STATEMENT ON THE





The topic of “Globalization of Capital Markets” is an exciting and challenging one:
Economists are still debating the relative merits of “the good side” and “the dark side” of
going global, but the truth is that most countries do not really have much choice in the
matter. International forces are at play and countries will either be included or excluded.
Most developing countries, in need of capital to fund growth, are taking steps to facilitate
capital flows, for they realize that, if they don’t, the scarce funds will go elsewhere.

An economy is financially open when its residents are able to trade financial assets with
residents of another country. However, the degree of financial openness is neither easy to
define nor measure. That is unfortunate since the nature of the relationship between
domestic and world financial markets (i.e. the degree of capital mobility) is one of the
key characteristics of any economy, serving as a fundamental determinant of many of its
most basic macroeconomic properties.

Traditionally, it was domestic savings that supplied the economy with investments to
ensure growth and employment. While domestic savings are clearly an alternative
solution to the call for foreign capital, such savings have tended to decrease in recent
years and is insufficient to meet overall capital needs.

The purpose of this presentation is to discuss some of the forces at play and some of the
policy steps that developing countries can take to facilitate capital inflows. The emerging
importance of the stock market to longer-term development is also considered.

Turnaround: A brief look backwards

A debt crises occurred from 1982 to 1989. Immediately prior to this, from 1973 to 1981,
there were massive capital flows to many developing countries. But in recent years
several developing countries around the world have again begun to receive substantial
flows of foreign capital.

The turnaround in the external financial position of many debtor countries since 1989 has
been nothing less than phenomenal improvement is particularly impressive in countries
that had Brady Plan restructuring of their external debt, including Argentina, Costa Rica,
Mexico, Nigeria, the Philippines, Uruguay, and Venezuela.

In the first quarter of 1989, the external debt of these countries sold for an average price
of only fourty cents on the dollar. Private capital inflows were largely restricted to
concerted lending and interest arrears. Today, the recovery in real economic activity and
capital formulation in debtor countries is just beginning, but a financial recovery is well
under way. In general, these countries have experienced very large private capital
inflows, real exchange rate appreciation, stock market booms, and dramatic increases in
the prices of their external debt.

During the nineties, over fifty developing countries have created capital markets. During
this period, three billion people have freed themselves from Marxist or government-
controlled economies. These countries need capital to get their new market economies to
take off.

To better understand this turnaround, it is necessary to identify the main factors that can
account for the remarkable improvements in debtor countries’ creditworthiness.

Changes in international interest rates and real domestic interest rates in debtor countries,
some argue, can account for all of the improvement in secondary market prices (which
serve as a useful measure of market prices). Further, rising secondary market prices
(falling yields) suggest that residents of the debtor country can issue new debt or equity
on better terms than those on past debt.

Five factors help to explain secondary market prices for developing country debt:

       a.   Debt reduction;
       b.   Economic policy reform;
       c.   International interest rates;
       d.   Domestic interest rates; and
       e.   Exchange rates.

Debt reduction. A rise in domestic debt service payments should, for a given overall
capacity to pay, reduce expected payments on external debt and, in turn, lower secondary
market prices for external debt. The reverse should also hold true.

Economic policy reform. Admittedly, it is difficult to quantify the effects of economic
reform on market evaluations of external debt but, intuitively, it appears that policies
changed for the better in Brady Plan countries. Aggressive fiscal reform and adoption of
market-oriented reform programs also helped.

International interest rates. Another potential source of improvement in debtor
countries’ positions has been the change in the external environment, the dominant
change alter 1989 being a fall in nominal and real interest rates in the United States and
in other major industrial countries.

Domestic interest rates. Recent empirical research has documented a strong link
between international interest rates and domestic rates in developing countries. Most
internal debt is rolled over several times a year in debtor countries, and so real debt
service payments are very sensitive to changes in domestic real interest rates.

Exchange rates. Government revenue in domestic currency can cover greater debt
service payments if the foreign currency value of revenues rises, as happens when the
local currency appreciates.

From the above it would follow that, if there were to be a reversal of US interest rates,
real trouble could be created for debtor countries, particularly if it spreads to domestic
markets. Further, a fall in secondary markets would signal a halt of capital inflows, rapid
decisions in international reserves, and exchange rate depreciation.

What has changed: Characteristics of new capital inflows

The recent inflows are notable because of their magnitude and because they represent a
break from the period of debt crises for many of the recipient countries. The surge of
inflows has been widespread, and especially strong in East Asia and Latin America. The
composition of assets acquired by external creditors stands in stark contrast to what took
place during the period of debt accumulation before 1982. Four characteristics are

              a. There has been a shift away from debt instruments in favour of equity
                 instruments, both direct and portfolio.
              b. Within debt inflows, syndicated bank loans are relatively unimportant.
              c. Portfolio flows have increased tremendously in importance.
              d. Recent capital inflows have been directed overwhelmingly to the private
              e. Sector of recipient countries whereas, beforehand, they were largely in
                 the form of private syndicated bank loans directed to the public sector.

Policy implication?

Some have suggested that this surge in capital inflows presents a policy problem for the
recipient countries. The problem being will decentralized borrowing by the private sector
produce the desirable outcomes that would be generated by a central planner? The
concern is that inflows may threaten macroeconomic stability in part from a fear that the
flows may be transitory. Inflows that cannot be sustained can potentially destabilize the
domestic economy when they arrive and when they part.

Is the alternative to the current level of inflows a continuation of inflows at a reduced rate
(soft landing), a cessation of inflows (hard landing), or pressure for the reversal of
capital flows and a balance of payments crises (crash)?

Although this surge constitutes a welcome relief from the earlier constraints of credit
rationing, it may also pose structural and macroeconomic policy challenges. Policy
alternatives to reduce the rate of inflows include imposition of controls or taxes on capital
imports, remove restrictions on capital outflows to reduce net inflows, trade
liberalization, intended to switch spending from domestic to foreign goods and thus
increase the trade deficit, increase exchange rate flexibility.

Linkages between stock markets and economic development

World stock markets are booming, and emerging markets comprise a disproportionately
large amount of this boom. Furthermore, emerging markets have become more

integrated with world capital markets. For example, portfolio flows of equity
investments to emerging markets soared to $39 billion in 1995 from a mere $0.1 billion
in 1985.

On the policy front, many countries have reformed their laws and regulations and
removed capital controls and other barriers to attract foreign portfolio flows.

It is important to note that the financial structure of economies varies with their income.
That is, moving from poorer to richer economies, commercial banks and non bank
financial institutions grow in importance, while the role of the central bank diminishes.
Richer countries tend to have larger overall financial systems and stock markets as
percentages of GDP than poorer countries. At low levels of development, commercial
banks are the dominant financial institutions but, as economies grow, specialized
financial intermediaries and equity markets develop and prosper.

Although stock market development is a common feature of financial and economic
development, some still view stock markets as “casinos” that have very little positive
(and potentially a large negative) impact on economic growth.

One of the main features and advantages of stock markets is that they create
liquidity for investors. Many profitable investments require a long-term commitment of
capital. However, investors are often reluctant to give up control of their savings for long
periods of time. Liquid equity markets make investment less risky and more attractive
because they allow savers to acquire an asset (in this case equity) and to sell it quickly
and cheaply if they need their funds or wish to alter their portfolios. At the same time,
companies enjoy permanent access to capital raised through equity issues. By
facilitating longer-term, more profitable investments, liquid markets improve the
allocation of capital and enhance prospects for long-term economic growth.

By constructing aggregate indexes of overall stock market development that combine
information on stock market size, liquidity, and international integration, economists
have examined the empirical relationship between measures of stock market development
and long-run economic growth. They have found that the strong correlation between the
two is important. At early stages of market development, improvement in stock market
functioning tends to improve information quality, monitoring, and corporate control, such
that these improvements induce creditors to lend more.

The available information suggest that policy makers should remove barriers and
impediments to stock markets, such as tax, legal and regulatory barriers. Investors will
come if they can leave.

Attracting new capital inflows

Governments compete for capital. They do this through variations in their interest rates
or their rates of exchange and through the competitiveness of their markets. The world
has become more capitalistic and the ever-increasing financial movements can reward

savings and productivity and thus strengthen a country’s economy (the good side).
Conversely, foreign capital can also abandon an economy or withdraw abruptly if an
unfavourable fiscal policy drives it away (the dark side).

Investors prefer to steer their capital to countries where the climate is more favourable to
them. Capital has become much more mobile and more difficult to stabilize and control.

In the face of increased demand for capital, largely from the new developing countries
and eocnomies in transition, the competition has increased dramatically. For example,
Argentina, having abandoned its government-controlled policy, has opened its economy
to capital imports and has privatised its national companies. By doing so, it has brought
about an economic expansion, following the investment of $10 billion raised on the
international capital market.

Moreover, the increasing budget deficits of the United States, Europe, Japan and others
has triggered an additional demand for capital. All these countries have feverishly
engaged in establishing a complete capital market infrastructure. Those that do so will
have the benefit of direct and preferential access to international investors.

Where does the capital come from?

Private capital for the purchase of bonds and shares comes mainly from mutual funds,
pension funds or insurance funds. Because of a worldwide network of computerized
communications, these funds circulate freely in search of the maximum profit.

In terms of order of magnitude, it has been estimated that the assets of institutional
investors in the Untied States amounts to about $8 million dollars and in Europe about $6
trillion. As of 1995, these funds have invested about 1 per cent of their assets in the
emerging markets. Projections indicate that investments in these markets will increase to
5 to 10 percent of the total assets in the next 10 years.

The free circulation of capital outside government control has led to the transfer of the
concept of power, traditionally invested in Governments, to private holders of capital
Governments have thus seen their ability to control their budgets and their capital
reduced. As has been stated in a 1995 United Nations Paper on this subject, “…the
emergence of private capital as a leading actor on the international scene marks a great
turning point in the evolution of world financial management”. Further, “According to
some financial circles, it would seem that the world capital markets have become the
International Monetary Fund of the nineties.”

So what does all this mean?

The good side. There are many beneficial effects resulting from the globalization of
capital. To attract the necessary capital, national economies have to become and remain
open to foreign investment and have to adopt responsible fiscal and monetary policies.

For example, since Brazil opened the BOVESPA stock exchange to foreign investors, the
volume of transactions has increased tenfold.

An increased availability of external financing during adjustment and reform can
facilitate growth by financing higher investment, helping to avoid sharp declines in
domestic absorption or imports, and improving confidence by bolstering reserves or
resolving arrears problems.

The majority of developing countries have made economic stability one of their highest
priorities. They have also reduced economic constraints, such as lowering of customs
barriers to help introduce competitiveness to previously protected markets.

It is believed that, if governments reduce taxes on capital movements, create offshore
markets and establish a stable and convertible currency, private capital will flow in.

The dark side. Market forces may also have adverse consequences. Those with capital
may turn away from countries experiencing serious budget deficits or those not taking
economic and financial reforms seriously. A consequence is that the gap between rich
and poor may therefore widen. There is also a concern that if economic growth is too
rapid that renewed high inflation will result.

It should also be recognized that liberalizing the foreign exchange market to attract
foreign capital also enables local people to move their money out to other markets. In the
Philippines what was an insignificant outflow of $115 million in 1992 rose to $3.6 billion
in 1996.


The Economist stated in its June 21, 1997 issue that:

       The debate about globalization is largely a dialogue of the deaf. On the one side,
       Ivory-tower economists tout the benefits of increased trade and cross-border
       investment, while ignoring (or at least downplaying) the costs. On the other,
       the critics of freer trade and open capital markets refuse to acknowledge the
        gains from closer integration, often displaying at best an elementary grasp of

While the debate continues, globalization of capital markets continues to grow at a fast
pace, thanks in part to technological advancements. In light of the spreading of
globalization, developing countries should reconsider their policy options and work
towards liberalization of their regulatory framework in order to encourage foreign and
domestic capital investment to finance long-term development and sustainable growth.
They should also keep in mind that, indeed, there may be a “dark side” that will require
continuous monitoring.


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