Emerging Equity Markets and Market Integration.

• Author: Bekaert, Geert

Geert Bekaert [*]

Overview

In the early 1990s, developing countries shrugged off a decade lost in the costly complications of the Debt Crisis and regained access to foreign capital. Not only did capital flows to emerging markets increase dramatically, but their composition changed substantially as well. Portfolio flows (fixed income and equity) and foreign direct investment replaced commercial bank debt as the dominant sources of foreign capital. This could not have happened without these countries embarking on a financial liberalization process, relaxing restrictions on foreign ownership, and taking other measures to develop their capital markets, often in tandem with macroeconomic and trade reforms. [1] New capital markets emerged as a result, and the consequences were dramatic. For example, in 1985 Mexico's equity market capitalization was 0.71 percent of GDP and only accessible by foreigners through the Mexico Fund trading on the New York Stock Exchange. In 1995 this figure rose to 20.53 percent of GDP, and U.S. investors were hol ding about 19 percent of the market.

From the perspective of investors in newly available developed markets, what are the diversification benefits of investing? And from the perspective of the developing countries themselves, what are the effects of increased foreign capital on domestic financial markets and ultimately on economic growth?

Market integration is central to both questions. In finance, markets are said to be integrated when assets of identical risk command the same expected return. In theory, liberalization should bring about integration with the global capital market, and its effects on equity markets are then clear. Foreign investors will bid up the prices of local stocks with diversification potential while inefficient sectors will be shunned by all investors. Overall, the cost of equity capital should go down, which in turn may increase investment and ultimately increase economic welfare. [2]

Foreign investment can also have adverse effects, as the recent crises in Mexico and Southeast Asia have illustrated. For example, foreign capital flows may complicate monetary policy, drive up real exchange rates, and increase the volatility of local equity markets. Moreover, in diversifying their portfolios toward emerging markets, rational investors should consider that the integration process may lower expected returns and increase correlations between emerging market and world market returns. To the extent that the benefits of diversification are severely reduced by the liberalization process, there may be less of an increase in the original equity price. Ultimately, all of these questions require empirical answers, which my research has attempted to provide.

Diversification

Although emerging market equity returns are highly volatile, they are only slightly correlated with equity returns in the developed world, making it possible to construct low-risk portfolios. Early studies show very significant diversification benefits for emerging market investments, even billing them as a "free lunch." However, these studies used market indexes compiled by the International Finance Corporation (IFC) that generally ignore the high transaction costs, low liquidity, and investment constraints associated with emerging market investments.

Michael S. Urias and I [3] measure the diversification benefits from emerging equity markets using data on closed-end funds, open-end funds, and American Depositary Receipts (ADRs). Unlike the IFC indexes, these assets are easily accessible to...