Analysis of Financial Market Trends

The previous section has shown important differences between financial markets in Latin America and East Asia along a number of dimensions. The most important is the much deeper domestic markets in Asia, combined with more emphasis on providing resources to the private sector. Latin America's greater participation in international financial markets provides some counterbalance, but not enough to make up for Asia's advantage in the domestic sphere. In addition, as we will see, international capital market participation may be a double-edged sword, offering important benefits in terms of volume and price of finance but also providing channels for contagion in periods of financial crisis.

In this section, we want to examine several issues related to the different regional patterns. First, we explore some macroeconomic and structural reasons for the differences in the domestic markets. Second, we turn to policy differences as another aspect of the explanation. Third, we analyze the role of international financial markets in the two regions. Finally, we consider the implications for future economic performance and ask if East Asia is positioning itself to continue to outperform Latin America as it did in the several decades before the 1997-98 crisis.

Why are East Asia's domestic financial markets twice as deep as those in Latin America when measured as a share of GDP, and why has the gap been widening? One reason has to do with differences in macroeconomic performance in the two regions. Table 7 compares them with respect to three macroeconomic variables that are relevant for financial sector development: the domestic savings rate, GDP growth, and inflation. The savings rate is obviously important since it is a nation’s savings that are recycled through the financial system. Inflation influences the willingness to hold local currency and financial instruments priced in that currency. The role of growth is more complex. While most scholars currently argue that the dominant causal relationship between finance and growth runs from the former to the latter,¹⁹ there is also agreement that this is a messy area and that feedback and simultaneity are probably involved. In this sense, higher growth rates help stimulate financial markets, which leads to higher growth in a virtuous circle.²⁰

As Table 7 reminds us, the savings rate in East Asia has traditionally been almost double that in Latin America. Likewise, the inflation rate has been lower in East Asia, but in this case, Latin America's record improved substantially during the 1990s. Finally, East Asia’s growth rate was the highest in the world in the 1960-90 period. It remained high in the 1990s, until the crisis of 1997-98. Latin America's growth rate, while high in the early postwar decades, nonetheless lagged East Asia and fell sharply in the 1980s as a result of the debt crisis. It then picked up in the early 1990s, only to fall back after the Mexican financial crisis of 1994-95. All of these comparisons suggest that financial markets should have performed better in East Asia than in Latin America, as indeed did happen. In addition, it is interesting to note the correlation between the halts in growth in both regions and problems in the financial markets. In Latin America, a serious credit crunch developed in the banking sector in several countries (especially Mexico) after 1995, while in East Asia stock market capitalization has fallen substantially since 1997-98, leading to overall stagnation in volume of finance outstanding.

We have seen that the biggest source of the financial gap between East Asia and Latin America is bank credit. In this area, structural explanations supplement macroeconomic trends in explaining East Asia’s superior performance. Specifically, there is a long history of close ties between governments, banks, and firms in East Asia; these links played a key role in propelling growth during the so-called East Asian Miracle period. Governments provided large amounts of funding to the banking sector with explicit or implicit instructions as to where and how it should be lent. In the extreme, banks were little more than conduits for government funds, and credit was readily available.²¹ Even absent this government role, the structural relationship between banks and firms, operating in close-knit economic groups in many Asian countries, led to relaxed lending policies to firms in a bank’s own group and to high leverage for firms. While these tendencies also existed in Latin America – "directed lending" was present in most countries, and economic groups have been a prominent part of the economic landscape – they were never as extensive as in East Asia. These structural links make it less surprising that East Asia should have a deeper banking sector, although they have also created problems for the operation of the banks in the new, more liberalized environment.²²

Complementing the domestic structural argument is the sphere of influence in which the two financial systems developed. Japan, which had a major impact on its East Asian neighbors through trade and investment links (as well as military occupation in some cases), has been identified as a prime example among industrial countries of a "bank-based" financial system. There is a good deal of evidence that Japanese economic characteristics formed a model for developing Asian economies. In the Latin American case, the United States was the dominant partner, and the United States is regarded as the leading example of a "market-based" economy, where banks play a less important role.²³

Government policy with respect to capital markets is also likely to have had an impact on the trends observed. By the early 1990s, a number of countries in both East Asia and Latin America already had active stock markets. In addition, two in each region (Brazil and Chile, Korea and Malaysia) had relatively active bond markets, when measured as a share of GDP. With the exception of Korea, however, the bond markets were mainly a way to finance government deficits, and the private sector raised minimal amounts. During the 1990s, governments in both regions took steps to expand their capital markets, but the nature of their policy measures varied. In East Asia, the government acted directly to promote market development. In Latin America, the most important step was to create private institutional investors, which, in turn, helped stimulate market development. As mentioned previously, international and regional financial institutions have also been active in promoting bond market development.

The main impetus to market promotion in East Asia was the financial crisis of 1997-98. Governments and other actors became convinced that if their countries had had adequate domestic bond markets, much less foreign borrowing would have taken place, and the crisis either would have been averted or would have been much milder. Individually, they began taking steps, such as opening financial markets to foreign investment, modernizing and expanding government bond markets, creating new institutions, and improving corporate governance.²⁴

In addition, both politicians and technocrats began promoting the idea of regional collaboration in market development. On the government side, political leaders recently approved plans for a pilot project to pool a small portion of the region's huge international reserves to purchase regional bonds. The initial size of the fund is only $1 billion, but it is expected to increase. The fund would be used to buy sovereign dollar bonds, although its purview may be extended to include purchase of local currency corporate bonds with high credit ratings.²⁵ In a complementary vein, a prominent Korean technocrat has recently called on countries to strengthen the region’s private-sector institutions in the financial services area (e.g., securities firms, investment banks, insurance companies), since U.S. and European firms currently mediate almost all of the region's international transactions.²⁶ In general, regional financial integration has been more prominent on the agenda in East Asia than in Latin America.

In Latin America, the most significant promotion of capital markets has been indirect. In 1981, as part of an overall program of market-oriented structural reforms, the Chilean government privatized its pension system. Individual accounts are managed by fund administrators (AFPs, by their Spanish initials), which have the obligation to have resources ready when members retire. Given their long time horizon, the AFPs became a source of demand for long-term assets. While initially pension monies were all invested in government debt, the AFPs were soon given permission to expand into domestic stocks and bonds, and eventually into international assets as well. Experts view the successful development of capital markets in Chile as directly related to the new institutional investors.²⁷

By the 1990s, many other Latin American countries were following the Chilean example. While their assets are not nearly as large as Chile's (as a share of GDP), they are already serving to buttress local capital markets. In most cases, however, governments in other countries have been more reluctant to permit investment in private-sector paper, so that government debt is their principal asset. Among major countries in the region, Brazil is the only one not to have embarked on privatization of its pension system. Thus, while the Brazilian pension system is very large, it consists mainly of employer-sponsored defined-benefit schemes; private funds complement the government controlled system for high-income individuals.

International capital has always played a large role in emerging market economies, although a few in Northeast Asia restricted foreign capital inflows in the early postwar period. The channels through which foreign capital entered have varied over time. Foreign direct investment (FDI) was the most important in the 1950s and 1960s, but was replaced by syndicated Euroloans in the 1970s. The latter led to a severe debt crisis in the 1980s in Latin America and some Asian countries as well. In the 1990s, while FDI again became significant (including important investments in banking, pension funds, and other parts of the financial sector itself), portfolio investment also played a large role. The latter entered via investment in local stock markets and, to a lesser extent, bond markets; in smaller countries where the capital markets were poorly developed, bank deposits constituted the main channel.

At the same time, governments, banks, and large non-financial corporations in emerging market economies sought funds on international markets by floating bonds, issuing American or Global Depository Receipts (ADRs/GDRs), or borrowing from international banks. As shown in Table 5, international bank loans reached about 15% of GDP for each region by 2001, while international bonds were about the same level in Latin America and nearly 10% in East Asia. [Add figures for ADRs/GDRs] Those with access to the international markets could obtain larger amounts of finance at a lower price than was available locally.

Despite these advantages, volatility, exchange rate risk, and (all too frequently) financial crises accompanied access to the international markets. This is not the place to go into the vast literature on financial crises and, indeed, much controversy exists over the relative weight of domestic and international sources of crisis. Nonetheless, at a minimum, there is agreement that international financial markets have been the source of serious problems, both for macroeconomic management and for the operation of firms at the microeconomic level.

Several significant problems have been identified. The most obvious is that foreign capital tends to move in waves. Large inflows enter as enthusiasm builds for emerging market economies, but they can retreat as rapidly as they arrived if confidence wanes for some reason. These surges and droughts are extremely difficult to manage, given their large size in comparison with most emerging economies. A related problem is the pro-cyclicality associated with private capital flows, which can produce asset price bubbles that – when they burst – wrack greater havoc on these economies than in the industrial countries. A third problem involves exchange rate appreciation, which is fed by capital inflows and undermines the trade balance – thus leading to the need for more capital inflows.²⁸

Adding up these various pieces, do they give us any clues about the future performance of the economies in the two regions? If we believe that finance is an important determinant of economic growth, then the vastly deeper financial markets in East Asia would appear, ceteris paribus, to provide the basis for continued higher growth in that region.²⁹ Equally important is the relative weight of private versus public finance; East Asia favors the private sector in both bonds and loans, while a large majority of Latin American finance goes to cover deficits or for other government activities (including public-sector investment and sterilization of capital inflows as a part of monetary policy). While some of these government activities are surely useful for growth, crowding out the private sector can only have negative consequences for the future of Latin America’s economic development.

Insofar as participation in international capital markets increases risks for emerging market economies, then the possibility of substituting local capital markets for international ones – for both public and private-sector actors – becomes a relevant issue for the policy agenda. Our research has some implications for this question, but it does not provide much source of optimism at the present time. The primary markets for equity in emerging market economies have been stagnant for a number of years; indeed, as seen in Table 4, delisting means that the number of firms has fallen in most Latin American countries, although not in Asia. At the same time, secondary markets have been extremely volatile, which lowers the incentive for listing. Bond markets, by contrast, have been expanding, but in a number of cases this has been due to heavy government pressure (e.g., Argentina) or to indexing bonds to the exchange rate (e.g., Mexico in 1994 and Brazil more recently). The latter creates many of the same problems as direct participation in international markets.

A crucial point for both equity and bond markets in emerging market economies is their absolute size. As Table 1 indicated, the two together were about $1.2 trillion in 2001 in Latin America and $1.3 trillion in East Asia, with the bond markets around $500 billion in each. In individual countries, however, only six markets exceeded $200 billion; only Brazil and Korea had bond markets over $200 billion. As mentioned earlier, this compares with an average of $5 trillion each for bond markets in the leading OECD economies. Overall, Latin America and East Asia accounted for less than 5% of total bonds issued in world markets.³⁰ This size factor has led some experts to argue that it would be much more efficient for emerging markets not to have local capital markets, but to become better integrated into international markets. The downside to this efficiency argument is precisely the problems outlined above: volatility, exchange rate risk, and contagion. An alternative for dealing with the size issue is greater regional financial integration as the Asians are trying to promote. We will return to this issue in the concluding section of the paper.