Pergamon

pp. 607-622, 1998 0 1998 Elsevier Science Ltd All rights reserved. Printed in Great Britain 0305-750X98 $19.00+0/00 PII: SO305750X(98)00003-5

World Development Vol. 26, No. 4,

Emerging Stock Markets, Portfolio Capital Flows and Long-term Economic Growth: Micro and Perspectives Macroeconomic

AJIT SINGH* and BRUCE A. WEISSE

University of Cambridge, Cambridge, U.K.
Summary. - The paper examines two major components of financial liberalization, stock market development and portfolio capital flows in the context of less developed countries. The paper considers microeconomic and macroeconomic perspectives on their implications for long-term development and economic growth. It concentrates on: (a) the role of stock markets in financing corporate growth; (b) the implications of stock market volatility for resource allocation and productive efficiency; and (c) the interactions between the foreign exchange and stock markets in the context of economic shocks. Its policy recommendations are that LDCs should promote bank-based systems, influence the scale and composition of capita1 inflows, and prevent a market for corporate control from emerging. 0 1998 Elsevier Science Ltd. All rights reserved

Key words -

Stock markets, capital flows, financial systems, Latin America, East Asia, India

1. INTRODUCTION In the late 1980s a distinguished international study group for the World Institute for Development Economics Research (WIDER) headed by Sir Kenneth Berrill, former Chairman of the Securities and Investment Board in the U.K., forcefully argued for developing countries to liberalize their financial markets in order to attract foreign portfolio equity flows. The study groups essential argument was that there was a huge amount of financial capital available in developed countries through pension and investment funds that could be attracted to developing countries provided they liberalized their markets externally and developed their stock markets internally. Liberalization was imperative, the group argued, because foreign bank loanswhich dominated inward capital flows to the developing world in the 1970s-were decreasing in the aftermath of the Latin American debt crisis. Although the report noted the lack of a clear connection between economic growth and stock market development, it presented a large number of benefits that developing countries can reap. These included: (a) an additional channel for encouraging and mobilizing domestic savings; (b) improvements in the productivity of investments through market allocation of capital; and (c) increased managerial discipline exercised

though the market for corporate control (WIDER, 1990). A similar conclusion has been reached on the grounds that the differing demographic profiles of developed and developing countries make portfolio flows a Pareto-optimal solution to systemic problems in the world economy. Helmut Reisen has argued that the rapid aging of populations in developed countries has called into question the viability of state-sponsored pension schemes and that the only realistic alternative is the growth of privately funded pensions. By encouraging the flow of these funds from aging, slow-growth economies to younger, highgrowth countries in the developing world, pension fund managers can achieve an improved combination of risk and return, while developing countries could benefit from a steady long-term flow of capital (Reisen, 1994). In the event, many developing countries were undertaking far-reaching financial already market reforms in the 1980s as part of structural adjustment programs of the international financial institutions. The ancien regime of statedirected credit and repressed interest rates began giving way in many countries to a more market-based regime. Privatization programs that were aimed at diminishing the role of the
*Corresponding author. 607

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state in the economy required, among other of stock markets things, the development through which new ownership structures could be determined at market prices. Similarly, the rise in real interest rates due to the relaxation of government controls (financial de-repression) obliged large companies to diversify their sources of funds; this also contributed to the growth of equity markets. The logic of internal financial liberalization also led to an increasing movement towards external liberalization which then interacted with the internal reforms. Markets could expand and relatively thin, illiquid markets could benefit from inflows of foreign funds. Thus, a process of dismantling capital controls and limitations on foreign ownership was set in motion during the last decade in many developing countries. In Section 2 we will illustrate the enormous increase in portfolio capital flows and stock market development that have resulted from these measures. The essential question remains how, if at all, this enormous stock market development and foreign portfolio capital flows will help industrialization or long-term economic growth. To that end, this paper will consider certain microeconomic and macroeconomic perspectives on these unprecedented developments in the industrializing economies. Specifically, it will concentrate on the following: (a) the role of stock markets in financing corporate growth; (b) the implications of stock market volatility for resource allocation and productive efficiency; and (c) the destabilizing interactions between the foreign exchange and the stock markets in the context of internal or external economic shocks. To anticipate some of our findings, the paper will show that the stock market has been a surprisingly important source of finance for funding corporate growth in industrializing economies. This conclusion is theoretically unexpected as is the extraordinarily fast growth of new listings on many of the stock markets. With the myriad imperfections of stock markets in developing countries-from asymmetric information, poor supervision, inadequate disclosure requirements to high price volatility, rampant insider trading, and poor information-it would be more consistent to expect firms to shun the stock market and instead rely more on internal finance. The conclusion that stock markets are indeed important in financing corporate growth is therefore surprising, not least to the orthodox economists themselves, who naturally welcome it. This paper, however, suggests that at the crucial macroeconomic level the results have been disappointing. The paper will explore the

reasons why reality has diverged so sharply from expectations and will consider the policy implications it raises. 2. TRENDS IN STOCK MARKET DEVELOPMENT AND PORTFOLIO CAPITAL FLOWS TO LDCS The speed and extent of stock market development in the less-developed countries (LDCs) over the past 15 years have been unprecedented and have led to fundamental shifts both in the financial structures of LDCs and in the capital flows they receive from advanced economies. The present section will provide an overview of these trends as well as illustrate them with reference to the case of India. A key indicator of stock market development, the capitalization ratio (market capitalization as a proportion of GDP), rose at an unprecedented rate in leading developing countries during the 1980s climbing from 10% to over 70% of GDP in countries such as Taiwan and Chile in the course of a decade, while it probably took the U.S. over 80years to reach a similar ratio (Mullins, 1993). In terms of comparative market capitalization, many emerging markets have now achieved or surpassed the average medium-sized European stock market. In addition, the number of new listings and investors in these markets have soared and the total value of shares traded on LDC markets rose over 12-fold during 1986-95, increasing from just over 2% to nearly 9% of the total world value (IFC, 1996). This stock market development was aided by external financial liberalization and the consequent influx of foreign portfolio capital flows. As Table 1 shows, there has been a major change in the scale and composition of capital flows to developing countries. The most salient aspect has been the huge increase in private finance. The average annual net private capital flow to over 1983-88 was developing countries $15.1 billion, whereas over 1989-95 the figure surged to $107.6 billion. In 1996 the flow had reached $200.7 billion. While net direct investment has remained an important component of these flows, it has been the surge in net portfolio investment that has most characterized recent flows, increasing from $3.4 billion in the earlier period to $44 billion in the latter. There is a regional difference, however, in the composition of the flows. Net direct flows predominate in Asia while net portfolio flows have been more pronounced in Latin America. In the 1970s and early 1980s by contrast, bank loans dominated private capital flows to developing countries.

EMERGING STOCK MARKETS Forces driving advanced country flows to developing markets (push factors) and those drawing them into these markets (pull factors) have both operated to accelerate capital flows (Fernandez-Arias and Montiel, 1996; Smith and Walter, 1996). Among the former have been low US interest rates in the early 199Os, lower growth prospects in developed country stock markets and the increasing desire of US institutional investors to diversify their portfolios. The pull factors have been numerous and revolve around the economic, legal, regulatory and political environments in developing countries. The ability of foreign investors to quickly move funds in and out of emerging stock markets following external liberalization and the high growth rates of many LDCs have been of considerable importance in attracting foreign capital inflows. The developing countries currently account for a disproportionate share of global equity issuance. In developing countries 1994, accounted for 12.6% of total world market capitalization, but for 37% of global equity Table 1. Developing countries: capital flows (annual
average, US$ billion)

609

1983-88 1989-95 Developing countries Net private capital flows Net direct investment Net portfolio investment Other net investments Net official flows Change in reservesC Asia Net private capital flows Net direct investment Net portfolio investment Other net investments Net official flows Change in reserves
Western Hemisphere Net private capital flows Net direct investment Net portfolio investment Other net investment Net official flows Change in reserves 15.1 10.4 3.4 1.3 29.0 8.4 107.6 41.8 44.0 22.1 21.4 -42.7

1996
200.7 90.7 44.6 64.9 -3.8 - 82.3

11.9 3.6 1.2 7.1 7.6 -2.2

43.6 25.0 5.2 13.6 8.4 -23.8

94.7 54.8 9.2 30.1 7.2 -43.2

-2.0 4.7 -1.1 -5.1 9.7 0.5

33.0 13.2 25.4 -5.6 5.7 - 12.2

77.7 29.9 27.1 20.7 -11.6 -20.8

aNet capital flows comprise net direct investment, net portfolio investment, and other long- and short-term net investment flows, including official and private borrowing. hBecause of data limitations other net investment may include some official flows. A minus sign indicates an increase. Source: IMF (1997).

issues. In the wake of the Mexican crisis in 1994 and the subsequent flight of foreign portfolio capital, the latter figure declined to a still significant 25.3% (International Monetary Fund, 1996, p. 101). This rapid development does not, however, mean that the even the most advanced emerging markets are mature. In most markets, trading occurs in only a few stocks which account for a considerable part of the total market capitalization. Beyond these actively-traded shares, there are serious informational and disclosure deficiencies for other stocks. Further, supervision by regulatory authorities is often far from adequate. The less developed of the stock markets suffer from a far wider range of such deficits.3 The development of the Indian stock exchanges provides a striking illustration of the trends noted above, despite the fact that it has been a laggard in financial liberalization? While the Indian stock market was founded more than a century ago, from independence in 1947 up until the 1980s it had remained a sleepy backwater in the Indian financial system, with little scope for expansion in a regime dominated by state-directed credit. In 1980, the capitalization ratio was only 5%. As a result of liberalization measures initiated in the 198Os, by 1990, the ratio had risen to 13%. After the major change in government policy and the acceleration of the pace of liberalization in 1991, stock market growth has been explosive. By the end of 1993, total market capitalization had reached 60% of GDP. The number of shareholders and investors in mutual funds rose from two to 40 million over 1980-93. This makes the Indian investor population the second largest in the world, second only to the U.S. which has about 51 million investors. But, in terms of the number of companies listed on the stock markets, the Indian stock market by the end of 1995 was the largest in the world, with nearly 7985 listed companies. This surpassed the 7671 listed domestic companies on U.S. exchanges and far exceeded those of the U.K. and Germany with 2078 and 678 listed companies, respectively.5 On the largest Indian stock exchange at Bombay, the daily turnover of shares increased almost 30-fold during the 1980s and early 1990s-from 0.13 billion rupees in 1980-81 to 3.7 billion rupees in 1993-94. The average daily trading volume on the Bombay stock market in the early 1990s was about the same as that in London-about 45000 trades a day. At the peak of stock market activity trading has occurred at double that rate. As these deals are put through

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in a short period of 2 hours, the Bombay stock exchange is reported to have the highest density of transactions in the world, behind only that of the Taiwan stock exchange.6 The Indian economic reforms of the 1990s have not only been associated with the vast expansion of stock market activity, but also with important steps to improve the functioning of the markets, to make them more transparent, and less subject to insider dealing and fraud. newly-appointed regulatory Although the authority, the Securities and Exchange Board of India (SEBI), has apparently made some progress in a number of these areas, it will be a long time before the Indian stock market loses its justly deserved reputation of being a snake pit to use Joshi and Littles expressive phrase. Indeed, notwithstanding SEBIs valiant efforts the Indian press continues to regale stories of fresh stock market scams. One leading Indian magazine recently wrote that market regulation is almost non-existent and that the financial markets have become as a consequence a virtual freeway.

3. THE FINANCING OF CORPORATE GROWTH The engine of economic growth in East Asia in the post-war period has been spearheaded by large, private diversified business groups, such as the zaibatsu in pre-war Japan or the chaebol of South Korea. Large business groups dominate the economic landscape in most developing countries today, from Indonesia and Malaysia to

India and Turkey. But, development economics, whether theoretical or empirical, has paid little attention to the role of the LDC firm and their financing patterns. In the first large-scale empirical studies of corporate finance in developing countries, Singh and Hamid (1992) and Singh (1995a) have to some extent filled this gap in the literature and have produced some extremely surprizing results. They have shown that contrary to a priori expectations, large LDC firms rely heavily on: (a) external finance; and (b) equity finance. The relevant data from Singh (1995a), which is the more comprehensive of the two studies, are presented in Figure 1. The study analyzed accounting data for the top 100 listed manufacturing corporations in 10 developing countries, generally over the period 1980-90. The 10 developing countries were India, Pakistan, South Korea, Jordan, Thailand, Mexico, Turkey, Malaysia, Zimbabwe and Brazil. The data indicate that corporations in the sample of developing countries rely extensively on external financing. In five out of the 10 sample countries (Korea, Thailand, Mexico, Turkey, Malaysia), more than 70% of the growth of corporate net assets during the period was financed from external funds. In another two (India and Brazil), the external financing proportion was more than half. Further, the importance of equity financing of LDC corporations is revealed by the fact that in five of the 10 sample countries (Korea, Mexico, Turkey, Malaysia, Zimbabwe), more than 40% of the growth of assets in the 1980s was financed by new share issues. In another two countries (Jordan and Brazil), equity finance accounted for more than

70.0 60.0 50.0

0.0

Korea

Mexico

India

Turkey

Malaysia

Figure 1. Top listed companies in manufacturing, internal and external financing of corporate growth: median values.

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611

25% of corporate growth during the relevant period. This pattern of corporate financing in developing countries goes against the pecking order theory of finance which is thought to characterize advanced country markets. The pecking order theory asserts that there is a strict hierarchy of firm preferences in financing decisions. The most preferred method of financing investment is internal finance from retained earnings; if more finance is required, bank finance is utilized followed by long-term debt, and only as a last resort through the issuance of new equity on the stock market. Figure 2 presents data from a study by Corbett and Jenkinson (1994) of developed countries which indicates such a pecking order of financial sources. The results of the Singh and Hamid analysis are theoretically unexpected for a number of reasons. First, while it is not surprising that developing and developed countries should have a different pattern of finance, the puzzle is that the observed patterns are counterintuitive. Developed country corporations, operating as they do in the context of sophisticated capital markets, could be reasonably expected to finance more of their growth through the intermediation of the market. In contrast, the far less mature capital markets in developing countries should, theoretically, lead firms to utilize internal sources of finance for investment. This is because the informational and regulatory shortcomings of developing markets, as well as the fact that most firms in these markets will not have established market reputations, should be reflected in their pricing processes being noisy and arbitrary.

The result is greater share price volatility in emerging markets than in more mature markets, a fact that many empirical studies have confirmed. In extreme cases, for example those of Mexico and Turkey, El-Erian and Kumar (1994) report that share price fluctuations were lo-20 times larger than those on the New York or London stock markets. This will tend to discourage firms from seeking a stock market listing or attempting to raise funds by new issues (Shleifer and Vishny, 1996). Second, share price volatility reduces the efficiency of market signals and may also be expected to discourage riskaverse investors from raising funds on the stock market, and indeed even from securing listings on the market. Third, the fact that many of the large, diversified companies in the developing world are family-owned should make their managers more reluctant to issue equity for fear of losing control of the corporation. The two consequences that would seem to flow naturally from these considerations, namely that developing country firms would rely heavily on internal finance and would raise only small amounts on the stock markets or indeed shun listings altogether, are not seen in actual behavior in emerging markets. While India is a clear outlier with its nearly 8000 listings, there is strong evidence of extremely fast growth of listings on stock markets during the 1980s in most leading industrializing economies (IFC, 1990, 1993). As seen above, the average sample LDC firm does not exhibit a pecking order structure of finance. Singh (1995a) has put forward a number of interlinked hypotheses to explain these phenomena in their specific historical and institutional

70 60 50 g t
0 f

40

&Bank Finance
30 20 10 0 -10 Figure 2. Gross sources of finance for the corporate sect05 1970-89 (percentage of total jkance).

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context. First, unlike in the U.S. at the beginning of this century, the development of stock markets today is not a spontaneous response to market forces. For a variety of reasons, developing country governments have played a major role in promoting the expansion of these markets. Extensive privatization programs in many countries have been an important stimulus to stock market development (Pfeffermann, 1988). Similarly, governments have also seen stock markets as a vehicle to tap private savings to finance state-owned enterprises. In addition, as will be discussed more below, in the wake of the debt crisis, developing countries were encouraged to foster stock market development in order to attract non-debt creating foreign portfolio investment. Finally, the global trend toward deregulation and liberalization has been supported by the international financial institutions in their policy advice as well as by advanced countries who have consistently applied pressure on developing countries to liberalize their financial markets. Second, a key reason why developing country corporations resorted so much to stock market finance was because the relative cost of equity capital fell significantly as a result of large rises in share prices during the course of the decade. In addition, the large increase in international interest rates as well as the process of financial de-repression in many countries during the 1980s raised the cost of debt finance and encouraged a substitution towards equity issuance in financing corporate growth. Third, the government also used active measures to ensure that managers were willing to go to the stock market to raise new issues, thus increasing the supply elasticity of corporate securities. In Korea, these active measures took the form of debt-equity ceilings that compelled Korean conglomerates to seek stock market financing. In India, Atkin and Glen (1992) found that the ability of state-owned banks to convert a portion of corporate loans into equity, at terms disadvantageous to corporations, made firms reluctant to take on debt. The microeconomic effects of stock market expansion in LDCs can thus be argued to have been beneficial as large companies have been able to raise large amounts of finance at cheap rates by issuing equity to fund their corporate growth. The critical test is, however, whether the stock market has helped the overall long-term economic performance of LDCs by increasing aggregate savings and the amount and productivity of investment. However, before these questions can be addressed, a prior question

must be answered: financing overstated adopted?

are the results on external because of the methodology

4. IS THE ROLE OF STOCK MARKETS IN CORPORATE GROWTH OVERSTATED? It has been suggested that the contribution of equity to corporate growth has been overstated in the Singh and Hamid (SH) analysis. In a recent paper, Cobham and Subhramaniam (1995) (CS) suggest that the methodology used by SH overstates the contribution of equity finance to Indian corporate growth and, therefore, exaggerates the apparently positive role of the stock market. Using the alternative methodology of Mayer (1990) Corbett and Jenkinson (1994) (MCJ), the CS estimate of the contribution of new equity to Indian corporate investment is considerably smaller. The MCJ methodology has traditionally been employed on advanced economies using flowof-funds data. CS use the same method for measuring the contribution of the internal and external financing variables to Indian corporate growth. But, they employ this methodology both with the flow-of-funds data as well as aggregate accounting data. Their results, based on the latter data, show, for example, that Indian corporations during the 1980s financed only 7% of their investment requirements from equity II issues. The CS exercise raises important conceptual issues about how in general the contribution of the stock market and other sources of finance for corporate growth should be estimated. The difference in the empirical results are indeed due to the different methodologies used in the two exercises. The respective methods, however, have important implications for the economic interpretation of the results. The following points are salient. First, a substantial part of the difference in the empirical results from the two methods is likely to stem from the fact that under MCJ, depreciation is included as a major component of internal finance, whereas in the SH work it is excluded both from the numerator and the denominator in the relevant ratios. But, as the purpose of the SH exercise is to measure the sources of finance for corporate growth of net assets, it is necessary to focus on the net increase in corporate assets, because the depreciation provision for replacement is normally required to merely maintain the stock of assets. Prais (1976) provides the classic discussion of this issue.

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The second important point is that the MCJ method, when used with the flow of funds data (as is generally the case), relates to the corporate sector as a whole, rather than to the individual firms. In this approach intra-corporate sector transactions are normally netted out and external finance means funds from outside the corporate sector. Therefore, the question being addressed by MCJ with the flow-of-funds data is: how is gross physical investment of the corporate sector as a whole financed, by internal sources (within the corporate sector) and by external sources (from outside the sector, e.g. the household or the financial sector). This is a rather different question than that addressed by SH. The latter use firm-level accounting data to enquire how individual corporations, rather than the corporate sector as a whole, finance the growth of their net assets, net of depreciation. As noted by Singh (1995a), the differences between the SH and the MCI perspective comes out most starkly in the case of takeovers. If a corporation takes over another corporation within the non-financial corporate sector, for example by paying for the acquisition with its own shares, this is regarded by SH as new investment financed through the issue of fresh equity. The rationale for this approach is that from the point of view of the individual firm, growth by acquisition is an alternative to growth by creation of new productive capacity. From the standpoint of the corporate sector as a whole, however, there is no increase at all either in physical investment or in the shares issued. Thus, in the MU methodology, such intrasectoral transactions are netted out. Although the above example refers to the case of takeovers, the general point has wider application. Indeed, Corbett and Jenkinson themselves note: a firm that uses its cash flow to buy the equity of another company (from the household or financial sector), and issues no additional equity, will produce a negative net source of finance figure for equity. Thirdly, it is important to note that the differences in the corporate financing patterns between developed and developing countries are greatly reduced when these patterns are estimated by the use of the same methodologywhether it is MCJ or SH. This is one of the main results of Singh (1995a) which revised one of the earlier conclusions of Singh and Hamid. To sum up, the overall conclusion of this analysis is that the Singh and Hamid method does not overstate the contribution of equity finance to corporate growth in India and other emerging markets as: (a) it is looking at this

issue from the perspective of the individual firm rather than that of the corporate sector as a whole; and (b) considering the expansion of the firms net rather than gross assets.

5. STOCK MARKETS, PORTFOLIO CAPITAL FLOWS AND LONG-TERM ECONOMIC GROWTH: MACROECONOMIC ISSUES We turn now to the macroeconomic issues raised by the enormous stock market expansion in developing countries. In any macroeconomic analysis of the impact of stock market expansion, the question of portfolio capital flows is of critical significance. This is because, as a consequence of the debt crisis many LDCs, particularly in Latin America, have been balance of payments constrained. The availability of portfolio capital inflows at the end of the 1980s and into the 1990s enabled the relaxation of this constraint and the resumption of economic growth after the lost decade of the 1980s. In addition to this immediate benefit of capital inflows, the WIDER report noted at the beginning of this paper as well as a report from the United Nations Industrial Development Organization (UNIDO, 1996) have urged the promotion of portfolio capital flows on a number of grounds. These included not only their capacity to bolster a countrys external payments position, but also the greater flexibility of equity flows as compared to debt, their immunity from interest rate shocks, and their ability to promote local capital-market development. Thus, LDCs were advised to abolish exchange controls and liberalize their capital accounts in order to attract institutional finance. These massive capital inflows have proved, however, to be a double-edged sword. Although they enabled growth to resume, the case of Mexico illustrates that they also led to a crisis of massive proportions, not only for that country, but also for the international financial system as a whole. In the early 1990s Mexico suddenly received a vast quantity of foreign capital in response to its reforms aimed at deregulating major markets, privatizing state enterprises and combating inflation. These developments raised expectations of economic growth and enabled Mexico to attract huge net capital inflows. amounting to $91 billion over 1990-93, one-fifth of all net inflows to developing countries (International Monetary Fund, 1995, p. 53). During 1992-94, the annual capital inflows averaged 8%

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of GDP, compared with 5% of GDP during the previous peak period of 1977-81. Net portfolio inflows accounted for the largest share of these inflows, over 1990-93 it amounted to $61 billion or 67% of net capital inflows. The Mexican stock market received $22 billion of these net portfolio inflows during 1991-93 which fueled a rise in the share price index of 436% in dollar terms (International Monetary Fund, 1995, p. 53).13 In the wake of the steep devaluation of the Mexican peso in December 1994 which triggered the crisis which overwhelmed the country, it became apparent that the capital surge was not based on performance or on fundamentals 1995; Rodrik, 1994). Mexicos (Krugman, average annual growth rate of GDP over 1990-94, notwithstanding these huge capital flows, was only 2.5%, only slightly above the population growth rate.14 During this period it was also apparent that the current account balance was also deteriorating: a deficit of $7 billion in 1990 had mushroomed to over $29 billion in 1994 (ECLAC, 1996, p. 248). In 1993, the current account deficit was 6% of GDP despite the fact that the economy had expanded at a rate of only 0.6% per annum while in 1994 it widened to 9% of GDP as growth increased to three and a half percent per annum. These deficits were greater than those which occurred in 1981 on the eve of the debt crisis when the economy expanded at a rate of 7% per annum. Further, during 1990-94 Mexican private savings fell from 15% to 5% of GDP. Cumulatively, these figures strongly suggest that the huge capital inflows led to a collapse of private saving and caused an unsustainable credit-driven consumption boom that ended in forced devaluation (McKinnon and Pill, 1996). The collapse of the speculative bubble in December 1994 had a devastating effect on the Mexican economy and, through the so-called contagion effect, on Latin America as a whole. The gross domestic product of Latin America and the Caribbean grew by only 0.3% in 1995 while per capita GDP declined by 1.5%, in contrast to a 3.5% increase in 1994 (ECLAC, 1996, p. 67). Despite the unprecedented IMF-led rescue package of more than $50 billion, real GDP in Mexico fell by 7% in 1995, while in Argentina, the Latin American economy most affected by the contagion, real GDP fell by 5%. Indeed, the IMF regarded the episode as a systemic crisis for the international financial order as a whole. How can we account for this stunning reversal of the expectations both orthodox theory and policymakers had placed on portfolio capital

inflows? At a theoretical level, we can identify a number of different microeconomic as well as macroeconomic elements that heighten the instability and negative impact of capital inflows. First, the uniqueness of financial markets in terms of their susceptibility to market failures has been noted by many economists, most notably by Stiglitz (1994) and Diaz-Alejandro (1985). Since financial markets are concerned with the production, processing, dissemination and utilization of information, many of the associated market failures revolve around the problems of asymmetric information, moral hazard, and adverse selection which lead to further problems of missing and incomplete markets. Further, the cost of information also creates problems of imperfect competition as each financial institution, for example, has specific knowledge about its customer base that others do not have. Thus, Stiglitz notes that two of the crucial assumptions underlying the fundamental theorem of welfare economics-that there must be a complete set of markets and that information must be exogenous-are absent in the case of financial markets. The prevalence of these market failures, Stiglitz argues, open up a wide range of regulatory interventions that can raise general welfare. In the case of Mexico, a consequence of the presence of incomplete markets was that there was a consumption binge instead of heightened investment as a result of massive capital inflows. Complete markets would have relayed to market agents the costs associated with such a pattern of behavior. Government intervention to provide a mechanism to resolve this coordination failure therefore can raise welfare, as will be illustrated shortly in the case of Chile. Second, the deteriorating macroeconomic performance of Mexico and the huge amounts of capital flowing into the country suggest that the primary motive of investors was speculative and not based on economic fundamentals. How can we account for this seemingly irrational herd behavior of institutional investors? In the 1930s John Maynard Keynes provided an important insight into this question. He argued that since people do not trust their individual judgments under conditions of uncertainty, they endeavor to fall back on the judgment of the rest of the world which is perhaps better informed. That is, (people) endeavor to conform with the behavior of the average. Imitative and bandwagon behavior-concepts which have been rationalized in recent works both by economists and sociologists5-thus, come to dominate the market.

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Third, there is a psychology built into the process of liberalization that often generates wild expectations about growth in everything from the stock market to property values. There is, thus, a large difference between current income levels and those expected in the future. As a consewhat economy experiences quence, the McKinnon and Pill (1996) have called the overborrowing syndrome as consumers increase consumption and investors step up borrowing to meet increased expected production. The excessive optimism and consequent credit expansions are reinforced by large scale capital inflows which further buoy share and property values (White, 1996). Thus, at the empirical level, there is invariably a crowding out of domestic savings by foreign capital inflows. This factor was particularly conspicuous in the case of Mexico as noted above. It is interesting to note that even for developed countries, Bayoumi (1993) provides evidence to indicate that internal financial liberalization is linked to declining domestic private savings. Fourth, at a macroeconomic level, Akyuz (1993) has pointed out that external financial liberalization leads to an interaction between two inherently unstable markets-the stock market and the market for foreign exchange. In the context of internal or external economic shocks, the relationship between these two unstable markets can lead to a negative feedback loop and even greater instability. This, in turn, would affect other important economic variables such as investment, exports and imports (through exchange rate fluctuations), and consumption (through the wealth effects arising from stock market fluctuations). Finally, instead of a predictable and durable supply of foreign capital, portfolio capital inflows are often short-term and speculative, reflecting the desire of advanced country investors to have instant liquidity in what are risky markets. They are also in large part dictated by the vagaries of supply side conditions in the industrial countries (e.g. changes in U.S. interest rates) where portfolio managers are based. The main policy conclusion which the paper draws from this analysis is that in order for a country to maximize the benefits of capital inflows, which may inevitably come in the form of surges, and minimize their costs, it is important to have appropriate and coordinated government action in a number of different spheres. The welfare costs of non-intervention are huge. The kind of interventions required for this purpose are illustrated by considering the case of

Chile. In contrast to the dramatic drops in output in Argentina and Mexico in 1995, Chile achieved GDP growth of over 8%, a substantial increase over the previous years growth and the 12th consecutive year of sustained growth (ECLAC, 1996, pp. 67-68). This was accomplished despite the fact that net capital inflows declined from US$3.8 billion in 1994 to US$900 million in 1995 (ECLAC, 1996, p. 112). A substantial part of the explanation for this performance can be found in Chiles policy towards capital flows. Chile altered its non-interventionist policy stance on capital flows after its total failure during the surge of inflows over 1978-81. In the mid-1980s the Chilean authorities adopted a set of pragmatic policies to influence both the level the composition of capital inflows, and encouraging long-term inflows such as FDI and discouraging speculative short-term equity flows (Singh, 1996b). Ffrench-Davis et al. (1994) note that the Chilean government has used four basic instruments to neutralize any effects that, as a result of the influx of short-term capital, might be inconsistent with the countrys export development strategy. These instruments are: the application of taxes and reserve requirements to capital inflows; an exchange rate policy based on dirty floating of the exchange rate in relation to a reference value pegged to a basket of currencies; open market operations to sterilize the monetary effects of exchange rate dealings; and the prudent supervision of financial markets. Just as portfolio capital flows have turned out to be problematic in the context of economic development, the unprecedented expansion of stock markets also raises severe questions as to their capacity to generate rapid economic growth and promote late industrialization. Orthodox economists have almost unanimously concluded that stock market development leads to faster economic growth. A study by Atje and Jovanovic (1993) for example, concludes that stock markets on their own can raise a typical developing countrys economic growth by an astounding 2.5% per annum. Many of these researchers, however, have employed Barro-type international cross-section analysis to determine the sensitivity of economic growth to stock market development. As pointed out by Quah (1993) Lee et al. (1996) and Arestis and Demetriades (1997) it is difficult to draw any causal inferences from the cross-section regression methodology used in such work. Further, the endogenous finance models represent equations which abstract reduced-form altogether from the workings of the stock

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markets most important mechanisms-the pricing process and the takeover mechanism (Singh, 1997a). The operation of these mechanisms has been studied extensively in the context of advanced country markets, and a critical school has drawn attention to their shortcomings. In regard to the pricing process, stock market prices might be reasonably efficient in Tobins information arbitrage sense, but since they are subject to fads and speculation they are often dominated by noise traders and consequently not necessarily efficient in the most important dimension of reflecting fundamental values, that is, the value of the future discounted cash flows of the 1984). takeover company (Tobin, The mechanism is also subject to a number of intrinsic problems. First, evidence suggests that competitive selection in the market for corporate control is not based on the theoretically expected criterion of profitability or stock market valuation, but rather on the basis of size. Thus, because of capital market imperfections, a large unprofitable firm has a greater chance of survival than a small efficient firm. In addition, it is possible that large firms may further increase their chances of survival by increasing their size through the takeover mechanism itself. Second, there is both analysis and evidence to indicate that the actual operation of the takeover mechanism in the mature U.S. and U.K. stock markets leads to short-termism on the part of managers who must focus on quarterly returns rather than long term investment, particularly in firm-specific human capital. There are, thus, serious drawbacks to stock market based systems in advanced countries, which have led to an important debate on the disadvantages of such systems for international competitiveness. These disadvantages are further magnified in developing countries with their weaker regulatory institutions and greater macroeconomic volatility. The higher degree of price volatility on LDC stock markets further reduces the efficiency properties of market signals with adverse consequences for the optimal allocation of resources. Further, the presence of large and potentially predatory business groups in many developing countries makes it likely that the development of the takeover mechanism in LDC markets will increase the aggregate level of concentration in the economy and probably will increase allocative inefficiency. The short-term orientation encouraged by the takeover process and the tendency to emphasize financial engineering over productive activity in volatile and liquid financial

markets are both inimical to late development. A long-term investment horizon and patient finance are central in late industrialization, which is above all a long process of institutional and technological adaptation and learning (Amsden, 1989). Thus, although the stock market has made significant contributions to the growth of large LDC corporations in the recent period, the shortcomings inherent in a stock market-based system require us to examine whether the economy as a whole has benefitted through, for example, greater aggregate savings, investment or increased productivity of investment. There is little systematic empirical evidence on this issue for developing countries in the Singh (1995b) or Singh and Hamid (1992) samples. There is, however, some evidence that aggregate savings have declined in many of the countries over the relevant period. More importantly, there is some recent useful direct evidence for India compiled by Nagaraj (1996) which bears directly on these issues. Capital market growth can represent an increase in financial savings or a change in the composition of investors portfolios. Nagaraj provides evidence that it is the latter element which has predominated, with a substitution away from net bank deposits and toward shares and debentures reflecting the policyinduced changes in the return of these financial instruments. Thus, despite the rapid growth in financial markets since the latter half of the 197Os, the share of aggregate financial savings in the economy as a whole declined during the course of the 1980s. Further, the link between capital market growth and material investment has been weak and it has not been positively related to growth in value added. Finally, he notes that an increasing proportion of the economys financial resources have gone into a sector (private corprate manufacturing) whose share in manufacturing has declined. The observed results for India, the experience of Mexico and evidence from other LDCs as well as the high degree of share price volatility, suggest that despite some beneficial microeconomic results there are grounds to question the orthodox position that financial market development will necessarily have positive macroeconomic effects on savings and investment or their allocation. 6. THE MAIN BANK SYSTEM AND ECONOMIC DEVELOPMENT In spite of the neo-liberal policy advice of the Washington consensus encouraging more rapid

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development of stock markets, main bank systems have been the most successful financial vehicles for late industrialization. They have characterized-in different forms-the financial systems of the two most successful late industrializers, Germany and Japan. The bias within the financial literature, however, is that such systems are inefficient and a half-way house on the road to more developed and sophisticated financial structures (Allen and Gale, 1995, p. 180) The rapid industrialization of South Korea and Taiwan-two countries with strong bank-based systems during their periods of rapid growthsuggest that there are features of the main bank system that are conducive to the provision of the high and steady investment required for late industrialization. While the institutional arrangements underlying main bank systems vary, the basic contours of the system are that banks establish long-term relationships with industrial companies, often solidified by cross-shareholding. The relationship is complex and entails both benefits and obligations to the bank and the firm. It is understood that the main bank will have preferential access to the firms transactions deposits, as well as to those of its employees, subsidiaries and subcontractors. In return, the firm receives from its main bank secure access to loans when credit is tight and the unwritten assurance that the bank will rescue it through restructuring or merger rather than liquidate its assets (Patrick, 1994). The main bank system is efficient in two major respects in the context of economic development. First, through its detailed knowledge of its clients operations the banks are able to effectively evaluate credit risk, ex post, as well as monitor the performance of the management during the course of the investment itself (Aoki, 1994). The main banks equity participation in the firm ensures that there is a strong incentive to monitor.** In addition, in an environment with undeveloped sources of market and corporate information as well as more limited amounts of managerial talent, there are efficiency gains in monitoring being concentrated in banks which possess the capabilities to assess projects and management. In so doing the system avoids reliance on stock market prices which are, as noted earlier, much more volatile in such an environment. Second, the stable and patient provision of finance is essential in a process of late industrialization. The main bank system with its focus on long-term relationships and lending is capable of providing this as well as shielding the firm from instabilities in financial markets.23 Despite the

fact that in theory capital markets with their varied instruments are more equipped to provide predictable, long-term finance, Akyuz (1993) notes that historically, financial asset prices, interest rates, and bank deposits have been less volatile and financial disruptions and bank failures less frequent in the bank-based sytems of Germany and Japan than in the U.S. As a consequence, lower capital costs and a more stable supply of finance have enabled Japanese firms to undertake longer-term projects. The main bank system has also promoted a longer-term perspective by precluding a market for corporate control which has enabled managers to focus on longerterm productive investment rather than on quarterly returns in a stock market (Singh, 1996b). Bank-based systems of finance have characterized LDC economies, including those of India, China Mexico, and Turkey, although these systems have not been as successful as those in East Asia and Europe for a variety of reasons. These reasons have included, in particular cases, regulation and poor supervision, crony capitalism, monopolistic abuses, and corruption. Nevertheless, in general these systems supported the unprecedented rates of economic growth and industrial development in the LDCs in the postwar era, an achievement of historic dimensions and one that has yet to be replicated by more liberalized financial systems. Bhatt (1994) points out that while the lead bank system in India has not been as successful as its Japanese counterpart in improving the investment and productive efficiency of assisted companies, it has ensured adequate long-term finance for sound industrial projects and has been responsible for the diversification of the industrial structure. The lead bank system was a key factor behind the 6% annual growth rate of Indian industrial output over 1950-90, which is a respectable record sustained over a long period of four decades. Developing countries would do better to reform the institutional structures of their banking systems rather than create stock markets which require sophisticated monitoring systems to enable them to function effectively, quite apart from their intrinsic shortcomings discussed earlier. If the banking system, the fulcrum of any financial system-including stock market based ones-remains fragile, corrupt and unreformed, there is little hope that the stock market can remain immune from these defects. In addition, financial liberalization has exposed banking systems to increasing shocks and cumulative sums expended in bank bail-outs since 1980 has

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amounted to almost $250 billion by one estimate (White, 1996). In much the same way as stock market development has been a conscious policy choice, there is evidence that Japan, in the wake of WWII, deliberately encouraged the development of a bank-based system (Patrick, 1994; Ramseyer, 1994). Underlying the move towards stock markets, however, has been the presumption, implicit in modern financial theory as noted earlier, that an evolution towards a stock market based system is a natural progression in financial development. A study by de Cecco (1993) reveals that historically such a progression has not occurred in leading European countries. Germany and Italy, like Japan, achieved their economic miracles in the post-WWII period with little reliance on the stock market (Pagano, 1993).

unstable markets, the stock market and the foreign exchange market. 5. The dominance of stock markets may undermine the existing group-bank financial systems which have served many developing countries well, particularly in the dynamic economies of East and South-east Asia. It is commonplace for orthodox economists to argue that the fundamental problem is one of sequencing reforms in the proper order. This perspective, however, fails to take into account the fact that developing countries are more subject to internal and external shocks which can destabilize any conceivable ordering of reforms. The instability of international terms of trade arising in relatively undiversified economies is a major source of financial disruption (White, 1996). In addition, the structural adjustments within developing economies leads to increased uncertainty and volatility which are easily transmitted through financial markets. While banking systems are also exposed to these threats, the speculative character of immature stock markets will magnify these effects and lead to negative interactions in other markets, particularly foreign exchange markets. Governments, therefore, face a choice of either investing huge sums in adequately monitoring and supervising stock market activity, or to focus on reforming their existing bank-based systems. This paper has argued that the latter course is more appropriate and institutionally more feasible for developing countries. The liberalization of finance and the proliferation of stock, bond, and futures markets also threatens to lead to the dominance of finance over industry, of financial manipulation over productive activity. Instead of focusing on improving products and production processes, managers could increasingly be selected on the basis of their ability to play the financial markets. Further, positions in the financial sector are often the most lucrative and draw a considerable amount of talent away from the manufacturing sector, which is the spearhead of late industrialization. There are three policy implications which emerge from this analysis. First, LDCs should move to influence both the size and composition of capital inflows. Short-term and speculative flows should be discouraged through reserve requirements and tax policy. Second, LDCs should focus on strengthening their banking systems rather than promoting stock markets. Banks provide the surest vehicle for promoting long-term economic growth and industrialization.

7. CONCLUSION AND POLICY IMPLICATIONS The essential conclusion of this paper is that unfettered financial liberalization, and specifically the two dimensions considered in this paper, stock market development and portfolio capital inflows, are unlikely to help developing countries in achieving speedier industrialization and faster long-term economic growth. The reasons behind this conclusion can be summarized as follows: The high volatility of share prices in emerging markets makes them even more of a gambling casino than fully developed markets. It would indeed be foolish, as Keynes warned, to leave the capital development of a country to such casinos. The share price volatility renders the prices inefficient as signals for resource allocation. Stock markets invariably encourage short term profits rather than permit corporate managers to take a long-term view of investment. The latter perspective is, however, particularly important for efficient investment in a developing country. Portfolio capital inflows are invariably shortterm and speculative and are often not related to economic fundamentals but rather to whims and fads prevalent in international financial markets. Thus, their rapid reversal can lead to crises and collapsing economic growth as in Latin America in 1994-95. In the context of internal and external shocks to which LDCs are particularly prone during the course of development, there may be negative interactions between two inherently

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Third, since stock markets are here to stay, governments should try to shield the real economy from their vagaries. The presence of large and potentially predatory industrial groups in many LDCs makes the spontaneous emergence of a market for corporate control

imminent in the absence of government action (Singh, 1994, 1997b)., The burdens of globalization are heavy enough for developing countries to bear without adding to them speculative portfolio capital flows and the perils of an active takeover market.25

NOTES
average change in the relevant ratios over the short time period examined in their study are the same (different). The authors may well be right that the null hypothesis of no difference between large and small firms cannot be rejected, but they have not established that conclusion, since that requires firm-level panel data which the authors do not use. 12. The conclusions Singh (1995a) arrived at on this point was as follows: (The conclusion) . ..with respect to the comparative patterns of the financing of corporate growth in the industrializing and the Anglo-Saxon economies is somewhat more complex than that put forward in Singh and Hamid. Nevertheless, the significant point to emphasize is that leaving aside the question of any comparison with industrial countries, in absolute terms, the degree of external financing, as well as equity financing for the top developing country corporations is very high. This in itself is an extremely important phenomenon in its own right, both analytically and from a policy perspective. For reasons outlined earlier, this empirical finding runs contrary to what economic theory would suggest (Singh, 1995a, p. 21). 13. The Bolsa share price index rose from 250 in 1989 to 2500 in 1994 (IFC, 1996). 14. The average annual growth rate of population over 1990-94 was 2% (World Bank, 1996). 15. See, for example, DiMaggio and Powell (1983), Banerjee (1992), Bikhchandani et al. (1992) and Schenk (1996). 16. See, for example, the studies of King and Levine (1993) and Levine and Zervos (1995). For studies that point to different conclusions, see Demetriades and Hussein (1996) and Harris (1997). 17. For a review of the issues and evidence on this question, see JEP (1990). 18. For a more detailed exposition of the workings of the takeover mechanism, see Singh (1992, 1995b). 19. For a review of the issues see Singh (1995b), Porter (1992). For an opposed perspective, see Marsh (1992). 20. See McCauley and Zimmer (1989) Poterba (1991) Zimmer and McCauley (1991) and Porter (1992).

1. See, for example, McLaury (1994) and El-Erian and Kumar (1994). 2. The huge net private capital flows into Latin America are all the more dramatic when it is remembered that there was a net outflow of capital from Latin America over 1983-88 because of the debt crisis. 3. Feldman and Kumar (1994) divide emerging markets into four groups according to their stage of development. 4. The following sections are based on Singh (1996a).

5. See Nagaraj (1996) who suggests that the Indian figures in this paragraph may be overstated to some extent. 6. See further Mayya (1995) and Singh (1996a). 7. India Today (June 16, 1997). 8. Leff (1979), Pfeffermann (1989) are notable exceptions. (1988) and Amsden

9. The seminal paper of Myers and Majluf (1984) provided an explanation for this phenomenon for developed countries in terms of assymetric information between managers and the investing public. 10. For a theoretical discussion of the pricing process in LDCs, see Tirole (1991). 11. Unlike Singh (1995a) and Singh and Hamid (1992) (SH), who use accounting data for the 100 largest individual manufacturing firms, the CS estimate of the contribution of equity finance above is based on aggregate accounting data for more than 1500 corporations in the Reserve Bank of India data set. So some of the differences in the results between the two set of studies could be due to differences in the sample frames. Since SH samples consist only of the largest firms quoted on the stock markets, these may be expected to raise a greater amount of finance from equity issues than the firms in the CS sample. CS suggest, however, that: (a) there was no difference in the financing of large and small corporations; and (b) that the smaller Indian companies including the unlisted ones issue large amounts of equity to finance their investment needs.There are some difficulties with the CS size invariance results. The basic problem is that CS base their finding entirely on aggregate accounting data for a small number of size-groups of firms for a few years. Therefore, what their r-tests show is not that the financing patterns of the large and small firms are the same (different), but that the

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WORLD DEVELOPMENT speculation, although it may help dampen its effects (Patrick, 1994; Tabb, 1995). 24. For a discussion of the bank system in India, see Bhatt (1994); for China, see Qian (1994); and for Mexico. see Revnolds (1994). 25. For a fuller discussion, see Singh (1994, 1997b).

21. See, for example, the survey on Japanese finance in The Economist(June 28, 1997). For a more explicit treatment. see World Bank (1989). \ , 22. For a discussion of problems of monitoring with large numbers of shareholders, see Diamond (1984). 23. It must be noted, however, that a main bank system does not insulate an economy from excessive

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