of crowds infected byinvestment euphoria, but the rational behavior (how-ever volatile) of a large number of institutional inves-tors with huge stakes in the market, each trying tooutperform or at least keep up with the others.

Two things make this confluence of investorbehavior a potential source of problems for emergingmarket countries. First is the fact that these investorsmanage such large asset pools relative to the marketcapitalization of the emerging financial markets thattheir relative impact can be enormous. In 1996, asagainst the $1.9 trillion aggregate market capitalizationof 100 or so emerging stock markets, global institu-tional fund managers controlled more than $8 trillionin equity investments alone, of which perhaps as muchas $1 trillion was available for investment in interna-tional stocks. A sudden interest in Chile (with 1996market capitalization of $40 billion) or Taiwan (with$54 billion), could result in a huge inflow of capital tothe relatively small equity markets in those countries.By the same token, a loss of global investor interest inThailand ($17 billion) or Poland ($6 billion) couldinitiate a sudden market collapse.

Second is the fact that the institutional herd tendsto look for new investment areas rather than revisitpreviously discredited ideas. After the herd has left, itcan be much more difficult—because of the trailingdisappointment—to re-attract foreign portfolio invest-ment in significant amounts. To some countries (Chinafor example), it must seem that when the herd isrunning, the country can attract overseas capital with-out any effort to improve investment conditions be-yond making shares available. But once the boom hassubsided, interest in local investments can becomeextremely difficult to restart.

UNDERSTANDING EMERGING MARKET RISKS

Informed investors generally measure risk interms of the volatility, or standard deviation, ofreturns of specific assets or asset-classes in compari-son to the corresponding volatility of a base ormarket standard such as the S&P 500. So observedvolatility over a particular time period should reflectthe amount of risk that the investors have actuallyassumed. And the rewards, of course, are expectedto be commensurate with the risks.

But sometimes they are not. For example, theannual volatility of the IFC Composite for the threeyears ended 1996 was 17.7%, and the volatility ofMexican stocks (in dollar terms) over the sameperiod was 23.5%; by comparison, the volatility ofthe S&P 500 was only 10.3%.8 However, the IFCComposite and the Mexican market returns for thethree years ended 1996 (–3.4% and –16.0%, respec-tively) were hardly adequate to cover the higher riskexposure that was associated with them. So onecould argue that, in retrospect, these were not at allsuccessful investments in those years.

But at the time that the investments were made,the forward-looking, risk-adjusted returns expectedfrom these same markets based on 1991-1994 datalooked very attractive indeed. Obviously, forecast-ing future returns and the risks by which to adjustthem is itself a highly risky business in the case ofemerging market securities. So institutional investorsbuy some of these securities for their portfolios onthe basis of their very unpredictability itself, and onthe assumption that in the long run the appropriatereturns will be realized. In other words, they makethe investment and hope for the best.

The risks in emerging market investments are,however, identifiable and, to an increasing degree,quantifiable in terms of factors other than conven-tional volatility measures. And this means that selec-tion of investments in particular countries may bepossible on a basis that is more likely to succeed thaneither buying the indices or in making randomsecurity selections.

In standard capital asset pricing models, theinvestor looks for a return that represents a risk-freerate plus a premium to account for the particular riskbeing taken, either a credit risk or market risk. There

7. Securities Industry Association, 1996 Fact Book, and Barry Riley, “Growthon a Grand Scale,” The Financial Times, April 24, 1997.

8. Data: International Finance Corporation, Emerging Market Statistics.

With the collapse of the Mexican peso in late 1994 and early 1995, emerging marketequity securities crashed in a simultaneous pattern all over the world. These

markets, which were seen to offer low correlations in investment returns (and weretherefore attractive in the perspective of modern portfolio theory), turned out to be

highly correlated after all.


are three special risks we can identify in emergingmarket investments: (1) country risk; (2) risks ofmarket imperfections and illiquidity; and (3) corre-lation risks. These risks apply to all types of expo-sures—equities, bonds, bank debt, and direct invest-ments. By attempting to calibrate these risks, it ispossible to obtain useful information affecting in-vestment selections.

Country Risk. This is the risk of macroeconomicunderperformance due to policy errors, politicalintervention, or other causes. The investment lossesexperienced in the Mexican peso crisis of late 1994or Indonesia in 1997 were examples of country riskthat materialized. This risk is within the purview ofsovereign credit analysts and is reflected in, amongother things, government debt ratings. Yield differ-entials for various country debt instruments relativeto U.S. Treasuries or LIBOR are observable daily inthe market. These differentials may be the bestindications of country risk that is available. If Brazil-ian sovereign debt trades at 330 basis points abovea comparable-maturity U.S. Treasury security yield-ing 6.5% (i.e., a Brazil risk-free rate of 9.8%), then thatdifferential can be interpreted as the return necessaryto compensate investors for the Brazilian countryrisk that has been assumed.

There are active markets today for many emerg-ing market sovereign and other debt issues, cover-ing a range of credit ratings from BBB to B, andthese can provide a useful proxy for country risk.Indeed such indicators of country risk are availableeven for untraded bonds by extrapolation from atable showing rating vs. risk premium. An alterna-tive in the case of an unrated country is to estimatethe probable ratings by using country risk rankingtables or benchmarking against non-investment-grade corporate debt.

Market Imperfections. Emerging market econo-mies are often plagued by substantial financial-market imperfections, such as poorly defined orenforced legal rights of investors, inadequate invest-ment information, poor custody or clearance andsettlement arrangements, inefficient secondary mar-kets, as well as corruption and fraudulent tradingactivities. These imperfections appear to affect eq-uity investments considerably more than they affectdebt investments. Nevertheless, for domestic debttraded mainly inside the country, these imperfec-

tions can be comparable to the risks experienced byequity investors.

The conventional capital asset pricing modelrequires the addition to the risk-free rate of a pre-mium to reflect the risks inherent in a particularequity investment. One way to calculate the equityrisk premium for a particular emerging market is tomultiply (a) the U.S. equity premium by (b) the ratioof the volatility of the emerging market stock marketindex to the volatility of the S&P 500, both defined interms of standard deviations. But forecasting volatil-ity ratios is always difficult, and perhaps more unre-liable in emerging market situations, especially thosewhich involve substantial market imperfections.

The effect on investors of deficiencies in marketstructure is to reduce liquidity—that is, to interferewith the investors’ ability to buy or sell securities ata fair market price at any time. Either the interferenceshows up in the ability to transact at all, or in theability to transact at fair prices. We know that themarket applies a penalty to investments that areilliquid in the form of a price discount, or yieldpremium. William Silber, among other academicobservers, has estimated that the amount of thediscount in cases involving equity investments thatwere restricted from trading, or “locked up,” forapproximately two years has often been more than30%.9 Depending upon the degree of illiquidity thatappears to be threatened through market imperfec-tions, one could project a required increase in theexpected return to investors that would be equiva-lent to a discount of perhaps as much as 40%.Examples of markets with low levels of structuralilliquidity might include Chile, Hong Kong, andTaiwan—and those with high levels would includeRussia, China, and Vietnam.

Correlation Risk. Central to the principle ofdiversification is that the different investments se-lected for a portfolio not have returns that are highlycorrelated with the returns on the rest of the portfo-lio. Low correlation is as important to asset allocationas any other factor under the control of the investor.But as discussed earlier, in the aftermath of theMexican peso crisis (and the 1997 East Asian crises),an investor does not know whether investmentchoices are going to be highly correlated in thefuture. Not knowing is a risk, one that to some degreecan be estimated.

9. William L. Silber, “Discounts on Restricted Stock: The Impact of Illiquidityon Stock Prices,” Financial Analysts Journal, July/August 1991. Silber relates the

amount of the discount on the restricted stock sales he studied to how much of thetotal stock outstanding was restricted and the creditworthiness of the company.


Before the 1994-95 Mexican problem began, aninvestor seeking an optimum portfolio consisting ofmajor global equity markets and emerging equitymarkets would have found substantial evidence of lowcorrelation across the various emerging markets, andbetween them and the major markets. As little as 12months later, after the shocks in one emerging markethad been transferred to most others, it was clear thatthe earlier assumption of low correlation across thosemarkets was wrong. The efficient frontier was notwhere it had been thought to be. Indeed, the newoptimal portfolio required significantly fewer invest-ments in emerging market securities than before.Figure 4 shows the impact of the Mexican crisis on theefficient frontier for U.S. investors by extending theperiod 1987-1994 by one year—to the end of 1995—the year when the full market impact made itself felt.Note the greater convexity of the efficient marketfrontier and the drop in total returns as exposure toemerging market equities increases.

The experience with the high correlation amongemerging market returns following the Mexicanpeso crisis may be unusual, but it was repeated in1997 in southeast Asia, and it seems likely to showup again. As long as large U.S. and Europeaninvestors are among the most significant traders inthese small-capitalization markets, some form ofcorrelation instability must be assumed. And thisdistortion could involve an increase in portfoliovolatility of as much as 25%—which, in the examplecited in Figure 4, could involve a reduction of risk-adjusted total portfolio return of 0.5%-0.75%.

But not all emerging market countries wereequally affected by the Mexican experience. Many

countries with large domestic investor bases, such asSingapore, Hong Kong, Chile, and Argentina, suf-fered far less from the peso collapse than countrieswith large foreign investor participation such asPeru, Pakistan, Hungary, the Philippines, and China.Moreover, countries that had imposed restrictions oncapital inflow to avoid various distortive effects ofcapital inflows on the domestic economy and moneysupply, such as Chile, South Africa, and South Korea,had less capital to be abruptly pulled out by fright-ened investors abroad.

PORTFOLIO SELECTION

It thus appears that investors can benefit bymore careful selection among emerging marketcountries. They can do this by estimating the aggre-gate emerging market risk more carefully, and byconverting this risk to minimum returns needed tojustify a given portfolio allocation. The expected riskof the investments can be reduced by selectingcountries with less imperfect market structures andthose which appear to be less exposed to correlationrisk. And careful assessment of whether the mini-mum returns are likely to be reached, based oncurrent asset price comparisons, may also improveinvestment results.

As an example, assume an investor in late1996 was considering an investment in a Brazilfund with a five-year time horizon. He or shehoped to be able to significantly outperform theS&P 500 index because of the emerging marketrisk that is involved in the fund. Using the capitalasset pricing model, the return needed to balance

FIGURE 4INVESTOR GAINS FROMEMERGING MARKETPORTFOLIO ALLOCATIONS:1987 Q4 TO 1995 Q4AGAINST 1987 Q4 TO1994 Q4*

Source: Merrill Lynch Global Investment Strategy.*Our proxy for the major global equity markets is the US dollar-based MSCI World Index, which is composed of securitiesin the major markets worldwide, including the US. For emerging markets, we use the US dollar-based IFC Emerging MarketsComposite Index, an aggregate of activity in emerging markets globally. Risk is defined as absolute volatility using the standarddeviation of month-to-month total returns. Average return is the annualized total return performance over the designatedperiod. We assume no adjustment for withholding taxes.

The efficient frontier was not where it had been thought to be. Indeed, the newoptimal portfolio required significantly fewer investments in emerging market

securities than before.


the Brazil market risk would have been 16.2%,consisting of a country risk-free rate of 9.8%(based on a Brazil country risk premium of 3.3%),and an equity risk premium of 6.5% (an estimatedU.S. risk premium of 3% multiplied by the ratio(2.166) of the Brazilian market volatility to the S&P500 volatility).

On this basis, a Goldman Sachs study calculatedthat an equivalent “fair value” price-earnings ratio forBrazil was 11.6x. At the time the Brazilian market wastrading at a P/E ratio of 13.4x, thus representing a15% premium over the risk-adjusted level. The study,which looked at the largest seven markets in LatinAmerica, concluded that whereas some markets, likeBrazil, might be overvalued, other markets wereundervalued by as much as 15% based on thisparticular model.10

The predicted return of 16.2% was derived bytaking into account both country risk, as reflected inthe debt premium, and the market imperfection risk,through the equity premium. But there are at leasttwo good reasons to interpret these numbers withcaution. For one thing, the risk premium so deter-mined might be understated as compared to theliquidity-discount approach. And, perhaps equallyimportant, the estimated return does not account forthe correlation effect discussed above, which couldadd another 3.0% or so of required return.11 On thisbasis, investors would be looking at an expectedreturn of 20% or more to justify participation inBrazilian equities.

Investors, of course, can shop around. As theybecome more knowledgeable about emerging mar-ket investments, they will select some and rejectothers more on the basis of careful country andmarket risk evaluation than before. Consequently,we can expect to see a greater amount of competitionfor capital investments on the part of emergingmarket countries. Indeed, to the extent we can judgefrom recent returns, it appears that this competitionhas already begun. Although high-risk markets likeRussia will continue to attract investors with long-shot, “casino” mentalities, the bulk of the assets to beinvested in emerging markets are likely to followmore cautious lines.

CROSS-BORDER INVESTMENT ANDCAPITAL FORMATION

Countries have plenty of incentives to pursuepolicies that deal with both the country and marketrisk elements facing foreign investors. The followingfindings of recent World Bank research suggest thatthe development of local equity markets plays acritical role in the economic growth process:

Countries that had more-liquid stock markets in1976 tended to grow much faster over the next 18years than those which did not.

High levels of stock market liquidity, as measuredby the turnover ratio (trading volume divided bymarket capitalization), were associated with morerapid growth over the same period.

Countries with high trading-to-volatility ratios like-wise tended to grow faster, after controlling forconventional economic, political, and policy vari-ables associated with growth differentials for variousperiods and country samples. Volatility per se doesnot seem to be related to growth; the key variableinstead seems to be the ease with which stocks canbe traded.

Stock market development seems to comple-ment—rather than substitute for—bank finance,both of which seem to promote growth independentof each other. Higher levels of development of thebanking system were associated with faster growthno matter what the state of development of the stockmarket, and vice versa, for reasons that are not yetwell understood. Although most corporate invest-ment in developing countries is financed throughbank loans and retained earnings, both sources ofcapital (as well as the debt-equity ratio) are positivelyassociated with stock market liquidity.12

Such findings suggest that international portfo-lio capital flows may play a substantially morecentral role in the emerging market growth processthan previously thought. They can contribute dis-proportionately to market liquidity, especially in thepresence of “noise traders” such as open-end mu-tual funds that must buy and sell in response tonew client investments and redemptions and tomaintain portfolio weights. They can force securi-

10. Jorge O. Mariscal and Emanuel Dura, “The Valuation of Latin AmericanStocks: Part III,” Goldman, Sachs & Co., November 29, 1996.

11. To raise the total return on a portfolio invested 80% in the S&P 500 and20% in a selection of emerging-market countries by 0.5% in order to adjust forcorrelation risk would require the emerging market portion to return an addi-tional 3%.

12. For a summary of twelve papers presented at a World Bankconference on Stock Markets, Corporate Finance and Economic Growth, seeRoss Levine, “Stock Markets: A Spur to Economic Growth,” Finance andDevelopment, March 1996.


ties prices into line with those prevailing on globalmarkets. The portfolio flows can encourage up-grading of the legal infrastructure, trading systems,clearance and settlement utilities, information dis-closure and accounting standards, and custodyservices. They can improve the process of corporategovernance, perhaps in association with significantshareholdings by banks. And they can serve as abellwether for local portfolio investors, who mayfind encouragement from a significant foreign pres-ence in the marketplace.

But many governments have been reluctant toact to improve investment conditions in their capitalmarkets. The “Big Bang” market reforms have beenextremely slow in coming to most emerging marketcountries, and when they have come they have oftenbeen gradual, irregular, and ineffective. On the onehand, it may be that policy-making officials do notfully appreciate, relative to other matters of concernto them, the importance of financial market reformand re-regulation. On the other hand, there may bea reluctance to change rules that have permittedpowerful local insiders to amass great fortunes.Nevertheless, as investors become more aware of thespecial risks of investing in emerging market secu-rities, they are likely to be more selective and choosecountries that provide a higher-quality market envi-ronment. Market forces, in other words, will ulti-mately compel those countries seeking foreign capi-tal to conform to world standards.

INITIATIVES BY COUNTRIES

Moreover, there appear to be considerableadvantages in being among the earliest converts toso conform. Some of the initiatives that can be takenby governments are the following:

Sound macroeconomic policies. Providing aneconomic environment that holds out adequateprospects of good, long-term, risk-adjusted returnsis a big job that includes many changes and reforms;it should by no means be shrugged-off with thenotion that legislation is planned to take care of thisor that. Investors care about what actually happens,not whether legislative bills are passed or not.

Reforms must begin with the basics. Emergingmarket nations must adopt strong macroeconomicand structural policies that transform the country’s

economic system from the centralized, socialistic,import-substituting, foreign aid-dependent modelsof the past to the new “consensus” model of theopen-market, low-inflation, deregulated, private-sector-oriented economy of the future. Many coun-tries have moved in this direction in the past fewyears—notably several in Latin America and EasternEurope—but much remains to be done. Privatization,the elimination of government subsidies, and theremoval of restrictions on foreign investment havebeen powerful tools to jump-start the transition.Once market forces begin to take hold and shapeevents, a great deal of progress can be observed.

Progress breeds an appetite for further progress,which can take the form of increased transparencyof government economic policies and market trans-actions, and of increased toughness in dealing withfailed institutions, especially those financial institu-tions that have been used to finance and prop-upinefficient state-owned enterprises in the past. Suchdiscipline, however, can be politically expensivesince, as many countries have already experienced,they often result initially in higher unemployment.Backsliding is an expected outcome when thisoccurs, and some amount of it may be tolerated forbrief periods; but the long-term requirement for theinstitutionalization of free-market practices musthave greater priority. No doubt, much of the futureseparation of emerging market investment winnersand losers will be determined by both the extent ofthe initial free-market conversion and the tenacitywith which such changes are defended.

Building financial infrastructure. Govern-ments that want to attract international portfolioinvestment must be clear about the importance ofcreating some basic preconditions for viable capitalmarkets—an obvious point honored as much in thebreach as in practice.13 Fundamental is a functionalfinancial system that embraces a viable bankingindustry, insurance and securities industries, andpension and mutual funds. Banks in many emerging-market countries are all too often large, subsidizedbureaucratic institutions that possess few skills infinance and sometimes drive customers to transact inparallel (unofficial) markets. Many are loaded downwith nonperforming loans from state-owned enter-prises or large domestic corporate combines deemed“too big to fail.”

13. Ingo Walter, “Cross-Border Equity Flows: Tapping Into Global Markets,”ASEAN Economic Journal, October 1993.

Emerging market nations must adopt strong macroeconomic and structural policiesthat transform the country’s economic system from the centralized, socialistic,

import-substituting, foreign aid-dependent models of the past to the new“consensus” model of the open-market, low-inflation, deregulated, private-sector-

oriented economy of the future.


The worst of this debt ultimately must beseparated from the banking system and put into “badbanks,” from which future recoveries might some-day be paid. The “bad bank” in such a country,possibly a subsidiary of the central bank, can “pur-chase” impaired loans from commercial banks usinggovernment bonds. Thus recapitalized and solvent,banks can begin again to develop a viable lendingbusiness. Banks in some developing countries shouldbe encouraged to develop close relationships withviable companies to improve information flows andmonitor their progress.14

Countries also need to enact sensible securitieslaws in order to provide regulatory and enforcementauthority against market fraud and other abuses(and because many emerging market countries havedone this in recent years, ample precedents areavailable). Such rules should address the principlesof fiduciary responsibility, full disclosure, fair mar-kets, and surveillance and enforcement; and theyshould require that minimum standards for trainingand certification of fiduciaries and intermediaries bemet. This involves providing a central marketplace,a trading system that includes rules for price disclo-sure and settlements, and rules providing for thefitness and capitalization of securities firms dealingwith the public.

The role of banks in the securities industry mustalso be determined, as well as the extent to whichthe participation of qualified foreign firms is to bepermitted. Foreign securities firms can contributegreatly—often through joint ventures—to the train-ing of employees and management of local firms,and to the general professionalism and efficiency ofnational financial systems. Some developing coun-tries have also created short-term markets in govern-ment securities and commercial paper—in tandemwith banking activities—as a competitive alternativefor borrowers and depositors. Countries like Korea,the Philippines, and Colombia have had domesticcommercial paper markets in operation for 20 years ormore, while Poland has more recently created one.

Overhauling corporations. Governments mustalso attach priority to making corporations fit forpublic ownership, which requires common financialaccounting and auditing standards, a company law,and protection against exploitative concentrations of

voting power by insiders. The largest source ofshares in many countries will inevitably come fromthe privatization of state-owned enterprises intendedto end such firms’ operating inefficiencies, raiserevenue for the government, develop a publicshareholder base, and establish a growing, profit-able, market-oriented private sector. Some nations,especially in Latin America and Asia, have enjoyedgreat success with privatization programs, and haveused the strong markets of the 1990s to float as manyissues as possible. Others, such as Russia and theformer Czechoslovakia, rushed through privatizationprograms in the interest of quick reform, but on abasis that may ultimately prove to be self-defeating.None of the foregoing conditions for public owner-ship was in place, few of the enterprises wereeconomically viable in their own right (they typicallydepended on continued government subsidies orpublic procurement to continue in business), man-agement was not substantially improved, and theprocess of ownership-distribution through voucherswas rife with fraud, corruption, and racketeering. Itis difficult to see how ordinary citizens will benefitfrom such privatization efforts if left with worthlessshares while the valuable ones fall into the hands ofthe well-connected or corrupt.

Absent basic conditions for viable public owner-ship, governments should consider privatization throughthe sale of assets to corporate buyers, perhaps mostlyforeign, who can inject new capital, knowhow, andmanagement, and so contribute to the process ofrebuilding the companies. Although there may besome political reasons to restrict foreign direct invest-ment in developing economies, there are no goodeconomic ones. Few sources of economic growth aremore assured and quick-acting than direct investmentby knowledgeable foreign corporations seeking long-term market opportunities.

The role of capital controls. Governments mightconsider certain techniques that involve limiting theform of portfolio investment inflows—a recommen-dation that goes against the grain of the WashingtonConsensus. Although at the end of 1996 all emergingequity markets combined represented only about14% of global stock market capitalization, the effectof portfolio equity inflows on many countries hasoften been a glut of foreign exchange and liquidity,

14. Roy C. Smith and Ingo Walter, “Bank-Industry Linkages: Models for EasternEuropean Economic Restructuring,” in Christian de Boissieu (Ed.), The New Europe:Evolving Economic and Financial Systems in East and West (Amsterdam: Kluwer,

1993); Ingo Walter, The Battle of the Systems: Control of Enterprises in the GlobalEconomy (Kiel: Institut für Weltwirtschaft, 1993).


which can have severely adverse effects. Principalamong these is inflationary pressure—caused by asudden, substantial increase in the money supply—and appreciation of real exchange rates. Imports insome countries subjected to such inflows conse-quently increased, exports declined, and so tradebalances deteriorated and had to be financed byforeign borrowing.

Some governments, such as Chile, South Africa,and several Asian countries, have limited portfoliocapital inflows in various ways to avoid the problemof excess liquidity and to maintain a competitiveexchange rate. In Chile, such controls seek in effectto increase the cost of investment by imposingreserve requirements on loans and stamp taxes onsecurities transactions, and by widening the bandswithin which the currency can fluctuate. Of thecountries that experienced increased equity marketprices in 1994, as against emerging market trends atthe time, most maintained some restrictions oncapital inflows. Without such controls, the impact ofmassive portfolio flows is hard to counteract.

Interestingly, a 1997 report on emerging mar-kets by the World Bank suggested that massive short-term capital inflows can trigger domestic inflationand real appreciation of currencies, as well asdeclining lending and investment standards, withmassive subsequent shocks possible in the event ofa sharp reversal of investor sentiment.15 The Bank’sstrong advocacy of free-market economic policiesnotwithstanding, the analysis concludes that capital-inflow controls can be useful techniques underappropriate circumstances in fostering macroeco-nomic stability, long-term capital formation, andeconomic growth. Its recommendations are never-theless heavily qualified in order to preempt justifi-cation of a reversion to traditional, highly distortiveuses of cross-border capital controls.

As noted earlier, it may also be worth consider-ing whether foreign portfolio equity investments viamutual funds should be tapped using closed-endrather than open-end funds. In closed-end funds,the shock of investor-demand shifts is taken bysecondary-market prices of the funds in the devel-oped-country stock markets rather than by massive,destabilizing, cross-border financial flows.

WHERE NEXT?

Perhaps few emerging market countries havethe economic capacity or the political will to adoptfar-reaching free-market policies all at once. Whodoes? Gradual but steady approaches do work,however, perhaps best of all. At no point in theirdevelopment did now-established, but once-devel-oping countries like Japan, Germany, South Korea,Taiwan, Singapore, Spain, and Chile adopt a totallyfree-market approach. They moved purposefullyover decades in that direction, but only at a pacethat could be accommodated by the accompanyingpolitical thinking and infrastructure-building. Othercountries that have tried hard to accept the newpolicies—nations such as Mexico, Argentina, Bra-zil, and, to a lesser extent, India—have had consid-erable success despite some disappointments. Theyneed more time for their efforts to bear the fruit thattheir more successful peers have enjoyed. And,thus far, there appear to be few signs in any ofthese countries of a reversion to the pre-Washing-ton Consensus era.

The most powerful part of the new paradigm,however, is that countries must know that it alldepends on them. The most reliable barometer oftheir efforts, as flawed as financial markets may befrom time to time, is in the capital they are able toattract.

15. Amar Bhattacharya et al., Private Capital Flows to Developing Countries(Washington, D.C.: World Bank, 1997).

ROY SMITH

is Professor of Finance and International Business at the NewYork University Stern School of Business.

INGO WALTER

is Charles Simon Professor of Applied Financial Economics at theNew York University Stern School of Business.

Governments might consider certain techniques that involve limiting the form ofportfolio investment inflows—a recommendation that goes against the grain of theWashington Consensus. Of the countries that experienced increased equity market

prices in 1994, most maintained some restrictions on capital inflows.

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