Introduction

Since the early 1990s, emerging economies have been rapidly integrating with the international financial system. Financial integration has manifested in many ways, including financial liberalization of previously closed economies, larger cross-border capital flows, entry of foreign banks, and participation of domestic firms in international markets. In particular, as firms go abroad, part of the domestic market activity has migrated to international markets. Capital is raised in international markets and securities are traded in international stock exchanges, in addition to domestic ones.¹ This process of financial integration has been fueled by the belief that it encourages better allocation of resources and risks worldwide, and ultimately promotes higher growth.²

Two factors have emerged to threaten this financial integration. Firstly, a series of crises erupted when countries opened up to capital flows, which led to some reservations regarding the net benefits of outright financial liberalization.³ Secondly, capital controls have emerged as a way to mitigate financial integration.⁴ In times of crises, controls on capital outflows have been used to stem reserve losses, currency devaluations, and the collapse of the banking sector. Two such well-known cases are those of Malaysia during the East Asian crisis of 1997–1998 and Argentina during its 2001–2002 collapse.⁵ In tranquil times, controls have been used to avoid the currency and maturity mismatches that short-run foreign flows can produce, and to mitigate the currency appreciation that tends to negatively affect trade balance and domestic production. In fact, Chilean-style controls on capital inflows have regained interest in recent years, with appearances in Argentina, Colombia, Peru, and Thailand.⁶

This paper analyzes the effects of capital controls and crises on the integration of emerging economies with the international financial system.⁷ Specifically, using a large set of firms from emerging economies, we examined the percentage price difference between the stocks that traded domestically and the corresponding depositary receipts (DRs) that traded internationally. We call this price difference the cross-market premium. DRs are certificates traded in major financial centers (New York in this case). They are issued by a US depositary bank and they represent shares of ordinary stocks held by a custodian bank in the issuer's home country. The stocks and the DRs represent the same asset traded in two different markets, because underlying stocks can be easily transformed into DRs and vice versa. This characteristic allowed us to measure international financial integration through the law of one price (LOOP), which stipulates that countries are integrated when the DRs in New York and the underlying stock are equally priced.

When there are no barriers to cross-country capital movement, arbitrage is expected to equalize the prices of the DR and the underlying shares. It follows that, in a fully integrated market, the cross-market premium should be approximately zero. However, full integration of capital markets can be disrupted by capital controls and crises.

Effective government controls on cross-country capital movement are expected to segment the markets, widening the cross-market premium. Controls on capital outflows put upward pressure on the underlying stock relative to the depositary receipt, since investors can purchase the security domestically and sell it at a discount in the international market, without having to pay tax to transfer funds outside the country. This positive cross-market premium could not be arbitraged away, because it would imply purchasing the DR in New York, selling it in the domestic market, and transferring the proceeds abroad. However, controls on capital outflows prevent the latter transaction. On the other hand, when the price in New York is higher than the domestic price (implying a negative cross-market premium), arbitrage can take place because investors can purchase the underlying stock domestically, sell it in New York, and transfer the funds back to the country. Note that capital controls limit the cross-border movement of funds, not stocks; therefore, arbitrageurs can transfer the stock from one market to another, with the goal of selling wherever the price is higher, but transferring proceeds from such transactions is governed by capital controls.

Controls on capital inflows have the opposite effect: they push up the relative price of depositary receipts (implying a negative cross-market premium), as investors buy them abroad and sell them domestically, avoiding the tax to enter the country. In this case, the negative cross-market premium could not be arbitraged away, because investors would have to purchase the underlying stock domestically, sell it in New York, and transfer the funds back into the country, but controls on capital inflows prevent the latter transaction. In sum, the cross-market premium reflects the effectiveness of capital controls and the price that investors are willing to pay to hold securities that can be freely transferred across borders when other restrictions are in place.

The impact of financial crises is more ambiguous. In principle, there are no obstacles to arbitrage; therefore, the cross-market premium would fluctuate around zero. However, the risks associated with swapping the underlying stock for the DR (and vice versa) increase due to transfer and convertibility risks, higher exchange rate volatility, and most importantly, reduced liquidity, which in turn induce market players to reduce their open positions at any point in time to a minimum.⁸ Consequently, one would expect crises to be associated with a more volatile cross-market premium that oscillates around zero, and that can turn positive or negative depending on the risks involved.

Recently, DRs have been used to assess the impact of capital controls and crises. Rabinovitch, Silva, and Susmel (2003) attribute the persistence of return differentials between ADRs and stocks in Chile to the presence of capital controls. Melvin (2003) and Auguste, et al. (2006) examine the large ADR discounts that built in the midst of the Argentine crisis in early 2002, which Levy Yeyati, Schmukler, and Van Horen (2004) interpret as a reflection of the strict controls on capital outflows and foreign exchange transactions imposed at the time. Pasquariello (2008) presented evidence of large return differentials during crises. In Levy Yeyati, Schmukler, and Van Horen (2008a), we investigated the statistical properties of the cross-market premium using linear and nonlinear models to measure the no-arbitrage bands, the convergence speed to those bands, and the mean-reverting properties of the premium. We further studied the effect of capital controls and liquidity on the cross-market premium, and analyzed the advantages of this measure of financial integration over alternative ones.

In this paper, we characterize the behavior of the cross-market premium around crises and changes in different types of capital controls by computing summary statistics and by using an event-study methodology. To do so, we worked with daily cross-market premium for a set of 98 stocks from nine emerging economies: Argentina, Brazil, Chile, Indonesia, Republic of Korea (hereafter Korea), Mexico, Russia, South Africa, and Venezuela. For all countries, except Argentina, we sampled the period 1990–2004. In the case of Argentina, we extended the sample period to 2007 in order to analyze the impacts of the controls on inflows introduced in 2005.

We found that capital controls were able to segment domestic markets from international ones. When binding (that is, when flows move against the controls), controls on outflows resulted in a positive premium, while controls on inflows resulted in a negative premium, as market participants were willing to engage in costly arbitrage only to a limited degree. Crises, on the other hand, while they did not tax arbitrage directly, affected financial integration by increasing volatility and by putting downward pressure on the domestic price, such that the underlying stock on average traded at a discount compared to the DR.

The remainder of the paper is organized as follows: section II discusses the methodology and data, section III analyzes the effects of capital controls on the cross-market premium, section IV illustrates the impact of crises on the premium, and section V gives a summary and conclusion.

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