Capital markets are markets in which equity (shares) and debt (bonds) are traded. If they exist at all in less developed countries they are typically small. Most financing to help companies grow is done through bank financing rather than through the equity markets. Over the past decade or so, an “emerging markets” capital market has emerged. Based primarily in New York and London, this market has permitted developing countries’ governments (“sovereigns”) to access international capital markets.
Stock markets are usually small because companies prefer to raise money from banks rather than through the sale of shares. A share offering forces them to offer a higher degree of transparency than would otherwise be necessary and will make their managers accountable to shareholders, something not all managers want! Corporate bonds are rare if a company has not already sold shares.
When stock markets open in less developed countries they usually have a small number of shares listed on the exchange and have limited hours and often rules about how much share prices can rise or fall on a given day. Disclosure is usually a problem as companies—more often than not still largely family-owned even after listing—are not accustomed to disclosing details of their finances. Because the markets are so illiquid they tend to be volatile. Moreover, the thinness of the markets as a whole means that the multitude of institutions, like analysts, that provide information to potential investors, are scarce, reinforcing a vicious cycle associated with information asymmetry.
There are a number of other reasons why developing countries don’t have stock markets (such as Laos, Somalia or Sudan) or have ones that are small (Vietnam, Ecuador) compared to the size of the economy. Low economic growth, high inflation, low savings rates all discourage the creation of strong markets. As well, weak regulations on investment, inadequate bankruptcy laws and a lack of protection for investors all work against the development of robust capital markets in developing and transition countries.
Most economists say the creation of a stock market helps overall economic growth by:
- Giving companies an avenue outside the banking system through which to raise investment capital. Traditionally, capital market financing, when capital markets are working well, is both cheaper and longer term than bank lending.
- Bringing private savings into the public arena where they can be efficiently used
- Raising corporate accountability
- Facilitating foreign capital inflows.
To take advantage of these benefits, some less developed countries are now working on plans to launch a stock market. The World Bank and IMF generally view stock markets as important and urge countries to set them up. Foreign financial firms also benefit from the creation of new stock markets and also get involved in the process; Japanese banks provided assistance to Vietnam when it set up its stock market which opened in Ho Chi Minh City in July 2000.
However, while most economists agree that stock markets help countries develop, many would agree it’s not a first priority. After all even in the US and the UK a relatively small fraction of new funds for investment are raised through the stock market. So in terms of developing new business, having a strong banking system is far more important. But while having a robust capital market won’t do a lot to help a country develop, having a poorly-regulated one prone to corruption and abuse can certainly cause major problems—the pyramid schemes in eastern Europe being a case in point.
Developing the legal reforms required to make an effective stock market are not likely to be easy. In particular, creating a stock market before there are effective shareholder protections is an invitation to disaster down the line: if abuses occur, as they have so often, then there will be a backlash against equities markets that may be long lasting. Even when the necessary reforms are made, the larger and more successful firms, those with good corporate governance, able and willing to meet the standards of more advanced countries, are likely to want to be listed on the major exchanges, meaning that the local exchanges will continue to be dominated by smaller firms. Companies that want to be listed in the U.S. can do so by issuing American Depository Receipts (ADRs) which are listed on the New York Stock Exchange and on the NASDAQ.
Bond markets (see separate primer on this website), through which corporate and government debt are sold and traded, tend to develop domestically before borrowers attempt to raise money overseas. There are good reasons: Typically they have to borrow abroad in dollars or other hard currencies, making them bear the risk of exchange rate changes. Moreover, markets typically charge a very high premium. Governments in less developed countries may shy away from the risks associated with an international debt sale for as long as possible – although they often issue short-term treasury bills – and instead fund much of their country’s development using money borrowed at concessional rates from donors, such as the World Bank, International Monetary Fund, regional development banks, and bilateral donors. However, this money is sometimes tied to promises of economic reform and can be limited in its scope.
Equity Market Coverage
Stocks, or equity, represent ownership in a company. Although it is possible to buy and sell stocks that are not listed on a stock exchange (see off-market trading below), many investors find it easier to trade through an exchange because of the high level of corporate transparency listed companies must offer and because of the strict regulations that usually accompany exchange-based trading. Such trading, in addition, offers investors a way to deal with cumbersome and expensive issues related to settlement, delivery, and payment systems.
When a less developed country sets up a stock exchange it may differ from exchanges in more developed countries in the following ways:
- Government influence. Governments in many less developed countries tend to micromanage their economy and this can reflect on their stock market too. How independent is your country’s exchange and the regulatory body that governs it? Does the government try to influence trade? If so, how?
- Trade regulation and policing. Some emerging market regulators impose very few rules on equity trading when a market first opens in order to attract speculators and push prices up. China did this in the early 1990s and saw phenomenal growth in its two stock markets. However, many investors were burned during the inevitable crash that followed each bull rush and China was forced to tighten its regulatory environment. In the long run, trading migrates to markets that are better regulated. This is perhaps why other countries, like Vietnam, Egypt, and, to a lesser extent, countries in central Europe, have taken the opposite tack, imposing strict rules from the onset. Markets in these countries will probably take longer to develop but may fare better in the long run. What is the regulatory framework like in the country you cover? What is relevant are not only the rules governing trading itself, but those having to do with corporate governance, protection of minority shareholders, voting rights. For instance, the New York Stock Exchange has regulations which greatly restrict non-voting equity shares. What impact will that framework have on investor sentiment and on companies’ willingness and ability to list? Whatever the rules appear to be, many less developed countries lack the legal and administrative infrastructure to enforce them. Watch out for broken rules: Who is doing the breaking, listed companies or investors? Does your regulator try to rectify the situation? How effective is it?
- Limits on trade. Some less developed markets will impose limits on the various aspects of trade. These can include: The degree to which a stock price can rise/fall each day; the number of shares an investor can buy in a single trade or own in a single listed company; the degree to which a foreign investor can access the market; etc. These rules serve a variety of purposes, e.g. limiting stock market volatility, preventing someone cornering the market, and making sure that there is a “level playing field.”
- Types of equity offered. While most developed stock markets will allow any company that has met listing requirements to list its shares, less developed countries have specific development priorities and may impose rules governing which types of companies can or can’t list. You should consider whether the types of companies allowed to list in your country will attract investors. If not, why not? In transitional economies, you should also ask how large a percentage, if any, the government will retain in a listed company. In China, the government holds a 51% majority in most listed companies (which are usually partially privatized state-owned companies) and thus retains majority voting rights. But even if the government retains majority control, it may not exercise those rights, leaving the management to the company, or it may intervene only through the appointment of members of the Board. Look at the experience of your government, and the impact of government “control.” Each time a company lists it will provide you with a slew of new stories: What type of company is it? How is it preparing for its debut? Will it sell shares through a private placement or will it offer an initial public offering (IPO) to the public? How much interest is its debut creating in the investment community? IPO’s often are issued at a substantial discount, giving those who are lucky enough to get an allocation a bonanza, but effectively depriving the old shareholders of money that should be theirs. What is the magnitude of the IPO discount? Who gets the bonus?
- Investment Banks. In more developed countries, investment banks play an important role in the issuance of stocks (and bonds and other securities). Before the development of exchanges, they helped “make the market.” That is, they would bring together suppliers of stock (firms that needed capital) and suppliers of funds (potential investors.) Today, they continue to play an important role, in providing information to the issuer of the stock about how and when to issue the securities, and in “placing” the securities, i.e. finding buyers. Many believe that they help make the market by providing certification services, that is, investors are more willing to buy shares issued by a reputable investment firm who has advised the firm on a “fair” price at which to issue the shares. The lack of informed and reputable investment banks in many developing countries may be an impediment to the workings of an effective securities market.
A less developed stock market may face problems that developed markets generally avoid. Issues to watch for include:
- Technical problems, such as a failure to process orders, loss of information because of a computer failure, lack of communication between the trading floor and brokerage offices, etc. “Technical gliches” in stock market registration may be used to inhibit takeovers.
- Insider trading, through which company executives, underwriters (See investment bank) and others with intimate knowledge of a company’s operations use that knowledge to trade shares. This gives them an unfair advantage over the public.
- Lack of corporate disclosure, as companies fail to provide the information demanded of them either at all or in a timely manner. This may be deliberate or may be the result of a lack of understanding of the rules. It may also be due to weakness in the country’s accounting system. Are reforms underway?
- High volatility can be caused, particularly in a young market, by a small elite of people who have the knowledge and money to invest in stocks and thus dominate trade. In such an illiquid market, one or two trades by such an investor can cause the overall market to rise or fall significantly and cause a knock-on effect as other investors follow, creating an even stronger gain or decline.
- Bubbles grow when people don’t understand the basic value of the companies they are investing. If prices begin to rise (sometimes because of a large single trade) some investors will anticipate further gains and buy stocks in order to take advantage of those gains. Others will follow until the stocks have become overvalued or, put differently, when the share’s market price materially deviates from its fundamental value (see PE ratio). This creates a bubble. When one or several investors realize how overvalued the market has become they start to sell, profit taking while they can. Again, others will follow and the bubble will burst. This happened in the Japanese stock market in the late eighties and early nineties and, more recently, in the U.S. when the dotcom bubble burst in 2000 and again, of course, when the housing market implosion spread into the entire financial system in 2007 and 2008 and subsequently the global economy.
- Investment funds, which buy shares in firms, are often absent in new, smaller, stock markets because there are too few stocks to make it worth their while to invest or because no regulation exists to allow them access. They allow greater diversification on the part of investors. In some larger countries, such as Russia, they developed quite rapidly. Some of the investment funds in Eastern Europe have been a source of major problems, as the managers of those funds used their power to channel money out of the companies which they managed to get effective control of, and to divert assets to their own benefit.
All of the above issues will provide fodder for stories. As your market develops you should also watch for stories in the following areas:
- Changes to the regulatory and accounting systems. Will the changes strengthen or weaken the system? Will they benefit investors, listed companies or both?
- Price manipulation, either by insider traders or by large investors with a big enough stake to influence the entire market.
- Are local companies listing overseas? High quality companies in less developed countries may list their share overseas using ADRs or GDRs. Why have they chosen to do so?
- The role of foreign investors. This may change (probably increase) over time as investment rules are relaxed and/or because the market grows and becomes more attractive to them. The large-scale arrival of foreign investors can help stabilize trade because it brings a degree of professionalism few domestic investors have had time to develop. On the other hand, by virtue of their size, foreign investors can often overwhelm domestic markets causing exacerbating rallies and, when they exit, deepening slumps. Adverse conditions abroad may thus quickly impact domestic markets. Some foreign investors have announced that they will only invest in countries will with corporate governance standards. Major institutional investors, like CALPERS, have blacklisted certain countries. Is your country one of those? If so, why?
- Who is investing? Is the market dominated by institutions or by retail investors? Is the profile of a typical investor changing? If so why?
- How are donor funds being used? Often, donors will give a country money to help set up its stock exchange. You can check with the donor community in your country how (and how effectively) those funds are being used.
Bond (Debt) Market coverage
The sale of bonds allows governments and corporations to borrow money from the public rather than from a bank and/or allows investors to trade with each other, creating a secondary market. This enables greater diversification and liquidity, allowing, in turn, increased competition amongst borrowers. The creation of a government bond market with bonds of different maturities may serve one other purpose: the information on the yields of different maturities helps the pricing of corporate debt of different maturity. Borrowers may chose to go to the debt markets because the amount of money they need to borrow is higher than any single bank is willing or able to lend, or in order to spread the risk associated with their debt between a number of those lenders. (However, banks often address these problems by forming a lending consortium.) The issuer (debtor) will sell the bonds for a certain number of years and will pay interest to the buyer (creditor) for the duration of the bond’s life. Interest can be paid annually or when the bond expires (matures). Interest rates are determined by the market which will demand a higher rate of return from risky debtors (to compensate them for the risk of default) than from relatively safe debtors. Some bonds, Zero Coupon Bonds, do not pay interest but are sold at a discount to their face (par) value. The ‘return ’ is the difference between the sale price and the face value at which the creditor will redeem the bond on maturity.
Bonds can be issued by governments and companies and can be traded domestically or on an overseas market. Domestically traded bonds are usually denominated in the local currency and sold to domestic investors, both individual and institutional (although it may be possible for foreign investors operating in the country to buy the bonds).
Bonds that are sold overseas are denominated in a major foreign currency, usually US dollars, and are sold to banks, investment funds, and other institutional investors. They are not usually targeted at individual retail investors. The sale of bonds on the international market carries a risk of default; a concern because the issuing country must repay the bond and its interest in a foreign currency and must ensure it will have enough foreign exchange to cover that cost at the right time.
Sovereign bonds are sold by governments. Their price is usually quoted in terms of basis points above the price of US Treasuries with the same maturity. Once on the secondary market, the higher the spread (i.e., the higher the interest rate the country has to pay), the lower the price of the bond. For example, in a crisis situation in which investors eschew a bond, bond prices could drop to 20 cents on the dollar—a level typically associated with extremely high spread levels. (Sometimes, the premium is described as the spread over LIBOR, or SIBOR which are the interest rates on interbank loans quoted in London and Singapore.
When reporting a sovereign bond issue, there are several things to watch for:
- Does the country have a sovereign rating? Ratings, which will include a current rating and a future outlook, give investors an idea of the issuing country’s credit worthiness. A country must have been rated by at least two agencies before it can sell a sovereign bond overseas. A change in its rating can be big news because that will impact how the market views a bond issued by that country and will affect its interest rate. (The major rating agencies are Moody’s and Standard and Poor’s.)
- How much money does it hope to raise and how much demand is there for new debt? If there is high demand for bonds from your country then the government may be able to borrow a lot of money relatively cheaply. If there is limited demand its borrowing plans may be constrained. Some investment funds have to hold a certain amount of emerging market debt and are always on the lookout for new offerings. It is worth finding out how much comparable debt is already on the international market as this will impact investor appetite for new debt.
- How long will the country borrow for? A bond’s maturity can affect its interest rate; creditors will demand a higher rate of return for a longer loan because of the increased risk it carries.
- Lender Constraints. Some international lenders, notably the IMF, cap the amount of money countries can borrow overseas. If the country you are covering has a lending agreement with the IMF there will be prescribed limits on how much foreign-currency debt your government can issue. To work out whether new borrowing plans are likely to run in to conflict with the government’s IMF program, you will need to find out what other debt is already outstanding and what the maturity of that debt is (the IMF has different limits for short-, medium-, and long-term debt).
Other types of Government bonds can include:
- Brady Bonds. These are named after former US Treasury Secretary Nicholas Brady who created them and are issued by a government in exchange for rescheduled commercial bank loans. Their principle, and typically one coupon payment, is backed by zero coupon U.S. Treasuries. Mexico, Peru, Bulgaria and Nigeria have all issued Brady Bonds.
- London and Paris Club debt. London Club debt is a forum through which private sector foreign creditors can reschedule overdue debt that is owed by foreign governments. The Paris Club is a grouping of wealthy countries that meet to reschedule the debt of developing countries The aim is to facilitate eventual payment by countries that are not able to repay outstanding debt on time.
- Regional/Municipal bonds are issued by different provinces or municipalities. These are less common in developing/transition countries and one finds them typically in countries whose fiscal structure is highly decentralized and in which regional governments run into deficits and need to raise capital internationally. Notable examples include Russia (cities of Moscow and St. Petersburg) and Argentina.
- Internationally traded corporate bonds are issued by companies in order to finance an overseas investment or because domestic capital markets are too small to facilitate a big enough bond issue at home. In countries that impose controls on the free exchange of currencies an international bond offering may be the only way to borrow foreign exchange. Internationally traded corporate bonds are not often issued by companies in less developed countries because foreign investors require a degree of corporate transparency that few can offer. There are some exceptions to this rule mainly associated with developing countries that are at a more advanced stage of development. The list includes Korea and Mexico and, to a lesser extent, Thailand and Brazil. Also, a company typically (but not always) must wait until its government has sold at least one sovereign bond (Brady Bonds, Paris Club, and other rescheduled debt do not count) before it can raise money overseas. This is because potential investors need a government benchmark before they will risk investment in a corporate bond.