Overview _ Capital Outflows to EMs

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Overview _ Capital Outflows to EMs Powered By Docstoc
 Lecture 1: Flow of International
         Capital to EMs
          Dr. Edilberto Segura
    Partner & Chief Economist, SigmaBleyzer
  President of the Board, The Bleyzer Foundation
                   January 2010
I.   Sources of Growth and Capital in EMs
II.  International Capital Flows to Emerging Markets
III. Determinants of Foreign Direct Investments
IV.  Reforms to Deal with Potential Reversals of and
     Problems with Short-Term Capital Flows
V. Market Correlation and Rationale for
     Diversification in Emerging Markets
VI. Emerging Stock Markets
VII. Emerging Markets Web Sites
 I. Sources of Growth and Capital in
• This course is about ―Emerging Capital Markets‖.
• What is the importance of Capital -- and Investments -- in EMs?
• In particular, we are interested on the role of investments on
• Investment has two effects, one is short-term, on the aggregate
  demand side (businesses expend more, the focus of Keynesians),
  and another in the aggregate supply side (more investment
  increases capital stock and thereby, in the next periods,
  businesses produce more).
• Economic growth models (Harrod-Domar, Solow, Endogenous
  models) have tried to find out the sources of economic growth
  over long periods of time: what factors explain the economic
  growth of countries.
              a. Harrod-Domar Model -- 1939-46
Y = f (K)            Aggregate Supply (Production, Y) is a function of capital ―K‖
                     Labor is abundant and the labor/capital proportions are fixed
I = S = sY           Investments ―I‖ equal Savings ―S‖ (―s‖= savings rate)
dY/dK = Y/K = c Marginal/average productivity of capital is constant at ―c‖
dY = c . dK          Accelerator principle and no diminishing returns to capital
dK = I – ∂ K         where ∂ is depreciation rate
dY = c . dK = c (I - ∂ K) = c (sY - ∂ K) = csY – c ∂ K = csY - ∂ Y
dY = Y (c.s - ∂ )
GDP growth: dY/Y = c . s – ∂ -- where c --Y/K-- and ∂ are constant.
↣ The rate of growth of GDP will depend only on the savings rate (i.e.,
   capital accumulation). (eg.: dY/Y= c.s - ∂ = 0.3 x 0.3 – 0.05 = 0.04).
• With stable savings rate, GDP growth will be constant and indefinite.
• To increase growth, an economy should save (and invest) more.
• But in this model, an economy will not easily find full employment;
   and to maintain for full employment, the savings rate ―s‖ must be
   exactly equal to the product of the capital output ratio (K/Y) times the
   growth of effective labor (dL/L= dY/Y+δ) -- a very unlikely event.
      b. The Solow Exogenous Growth Model -- 1956
• Solow was bothered with (a) the neglect of employment in the H-D model;
  and (b) the lack of a stable growth path implied in this model:
   – Because capital and labor are used in equal proportions and their
      relative prices are fixed, the model can not generate full employment.
   – The model‘s accelerator principle implies that if investments were to
      result in output larger than actual demand, this will result in much
      lower investments in the following period, thus magnifying economic
      fluctuations. The model implies substantial economic instability.
• In an extension of the Harrod-Domar model, Solow introduced explicitly
  Labor (L) and Technological change (E) to address these problems.
• The growth factor ―E‖ is also called ―Factor Productivity Growth"
• Solow assumed diminishing returns on Capital (keeping Labor constant).
• With diminishing returns on Capital, over the long run the contribution of
  Capital (per unit of labor) to income percapita diminishes over time and
  tends asymptotically to zero.
• Intuitively, therefore, we see that over the very long term, capital and
  savings do not contribute to a continuous growth in income percapita.
• Further growth in total income will need to come from increases in Labor
  or increases in Technological Change.
• Furthermore, even before this plateau is reached, the economy will reach a
  stable steady state (constant) level of capital percapita k* (as depreciation
  increases offset increases in capital).
• This steady state level of capital leads to a stable, steady state growth of
  income percapita ( y*) at k*.
• When this point is reached, the overall rate of total income growth will
  depend only to the growth of the labor force or growth in output per worker
  (due to technological change).
The Solow Model without Technological Progress
• Five equations define the model: (1) a production function; (2) an
   Aggregate Demand function; (3) a Consumption Function; (4) a Capital
   Accumulation function; and (5) Population growth ―n‖.
1. Production Function: Initially, let‘s assume that output is only a function
   of capital and labor (ignoring technological change):
    Y = F (K, L)      ↣      Y/L = F (K/L, 1)       ↣       y = f (k)
    – Where ― y‖ is income percapita and ―k‖ is capital per capita (per unit
      of labor).
    – Labor (population) grows at a rate ―n‖.
    – The production function has diminishing marginal product of capital
      (mpc), i.e., capital has diminishing returns.
2. Aggregate Demand Percapita Function: y = c + i (Closed economy)
3. Consumption Function: c = (1 - s)y
   Combining 2 & 3: y = (1 - s)y + i ↣ i = sy ↣ i = sf(k)
4. Capital Accumulation Function: ∆k = i – D = i - (∂ + n) k
   Capital percapita (k) increases with Investment percapita (i), and decreases
   with disinvestment percapita (D) coming from depreciation (∂) and
   population growth (n).
    Inserting 3 into 4: ∆k = sf(k) - (∂ + n) k ;
    when: sf(k) = (∂ + n) k ↣ then: ∆k = 0;

When ∆k = 0, k becomes constant at k*: k* / f (k*) = s / (∂ + n)
Where k is constant at k* - called the steady state level of capital percapita.
At k*, income percapita will also be at steady state y* (∆capital are not
    contributing to income percapita growth; ―total‖ income will growth
    only with increases in labor (―n‖ or population growth.)
Note that the higher the ―s‖, the higher the y* : the savings rate is important
    to establish the steady state level of income percapita, but not to
    sustain growth after this level is reached.
• There is a single capital percapita stock k* at which the amount of
   investment equals the amount of percapita dis-investment.
• When the economy ever finds itself at this level of the capital stock,
   the capital stock will not change because the two forces acting on it -
   investment and dis-investments- are just balanced.
• That is, at k*, ∆k = 0, both the percapita capital stock and income
   percapita are steady over time (rather than growing or shrinking).
• Furthermore, the economy will always move towards this level.
• Using these few simplifying assumptions about the growth of the
   inputs, this model demonstrates the existence of a stable growth path
   for ‗total‖ output equal only to the growth of the labor force.
Introducing Technological Progress in the Solow Model:
• This prediction of a steady state constant income percapita is at odds
   with the historical record, which shows sustained increases in per
   capita income over very long periods.
• To explain the growth of per capita income, Solow introduced the
   idea of technological progress.
• Technological progress can be embodied in the production factors
  (total factor productivity: Y = Akα L (1-α)) or it could be embodied
  in the labor input (labor augmenting technological progress).
• In this case the production function becomes: Y = Kα . (E . L) (1-α)
  where E is a variable called the efficiency of labor.
– The efficiency of labor reflects society‘s knowledge about
  production methods: as the available technology improves, the
  efficiency of labor rises.
– The efficiency of labor also rises with improvements in the
  education, skills or health of the labor force.
– The term (L × E) measures the number of effective workers.
• With E growing at a rate ―g‖, then when ∆k = 0 we obtain:
      i = s f(k) = (∂ + n + g) k
• At steady state, capital per effective worker and output per
  effective worker are constant (with zero growth rates), output per
  worker is growing at the rate ―g‖, and ―total‖ output is growing at a
  rate of (n + g).
• Without technological change, after steady state is reached, the
  growth of total income is limited to the growth of the labor force,
  meaning that percapita income (a crude measure of the standard
  of living) is constant through time.
• Technological change allows both total income and percapita
  income to growth.
• The model's assumption about decreasing returns on capital
  implies that per capita income does not grow without
  technological progress.
• Therefore, technological change becomes the most important
  factor explaining sustainable long-term growth in income
  percapita,much more important than the accumulation of capital.
• The savings and investment rate only explains the level at which
  this income percapita plateau will be reached.
• In other words, in the short term, the savings rate leads to capital
  accumulation and growth, but since capital has diminishing
  returns, over the long term the contribution of capital to growth
• Under this model countries can overcome a steady state
  stagnation of income percapita growth and continue growing only
  by inventing or copying new technology.
• The process by which countries continue growing despite
  diminishing returns is "exogenous" and is not determined within
  the model.
Empirical Evidence
• In the US, Total Factor Productivity (TFP) from technological
  change explains 20% - 40% of GDP growth (if GDP grew by 3%
  pa, 2% pa is due to increases in I & L and 1% due to TFP).
• In Europe, TFP growth lags US numbers by about 20%.
• In transition and developing countries, TFP depends on the
  adequacy of business environments: if they are favorable (such as
  in Chile, China) TFP can be as high as 50% of total GDP growth;
  but with inadequate business environments, TFP is negligible (all
  growth would come just from additional investments or labor.)
• A study by Bosworth and Collins in 2003 showed that for 84
  countries from 1960 to 2000, TFP accounted for a 41% share of
  GDP growth.
• The Solow model makes another important prediction: Developing
  countries with less capital per person will grow faster because each
  investment in capital will produce a higher return than in rich
  countries with ample capital.
• That is, the income levels of developing countries will tend to
  catch up with or converge towards the income levels of rich
  countries. One problem with the prediction of convergence is that
  it requires that countries be identical in every respect except their
  level of per capita output.
            c. Endogenous Growth Models -- 1980s
• A major limitation of the Solow model is its reliance on ―exogenous‖
  technological change to supply sustainable growth in percapita output.
• Instead of explaining the sources of technological change, the model
  assumes it will occur independent of factors considered by the model.
• Another limitation is the model‘s emphasis on technology alone,
  disregarding the empirical evidence that savings and investments are
  also closely related to percapita income growth over the long run.
• Thus, the neoclassical model provides only a limited framework for
  analyzing the effects of government policies on long-term growth.
• To address the shortcomings of the Solow model, Paul Romer initiated
  the development of new models that generate growth of per capita
  output endogenously--that is, without assuming that technological
  change occurs outside of the model's framework.
• Hence, they are known as endogenous growth models.
• Although these endogenous models share the same basic idea, they
  rely on different mechanisms to drive long-run growth.
• Some models explain the channels that lead to technological change, and
  others emphasize investments in human capital to sustain growth.
Externalities as a Channel for Technological Changes
• Paul Romer proposed the idea that externalities/spillovers in R&D permit
  the accumulation of knowledge beyond the firm, thus sustaining growth
  (a spillover is an action taken by one firm that affects another firm.)
• He showed that spillovers are strong enough to outweigh the drag caused
  by decreasing returns to capital and sustain growth in per capita output.
• Later, Romer explained why companies invest in R&D even when it will
  eventually benefit competitors: he found that as long as there is not any
  type of limit in technology, continuous innovation can allow percapita
  output to grow forever.
• One important advantage of Romer's model is that it does not supplant the
  neoclassical model but fills an important gap in the neoclassical theory by
  providing a rigorous description of the source of technological progress.
• Romer pointed out that if innovation in his model was to stop, then his
  model would collapse to the neoclassical model.
• Romer started from the observation that technological progress takes
  place through innovations, in the form of new products, processes and
  markets, many of which are the result of economic activities, in
  particular Research and Development (R&D).
• Because firms learn from experience how to produce more efficiently, a
  higher pace of economic activity can raise the pace of process-
  innovation by giving all firms more production experience.
• Furthermore, R&D activities are enhanced if it is rewarded by some
  form of ex-post monopoly powers (patent protection with exclusivity
  rights and with good intellectual property rights) but with sufficient
  flexibility to permit externalities.
• Because of all these factors, in these models capital do not show
  diminishing returns, contributing indefinitely to growth in income
• Innovation as the motor for economic change was first described in the
  writings of Joseph Schumpeter (the entrepreneur and big companies --
  through ―creative destruction‖ -- replaces old technologies with new
  and better technologies).
Human Capital
• Other models expand the idea of endogenous growth, using different
  variables and functions; but retaining the same fundamental characteristic:
  they reverse the effects of decreasing returns to capital.
• Several models focus on the importance of accumulating human capital--
  gaining increased skills through formal education or on-the-job training.
• One such model (by Rebelo,1991) is based on a variant of the H-D model,
  using a simple production function for the economy:
                 Y = AK
• where Y is output, K is the capital stock, and A is a constant measuring
  the amount of output produced per unit of capital.
• The key is that this production function does not exhibit the property of
  diminishing returns to capital. One extra unit of capital produces A extra
  units of output, regardless of how much capital there is.
• This absence of diminishing returns to capital is the key difference
  between this endogenous growth model and the Solow model.
• The capital accumulation function is similar to the H-D model:
                  ∆K = sY - ∂ K
• This equation states that the change in the capital stock (∆K) equals
  investment (sY ) minus depreciation (∂ K).
• Dividing this equation by K, we obtain: ∆K/K = sY/K - ∂
• Since Y/K = A, we obtain:
               ∆K/K = ∆Y/Y = sA - ∂
• This equation shows that, as long as sA > ∂, the economy‘s income
  grows forever, even without the assumption of exogenous
  technological progress.
• Furthermore, the permanent growth rate depends on savings (and
  investments) as in the H-D model. In Solow model, it does not.
• Thus, a simple change in the production function alters dramatically
  the predictions about economic growth and the role of savings and
• In the Solow model, saving leads to growth temporarily, but
  diminishing returns to capital eventually force the economy to
  approach a steady state in which growth depends only on exogenous
  technological progress.
• By contrast, in this endogenous growth model, saving and
  investment are important for persistent percapita growth.
• But the key question is whether it is reasonable to abandon the
  assumption of diminishing returns to capital in this model?
• Advocates of this endogenous growth model argue that the assumption
  of constant (rather than diminishing) returns to capital is plausible if K
  is interpreted more broadly to include Human Capital (Lucas) and
  Knowledge (Arrow, Romer).
• Clearly, knowledge is an important input into the economy‘s
  production—both its production of goods and services and its
  production of new knowledge.
• Compared to other forms of capital, however, it is less natural to
  assume that knowledge exhibits the property of diminishing
  returns. (Indeed, the increasing pace of scientific and technological
  innovation over the past few centuries has led some economists to
  argue that there are increasing returns to knowledge.)
• If we accept the view that knowledge is a type of capital, then this
  endogenous growth model with its assumption of constant returns to
  capital becomes a more plausible description of long-run economic
• In most respects, these models have similar conclusions to Solow‘s
  model. But they go further in explaining the need to foster education
  and knowledge, which leads to innovations and technological change.
• Although the Y = AK model is the simplest example of endogenous
  growth, the theory has gone well beyond this.
• One line of research has tried to develop models with more than one
  sector of production in order to offer a better description of the forces
  that govern technological progress (e.g., with one sector being R&D or
  Human Resources, H => Y = Kα Lβ H γ , with α+β+γ=1.)
• Other endogenous models focus on international trade--in particular,
  on how comparative advantage influences trade and growth.
• In any case, empirical studies by Robert Barro, Sala-i-Martin, et-al
  indeed show that long term economic growth in a group of 100
  countries was explained by a number of measures of the quality of
  human capital (such as university school enrollment, health indicators,
  life expectancy), measures of investment (such as investment ratios),
  as well as measures of the business environment (such as rule of law,
  small government, favorable terms of trade).
Policy Implications
• One question these models are designed to address is whether, from
  the standpoint of society as a whole, private profit-maximizing firms
  tend to engage in too little R&D and Human Resource development.
• The empirical work in this area suggests that externalities are large in
  R&D and education, and as a result, the social returns are larger.
• This finding justifies government support to R&D and education to
  policies to influence the rate of innovation by affecting the private
  costs and benefits of doing R&D and undertaking education.
• These policies include: lowering barriers to trade, improving
  competition, reducing taxes on capital income, protecting intellectual
  property, and promoting investments and even subsidies for education.
• Furthermore, these newer models and studies also show the
  importance of promoting Foreign Direct Investments (FDIs), since
  worldwide experience has shown that FDIs provide not only capital,
  but new technologies and knowledge. SigmaBleyzer studies have
  shown that FDI‘s are highly influenced by the adequacy of the
  country‘s business environment.
               II. Capital Flows to EMs
• In an integrated global ―perfect‖ capital market, the real return on
  capital should be equal worldwide.
• Countries with low per-capita capital stock should have higher
  economic returns and attract capital flows.
• Indeed, rates of return seems to be higher in developing countries.
• So, why capital flows from rich to poor countries is so limited?
  And why most capital goes to a handful of EMs?
• Capital Markets are not perfect: Traditional reasons:
   – asymmetric information.
   – agency problems.
   – lack of complementary factors (infrastructure, human capital).
   – inability of foreign investors to capture externalities.
• In emerging markets, new studies show that the key main reason is
  country risk, arising from macro-economic instability, unfriendly
  business environment, and governance problems.
   Capital Flows and Market Segmentation:
Sources of capital to EMs are segmented in various ways:
  Official Capital:
  – Multilateral: Mostly policy-related. Financing provided by the IFIs
    (International Financial Institutions) such as the World Bank, IMF,
    European Bank, Asian Development Bank.
  – Bilateral: Mostly political. Government-to-Government.
  – NGOs: Relief operations, environment.
  Within Private Capital:
  – Direct Foreign Investments (FDI): Equity, reinvested earnings and
    other capital associated with inter-company transactions between
    affiliated companies (over 10% ownership and management influence).
  – Portfolio Investments: Financial securities of any maturity (equity,
    bonds, notes, CDs, derivatives) other than FDI.
  – Bank Loans: Bank loans, trade credit and deposits by EM countries
• Destinations of capital flows are also segmented:
  – Five EMs received the bulk of direct foreign investments: 65% of FDIs
    goes to 5 countries: China, Brazil, Mexico, Chile and Poland.
  – Other EMs received the bulk of Portfolio and Bank flows, with large
    share/bond offerings, often related to privatization.
  – The less developed countries, mostly South Asia and Africa, are
    dependent on official aid, which have been declining.
• The large increases in private capital flows to EMs since 1998 are
  due principally to improvements in the risk/return characteristics of
  assets issued by EMs as a result of better Business Environments
  (East Asia and Emerging Europe):
   - Many EMs have undertaken substantial changes in policy
     regimes, improving macroeconomic management and
     implementing business liberalization policies.
   - Inflation and fiscal deficits have both been reduced, and the rate
     of economic growth has increased.
   - Export composition has become more diversified in many
   - Removal of restrictions on foreign ownership which had impeded
     inflows of foreign direct investment.
   - Broader capital account liberalization has been undertaken in a
     number of countries.
• ―Push‖ factors have also been important -- with falling U.S./Japan
  interest rates playing important roles in driving capital flows to
  developing countries.
         Trends in Net Capital Flows to EMs (US$bn) 1/
                    84-9 94-6 1997 1999 2001 2003 2005 2007 2008 2009
Total Private          12 156 192 75 76 163 248 696 129 -52
- Foreign Direct Inv   13 98 146 177 187 166 262 411 425 279
- Portfolio Flows       6 65 60 62 -79 -13 -20       88 -85 -100
- Bank Loans/Dep       -5  -7 -15 -162 -33   9    7 197 -210 -232
Official Assistance    24 15 28 22       0 -50 -110 -69 -106 50

Fuel Exporters         19   -13   -27    -27    -12    12     -7   118 -223      -88
1/ Include Developing and Transition countries, Israel, Korea, Singapore and Taiwan.
   The figures for 2008 are estimates and for 2009 are forecasts.
2/ Despite the current international crisis, in 2009 FDIs are expected to remain
   positive, whereas Portfolio flows and Bank Loans are expected to drop dramatically.
SOURCE: IMF, World Economic Outlook, October 2009.
       Foreign Direct Investments by Region (US$bn)

                84-9 94-6 1997 1999 2001 2003 2005 2007 2008 2009

Total FDIs          13   98 146 177 187 166 262 411 425 279

Latin Am & Carib    4    29   58   67   69   38 52 87 90      71
Emerging Asia       7    51   56   71   54   70 105 153 140   93
Middle East         1     4    8    4   12   18 17 35 34      40
Centr/East Europe   1     4    8   22   24   17 52 77 69      32
CIS                 0     3    6    5    5    5 12 28 49      16
Africa              1     2    8    9   23   18 24 31 41      26
         Gross EM External Financing, by Securities
                       1999 2000 2001 2002 2003 2004 2005        2006 2007 2008
Total Issuance ($Bn) 164 216 162 157 215 325 462                  572 741 453
Issuance by Instrument
       Bonds             82 80 89 58 89 128 179                   163 184 106
       Equities          23 42 11 17 28 49 93                     157 229 54
       Synd. Loans       58 94 62 82 98 148 190                   252 327 293

Issuance by Region
       Asia                56     85     67     76 100 152 195 243      315 185
      LAC                  61     69     54     32 47 56 86 76          133 61
      Europe               38     51     43     29 45 70 104 134        165 126
      ME & AFRICA           8     10      8     20 23 46 75 119         127 81
Note: In 2008, major issuers included Russia ($61bn), China ($44bn), Brazil ($31bn),
      India ($37bn), Korea ($34bn), Taiwan ($18bn).
      In 2008, Ukraine issued $4.8bn ($0.9bn as bonds, $0.9bn as equity and $
      as loan syndications)
Source: IMF, World Economic Outlook, October 2008/2009
UKRAINE- Gross External Debt, $ Billion
  Domestic Gvt Debt - Selected Emerging Countries
               Domestic Gvt Debt/          Domestic Gvt/
                    GDP                   Total Gvt Debt
             ------------------------- --------------------------
             1990 1995 2004 1990 1995 2004
Argentina     32.2       9.0      51.2   0.48      0.26 0.45
Brazil        40.8      32.5      50.8   0.64      0.69 0.69
Chile         56.7      36.2      26.8   0.57      0.77 0.74
China           4.2      5.1      20.0   0.27      0.30 0.82
Colombia        3.4     12.7      32.3   0.13      0.38 0.51
Czech Rep     12.1       9.8      16.9   0.41      0.35 0.63
Egypt         61.4      45.8      72.8   0.51      0.44 0.76
Hungary       69.3      80.4      44.2   0.55      0.60 0.67
India         49.8      46.7      61.9   0.68      0.65 0.83
Indonesia       2.9      4.5      34.3   0.06      0.11 0.50
Malaysia      58.8      35.1      44.2   0.69      0.58 0.84
Mexico        22.7 15.6 32.5 0.40                   0.26 0.74
Morocco       27.0 33.2 50.5 0.32                   0.32 0.64
Pakistan      38.5 37.1 40.7 0.48                   0.48 0.50
    Domestic Gvt Debt- Selected Emerging Countries (Cont)
               Domestic Gvt Debt/             Domestic Gvt/
                       GDP                     Total Gvt Debt
                -------------------------   -------------------------
                1990 1995 2004              1990 1995           2004
Peru            12.3       2.4      12.4     0.19 0.07           0.26
Philippines     28.1      37.7      41.2     0.30 0.48           0.49
Poland          27.4      20.1      36.2     0.32 0.40           0.76
Russia Fed.     10.2      14.1       6.9     0.11 0.28           0.29
Slovak Rep.     18.4      19.7      36.7     0.46 0.49           0.74
Thailand        12.7        2.0     26.8     0.46 0.16           0.74
Tunisia         14.9      19.1      21.9     0.22 0.26           0.30
Turkey          14.6      17.5      52.9     0.33 0.31           0.71
Ukraine             0         0      6.0         0        0      0.25
Uruguay         24.6      17.2      29.5     0.50 0.44           0.28
Venezuela       12.1      14.0      17.2     0.18 0.19           0.40

Average EMs      26.3     22.9     34.8     0.37     0.38      0.58

Source: World Bank
   III. Determinants of Foreign Direct
       Investments -- Study for Ukraine
Major Deterrents for FDI. A survey of 65 large foreign
 firms ranked the major deterrents to FDI in Ukraine in
 the following order, descending in significance:
   •   Excessive Government‘s regulations
   •   Ambiguity of the legal system
   •   Uncertainty of the economic environment
   •   Corruption
   •   High Tax burden
   •   Problems establishing clear ownership conditions
   •   Difficulty negotiating with Government authorities
   •   Volatility of the political environment
   •   Lack of physical infrastructure
• Starting from this basis, SigmaBleyzer studies concluded that
  macroeconomic stability was a precondition for FDIs and
  identified nine key ―policy actions‖ or ―drivers‖ that ―induce‖
  foreign investments ( :
   1. Secure domestic and foreign Macroeconomic stability
   2. Liberalize and Deregulate Business Activities
   3. Provide a Stable and Predictable Legal Environment
   4. Reform Public Administration, including Taxation
   5. Remove International Capital & Foreign Trade Restrictions
   6. Facilitate Financing of Businesses by the Financial Sector
   7. Prevent and Deal with Corruption
   8. Minimize Political Uncertainties and Risks
   9. Improve the Country‘s International Image
   But, how important are these drivers??
   SB’s Cross-Section Statistical Analysis of FDIs

• The objective of the statistical analysis was to determine
  the relative importance of the nine investment ―drivers‖,
  by quantifying the ‗relationship‘ between these nine
  actionable policy actions and foreign capital inflows in a
  cross-section of 50 countries.
• Scores from 0 to 100 were given to the nine policy
  actions in a group of 50 Emerging Markets.
• These scores were statistically tested against the capital
  inflows in the 50 countries to arrive at the coefficients of
  a ―formula‖ that would explain FDI.
• The coefficients of the multiple regression measure the
  relative importance of the nine factors in explaining FDI.
• Other ―drivers‖ -- including Financial Sector, Political Risk,
  International Capital Controls, Corruption, and Government Image
  -- were not statistically significant in the regressions.
• But this may be due to multicollinearity problems, since these
  factors were highly correlated to the other significant factors:
   – Corruption was 82% correlated to Public Governance;
   – Removal of Capital and Trade Restrictions was 79% correlated
      to Liberalization;
   – Financial Sector Reform was 70% correlated to Liberalization;
   – Political Risk was 71% correlated to Governance.
JR’s Analysis of FDIs as % of Fixed Capital Formation
Cross-Country analysis of 49 Emerging Economies; data for 2007
Dependent Variable: FDI as % of Fixed Capital Formation
Independent Variables      Coef. Std.Err.     t         P>t [95% Conf. Interval
Bus Deregulation/Liberal   .246 .1126         2.19      0.034 .019335 .47352
Pub Adm and Taxation       .780 .2505         3.11      0.003 .27525 1.2851
Political Risk             .498 .2197         2.27      0.028 .0551    .94095
Labor Freedom              .224 .1279         1.75      0.087 -.03379 .48213
Cons                       -99.39 23.14       -4.29     0.000 -146.03 -52.748
Source      SS             df    MS                     Number of obs =   49
                                                        F( 4, 44)     =   10.07
Model 5300.38              41    325.09                 Prob > F      =   0.0000
Residual 5792.07           44    131.63                 R-squared     =   0.4778
                                                        Adj R-squared =   0.4304
Total    11092.4597        48    231.09                 Root MSE      =   11.473
Test results show that there is no autocorrelation: DarbinWatson [1.9]; Breusch-
Godfrey one-lag [Prob > chi2=0.87]. There is no heteroskedasticity: White test [Prob >
chi2 = 0.4366]. The Ramsey RESET test shows that the model has no omitted variables
[Prob > F = 0.6514]. The correlation matrix for independent variables shows that there
is little multicollinearity among them.
Source: Julia Radchenko, EERC Term Paper
            Morgan Stanley Analysis of FDIs
• A USAID-funded regression study of 67 emerging economies
  was made by Morgan Stanley Dean Witter in July 1998 (titled
  “Foreign Direct Investments and its determinants in Emerging
• This study’s results were as follows:
   – Finding 1: Foreign investment inflows are influenced very
     little by generic variables such as:
       • locational advantage,
       • proximity to financial centers,
       • total population,
       • size of the country.
     These variables show little significance throughout the
   – Finding 2: On the other hand, foreign investments are heavily
     influenced by the countries‘ policies and institutions.
– Finding 3: The above means that even though initial, country-
  inherent conditions may play a certain role, they can be
  overcome by sound policies and their thorough
– Finding 4: Economic policies allowing for free open markets,
  investment and trade are key determinants of FDI inflows
  (Economic Openness had the highest coefficient value).
– Finding 5: The key determinants of ―Economic Openness‖
    • Little government interference in markets; that is, "free"
      markets with minimum directive regulation.
    • Open import and export regimes.
    • An exchange rate that reflects a currency‘s true value, with
      no controls on currency exchange.
Morgan Stanley Model
                    Predicting FDIs in Ukraine
• Based on the statistical tests, we can construct a formula to predict the
  flows of FDI to Ukraine over time on the basis of the identified
  actionable policies :
               FDI = SUM [C(It) x (It)]
• We can then develop different scenarios for the evolution of FDIs,
  depending on the depth of changes in the policy drivers:
• With continuation of current policies, capital inflows will not increase
  from its current levels.
• Under a middle scenario, with policy actions to reduce in five
  years 50% of the policy level differential with the Bests-in-Class,
  Ukraine would increase foreign direct investments significantly.
• Under an optimistic scenario, with stronger policy actions to reduce in
  five years 80% of the policy level differential with the Bests-in-Class,
  the level of foreign direct investments could several times
                  FDIs For Ukraine
Possible FDIs Scenarios as of June 2000
• A mid-2000 presentation to the Prime Minister showed that
  Ukraine could choose between three possible scenarios for FDIs,
  depending on its policy reforms:

FDIs in 2007
• In 2007, Ukraine received $9.9 billion in FDIs. Based on the 2007
  statistical analysis presented earlier, given Ukraine‘s policy
  framework in 2007, it should have only received $6.3 billion. The
  residual amount of $3.6 billion was unwarranted.
FDIs in 2009
•   With stable FDIs to EMs in 2009 and given a deterioration in the
    current economic policies in Ukraine, from the previous
    statistical studies, Ukraine can expect to receive only about $5
    billion in FDIs in 2009.
•   To secure larger flows of FDIs, the four most important policy
    actions that Ukraine should take are:
     – Deregulation and Liberalization of Business Activities
     – Improvements in the Legal Environment
     – Improve Public Administration to improve efficiency and
          deal with political uncertainties
     – Improve Fiscal aspects, including taxation
•   However, in order to get a significant increases on capital flows
    actions on all nine factors are required.
      IV. Dealing with Potential Reversals
         of Short-Term Capital Flows
 In 1996, Thailand, South Korea, Indonesia, Malaysia, and the Philippines
  received net private capital inflows of about $100 billion.
 In 1997, in the wake of the financial crisis, they recorded an outflow of
  $12 billion---a turnaround of $112 billion.
 Most of the reversal was accounted for by changes in bank lending and
  portfolio flows; foreign direct investment remained unchanged.
• International capital volatility and repeated financial crises have led to
  recognition of need for actions to deal with the risks of potential reversals
  of short-term capital.
• A first set of measures aim at improving the overall regulatory and
  information environment in which banks and financial institutions
  operate, the so-called international architecture:
       1. Better international financial supervision and regulations.
       2. Improve the institutional infrastructure of the International
            Financial System.
       3. Enhance market discipline through information and
• A second set of measures aim more specifically at dealing and containing
  short-term capital inflows in individual countries.
    A. Improving the International Architecture

1. Better International Financial Market Supervision
   and Regulations.
    – Banking Supervision: Countries to Apply the Basle
      Committee‘s recommendations on Core Principles
      for Effective Banking Supervision.
    – Securities Regulations: The International
      Organization of Securities Commissions is
      developing universal principles for securities market
      regulations, including disclosure requirements.
    – Insurance Supervision: The International Association
      of Insurance Supervisors is issuing principles and
      standards for the insurance industry.
2. Improve the Institutional Infrastructure.
    – Auditing and Accounting. The International
      Accounting Standards Committee and the International
      Federation of Accountants should be more active in
      ensuring application of international standards already
    – Bankruptcy. International agencies to pay more
      emphasis to harmonize domestic bankruptcy laws.
    – Payment Systems. Continue implementation of
      payment system reforms , including real-time gross
      settlement systems, delivery-vs-payment systems and
      foreign exchange settlement systems.
    – Last Resort Interventions. Improve coordination and
      Governance of Multilateral Financial Institutions (incl.
      role of the Development Committee for IMF/WB).
3. Enhance Market Discipline through better
   Information and Transparency.
    – Data Dissemination. Multilateral Institutions to play
      a more active role in requiring countries to
      disseminate economic/financial data, such as level of
      international reserves and foreign debt.
    – Fiscal Transparency. The IMF to encourage
      countries to improve transparency of fiscal budget

• These measures were also accompanied by proposals to
  change the role of the International Financial
  Institutions, in particular the IMF.
    B. Country Measures to Deal with Short-Term
                      Capital Inflows
Recent Financial turmoil has prompted new interest in
  Capital Controls by individual countries.
• Article VIII of the IMF‘s Articles of Incorporation
  requires members to avoid imposing restrictions on
  current account transactions and remittance of profits.
• But there is no such obligation for capital account
  transactions;convertibility of these payments is not
• In September 1997, the IMF Interim Committee agreed
  that full convertibility for capital account transactions
  should be an ultimate goal for member countries. This
  should enhance world welfare, allowing lenders to invest
  where funds can be used more efficiently and returns are
• But many EMs believed that the above argument ignored
  the high cost of financial crises.
• They believed that their exposure to short-term bank loans
  and portfolio flows had high risks:
   – They destabilize real economic performance: the likely
     foreign exchange appreciation leads to poor export
     performance and excessive imports, leading to high
     current account deficits.
   – They disrupt financial systems: reduce local interest
     rates, lead to more consumption and lower domestic
• Excessive inflows could be followed by excessive
  outflows, if investors sentiments were to change, without
  regard to the country‘s economic situation.
Making Short term inflows less profitable: The Tobin Tax
• James Tobin has proposed a more radical attempt to combat short-
  term speculation: the introduction of a tax on foreign exchange
• It would discourage speculation by reducing the profitability of FX
• It would apply to all transactions in foreign exchange, including
  spot and forward transactions, foreign exchange swaps, and
  currency futures and options.
• The imposition of this tax would be difficult:
   – Requires collective action, to avoid negative selection.
   – Increases the cost on non-speculative transactions .
   – Would be difficult to apply to all financial institutions.
   – Has perverse incentives to develop tax bypasses.
• What are other Policy Responses to short term inflows?
Policy Responses to Short Term Inflows
Chile was one of the first countries to couple open exports and
imports with restrictions in short-term capital inflows. The Chilean
model included:
  – Reserve Requirements. The CB imposed a 1-year, 30% reserve
    requirement on short-term capital inflows.
  – Investment Regulations. Capital investments were subject to laws
    specifying minimum entry amounts and the minimum time
    before repatriation.
  – Restricting External Financing: A number of restrictions were
    put on the issuance of external bonds and equity issues.
  – Sterilized CB Intervention: The Central Bank purchased dollars
    with local currency to maintain stability in the exchange rate. The
    impact on the money supply was ―sterilized‖ by massive
    placements of CB bonds to control inflationary pressures.
• These measures may be effective over the short-run. Over the long
  run they are not feasible (there are limits to the amount of debt of
  the CB; high reserve requirements leads to by-passing the banking
  sector; financing restrictions are avoided through loops).
• One better option (though politically more difficult) is for the CB
  and the Government to act in coordination:
   – The CB just intervenes and ―monetizes‖ the inflows of foreign
     capital (buy dollars with local currency to reduce exchange rate
     appreciation). But the Central Bank does not ―sterilize‖ these
     increases in money supply.
   – The additions to local money supply would reduce interest
     rates making capital inflows less attractive; but they may also
     generate inflationary pressures.
   – Therefore, to reduce inflationary pressures, the Government
     applies tight fiscal policies (generates a fiscal budget surplus).
• Over the longer term, if the capital inflows are ―permanent‖ the
  Government should just let the exchange rate to appreciate.
      V. Rationale for Diversification in EMs
• In a fully efficient, integrated international market, buying
  the world market portfolio should be the natural strategy.
• But as the world‘s capital markets are imperfect, without
  full integration, foreign investments offer the possibility
  to reduce the total risk of a portfolio.
• That is, international diversification may help improve the
  risk-adjusted performance of a portfolio.
• Domestic securities tend to be correlated with each other,
  since they are similarly affected by the country‘s
  macroeconomic parameters.
• But correlation with foreign securities is lower, thereby
  offering successful diversification opportunities by
  expanding the efficient frontier.
• A favorable ―Diversification Effect" can be achieved
  even though risks are higher in emerging markets than in
  more developed countries, due to their uncertain policy
• Even if an EM has higher risk than, say, the US market,
  the addition of a more risky EM asset will reduce the
  total risk of the portfolio as long as the EM asset
  correlation with the US market is not too large.
   Correlation of Mkt: R= 0.15
   Standard Deviation for US: Su=15; for EM: Se=20
          Vp = 0.5^2(Vu + Ve +(2xRxSuxSe)
          Vp = 0.25(225+400+(2x0.15x15x20)=178
          Sp = 13.4%
• Classical example: if in bad weather, a business is down
  whereas another business is up, then a portfolio including
  both businesses will reduce overall risks.
• If market correlation or foreign risk are large; then for
  successful diversification, foreign returns must be higher.
  This is the case in many EMs. But to tap it, forecasting
  skills are needed.
  Market Correlation

• Regardless of the period analyzed, studies show that
  correlations between international markets are always
  far from unity: For example, during 1971-94, the
  correlation between the US stock exchange and the
  Hong Kong stock exchange was 0.29.
• The common variance between these two markets was
  8% (R^2=0.29^2) .
• That is, only 8% of the HK stock price movements
  were the results of influences common to the US stock
• 92% of the stock price movements were independent.
            EM‘s Risk/Returns for 1985-93
Country     Annual Return   Total Risk   Correlation
                (%)         ($ StDv)     with World (R)
Argentina          40          106           -0.06
Brazil             13           70            0.12
Chile              52           27            0.11
Mexico             52           46            0.25
Colombia           41           32           -0.01
Indonesia        -2.6           24            0.11
Korea              22           30            0.30
Zimbabwe           28           32            0.07
USA                16           16            0.70
World              17           16            1.00
          EM‘s Risk/Returns for 1992-97
Country      Annual Return Total Risk Correlation
              (%)          ($ StDv) with US (R)
Argentina       20             31          0.48
Brazil          37             38          0.30
Chile           15             24          0.32
Mexico          10             37          0.33
Colombia        15             24         -0.09
Indonesia       -2             38          0.43
Korea           -21            31          0.09
Thailand        -21            39          0.32
Zimbabwe        29             39          0.04
USA             19             11          1.00
                              Combination of World/EMs Portfolios

Return in Percent






                         12    13   14   15   16   17   18   19   20   21   22   23   24   25
                                                   Risk in Percent
             VI. Emerging Stock Markets
• Emerging Stock Markets have developed rapidly during the last
  decade, with stock market capitalization growing by 18% per
  annum from US$500 billion in 1988 to US$5,400 billion by 2005.
•    However, EMs are still small in size compared with developed
    countries : the market capitalization of EMs is only 10% of the
    world equity capitalization.
• Nevertheless, the stock market capitalization of countries such as
  Taiwan, Brazil, South Africa, and China are in excess of US$200
  billion and are comparable in size to those of Sweden and Spain.
  They are twice as large as those of Belgium, Denmark and Norway.
• The growth of capital markets in developing countries has been
  large and international corporations have not ignore them for
  diversification purposes and to reduce production costs.
• In 2007, Ukraine‘s stocks had the one of the highest rate of growth in the world.
• This growth was supported by the creation of all-Ukrainian stock indexes in the
  Vienna Stock Exchange that led several banks (such as ABN-AMRO) to create
  products based on this index.
• But during 2008, Ukraine stock exchange was one of the worse performers in
  the world, loosing 70% of its value.

                          Ukraine - PFTS Stock Index






















Developed Market Stocks
 •   MSCI,
 •   Prices,
 •   in US Dollars,
 •   as of December 2008
• The stock bubble of the 1990s (dot-com bubble) was due to the speculation that
  a ―New Economy‖ -- supported by better technology, computers, e-commerce and
  other internet applications -- would generate higher productivity growth.
• For several years, this led to a financing boom (supported by new Venture Capital),
• higher investments and growth, high P/E ratios and high stock prices…until 2000!
• Then another boom (in housing) was supported by low interest rates and de-
   regulation of banks….until 2008!!.
Emerging Markets Stocks
•   MSCI,
•   Stock Prices,
•   in US Dollars,
•   as of December 2008
 Iceland: -94%               Tunisia:     +10%
 Bulgaria -80%               Costa Rica: -4%
 Ukraine -73%                Morocco:       -6%
 UAE       - 72%             Venezuela: -9%
 Serbia     -71%             Botswana: -15%
 Lithuania -71%              Slovakia:    -19%
 Romania -70%                Lebanon:      -21%
 Slovenia -68%               Chile:        -23%
 Vietnam -67%                Mexico:       -25%
 Greece -66%                 South Africa: -27%

*Local Currency Valuations   * Local Currency Valuations
          VII. Emerging Markets Web Sites
African Development Bank. Background information and
   economic/social studies on African countries.
African Country Information: Background information on African
   countries. News on African issues.
Asia, Inc. Online: Offers articles of interest on Asian emerging market
   and Asian stock market closings.
Asian Development Bank: Asian Country information.
Bank of New York: The best source for ADR information. It also has
   year-end and quarterly market reviews. There are also good hypertext
Bloomberg Markets: Financial Information and statistics (some date by
   subscription), including stocks, bonds, currencies, mutual funds, etc.
Bradynet. Mainly for Brady Bonds and other EM debt (most data by
Brookings Institution. NGO foundation with excellent research on
   selected issues in EMs.
Business Monitor International - Business information on Emerging
   Markets: it covers legislation and regulations, corporate finance, market
   and economic analysis (by subscription).
Buttonwood International Group. Provides reviews of issues and trends
   in Ems (by subscription).
Business Monitor International - Business information on Emerging
  Markets: it covers legislation and regulations, corporate finance,
  market and economic analysis (by subscription).
Buttonwood International Group. Provides reviews of issues and
  trends in Ems (by subscription).
Campbell R. Harvey. Professor Harvey of Duke University has a nice
  page on EMs.
Carnegie Endowment. NGO/Think Tank with excellent publications on
  EM issues.
Chicago Mercantile Exchange - Information and tips for trading in
  Interest rate, currency, commodity and index contracts.
Closed-End Funds and Quotes. Closing prices for closed-end funds.
Datastream International. Quotes of prices, P/Es, EPS, exchange rates,
Economist. Articles on EMs. Some financial indexes each week.
Emerging Markets Companion. Economic and financial data and
   commentaries on EMs. Price data.
Emerging Markets Data. Site of the Harvard Business School with
   useful links to EM data.
European Bank. Good collection of information and publications on
   transition economies in Central and Eastern Europe and Asia.
Euromoney. Good articles on current events in EMs.
External Debt Statistics. Join Database of IMF/WB/BIS/OECD
Financial Data Finder. Links developed by Ohio State University to
   sites that provide financial and economic data.
Financial Times. Best business daily for EMs.
   Financial data in:
FinCad. Data and tools for derivatives.
Finweb Financial Economics. Economic and finance related topics.
Global Financial Data. Historical stock market, inflation, interest rates,
   currency and commodity data.
Global Investor. Global financial data and analysis, including news.
   Includes an ARD directory.
Goggle Finance. Data on stocks and indexes.
Heritage Foundation. NGO with good publications on selected EM
Inter-American Development Bank: Information on LAC Countries:
International Finance Corporation. Home page of IFC and connect to
   the S&P/IFC indexes:
International Monetary Fund. Most complete macroeconomic
   information and reports.
Internet Securities, Inc. Provides hard-to-get information on EMs. Daily
   news, articles, political events, quotes, currencies, etc. For fee.
J.P. Morgan Emerging Market Bond Indexes (EMBI). By subscription
Mexico Official Economic Information. Since the 1994 crisis, Mexico
  publishes current information on Public Finances and Debt. Excellent
  country reference.
Morgan Stanley Global Economic Forum. Daily commentary on global
  economic issues.
Morgan Stanley-Barra Capital International. MSCI Global and County
  Equity Indices (Developed and EMs).
Moodys. Country and company ratings. Requires free registration.
New York Federal Reserve. Daily Foreign Exchange Rates and Implied
  Volatility Rates.
New York Times. You can use the search box to retrieve articles on your
   country of interest.
Pacific Exchange Rate Service. Service of the University of British
   Columbia. Provides current and historical exchange rates, back to 1971.
Privatization News. Information on privatization. For fee.
Resources for Economists. A comprehensive list of sites related to
   economics and finance.
Reuters. A comprehensive coverage of macroeconomics and financial
   data globally
SigmaBleyzer/The Blayzer Foundation. Studies and data on economic
   issues in EMs:
Standard And Poor’s Global Rating Book. For country ratings.
Standard And Poor’s Emerging Markets and Frontier Country
   Equity Indexes
Strategic Forecasting. Geopolitical trends in EMs.
Ukraine’s State Statistics Committee. Economic data on Ukraine,
   including GDP, Prices, Trade, Wages, etc.
Ukraine’s National Bank. Macroeconomic and monetary data.
Ukraine’s Stock Exchange
United Nations Statistics: Data from its Monthly Bulletin of Statistics, on
  national accounts, prices, labor force, etc.:
Wall Street Journal.
World Bank. Large source of data on EMs.
World Trade Organization. Trade topics, such as trade agreements,
  dispute settlements.