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Equity Market Liberalizations Benefit Developing Nations

November 2006

STANFORD GRADUATE SCHOOL OF BUSINESS—To open a market to foreign capital or not? That has been the question plaguing economists and governments alike for several decades now, particularly as market liberalizations have been followed by economic crises in countries such as Mexico, South Korea, and Thailand.

In his ongoing research, economist Peter Henry continues to find evidence that developing countries do indeed benefit from the liberalization of capital markets. The infusion of foreign monies results in a drop in the cost of capital in these nations, an upswing in stock prices, a surge in investments in business, and an increase in the standard of living.

So why have so many liberalized economies been brought to the brink of collapse in recent years? Henry's studies reveal that developing countries run into problems when they unwisely liberalize short-term debt. Moreover, he has found that firms that benefit the most from a rise in their stock prices as a result of market openings do not seem to be reinvesting in their companies' growth to the degree they should.

"To find out whether the opening of capital markets has been responsible for economic shocks in certain countries, you have to define what you mean by 'liberalization,'" says Henry, associate professor of economics and associate director of the Center for Global Business and the Economy at the Stanford Graduate School of Business. "The pessimism about liberalization is unfounded because people haven't been systematic enough about separating debt from equity—that is, separating the effect of capital flows that come in the form of foreign direct investment and portfolio equity investment in firms from those flows that come in the forms of bonds or foreign bank loans."

The problem, Henry has found, occurs when firms within developing nations that open their doors begin relying too heavily on short-term loans from foreign banks. Such loans typically must be paid back within a year—a recipe for disaster for companies looking to finance long-term projects. "That's what creates crises," Henry explains. "It would be like taking out a mortgage for a house that had to be paid within 12 months when realistically you'd need 25 years to pay it off."

On the equity side, in contrast, countries have gained substantial economic benefits from opening their stock markets to foreign investors. In earlier research, Henry found that in liberalized markets the cost of capital—the interest rate in the economy plus the risk premium, or the return that investors require to hold stock—decreases because foreign purchasers now share the risk with nationals. This results in a general rise in stock prices and an overall greater investment in business expansion efforts. "Capital becomes cheaper and more abundant," Henry says.

Henry, with co-author Anusha Chari, assistant professor of finance at the University of Michigan, also has looked at the behavior of individual firms' stock prices in response to liberalization. They found that when stock markets open to the rest of the world, the risk premium or cost of capital is tied to how much the firm's fortunes correlate with what's going on in the rest of the world—the globalization effect. "If your firm tends to do well when, say, the U.S. market tech stocks are doing badly, that's going to be a valuable firm for U.S. investors to hold," he says. For such firms, the risk premium goes down significantly.

But do firms that experience the largest fall in the cost of capital increase their investments to expand their companies more than other firms? If capital markets are behaving efficiently, they should. And Chari and Henry find that they do. But they also found that such firms do not invest in expansion at a rate commensurate with the increase in stock prices. "In short, firms that experience the largest fall in their cost of capital should be investing more heavily," he says. The consequences of them not doing so? Inefficient allocation of capital and slower economic growth for the developing nation as a whole.

Why don't the highflier firms invest more wisely? "There may be domestic impediments that prevent managers from engaging in profit-maximizing behavior, such as regulation, inequalities in firms' access to credit, and a host of other problems," explains Henry.

The lesson to countries considering liberalizing, he suggests, is to make sure one's domestic financial system is functioning efficiently and is properly regulated to allow firms to invest more easily. "That's an important precondition to a successful liberalization," Henry said. Countries like China with institutions such as state-driven lenders that are likely to impede investing, he cautions, will probably use the new inflow of capital inefficiently. And all liberalizing governments should also approach the debt market much more cautiously to avoid problems that short-term borrowing can bring.

Over the past three years, Henry has made these and other recommendations to the U.S. Congress, several panels of United Nations ambassadors in New York and Washington, D.C., and the Commission on the Regulation of U.S. Capital Markets in the 21st Century, a bipartisan panel formed by the U.S. Chamber of Commerce to investigate what the government should be doing to help the United States maintain its position of global economic leadership in capital markets.

A primary concern is that the ethical constraints of the Sarbanes-Oxley Act, the 2002 legislation passed by the U.S. Congress imposing strict new rules and liabilities on executives, boards, board audit committees, outside auditors, and others, may reduce the competitiveness of U.S. capital markets and cause firms to list their shares on foreign exchanges with less stringent standards. Extrapolating from his research, Henry says, "My position is that we should continue to focus on promoting high standards in investor protection. Vigilant protection of minority shareholders plays a critical role in keeping the U.S. capital markets strong. While it makes sense to change those parts of Sarbanes-Oxley that are unnecessarily burdensome, we must be careful not to go too far. Lowering standards of investor protection is not in the long-term interest of the country."

—Marguerite Rigoglioso

Related Information

"Firm-Specific Information and the Efficiency of Investment," Anusha Chari and Peter Blair Henry, Stanford Research Paper No. 1930, April 2006.

"Capital Account Liberalization: Theory, Evidence, and Speculation," Peter Blair Henry, Stanford Research Paper No. 1951, November 2006.

"Risk Sharing and Asset Prices: Evidence from a Natural Experiment," Anusha Chari and Peter Blair Henry, Journal of Finance, 59, 2004.

"Capital Account Liberalization, the Cost of Capital, and Economic Growth," Peter Blair Henry, American Economic Review, 93, 2003.