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Emerging Markets Review 3 ( 2002 ) 429–
1566-0141/02/$ - see front matter 2002 Published by Elsevier Science B.V. PII: S 1 5 6 6 - 0 1 4 1 Ž^ 0 2.^ 0 0 0 4 5 - 6
Research in emerging markets finance: looking to
the future
Geert Bekaert a,b, Campbell R. Harvey^ c,b , *
a Columbia University, New York, NY 10027, USA b National Bureau of Economic Research, Cambridge, MA 02138, USA c Duke University, Durham, NC 27708, USA
Received 31 January 2002; accepted 30 June 2002
Abstract
Much has been learned about emerging markets finance over the past 20 years. These markets have attracted a unique interdisciplinary interest that bridges both investment and corporate finance with international economics, development economics, law, demographics and political science. Our paper focuses on the research areas that are ripe for exploration. 2002 Published by Elsevier Science B.V.
Keywords: Emerging equity markets; Market integration; Market segmentation; Diversification; Market liberalization; Portfolio flows; Market reforms; Economic growth; Contagion; Capital flows; Market microstructure; Cost of capital
1. Introduction
The designation ‘emerging market’ is associated with the World Bank. A country is deemed ‘emerging’ if its per capita GDP falls below a certain hurdle that changes through time. Of course, the basic idea behind the term is that these countries ‘emerge’ from less-developed status and join the group of developed countries. In development economics, this is known as convergence.
(^) This paper is based on a presentation made to the conference on Valuation in Emerging Markets at University of Virginia, May 28–30, 2002. We have benefited from discussions with and the comments of Chris Lundblad and Bob Bruner. *Corresponding author. Tel.: q1-919-660-7768; fax: q1-919-660-8030. E-mail address: cam.harvey@duke.edu (C.R. Harvey).
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History is important in studying these markets. Paradoxically, many complain about the lack of data on emerging markets. This is probably due to the fairly short histories available in standard databases. The International Finance Corporation’s Emerging Market Database (EMDB) provides data from only 1976. Morgan Stanley Capital International data begins ten years later. However, many of these markets have long histories (Goetzmann and Jorion, 1999). Indeed, in the 1920s Argentina had a greater market capitalization than the UK. More fundamentally, even the US was, for much of its history, an emerging market. For example, in the recession of the 1840s, Pennsylvania, Mississippi, Indiana, Arkansas and Michigan defaulted on their debt. Even before this time, most Latin American countries had defaulted on their debt in 1825 (Chernow, 1990 ). So, many of the important topics of today, are issues that we have been dealing with for hundreds of years. Our paper provides a high level review of some important research advances over the past 20 years in emerging markets finance. While some country level historical data reach back to the 19th century, the work of the International Finance Corporation made firm-level data widely available for researchers. In addition, care was taken in data collection so that the data were deemed to be more reliable than what had been available in the past. We then explore some of the most interesting challenges for the future. While most of our analysis focuses on 20 countries with the longest history in the EMDB (countries with data from at least 1990), many more countries have been added— and many more countries will be added in the future. Indeed, part of what makes emerging markets research so interesting is that there is an immediate ‘out of sample’ test of new theories as new markets migrate to the status of ‘emerging.’ In addition, one cannot do emerging markets finance research in a vacuum. Emerging markets finance research is touched by many different disciplines. That is, it is very difficult to conduct meaningful research in emerging markets finance without having some knowledge of development economics, political science and demographics—to name a few. Finally, this article is not meant has a comprehensive review article. (A comprehensive review can be found in Bekaert and Harvey (in press).) Indeed, we purposely relegate most of the citations to footnotes. While we do not intend to minimize the importance of the hundreds of research papers that have studied emerging markets over the past 20 years, we have decided to emphasize the ‘big picture’. We apologize in advance to the researchers not cited. The paper is organized as follows. The first section presents a number of statements that reflect research advances that have been made in recent years. We supplement this with data analysis that contrasts the behavior of emerging market returns pre-1990 and post-1990. This analysis focuses on those countries that have the longest samples of emerging market returns. We break our analysis in 1990 because many of the capital market liberalizations are clustered around 1990. The study of the impact of these liberalizations is one of the important research advances in recent years. The second section details a research plan for the future. Some concluding remarks are offered in the final section.
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dating exercise: event association, inference from the behavior of financial assets and inference from the behavior of key economic aggregates and market infrastruc- ture. The event association strategies include: ( 1 ) the regulatory reform date, ( 2 ) the date (preferably announcement) of the first country fund,^1 ( 3 ) date (announce- ment) of the first local equity listing or American Depositary Receipt on a foreign exchange. The finance strategies involve looking for changes in the behavior of asset returns and linking the change date to market integration. For example, if dividend yields are associated with expected returns, a sharp drop in dividend yields could be associated with an effective market liberalization reflecting the permanent price increase associated with the liberalization (Bekaert, Harvey and Lumsdaine (2002a), Basu et al., 1999). The economic strategies involve the analysis of key economic aggregates that might be impacted by liberalization (Kim and Singal, 2000; Bekaert, Harvey and Lumsdaine (2002b), Basu et al., 1999). For example, a sharp increase in equity capital flows by foreigners would seem to be evidence of an effective liberalization (Bekaert and Harvey, 2000b; Bekaert, Harvey and Lumsdaine, 2002b; Stulz, 1999). Finally, market infrastructure refers to the degree of investor protection and the quality of the accounting standards. For example, some have looked at the date of the enforcement of capital market regulations, such as insider trading prosecutions as market integration (Bekaert and Harvey, 2000a; Henry, 2000a; Bhattacharya and Daouk, 2002).
2.3. Market integration is often a gradual process
We have learned that market integration is surely a gradual process and the speed of the process is determined by the particular situation in each individual country. When one starts from the segmented state, the barriers to investment are often numerous. Bekaert ( 1995 ) details three different categories of barriers to emerging market investment: legal barriers, indirect barriers that arise because of information asymmetry, accounting standards and investor protection and risks that are especially important in emerging markets such as liquidity risk, political risk, economic policy risk and currency risk. These barriers discourage foreign investment. It is unlikely that all of these barriers disappear at a single point in time. Empirical models have been developed that allow the degree of market integration to change through time. This moves us away from the static segmentyintegrated paradigm to dynamic partial segmentationypartial integration paradigm (Bekaert and Harvey, 1995, 1997; Adler and Qi, 2002). Whereas these models are indirect, relying on a model and econometric estimation to infer changes in the degree of integration, there are more direct measures available. For example, sometimes the ratio of ‘investable’ market capitalization to ‘global’ market capitalization, as defined by the International Finance Corporation, is used as a proxy for the degree of integration (Bekaert, 1995; Edison and Warnock, 2002). This realization is particularly useful because many countries are in the process of liberalizing their capital markets. Often the relevant question is how fast should this occur.
(^1) See Miller ( 1999 ). Other literature relevant for ADRs includes Karolyi ( 1998 ), Foerster and Karolyi ( 1999 ), Urias ( 1994 ).
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Fig. 1. Average annual geometric returns. Data through April 2002.
2.4. Market integration impacts expected returns
The theory suggests that expected returns should decrease. We have learned that this is, indeed, the case. Fig. 1 contrasts average annual average geometric returns for 20 emerging markets, the IFC composite portfolio and the MSCI world market portfolio, pre-1990 and post-1990. We choose this cutoff because a number of liberalizations are clustered around this point. The graph shows a sharp drop in average returns which is consistent with the theory. However, this type of summary analysis ignores other things that might be going on in both individual emerging markets and in global capital markets. Recent research attempts to control for other confounding economic and financial events, allows for some disagreement over the date of the capital market liberali- zation, introduces different proxies for expected returns, and allows for the gradual nature of the liberalization process. The bottom line is that expected returns still decrease (Bekaert and Harvey, 2000a; Henry, 2000a; Kim and Singal, 2000).
2.5. Market integration has an ambiguous impact on market volatility
We have learned that there is no obvious association between market integration and volatility. While some have tried to argue that foreigners tend to abandon markets when risk increases, leading to higher volatility, the empirical evidence shows no significant changes in volatility going from a segmented to an integrated capital market.
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Fig. 3. Correlation with the MSCI world market return. Data through April 2002.
However, we have learned that correlations do, on average, increase. Fig. 3 shows that 17 of 20 markets experience increased correlation with the world. The correlation of the IFC composite with the world return has doubled over the past 12 years. The evidence also suggests that the correlation among emerging markets has increased. Fig. 4 shows that the average correlation has nearly doubled over the past 12 years. Association can also be measured by the beta with respect to the world market return. In Fig. 5, the picture is very similar to the correlation analysis. In the overwhelming majority of countries, the beta increases. The beta of the IFC composite with the MSCI world increases from 0.36 in the pre-1990 period to 0. in the post-1990 period. Again, it is important to control for other events. As with the analysis of expected returns and volatility, both correlations and betas increase after liberalizations even after introducing control variables. When correlations increase, the benefits of diversification decrease. However, we have learned that the correlations of emerging market returns are still sufficiently low to provide important portfolio diversification.^2
(^2) De Santis ( 1993 ), Harvey ( 1995 ) detail the initial portfolio diversification benefits, Bailey and Lim ( 1992 ), Bekaert and Urias (1996, 1999), Errunza et al. ( 1999 ) evaluate the diversification benefits of country funds and ADRs. De Roon et al. ( 2001 ), Li et al. (in press) reexamine the diversification benefits in the presence of transactions costs and short-sale constraints.
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Fig. 4. Correlation with the IFC composite return. Data through April 2002.
Fig. 5. Beta with the MSCI world market return. Data through April 2002.
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Fig. 6. Average monthly skewness. Data through April 2002.
liberalization event impacts expected returns and correlations, it does not change the fact that emerging market returns are skewed and have fat tails. Figs. 6 and 7 show the skewness and excess kurtosis of emerging market log returns in the pre and post-1990 period. Notice that the considerable variation in the skewness of the individual country returns. The excess kurtosis is almost always greater than 0 indicating fatter tails than the normal distribution. There are a number of implications. First, this impacts the way that we model volatility in emerging markets. The standard distributional models are rejected by the data for many countries (Bekaert and Harvey, 1997). Second, the existence of higher moments means that we need to consider alternative models for risk (Harvey and Siddique, 2000; Harvey, 2000; Estrada, 2000). Third, portfolio decisions need to incorporate information about these higher moments (Bekaert et al., 1998).
2.10. Emerging markets are relatively inefficient
While it is common for informational efficiencies to exist in new and smaller equity markets, we have learned that many emerging equity markets do not behave like developed markets. Emerging market equity returns have higher serial correlation than developed market returns. This serial correlation is symptomatic of infrequent trading and slow adjustment to current information (Harvey, 1995; Kawakatsu and Morey, 1999). Emerging market returns are less likely to be impacted by company-specific news announcements than developed market returns. The evidence suggests that insider
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Fig. 7. Average monthly excess kurtosis. Data through April 2002.
trading occurs well before the release of information to the public.^4 Finally, there is a literature on stock selection in emerging markets that suggests that relatively simple combinations of fundamental characteristics can be used to develop portfolios that exhibit considerable excess returns to the benchmark (Achour et al., 1999; Fama and French, 1998; Rouwenhorst, 1999; Van Der Hart et al., in press). While none of these findings ‘prove’ that these markets are inefficient, the preponderance of evidence suggests that these markets are relatively less informationally efficient than developed markets.
2.11. There are important links between the real economy and finance
Market integration is associated with lower expected returns. Effectively, the cost of capital decreases. It makes sense that investment should increase as more projects have a positive net present value. We have learned that this is indeed the case (Bekaert and Harvey, 2000a; Henry, 2000b). Finance also impacts other aspects of the real economy. In addition to investment increasing, evidence shows that the trade balance worsens after equity market liberalizations suggesting that the additional investment is indeed financed by foreign capital. Interestingly, personal consumption does not increase—there is no evidence that a ‘consumption binge’ occurs when new capital
(^4) See Bhattacharya et al. ( 2000 ). There is also work that examines the informativeness of domestic versus foreign investors, see Choe et al. ( 2002 ).
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3. Future research directions
3.1. Theoretical models of the integration process
Our theoretical models are best characterized as static models of integratedy segmented economies. The true process is dynamic and much more complicated that our current models. For example, policy makers in emerging markets may strategically set the opening of their markets to maximize the revenue from privatization programs. 6 While some empirical models have tried to characterize the degree of openness of capital markets, they are lacking a theoretical framework.
3.2. What is the cost of capital in emerging markets?
It is particularly interesting to examine the state of the practice of finance in estimating the cost of equity capital in emerging markets. Most realize that the assumptions of the CAPM are violated. Numerous ad hoc attempts have been made to add something to the CAPM-based cost of capital—because the CAPM yields an expected rate of return that is deemed too low to be reasonable. One of the more popular attempts is to supplement the CAPM required rate of return with the addition of the yield spread between the emerging market’s US dollar denominated government bond yields and the US Treasury yield of the same maturity. Another method redefines the ‘beta’ as the ratio of local to world standard deviation (rather than the usual definition of covariance divided by world variance). Both of these attempts are without theoretical foundation.
3.3. What is the relation between different types of reforms?
There are many different categories of financial reforms: the banking sector or equity market may be opened up to foreign investment and foreign exchange restrictions may be lifted. Many of these reforms relax ‘restrictions on payments for capital account transactions’ defined by the International Monetary Fund which is the 0 y 1 variable underlying the capital account openness measures used frequently. 7 There are legal reforms as well as macroeconomic reforms. Most studies have focused on one particular type of reform without reference to the others. We need a better understanding of the relation between the different types of reforms.
3.4. The sequencing of reforms
The plethora of reforms begs an important policy question: What is the optimal sequencing of reforms? 8 For example, should banking liberalization precede equity market liberalization? The issue of sequencing is complicated because of the small
(^6) Megginson and Netter ( 2001 ) provide a survey of the privatization literature. (^7) Eichengreen ( 2001 ) reviews the literature on capital account liberalization; Beim and Calomiris ( 2001 ) discuss the domestic financial reforms that are often part of a financial liberalization. (^8) Edwards ( 1987 ) examines the sequencing of economic reforms.
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number of observations from somewhat heterogeneous markets. However, the stakes are high. Given the relation between economic growth and financial liberalization, the correct sequencing of reforms could make a substantial difference for the economic prospects of any particular country.
3.5. Microstructure in less than ideal conditions
Much of the important work on market microstructure has focused on US equity markets. Emerging equity markets provide special challenges and a diverse range of opportunities (Domowitz et al., 1998; Ghysels and Cherkaoui, in press; Lesmond, 2002 ). Many countries are setting up exchanges and struggling to decide the best structure. Indeed, the type of exchange may be dependent on the characteristics of the particular emerging market. While the goal is to maximize the chance of fair prices, microstructure alone cannot provide these answers. The institutional structure, legal and regulatory environment (e.g. accounting disclosure rules) all impact the outcomes. On the boundaries of market microstructure and asset pricing there is much interest in the effects of (time-variation in) liquidity on expected returns and asset prices (see Jones, 2000 for e.g.). Emerging markets constitute ideal laboratories to test predictions regarding liquidity and asset prices (Bekaert, Harvey and Lundblad, 2002c).
3.6. Firm level analysis
Most of the work on emerging markets has focused on country level aggregate indices. Relatively little work has focused on the behavior of individual companies. 9 For example, it would be interesting to examine the reaction of a particular company to liberalization measures. Is it the case that local firms become more specialized? In the segmented state, firms have the incentive to inefficiently diversify in order to reduce their volatility to attract local equity investment (Obstfeld, 1994). This could be tested. In addition, it would be interesting to follow firms’ investment policies after market integration decreases the cost of equity capital. Finally, it would be interesting to examine the impact, at the firm level, of different types of liberalizations, e.g. banking versus equity market.
3.7. Agency and management issues
In some respects, corporations in emerging markets provide an ideal testing ground for some important theories in corporate finance. For example, it is often argued that the existence of a sufficient amount of debt helps mitigate the agency problems that arise as a result of the separation of ownership and control. In a number of emerging markets, the existence of cross-ownership provides an environ-
(^9) Chari and Henry ( 2001 ) examine the change in risk of individual firms after liberalizations. The ADR literature also examines the behavior of individual firms, see, for example, Foerster and Karolyi ( 1999 ).
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demographics and the probability of success (measured in terms of economic growth) of capital market reforms? The field of demographics is virtually untrodden with respect to finance. 10
4. Conclusions
Much of the research in finance focuses on the most efficient markets in the world, in particular, the US and other G-7 markets. The conditions of these markets are most likely to be consistent with the assumptions of our theoretical models. Rich empirical tests can be carried out using data as granular as individual transactions. This luxury does not exist in emerging markets. Emerging equity markets provide a challenge to existing models and beg the creation of new models. While the data are not nearly as extensive, it is better for the empiricist to use what is available than to use nothing. Such work demands extensive robustness tests given the limited nature of the data. Nevertheless, the stakes are high. Given the relation between finance and the real economy, the research we do in emerging markets has a chance to make an impact beyond the particular equity markets that we examine. For example, in many of the emerging markets, the impact of a lower cost of capital (and its subsequent impact on economic growth) can be measured not just in dollars—but in the number of people that are elevated from a desperate subsistence level to a more adequate standard of living.
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