FDI and Stock Market Development: FDI and Stock Market Development: Complements or Substitutes?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

Motivating FactsMotivating 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

Motivating FactsMotivating 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?

Existing WorkExisting 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

Questions the paper tries to addressQuestions 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?

DataData • 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

Dependent VariablesDependent 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

Domestic stock market development (1)Domestic stock market development (1)

Market Capitalization / GDP

0

0.2

0.4

0.6

0.8

1

1.2

1.4

1975

1977

1979

1981

1983

1985

1987

1989

1991

1993

1995

1997

1999

High-Income Countries Middle-Income Countries Low-Income Countries

Domestic stock market development (2)Domestic stock market development (2)

High-Income Countries Middle-Income Countries Low-Income Countries

Value Traded Domestically / GDP

0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

0.9

1

1.1

1975

1977

1979

1981

1983

1985

1987

1989

1991

1993

1995

1997

1999

Domestic stock market development (3)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

Internationalization of stock market (1)Internationalization of stock market (1)

High-Income Countries Middle-Income Countries Low-Income Countries

Market Capitalization of International Firms / Market Capitalization of All Firms

0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

Internationalization of stock market (2)Internationalization of stock market (2)

High-Income Countries Middle-Income Countries Low-Income Countries

Value Traded Abroad / Value Traded Domestically

0

0.05

0.1

0.15

0.2

0.25

0.3

0.35

0.4

0.45

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

Internationalization of stock market (3)Internationalization of stock market (3)

Capital Raised Abroad / Capital Raised Domestically

0

0.5

1

1.5

2

2.5

3

3.5

4

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

Capital Raised Abroad / GDP

0

0.002

0.004

0.006

0.008

0.01

0.012

0.014

0.016

0.018

0.02

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

High-Income Countries Middle-Income Countries Low-Income Countries

Internationalization of stock market (4)Internationalization of stock market (4)

0% 25% 50% 75% 100%

Venezuela

Argentina

Mexico

Israel

Peru

Brazil

Russian Federation

Colombia

Philippines

Thailand

South Africa

1996-1999

1990-1995

Value traded in international markets/value traded in domestic markets

Internationalization of stock market (5)Internationalization of stock market (5)CoverageCoverage

Trading Values for Foreign Companies

London49%

NY (NYSE and

NASDAQ)37%

Deutsche Börse

6%

Others8%

2000

London62%

NY (NYSE and NASDAQ)

33%

Deutsche Börse1%

Others4%

1995

Summary of Internationalization TrendsSummary 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

Foreign Direct InvestmentForeign Direct Investment

High-Income Countries Middle-Income Countries Low-Income Countries

Foreign Direct Investment as % GDP(Averages)

0.00

1.00

2.00

3.00

4.00

5.00

6.00

7.00

8.0019

82

1984

1986

1988

1990

1992

1994

1996

1998

2000

MethodologyMethodology• 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.

Regression AnalysisRegression 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

Regression ResultsRegression ResultsVariable 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 - -

Interpretation of Regression ResultsInterpretation 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.

ConclusionsConclusions

• 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

ConclusionsConclusions

• 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.

ImplicationsImplications• 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

Future WorkFuture 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?