Domestic Capital Markets and Financial Integration: Issues and Challenges

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1 Domestic Capital Markets and Financial Integration: Issues and Challenges Guillermo Perry with Augusto de la Torre and Sergio Schmukler X LAC Meets the Market Washington D.C. April 2005

2 Intensity of Reforms Financial Liberalization More liberalization G-7 Rest of Western Europe Southeast Asia 1.5 Latin America Less liberalization The liberalization index is calculated as the simple average of three indices (liberalization of the capital account, domestic financial sector, and stock market) that range between 1 and 3, where 1 means no liberalization and 3 means full liberalization. These data are then aggregated as the simple average between countries of each region.

3 Intensity of Reforms Capital Markets Laws, Regulation, and Infrastructure Percentage of Latin American Countries Having Implemented Reforms 120% 100% 88% 94% 91% 100% 92% 80% 60% 56% 63% 64% 62% 40% 31% 25% 27% 33% 20% 15% 0% Supervisory Agency Creation Establishment of Insider Trading Laws Custody Arrangements Trading Systems Clearing and Settlement Processes 0% Before 1990 By 1995 By 2002

4 Stylized Outcomes LAC Local Financial Markets Remain Underdeveloped Percentage of GDP, 2002 Financial Sector Size Across Countries 160% 287% 140% 120% 100% 80% 60% 40% 20% 0% n/a U.S. U.K. Japan Thailand Malaysia Hong Kong Peru Mexico Colombia Chile Brazil Argentina Bank Credit to the Private Sector Stock Market Capitalization Amount Outstanding of Domestic Private Sector Bonds

5 Percent 100 Stylized Outcomes Dollarization Affects Corporate Bonds Private Sector Bonds by Currency (end-2000) Argentina Brazil Chile Mexico Hong Kong Malaysia Thailand Japan U.K. U.S. Domestic currency US Dollar Other currencies

6 Stylized Outcomes Long Maturities Easier to Obtain Abroad, But in Dollars Maturity of Corporate Dollar Bonds by Jurisdiction In years International market Domestic market Argentina Peru Uruguay Average maturities are weighted by amount issued. Maturities shorter than one year are excluded from the sample. Different periods of time are displayed due to limitations in the availability of data.

7 Stylized Outcomes LAC: Excessive Stock Market Internationalization? Ratio of Value Traded Abroad to Value Traded Domestically 140% 120% 122% 100% 96% 80% 60% 40% 20% 0% 1% 4% 0% 3% 0% 3% 4% Latin American Countries G-7 Countries East Asian Countries

8 600 Stylized Outcomes Significant De-Listings in LAC Stocks Markets Number of Firms Listed in Domestic Stock Exchanges in LAC Argentina Brazil Chile Colombia Mexico Peru Venezuela

9 Stylized Outcomes LAC: Excessive issuance of bonds in foreign markets? International Government Bonds to Domestic Government Bonds Outstanding 80% 70% 72% 60% 50% 40% 30% 38% 42% 20% 10% 7% 4% 5% 7% 9% 12% 0% Latin American Countries G-7 Countries East Asian Countries

10 Stylized Outcomes: Some Success Stories Chile: Internationalization without dollarization Chile - corporate bonds issues in domestic and international markets Million U.S. dollars 3,000 2,500 Local Issues International Issues 2,000 1,500 1, Sources: SVS, Larrain Vial Brokerage, Euromoney, Bondware, Bloomberg

11 Stylized Outcomes: Some Success Stories Mexico: Internationalization without dollarization June 2003 Pesos Local Issues International Issues Bonds Issued by the Private Sector Stocks in Billions U.S. Dollars

12 Stylized Outcomes: Some Success Stories Chile and Mexico: Derivatives markets are deep Growing and already large local market for FX derivatives Foreign Exchange Derivatives, Various Countries (Value Traded as Percent of GDP) FOREIGN EXCHANGE DERIVATIVES Various countries Forward, Swap, Options - Volume/GDP Thailand Chile Korea Mexico Hungary Israel India Brasil Colombia Peru

13 Stylized Outcomes: Some Success Stories Chile and Mexico: derivatives markets are liquid The local market for NDFs shows respectable liquidity 0.25 Various countries 1 Month Forward bid-offer spread (%) Thailand Brasil Korea Chile Mexico New Zealand Australia

14 Stylized Outcomes However, even for success stories, market access is limited Mega Large Medium Small Micro Corporate bond issues in local market by size of enterprise ( ) Chile 7% 0% 0% 0% GMAC 7% Pemex 7% IMSA 5% Other 12% Mexico Cemex 16% A. Movil 13% 93% Mega firms are defined as those with annual sales net of VAT above UF600,000 (US$17.2 million); large firms have sales between UF100,000 (US$2.8 million) and UF600,000; medium firms have sales between UF25,000 (US$0.7 million) and UF100,000; small firms have sales between UF2,400 (US$68,688) and UF25,000 and micro firms have sales below UF2,400. Micro firms represent around 82 percent of all firms, while small firms are 15 percent and medium firms two percent. Large and mega firms combined account for only one percent of all firms. Source: World Bank (2004) and Bolsa Mexicana de Valores, JPMorgan. Bimbo 7% Telmex 10% KOF 11% Ford 12%

15 Determinants of bond market development Econometric Results Macroeconomic and institutional fundamentals (foster both local and foreign currency bond markets) Flexible exchange rate policies (pegs induce foreign currency bonds issuance against domestic currency bonds) Size (determine liquidity and risk diversification options) Investor base (pension funds, insurance companies) Market regulation and Infrastructure Public debt management (provide base yield curve) Inflation indexing

16 Determinants of stock market development Determinants of stock market development Econometric Results Macro & institutional fundamentals (foster both domestic stock market development and internationalization of equity trading and issuance) Size (determine liquidity and risk diversification options) Investor base (pension funds, insurance companies) Market regulation and Infrastructure Internationalization adversely affects turnover of domestic (non-internationalized) firms (Trade migration, negative spillovers, and trade diversion)

17 Latin Securities Markets Key Result: Shortfall in Local Market Development Latin America is different robust econometric result Domestic stock markets are less developed than predicted by fundamentals and less responsive to reforms Internationalization of Latin stock trading and issuance is higher than predicted by fundamentals and more responsive to reforms Domestic currency bond markets are less developed, controlling for fundamentals and size Latin America is an extreme, but it is not alone Witness Eastern Europe and even Western Europe and East Asia is at the other extreme Is East Asia the future or the past?

18 Some Key Questions for the Discussion Sessions How is financial globalization affecting domestic capital markets? Is it making local stock and bond markets grow or shrink? What can domestic capital markets offer that international capital markets could not? Limiting currency and rollover risk? Broadening access to SME s? How to develop domestic markets for long-term local currency debt, without barriers to international integration? Is there a role for IFIs?