Emerging Markets: Finance and the Real Economy

1. Southern Finance Association Meetings Key West, November 22, 2002 Emerging Markets: Finance and the Real Economy Campbell R. Harvey Duke University and NBER

2. Emerging Markets Research Materials in my presentation are largely drawn from my past and on-going collaborations with Geert Bekaert at Columbia University.

3. Emerging Markets Research Program Harvey RFS95; WBER95 Predictable Risk Bekaert WBER95 Investment Barriers Bekaert and Harvey JF95 Time-Varying Integration Bekaert and Harvey JFE97 Emerging Market Volatility Bekaert, Erb, Harvey & Viskanta BOOK, JPM97 Behavior of Returns and Asset Allocation Bekaert and Harvey NBER98 Capital Flows Bekaert and Harvey JF2000 Foreign Speculators Bekaert, Harvey & Lumsdaine JFE2002 Dating Integration Bekaert, Harvey & Lumsdaine JIMF2002 Dynamics of Capital Flows Bekaert, Harvey & Lundblad WP2002 Liberalization and Growth Bekaert, Harvey & Lundblad JDE2002 Finance and Growth Econometrics Bekaert, Harvey & Lundblad WP2002 Liberalization and Growth Volatility Bekaert, Harvey & Lundblad WP2002 Emerging Mrt Liquidity & Expected Returns

4. Emerging Markets Research My first look at the data • Data through June 1992 • Published in RFS 1995 • What has happened since?

5. Average Annual Geometric Returns Through June 1992

6. Average Annual Geometric Returns Through June 1992 – What Happened After?

7. Average Annualized Standard Deviation Through June 1992

8. Average Annualized Standard Deviation Through June 1992 –What Happened After? Data through April 2002

9. Correlation with World Through June 1992

10. Correlation with World Through June 1992 – What Happened After? Data through April 2002

11. Beta with World Through June 1992

12. Beta with World Through June 1992 – What Happened After? Data through April 2002

13. Evolution of World Correlation Five-Year Rolling Window: 20 Countries IFC Composite Average of 20 Emerging Countries Data through April 2002.

14. Evolution of World Beta Risk Five-Year Rolling Window: 20 Countries IFC Composite Average of 20 Emerging Countries Data through April 2002.

15. Emerging Markets Research Why is the picture different? • Financial liberalizations

17. Asset Prices and Market Integration Prices Segmented Integrated PI PS Return to Integration Time High Expected Announcement Implementation Low Expected Returns of Liberalization Returns

18. Average Annual Geometric Returns Pre and Post Bekaert-Harvey Official Liberalization Dates Data through April 2002. There are no pre-liberalization data for Indonesia.

19. Average Annualized Standard Deviation Pre and Post Bekaert-Harvey Official Liberalization Dates Data through April 2002. There are no pre-liberalization data for Indonesia.

20. Correlation with World Pre and Post Bekaert-Harvey Official Liberalization Dates Data through April 2002. There are no pre-liberalization data for Indonesia.

21. Beta with World Pre and Post Bekaert-Harvey Official Liberalization Dates Data through April 2002. There are no pre-liberalization data for Indonesia.

22. Emerging Markets Research Implications • Lower cost of capital • More investment, employment • More economic growth • Current research with Geert Bekaert and Chris Lundblad explores the relation between equity market liberalization and the real economy

23. Emerging Markets Research Geert Bekaert, Campbell Harvey and Chris Lundblad, Does Financial Liberalization Spur Growth?Working paper 2002

26. Financial Liberalization Cost of Capital Growth Opportunities Relaxing Fin Constraints Financial Development Investment Efficiency of Investment Growth

27. Financial Liberalization and Growth Controversial exercise • Liberalization implies consumption booms and inefficient investment (crisis literature) • Liberalization may lead to reduced savings (endogenous growth literature) • Liberalization may lead to “hot speculative capital” and induce capital flight (Stiglitz & others)

28. Financial Liberalization and Growth What we already know(too many references to list!): • Financial/banking development associated with higher growth • Cost of capital decreases • Investment increases

29. Financial Liberalization and Growth Outline: 1. Did liberalization spur growth? • Large panel of data • Cross-sectional growth regression with temporal dimension 2. How did liberalization spur growth? 3. Accounting for the liberalization effect • Is is macro-economic reforms? • Is it financial development? • Other simultaneity biases? 4. Conclusions

30. Financial Liberalization and Growth Caveats: Not much guidance from theory. • As a result, it is important to conduct extensive robustness experiments

31. Financial Liberalization and Growth Econometric Framework: where yi,t+k,k is real per capita GDP growth between t and t+k Qi,1980 is initial GDP, Xi,t represents control variables Libi,t is a Liberalization indicator variable

32. Financial Liberalization and Growth Econometric Framework:

33. Financial Liberalization and Growth Econometric Framework: ST is the variance covariance matrix of the sample orthogonality conditions

34. Financial Liberalization and Growth Key issues: • Temporal dimension • Different weighting matrices • Liberalization variable • Choice of “k” • Endogeneity of the liberalization decision

35. Financial Liberalization and Growth Data: Four samples determined by availability of data • Sample I: 95 countries • Sample II: 75 countries [macroeconomic and demographic data]

36. Financial Liberalization and Growth Data: Four samples determined by availability of data • Sample III: 50 countries • Sample IV: 28 countries [add financial development indicators] As data requirements become more stringent, the variance of GDP levels across countries in the sample decreases.

37. Financial Liberalization and Growth Liberalization dates: • Use Bekaert and Harvey (JF 2000) “official liberalization” dates • These dates are based on a detailed chronology of important regulatory events • Augmented with IFC frontier markets and three developed markets, Spain, New Zealand and Japan

38. Financial Liberalization and Growth Liberalization dates: • Robustness of our results checked by examining Bekaert and Harvey (2000)’s “First Sign” dates • These dates based on the earliest date of {official liberalization, first ADR and first closed-end fund} • Example: Thailand • “Official” 1987:09 • “First Sign” 1985:07

40. Financial Liberalization and Growth Liberalization dates: • Capturing “intensity” or “comprehensiveness” of the liberalization • Ratio of IFC investable market cap to global stocks (Bekaert (1995) and Edison and Warnock (2001)) • U.S. holdings of domestic market capitalization • Is it just a proxy for capital account openness? [See Rodrik-Edwards debate]

41. Financial Liberalization and Growth Are the dates exogenous? Counter examples • Spain in the EU • Some countries cannot liberalize their financial markets

42. Financial Liberalization and Growth Findings so far: • We document a liberalization effect on growth with certain "standard control variables"

44. Financial Liberalization and Growth Findings so far: • The liberalization effect is robust to • different definitions of liberalization dates • to business cycle or interest rate controls • allowing for intensity of liberalization ...and independent of capital account liberalization

47. Financial Liberalization and Growth Channels of increased growth: • Both: • increased investment, partially through a cost of capital effect and • increased productivity (which is different from the financial development literature)

48. Financial Liberalization and Growth On the mechanism ... • Liberalization does not lead to consumption binge • investment increases • trade balance decreases

50. Financial Liberalization and Growth On the mechanism ... • Investment increases - but you need a minimum “country quality level” to see effect • decreased cost of capital associated with more investment