Impact of Foreign Investment on the Volatility and Growth of Emerging Stock Markets

Article excerpt

Since 1979 many LDC's have re-examined the interventionist development paradigm that had dominated their economies for many years and introduced economic reforms including financial sector reform and the creation of efficient equity markets. Although it is the widespread impression that influxes of foreign capital led to increased volatility in these emerging markets, short- and long-term tests indicate little evidence to support claims of increased volatility in these already volatile markets. The experiences of the recent crisis have shown that, despite initial improvements in regulatory and supervisory controls, a weak financial system combined with an open capital account is an accident waiting to happen.

HISTORICAL OVERVIEW OF EMERGING-STOCK MARKETS

The second oil price shock of 1979 and the ensuing global recession put an end to three decades of above-average growth in the developing countries and forced many LDC's to acknowledge the damage that had been caused by thirty years of interventionist policies. Development programs based on subsidies, protectionism, and over-investment had crippled the public and private sectors of these nations, plaguing them with inefficiency and burdening them with colossal amounts of debt. Facing inefficiency in their own countries and reluctant creditors abroad, these LDC's were compelled to re-examine the interventionist development paradigm that had dominated their economies for many years. This re-examination culminated in economic reform for a large number of developing countries. By 1990, most LDC's had implemented structural reforms including: fiscal deficit reduction, inflation control, currency stabilization, trade liberalization, privatization, and various other measures to stimulate growth of a dynamic and competitive private sector, including financial sector reform.

The creation of efficient equity markets in these LDCs was quickly identified as an important objective of financial market reform, because funds raised in these markets would enable firms in the private sector to decrease their overreliance on debt finance, thus increasing their overall efficiency, competitiveness, and solvency. Since the mid-1980s, stock market activity has increased substantially in many developing countries. International interest in emerging stock markets has generally followed several stages. In the 1980s the four Asian "tigers" (Hong Kong, Korea, Singapore, and Taiwan) attracted much attention because of their rapid economic growth rates. The expected entry of Greece and Portugal into the European Common Market led to a financial boom in those countries in the mid-1980s. Latin American countries regained international interest when Brady plans brought a solution to the rescheduling of their nonperforming debts, and their stock markets offered attractive returns in the early 1990s. The disintegration of communism led to the development of market economies in Eastern Europe and the hope for attractive investment opportunities for investors, including foreign investors.

Traditionally, investors have considered only developed markets in their international diversification strategies. These are markets that have been in operation for a long time and whose economies are already in a developed stage. In the past two decades, however, investors have come to appreciate the stock market development and economic growth potential of many emerging countries. The World Bank, which was substantially involved in assisting these developing countries, decided to promote their stock markets. The International Finance Corporation (IFC), a member of the World Bank Group, began to publish monthly Emerging Stock Market Indexes that allowed money managers to measure the performance of their portfolios invested in developing countries.

In the first half of the 1990s, several developing countries successfully attracted large external private inflows. These flows, compared with other episodes of large private capital flows to developing countries over the last 20 years, were dominated by portfolio flows rather than by bank financing and were part of a broader process of internationalization and integration of capital markets. …

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