Do foreign investors stimulate or inhibit stock market development in Latin America?

I. INTRODUCTION

Growing participation by foreign institutional investors has been a key force in the development of Latin American stock markets since 1990 while the accelerating trends of institutionalization and globalization of money management will increase the importance of these investors for the future development of stock markets in emerging economies.

As the value of global institutional assets has grown, a larger share has been invested internationally and emerging markets now comprise a growing share of this international allocation. The size of assets managed by institutional investors in the largest industrialized countries reached $17 trillion in 1994, up from $2.4 trillion in 19801 with U.S. pension and mutual funds accounting for the largest share, valued at $3.8 and $2.1 trillion respectively. The allocation of U.S. pension fund assets to foreign securities increased from 0.7% in 1980 to 5.7% in 1993 and 9.5% by 1995, slightly below the 10.1% allocation of U.S. mutual funds in 1993 while the value of international investments by pension funds worldwide surged from $302 billion in 1989 to $790 billion by 1994.(2)

The increasing share of emerging markets in this expanding pool of mutual and pension fund assets is evidenced by the fact that only 26 dedicated emerging market funds existed worldwide in 1986 with $1.8 billion in assets compared to 1,254 funds and $109 billion in assets by 1995.(3) The percentage of non-dedicated mutual funds invested in emerging markets has also grown, from 2% to 12% between 1989 and 1995. U.S. pension funds have dedicated a smaller portion of their larger asset base to emerging markets. Current estimates for U.S. pension fund holdings are between $50 and $70 billion dollars, similar to the amount for U.S. based mutual funds.(6)

This paper examines the interaction between the forces of globalization and institutionalization of money management and the development of emerging stock markets in Latin America. First, after motivating the importance of stock markets for economic growth, the theoretical impact of integration on stock market development is examined. Second, the stages of foreign participation in Latin American stock markets are investigated to determine the impact of this participation on stock market development.

II. STOCK MARKET DEVELOPMENT AND ECONOMIC GROWTH

Economists have often claimed that the evolution of financial markets is an important factor stimulating economic growth. Schumpeter (1911) argued that the services provided by financial intermediaries are essential for technological innovation, "The banker..authorizes people, in the name of society as it were, to...innovate." The work of Goldsmith (1969), McKinnon (1973) and Shaw (1973) and the resurgence of interest into the sources of economic growth during the 1990s have once again brought the importance of financial markets to the forefront of the policy debate in many emerging economies.

Many authors have documented a positive correlation between economic growth and indicators of financial market development. However, the direction of causality and the channels by which the two variables are associated have only been addressed recently. King and Levine (1993) find evidence of causation from financial development to growth by demonstrating that financial development is not only associated with current growth, but also influences future growth, investment and the efficiency of these investments. Levine and Zervos (1995a) show that stock market development, particularly stock market liquidity, is robustly correlated with future economic growth. They also demonstrate that even after adding indicators for the development of the banking system, stock market development remains significant. This implies that stock market and banking system development play complementary roles. Stock markets may be better at diversifying risk and providing liquidity to small investors while the banking system may be better at reducing informational asymmetries important in financing smaller companies.

Attempting to explain the above empirical findings, Bencivenga, Smith and Starr (1992), Levine (1991), Saint-Paul (1992) and Greenwood and Jovanovic (1990) show how liquid secondary capital markets help to allocate funds to projects with the highest marginal product, stimulating economic growth. Stock markets increase the productivity of capital by improving liquidity, enhancing portfolio diversification opportunities and gathering information on the profitability of risky projects.

Long-term investments in physical capital may have higher returns than short-term liquid investments. However, investors face unpredictable liquidity shocks which force the premature liquidation of long-term investments. Stock markets increase the willingness of individuals to invest in less liquid, more productive technologies by allowing these individuals to retain liquidity by selling their shares on the stock market. The availability of liquid capital markets thereby lowers the cost of capital, increases investment in more productive long-term assets and leads to higher rates of economic growth.

An equity market encourages portfolio diversification of firm specific risks. This allows each firm to specialize in riskier projects, helping to increase productivity without an increase in systematic risk. Consequently, productivity growth may be higher in an economy with a diversifiable equity market. Stock markets also give incentives for individuals to acquire information about companies. More liquid markets will offer greater opportunities for investors to profit from this information. These incentives will result in more research and monitoring of firms, improving the resource allocation role of the market.

However, the benefits of stock …