Developing Deeper Capital Markets in Emerging Market Economies

8/3/2019 Developing Deeper Capital Markets in Emerging Market Economies

1/5

Developing Deeper Capital Markets in Emerging Market

EconomiesRemarks by John LipskyFirst Deputy Managing Director, IMFat the U.S. Department of the TreasuryFebruary 2, 2007It's a pleasure to see so many old friends gathered around the room atthis seminar to discuss the development ofdeeper, more liquid, localcapital markets in emerging economies. I'm happy to be able toemphasize the word "deeper" because a lot has been accomplished sincethe crisis years of 1997-98-reasonably well-developed capital markets

are now in place in many emerging economies. Indeed, at end-2005, thestock of domestically issued bonds in emerging market countriesamounted to US$3.9 trillion, constituting an important global asset class,as you are aware. So what we are speaking of today is deepeningthesemarkets-making them more liquid, sounder, and more resilient.

That the key role of financial markets in emerging market economies iswidely recognized is particularly gratifying to me. When I was a graduatestudent, I had the good fortune of serving as a teaching assistant toProfessor Ed Shaw, the author of the path-breaking book "FinancialDeepening in Economic Development". Nearly four decades later, Prof.Shaw's insights are being applied around the world.

A striking sign that things have changed for the better in emergingmarkets is that international investors are increasingly purchasingsecurities denominated in local currency. To quote a few figures:Dedicated emerging market U.S. mutual funds have been growingrapidly, from US$27 billion in late 2000 to about US$230 billion as of

mid-2006; and the stock of domestic securities in emerging marketeconomies increased by some estimates from 26% of GDP to 40%

between 1996 and 2006.Thus, many emerging markets have seemingly managed to atone, ininvestors' eyes, for what some experts had typically characterized as

their "original sin." I mean, of course, that they are beginning toovercome the structural weakness and lack of market credibility thatmany experts assumed was more or less permanent, and which it wasclaimed relegated these economies to borrowing internationally only inforeign currencies.

The overcoming of "original sin" is an important development, even if itsimplications are not yet fully evident. Some see it as a riskydevelopment, arguing that it may reflect only an overly exuberant

"search for yield" in an environment of low interest rates and ampleliquidity. Of course, investors and officials need to be aware of potentialrisks. At the same time, however, overemphasizing these risks couldobscure what I hope are the more important implications of thesedevelopments.

My own view is that the growing internationalization of emerging marketsecurities reflects important structural changes taking place in the globaleconomy and in global markets. These include, notably, the growingintegration and new role of emerging market countries in the globaleconomy, and the growing sophistication of financial markets and riskmanagement. In addition, it also represents the unexpectedly benign

economic and financial environment of the past few years. We've had the


2/5

fastest five-year period of global growth in recent times. The moreforthcoming stance by international investors signals an important vote

of confidence in future economic and financial stability. With theprevailing environment of macroeconomic stability in OECD economiesexpected to continue in the coming year and probably beyond, emergingmarket countries are being offered a tremendous opportunity. Itisessentialthattheyfully capitalize on this unusual moment.

Many emerging economies, happily, have been taking the right steps.They have substantially improved their macroeconomic performance bystrengthening their monetary and budget policies and by developingmore complete and stable domestic financial markets. They have alsotaken advantage of the generally favorable environment to build cushionsagainst external shocks-through such measures as improved debt

structures, expanded regional reserve pooling arrangements (forexample in Asia), and increased stockpiles of international reserves.

For their part, international financial institutions (IFIs) and advanced

economy authorities can and should support the greater integration ofemerging market countries into world capital markets. An important

priority in this regard is to preserve the combination of steady growthand low inflation in mature markets. In addition, work is needed to betterunderstand the financial market trends that are driving globalization-including, for example, by helping to insure the healthy development ofcredit risk transfer instruments and institutions, including hedge funds.

These markets have been developing at high speed, underscoring the

need to help emerging markets build solid financial systems. Forexample, the aggregate capital of the hedge fund industry has growntremendously-from US$30 billion in 1990 to over US$1.3 trillion as ofend-2005-while the number of hedge funds has multiplied from only 530in 1990 to over 6,700.

These instruments provide obvious benefits-they have added to marketliquidity, and they have helped to transfer risk to a much wider variety ofwilling investors. In that sense, they've contributed to stability. They'vealso helped reduce market inefficiencies. At the same time, theknowledge and practices of regulatory and supervisory authorities willneed to keep up with these developments. The basic goal is to have as

much oversight as necessary, but not more. Beyond that, we need acomprehensive and systemic approach to deal with potential marketstress. We need to have crisis prevention and crisis resolution methodsthat work with the grain of markets, not against the grain.

I need hardly tell this audience that well-functioning local capital markets

make a vital contribution to the efficiency and stability of global financialintermediation. Certainly, the experience of the emerging economiesunderlines the fundamental importance of deepening and broadeningfinancial sectors in underpinning growth. In fact, new Fund researchindicates that, over the last 30-35 years, emerging markets economieson average have grown close to three times faster than the group ofdeveloping countries that have not actively participatedin financialglobalization.Nevertheless, there is still potential for additional substantial growth of

financial markets in these economies. At 43 percent of GDP, emergingmarket outstanding bond market capitalization is still nascent, compared

to 140 percent of GDP for mature markets. Moreover, the development of


3/5

domestic debt markets remains still very uneven across the emergingmarket universe. The largest six markets (South Korea, China, Brazil,

India, Mexico, and Turkey) account for about 70 percent of domesticoutstanding bonds in emerging markets. And corporate bond markets inmost emerging market countries remain very underdeveloped. At end-2005, emerging market non-sovereign debt issued in domestic marketsamounted to $1.2 billioncompared to $2.7trillion of sovereign debt.

So what are the key issues that emerging market authorities need toconsider? Some of these are being addressed during this conference so Iwill mention them only briefly. They include:

y Strengthening public debt management and submitting to marketdiscipline in domestic markets;

y Strengthening the investor base and improving regulation andconsistency of treatment of institutional, foreign, and otherinvestors;

y Developing financial derivatives such as repos and swaps, as well asasset-backed securities markets, improving access by foreigners todomestic hedging services. This must be matched by suitable

regulation of equity derivatives markets, as well as increased marketsurveillance and improved risk management at the firm level;y Bringing trading, settlement, custody, and delivery mechanisms up

to world standards, where necessary through regional linkages, andopening up to foreign investment in these services;

y And, finally, developing and refining regional solutions that can bringgreater efficiency and scale to smaller capital markets.

What can the IFIs and advanced economies do, for their part, to facilitatedeeper domestic capital markets in emerging economies? Let me firststate how the IMF is helping; second, how it is collaborating in this effortwith other institutions; and, third, how governments of mature markets

can help.Certainly, for the IMF, this is part of our responsibility to be a center ofexcellence in understanding the role of financial markets and their impacton the global economy. In a world of integrated financial markets andlarge-scale capital flows, the IMF cannot fulfill its key responsibility ofpromoting international monetary and financial stability and efficiency of

the international system unless Fund surveillance is underpinned by asolid analysis of macro-financial linkages and cross-country spillovers.

The IMF's Medium-Term Strategy (or MTS) sets out the framework underwhich we are 'raising our game' in this regard. It calls, in particular, forimproved analysis of financial sector issues, and the effective integration

of this analysis into country work-namely in the context of in our ArticleIV consultations, our regular bilateral checks of members' economies.This work is also supported, of course, by the global analysis of riskscontained in the IMF's semiannual Global Financial Stability Report(GFSR).

A recent internal reorganization should help us to deliver better on theseinitiatives. A new department-the Monetary and Capital MarketsDepartment-has been created by merging the work of two previousdepartments, one responsible for international capital markets, and theother for monetary policy and financial sector issues. The underlyingmessage is that it is no longer appropriate to view internal and external


4/5

markets as separate, and that financial and macroeconomicdevelopments are increasingly intertwined at both the national and

international levels.

One of the key tasks of this department is to work precisely on the issueof capital market development you are discussing today. Through this

work, we expect to strengthen the Fund's ability to give advice on thedevelopment of local capital markets. We know that diagnostic and

technical assistance work must reflect country demand and priorities, butthe IMF's advice on sovereign debt management also is becoming morecomprehensive in scope, taking into account not only debt managementbut overall sovereign asset-liability management. Our advice alsorecognizes the interface between sovereign debt management, monetarypolicy operations, inter-bank and money markets, and proper

capitalization of central banks. We also expect to undertake morediagnostic and technical assistance work relating to nonsovereign bondmarkets and emphasize such work in a multilateral or regional context.In short, we expect to be aggressive in promoting the development oflocal capital markets.

In conducting this work, it is of critical importance that we work closelywith the World Bank. The sister institutions have been very active indeveloping best practices, standards, lessons, and appropriateadaptations to emerging market environments. As you know, we havedeveloped data dissemination standards, and introduced the FinancialSector Assessment Program (FSAP) and Reports on the Observance ofStandards and Codes (ROSCs). This work plays an important role ininforming the IMF's surveillance at the national, regional, and globallevels.

Coordination with other IFIs and with bilateral agencies has also beengood. Regulatory agencies-such as the Basel Committee and the

International Organization of Securities Commission-have helpedprepared standards, while the IMF helps implement them through itswork with individual countries and gives these agencies valuablefeedback. In fact, the IMF played an important role in helping to improvethe Basel and International Association of Insurance Supervisors' coreprinciples on banking and insurance supervision. That said, the marketsare moving continuously, so this collaboration will always be a work inprogress.

More could be done by the IFIs and other institutions, however, toresearch and disseminate knowledge on select topics. These couldinclude:

y studies on best practice on themes of common interest (e.g. taxtreatment of foreign investors, responsibility and accountability ofdebt management offices);

y analyses and case studies of key drivers of intermediation costs inlocal currency bond markets;

y steps needed to develop the institutional investor base (somethingon which one of our staff already presented some analysis thismorning);

y linkages and role of bond markets with interbank, money, andderivative markets; and

y a more complete coverage of statistics on emerging market debt.


5/5

We welcome initiatives by advanced economies, notably the G-7, andother partners to facilitate these efforts. With their familiarity with well-

developed local capital markets, they can be an important source ofadvice and help to emerging market policy makers and regulators. Theycan help to propagate good practices and the identification of specificpolicy actions to foster local capital market liquidity and development.Other initiatives could involve leading and supporting seminars ortraining; funding or providing experts to support IFI technical assistance;hosting of emerging market sovereign debt managers, securitiesregulators, or staff of securitization conduits seconded to G-7counterparts. Advanced economies should have a direct incentive to

support such initiatives, given increasing institutional and retailinvestment by mature markets in emerging local capital markets. Theseare relatively low cost initiatives with a potentially big payoff.

***

Let me conclude by stressing again my belief that it is a combination of

policy improvements and good economic performance by emergingmarkets that has most contributed to the explosion of lending to

emerging economies and the unprecedented increase we have seen incross-border capital flows. In turn, these flows provide strong disciplineon borrowing governments to continue to perform well. We should allhelp to underpin these dynamics by supporting further reforms.

The overall message should be clear: Good policies should and will berewarded.

Emerging Markets

The capital markets of developing countries that have liberalized their financial systemsto promote capital flows with nonresidents and are broadly accessible to foreign

investors.

Documents

Developing Deeper Capital Markets in Emerging Market Economies