FDI and Stock Market Development: Complements or Substitutes?

1
FDI and Stock Market Development Complements or
Substitutes?

• Stijn Claessens
• Daniela Klingebiel
• Sergio Schmukler
• Conference THE FDI RACE WHO GETS THE PRIZE? IS
  IT WORTH THE EFFORT?
• Washington, D.C., October 3-4, 2002

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Motivating Facts

• Rapid development of equity markets during 1990s
• Increased cross-border capital flows
• In the 1990s, changes in the composition of
  capital flows bank lending was replaced by FDI
  and by portfolio investment
• At the same time
• Increased migration of listing, trading, and
  capital raising to international financial
  centers
• Supported by advances in technology, in
  particular remote access to trading systems
  allowing for listing and trading of securities
  abroad
• And changes in the nature of trading systems

3
Motivating Facts

• Questions on future of stock exchanges,
  especially in emerging markets
• Questions with respect to the relation between
  FDI and stock market development
• Is FDI a complement or substitute of capital
  markets?
• Does FDI help develop domestic and international
  capital markets?

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Existing Work

• Aggregate analysis of stock markets development
• Stresses role of legal framework, macro stability
• Micro perspective (firm-level) studies
• Effects of cross listings on firm cost of
  capital, maturity, liquidity, valuation, etc.
• Some studies on type and country origin of
  companies migrating abroad
• Focus on international companies, less on the
  relative importance of internationalization
• Findings do not fully explain why local markets
  are shrinking against background of improved
  local fundamentals

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Questions the paper tries to address

• How have stock markets developed in various
  countries and what have been the driving factors
  behind their development?
• What factors affect internationalization, i.e.,
  what factors drive the degree of foreign listing,
  foreign trading and foreign capital raising?
• What impact may these developments have on the
  future of domestic exchanges?
• What is the relation between FDI and stock market
  development at the local and international level?

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Data

• Domestic stock market capitalization, trading,
  and capital raised for 77 countries, at market
  level
• Listing, trading, and capital raising abroad at
  firm level to obtain
• Domestic firms listed abroad
• International activity at market level (trading
  and capital raised)
• Estimate international market capitalization
• Use NY and LSE data, therefore capturing 85
  percent of international activity for emerging
  market countries
• Explanatory data

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Dependent Variables

• Local stock market development
• Market capitalization/GDP
• Value traded domestically/GDP
• Value traded/market capitalization
• Internationalization
• Market capitalization of international
  firms/total market capitalization
• Value traded abroad/GDP
• Value traded abroad/value traded domestically
• Capital raised abroad/GDP
• Capital raised abroad/capital raised domestically

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Domestic stock market development (1)
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Domestic stock market development (2)
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Domestic stock market development (3)

• Significant increases in stock markets over
  1975-1999 in all countries
• High-income countries experienced much more
  pronounced increases of domestic stock market
  activity than low-income or intermediate income
  countries
• Especially middle income countries seem to have
  lost out in terms of market capitalization,
  number of firms, and liquidity in the second half
  of the 1990s

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Internationalization of stock market (1)
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Internationalization of stock market (2)
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Internationalization of stock market (3)
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Internationalization of stock market (4)
Value traded in international markets/value
traded in domestic markets
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Internationalization of stock market (5)Coverage
Trading Values for Foreign Companies
2000
1995
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Summary of Internationalization Trends

• Relative market capitalization of international
  firms has increased substantially for middle
  income countries (e.g., Latin America and Eastern
  Europe)
• Value traded abroad has risen sharply for
  middle-income countries
• Amount of capital raised abroad frequently
  exceeded the amount of capital raised
  domestically for middle income countries
• Results vary depending on whether foreign stock
  market activities are normalized by domestic
  stock market measures or by GDP

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Foreign Direct Investment
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Methodology

• Panel data with robust standard errors
• Alternative estimation methods (fixed effects,
  random effects, between)
• Tobit regressions, use of zero observations
• Different specifications, with different
  subsamples
• Endogeneity (for domestic and international
  variables)
• Instrumental variables
• Alternatives use of time lags
• Report only the core results.

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Regression Analysis

• Stock market development and internationalization
  are explained in a panel regression analysis,
  using a number of explanatory variables
• GDP per capita
• Inflation rate
• Foreign Direct Investment
• Law Order Index (Country Risk Guide)
• Shareholder Rights (La Porta et. Al)
• Capital Account liberalization (IMF measure)
• Trading Costs (Elkins McSherry)
• Data cover mostly NY and London

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Regression Results
Variable Market capitali-zation Capitali-zation of int. Firms/ Mkt Cap. Tradg. Volume abroad/ dom. Tradg. Volume abroad/ GDP Cap. Raised abroad/ Dom. Cap. Raised abroad/ GDP
Log of GDP per capita
Inflation - - - - -
Foreign Direct Investment
Law and Order
Shareholder rights -
Financial liberalization
Trading costs - -
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Interpretation of Regression Results

• Domestic stock market activity and the share of
  stock market activities taken place abroad is
  driven by the same fundamentals.
• Improving fundamentals domestically will lead to
  increased stock market activity, but more of this
  activity migrates abroad as countries
  fundamentals improve.
• This suggest countries need to pass a certain
  hurdle in terms of development and legal and
  regulatory framework to get access to foreign
  markets.
• But once hurdle passed, domestic activity as risk
  from internationalization.

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Conclusions

• While better fundamentals (including higher FDI)
  lead to an increase in domestic stock market
  activity, more of this activity is expected to
  occur abroad as better fundamentals also spur the
  migration in capital raising, listing, and
  trading
• Firm perspective
• As firms from emerging markets continue to
  expand, they will seek larger amounts of low-cost
  capital, which will only be available in global
  markets

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Conclusions

• Investor perspective
• Global investors will seek to invest in countries
  with not only sound fundamentals, but also with
  liquid markets.
• Domestic investors will become less captive, will
  also seek liquidity, in addition to good
  corporate governance, disclosure, etc.
• And liquidity has network properties,
  concentrating in a few global exchanges.

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Implications

• Countries will continue to need to improve
  fundamentals
• Helps raise domestic savings, allocate it better,
  etc.
• Facilitates access to foreign markets for
  domestic firms, with associated lower cost of
  capital, greater liquidity, etc.
• But exchange activity will not remain local
• As fundamentals improve, domestic liquidity
  declines making it hard to sustain local
  exchanges, especially small ones.
• Policy response countries need to try to get
  full gains
• Ease remote two-way access by local (and foreign)
  investors
• Allow entry of exchange related service providers
  (e.g. brokers)
• Adjust fee structures and trading systems
• Harmonize standards for trading and listing
• Facilitate mergers/consolidation of exchanges

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Future Work

• More micro level of internationalization
• What motivates individual firms to go abroad?
  How do listing costs matter? How do exchanges
  compete with each other?
• How does internationalization through equity
  relate to other forms of domestic and
  international financing (loans, bonds)?
• Exchanges and (alternative) trading systems
• What are economies of scale in exchanges? Is
  there path dependence? What is role of
  alternative trading systems? What are good
  options merge, link, harmonize? What is need in
  terms of consolidation in clearing/settlement,
  accounting, etc.?
• Financial markets development
• What are the options for firms which cannot
  easily go abroad?
• How does this relate to the development of
  private equity, venture capital, and other
  first-stage financing markets in emerg. mkts?