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FDI and Stock Market Development:
Complements or Substitutes?
Stijn Claessens
Daniela Klingebiel
Sergio Schmukler
Conference: THE FDI RACE: WHO GETS THE PRIZE?
IS IT WORTH THE EFFORT?
Washington, D.C., October 3-4, 2002
Motivating Facts
• Rapid development of equity markets during
1990s
• Increased cross-border capital flows
– In the 1990s, changes in the composition of capital
flows: bank lending was replaced by FDI and by
portfolio investment
• At the same time
– Increased migration of listing, trading, and capital
raising to international financial centers
– Supported by advances in technology, in particular
remote access to trading systems allowing for listing
and trading of securities abroad
– And changes in the nature of trading systems
Motivating Facts
• Questions on future of stock exchanges, especially in
emerging markets
• Questions with respect to the relation between FDI and
stock market development:
– Is FDI a complement or substitute of capital markets?
– Does FDI help develop domestic and international
capital markets?
Existing Work
• Aggregate analysis of stock markets development
– Stresses role of legal framework, macro stability
• Micro perspective (firm-level) studies
– Effects of cross listings on firm cost of capital,
maturity, liquidity, valuation, etc.
– Some studies on type and country origin of companies
migrating abroad
• Focus on ‘international’ companies, less on the
relative importance of internationalization
• Findings do not fully explain why local markets
are shrinking against background of improved
local fundamentals
Questions the paper tries to address
• How have stock markets developed in various
countries and what have been the driving factors
behind their development?
• What factors affect internationalization, i.e., what
factors drive the degree of foreign listing, foreign
trading and foreign capital raising?
• What impact may these developments have on the
future of domestic exchanges?
• What is the relation between FDI and stock market
development at the local and international level?
Data
• Domestic stock market capitalization, trading, and
capital raised for 77 countries, at market level
• Listing, trading, and capital raising abroad at firm
level to obtain:
– Domestic firms listed abroad
– International activity at market level (trading and
capital raised)
– Estimate international market capitalization
• Use NY and LSE data, therefore capturing 85
percent of international activity for emerging
market countries
• Explanatory data
Dependent Variables
 Local stock market development:
 Market capitalization/GDP
 Value traded domestically/GDP
 Value traded/market capitalization
 Internationalization:
 Market capitalization of international firms/total market
capitalization
 Value traded abroad/GDP
 Value traded abroad/value traded domestically
 Capital raised abroad/GDP
 Capital raised abroad/capital raised domestically
Domestic stock market development (1)
Market Capitalization / GDP
1.4
1.2
1
0.8
0.6
0.4
0.2
High-Income Countries
Middle-Income Countries
1999
1997
1995
1993
1991
1989
1987
1985
1983
1981
1979
1977
1975
0
Low-Income Countries
Domestic stock market development (2)
Value Traded Domestically / GDP
High-Income Countries
Middle-Income Countries
1999
1997
1995
1993
1991
1989
1987
1985
1983
1981
1979
1977
1975
1.1
1
0.9
0.8
0.7
0.6
0.5
0.4
0.3
0.2
0.1
0
Low-Income Countries
Domestic stock market development (3)
• Significant increases in stock markets over 19751999 in all countries
• High-income countries experienced much more
pronounced increases of domestic stock market
activity than low-income or intermediate income
countries
• Especially middle income countries seem to have
lost out in terms of market capitalization, number
of firms, and liquidity in the second half of the
1990s
Internationalization of stock market (1)
Market Capitalization of International Firms / Market Capitalization of All Firms
0.7
0.6
0.5
0.4
0.3
0.2
0.1
High-Income Countries
Middle-Income Countries
2000
1999
1998
1997
1996
1995
1994
1993
1992
1991
1990
1989
0
Low-Income Countries
Internationalization of stock market (2)
Value Traded Abroad / Value Traded Domestically
0.45
0.4
0.35
0.3
0.25
0.2
0.15
0.1
0.05
High-Income Countries
Middle-Income Countries
2000
1999
1998
1997
1996
1995
1994
1993
1992
1991
1990
1989
0
Low-Income Countries
Internationalization of stock market (3)
Capital Raised Abroad / GDP
0.02
0.018
0.016
0.014
0.012
0.01
0.008
0.006
0.004
0.002
1998
1999
2000
1998
1999
2000
1997
1996
1995
1994
1993
1992
1991
1990
1989
0
Capital Raised Abroad / Capital Raised Domestically
4
3.5
3
2.5
2
1.5
1
0.5
High-Income Countries
1997
1996
1995
1994
1993
1992
1991
1990
1989
0
Middle-Income Countries
Low-Income Countries
Internationalization of stock market (4)
Value traded in international markets/value traded in domestic markets
Venezuela
Argentina
Mexico
Israel
Peru
Brazil
Russian Federation
1996-1999
Colombia
1990-1995
Philippines
Thailand
South Africa
0%
25%
50%
75%
100%
Internationalization of stock market (5)
Coverage
Trading Values for Foreign Companies
1995
2000
Others
4%
Deutsche Others
Börse
8%
6%
Deutsche Börse
1%
NY (NYSE and
NASDAQ)
33%
London
49%
London
62%
NY (NYSE
and
NASDAQ)
37%
Summary of Internationalization Trends
 Relative market capitalization of international
firms has increased substantially for middle
income countries (e.g., Latin America and Eastern
Europe)
 Value traded abroad has risen sharply for middleincome countries
 Amount of capital raised abroad frequently
exceeded the amount of capital raised
domestically for middle income countries
 Results vary depending on whether foreign stock
market activities are normalized by domestic stock
market measures or by GDP
Foreign Direct Investment
Foreign Direct Investment as % GDP
(Averages)
8.00
7.00
6.00
5.00
4.00
3.00
2.00
High-Income Countries
Middle-Income Countries
2000
1998
1996
1994
1992
1990
1988
1986
1984
0.00
1982
1.00
Low-Income Countries
Methodology
• Panel data with robust standard errors
– Alternative estimation methods (fixed effects, random
effects, between)
• Tobit regressions, use of zero observations
• Different specifications, with different subsamples
• Endogeneity (for domestic and international
variables)
– Instrumental variables
– Alternatives: use of time lags
• Report only the core results.
Regression Analysis
• Stock market development and internationalization are
explained in a panel regression analysis, using a
number of explanatory variables:
– GDP per capita
– Inflation rate
– Foreign Direct Investment
– Law & Order Index (Country Risk Guide)
– Shareholder Rights (La Porta et. Al)
– Capital Account liberalization (IMF measure)
– Trading Costs (Elkins McSherry)
• Data cover mostly NY and London
Regression Results
Variable
Market
capitalization
Capitalization of
int. Firms/
Mkt Cap.
Tradg.
Volume:
abroad/
dom.
Tradg.
Volume:
abroad/
GDP
Cap.
Raised:
abroad/
Dom.
Cap.
Raised:
abroad/
GDP
Log of GDP
per capita
+
+
+
+
+
+
Inflation
-
-
-
-
Foreign Direct
Investment
+
+
+
+
Law and
Order
+
+
Shareholder
rights
Financial
liberalization
Trading costs
+
+
-
+
+
+
-
+
+
+
-
+
Interpretation of Regression Results
• Domestic stock market activity and the share of stock
market activities taken place abroad is driven by the
same fundamentals.
• Improving fundamentals domestically will lead to
increased stock market activity, but more of this
activity migrates abroad as countries’ fundamentals
improve.
• This suggest countries need to pass a certain hurdle in
terms of development and legal and regulatory
framework to get access to foreign markets.
• But once hurdle passed, domestic activity as risk from
internationalization.
Conclusions
• While better fundamentals (including higher
FDI) lead to an increase in domestic stock market
activity, more of this activity is expected to occur
abroad as better fundamentals also spur the
migration in capital raising, listing, and trading
• Firm perspective
– As firms from emerging markets continue to
expand, they will seek larger amounts of low-cost
capital, which will only be available in global
markets
Conclusions
• Investor perspective
– Global investors will seek to invest in countries
with not only sound fundamentals, but also with
liquid markets.
– Domestic investors will become less captive,
will also seek liquidity, in addition to good
corporate governance, disclosure, etc.
– And liquidity has network properties,
concentrating in a few global exchanges.
Implications
• Countries will continue to need to improve fundamentals
– Helps raise domestic savings, allocate it better, etc.
– Facilitates access to foreign markets for domestic firms, with
associated lower cost of capital, greater liquidity, etc.
• But exchange activity will not remain local
– As fundamentals improve, domestic liquidity declines; making
it hard to sustain local exchanges, especially small ones.
• Policy response: countries need to try to get full gains
–
–
–
–
–
Ease remote two-way access by local (and foreign) investors
Allow entry of exchange related service providers (e.g. brokers)
Adjust fee structures and trading systems
Harmonize standards for trading and listing
Facilitate mergers/consolidation of exchanges
Future Work
• More micro level of internationalization
– What motivates individual firms to go abroad? How do listing
costs matter? How do exchanges compete with each other?
– How does internationalization through equity relate to other forms
of domestic and international financing (loans, bonds)?
• Exchanges and (alternative) trading systems
– What are economies of scale in exchanges? Is there path
dependence? What is role of alternative trading systems? What are
good options: merge, link, harmonize? What is need in terms of
consolidation in clearing/settlement, accounting, etc.?
• Financial markets development
– What are the options for firms which cannot easily go abroad?
– How does this relate to the development of private equity, venture
capital, and other first-stage financing markets in emerg. mkts?