Emerging equity markets, capital flows and

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the Washington-based global development institutions, there has been ... 1. Introduction. Empirical evidence is largely supportive of the view that ... growth were to be optimized, private equity markets must work hand-in-hand with the public equity ...... Rejeb, A.B. and A. Boughrara, (2015), 'Financial integration in emerging ...

Emerging equity markets, capital flows and corporation finance: a globalization perspective

Odongo Kodongo and Kalu Ojah Wits Business School, University of the Witwatersrand. 2 St. David’s Place, Parktown, Johannesburg 2193, South Africa

Abstract Several years after the beginning of the implementation of liberalization policies, particularly promoted by the Washington-based global development institutions, there has been increased interaction between emerging equity markets and other equity markets that has heightened volatility transmission and covariation in liquidity risks across markets. However, currency risk, liquidity risk and other asset priceand market-impacting factors still remain, and still provide international investors a platform for diversification. Several of these important factors command a premium which suggests that the cost of external equity capital still face upward pressures, in spite of liberalization policies implicitly aimed at driving them down. Our attempt to make sense of the evolving body of works in the area, suggests that emerging market economies should carefully sequence the implementation of financial policies with, preferably, institutional and legal reforms preceding financial openness and/or that financial openness must be approached wisely in ways that minimize its destabilizing effects on the cost of equity (e.g., by concurrently provisioning requisite institutional infrastructure that foster efficiency of markets and mitigation of asset price distortion). Furthermore, we conspicuously flag areas needing future research.

September 2015

Introduction Empirical evidence is largely supportive of the view that financial development can explain economic growth (King and Levine, 1993; Rajan and Zingales, 1998) especially in economies at the take-off and/or fast growth stage of their development (Rousseau and Watchel, 1998; Luintel and Khan, 1999). However, findings of association between financial development and economic growth do not necessarily imply causality. That is, a causality inference would be justifiable only if the mechanisms through which finance works to influence economic growth can be established (Rajan and Zingales, 1998). Therefore, the question about how financial development enables and/or fosters economic growth must be addressed. Plausible responses to this question have been attempted. Rajan and Zingales (1998) show that firms in industries in which relatively more external finance (reflecting differences in industry production technologies) is needed would grow disproportionately faster in countries with high financial development than in countries with low financial development; this finding suggests that financial development aids economic growth through ease of provisioning of external finance. Shin (2013) argues that financial development drives economic growth through an economy’s total factor productivity and through financial frictions (arising from contract enforcement, for example) that encourage or impede the reallocation of capital from previously productive firms to newly productive firms. In this framework, institutional quality becomes the mechanism through which financial development drives economic growth: economies of countries with good quality institutions stand to benefit more from financial development than those without. Drawing from these two robust bodies of evidence, we argue that well developed financial markets, aided by good quality institutions and awareness of nuanced production technologies external finance needs, reduce the overall cost of production through lower cost of capital and therefore improve economic output. But, how does financial markets development lower the cost of capital? In financial markets, economic agents seek external long-term capital, broadly speaking, through debt or through equity. In the debt markets, private (or negotiated) financing and public issue of securities (bills and bonds) are both available in many countries. Private debt, according to Ojah and Kodongo (2014), is provisioned by intermediaries that pool funds from economic agents appropriating surpluses (savers) with the express intent of, in turn, repackaging the pooled funds into various denominations and channelling them via private contracting, in the form of credit, to finance activities of economic agents experiencing fund deficits (funds users). Private debt markets are invariably dominated (i.e., mainly populated), in the emerging markets and in most advanced markets, by commercial banks, largely due to their superior expertise, built over time, in financial intermediation and their relative adeptness at sharing and trading risks arising from financial intermediation (Ojah and Kodongo, 2014). Public debt markets, on the other hand, are designed to link borrowers directly to lenders, obviating the need for intermediation that defines private debt markets. Because of this direct linkage, public debt 1

contracts, typified by bonds, eliminate intermediation costs1 (such as hold-up costs), presenting important implications for the overall cost of capital (Ojah and Pillay, 2009). Public debt markets are designed to operate through organized (national) securities exchanges which rely on listing, registry, clearing and settlement infrastructure, that must exist at reasonable levels of efficiency to function effectively. Due, mostly, to institutional issues around quality of legal recourse, and low liquidity of the secondary market (see e.g., Burger and Warnock, 2006), emerging public debt markets have not been able, relative to private debt markets and other financial markets, to effectively play their financing roles. In emerging markets, therefore, it is possible that optimal levels of both capital allocation and the overall cost of capital might not have been achieved through the debt markets (see, de la Torre et al. (2007) for Latin America; Eichengreen and Luengnareumitchni (2004) for Asia; Ojah and Pillay (2009) and Gwatidzo and Ojah (2014) for Africa). Would equity markets of emerging economies perform better in capital allocation and in lowering the costs of enterprise financing? Like debt capital, equity capital is supplied through private and public equity markets. Private equity, like private debt, provides negotiated financing with a, typically, intermediate (five to seven years) maturity profile. The focus of private equity, which goes in tandem with a huge appetite for high required rates of return among private equity fund suppliers, is start-ups and troubled and/or fledgling business entities which do not yet qualify to list their equity in public markets. Yet, if economic growth were to be optimized, private equity markets must work hand-in-hand with the public equity markets to avail economic agents of lower-cost capital.2 Public equity markets, enabled by organized exchanges, provide a more permanent, limited liability financing to enterprises and are the most prominent of the markets for long-term capital in emerging as well as advanced economies. The relative success of public equity financing is not difficult to comprehend. This mode of financing operates on the principle of separation of ownership from management, which introduces agency problems. To mitigate agency problems, equity-holders (principals), assisted by legislation in many countries, put in place corporate governance mechanisms to check actions of management (agents) that may be detrimental to their (principals) interests in the financed entity. In countries with strong institutional quality, corporate governance principles are more entrenched and are applied relatively strictly, effectively reducing the agency risk premium and hence firms’ cost of capital. A further reduction in the cost of capital emanates from the existence of secondary markets, which provides liquidity, enables a price-setting mechanism and eases measurement of the market values of funded entities. The price setting facility, which works well with optimal regulation that improves the quality and speed of firm-specific and market information, has transformed equity markets – through aggregation of prices into indices – to act as important barometers of countries’ macroeconomic health. However, certain characteristics of equity markets might inhibit important liquidity and price-setting roles, and, in the process, distort required rates of return on equity, and consequently, lead to failure to achieve


optimal capital allocation. Our discussion here is based on the premise that optimal capital allocation can only be achieved through optimal cost of capital. Policies that encourage capital account opening were, at inception, encouraged on the argument that they would work, through increased cross-border capital flows to lower the cost of capital for domestic corporations by increasing the domestic supply of funds relative to domestic demand for funds. While there is no evidence clearly linking improved supply of funds to capital account openness in emerging markets or clear evidence on the behavior of return volatility following emerging equity markets liberalization (e.g., Blitz et al., 2013), the literature shows that equity and currency volatility are priced in international equity returns (e.g., French et al., 1987; Kodongo and Ojah, 2014). The impact of this pricing is an increase in the cost of equity capital for emerging markets corporations. Further, although capital account opening should be associated with increased integration of equity markets worldwide, the preponderance of empirical evidence suggests that emerging equity markets are largely partially segmented. Because segmentation increases international equity investors’ required rates of return (Carrieri and Majerbi, 2006; Kodongo and Ojah, 2011), corporations have not benefited, in terms of reduced cost of capital, from relatively higher fund supply that liberalization might have elicited. Equity markets liberalization and improved cross-border capital flows were also anticipated to positively impact liquidity in the emerging equity markets. Yet, this objective appears not to have been realized as various accounts suggest that emerging equity markets have not achieved levels of liquidity that can yield beneficial effects to required rates of return (e.g., Amihud et al., 2015). As shown in Table 12.1, market capitalization as a percentage of GDP, an important indicator of market size and, potentially, liquidity, tends to lie at or below 50 percent for the average emerging equity market but has a tendency to be above 100 percent for advanced equity markets. The number of listed firms, a rudimentary indicator of liquidity, is strikingly lower, with few exceptions, for emerging markets than for advanced markets. The widely used liquidity proxy, the stock traded turnover ratio, shows that a majority of the emerging stock markets are relatively illiquid. In addition to increasing the cost of capital for firms, the relative illiquidity of emerging equity markets is also effectively detrimental to the price-setting function of secondary equity markets. [Insert Table 12.1 Here] In summary, a relationship exists amongst capital account openness (liberalization), cross-border capital flows, volatility and liquidity, and equity market integration that drive corporation cost of equity capital. In turn, the cost of equity capital (required rate of return on equity) might present implications for market integration and cross-border capital flows. We examine these relationships in the emerging equity markets context, commencing with a brief discussion on the impact globalization has played in shaping the development and performance of these markets. After this, we examine the interrelationships amongst capital account liberalization, cross-border capital flows and corporation finance. Finally, we review the


role of globalization in the behavior of various risk factors priced in equity returns and the role played by this pricing on the cost of equity capital.

Globalization of emerging equity markets Globalization is the increased interdependence and interconnectedness of economies and cultures around the world (Goldin and Reinert, 2012). Globalization, therefore speaks to increased integration of markets for capital, goods and services, and less restricted flows of funds and, in rare cases, mobility of labor across national borders. Globalization around the world is believed to have been aided by recent technological advances that have enhanced the speed, and reduced costs, of communication following the advent of the Internet and by policies recently being pushed worldwide, especially in developing countries, to reduce protectionism and give markets wider latitude in influencing trade and financial flows. However, some economists (e.g., Stiglitz, 2003) have raised concerns that pro-globalization policies might increase instability and make economies more vulnerable to external shocks, reduce growth and increase poverty. Given these concerns, it is interesting to understand the extent to which emerging equity markets are integrated with world equity markets in general and, even more importantly, to examine the role of integration in the functioning of emerging equity markets. At the core of this discourse is the measurement of financial markets integration. Researchers have proposed several measures of equity markets integration, ranging from volume-based proxies such as stocks of aggregate bilateral asset holdings relative to GDP (e.g., Lane and Milesi-Ferretti, 2003; Imbs, 2006) to price-based indicators such as the correlation structure of equity returns (see a review by Adams et al., 2002 and Phylaktis and Ravazzolo, 2002), to more sophisticated methods of testing for the law of one price3 based on prices of cross-listed securities and depositary receipts relative to prices of the “same equities” in domestic markets (e.g., Gagnon and Karolyi, 2004) and econometric approaches (e.g., Kodongo and Ojah, 2011; Arouri and Foulquier, 2011). Many of these measures have shortcomings, which may create biases, arising from factors such as potential under-reporting, unavailability of data, and/or inadvertent omissions of important international risk sharing conduits. In a recent study, Bekaert and Harvey (2014) show that the correlation between the emerging markets and advanced markets equity portfolios has increased from about 0.4 in the early 1990s to about 0.9 in 2013 and both the capital account and equity market openness indices have also shown strong appreciation over the same period. Although these simple measures do not incorporate potential segmentation factors such as institutional quality, a consensus appears to be emerging that the degree of integration of emerging equity markets has been increasing, albeit with wide cross-sectional and time variation (Bruner et al., 2008; Arouri and Foulquier, 2012), even though they seem to be less integrated than advanced equity markets (e.g., Bruner et al., 2008).


Nonetheless, a critical appreciation of the effect of financial integration on the functioning of emerging equity markets is important. That is, how does increased integration impact the development and functioning of these markets in a manner that boosts their ability to serve their role, which is, foremost, to efficiently allocate capital to deficit centres in the economy at the lowest possible cost? Are there reasons to believe that this function, crucial to economic development, has been undermined by increasing integration? We turn to empirical evidence, and provide additional insights, in an effort to tease out informed responses to these questions. In the real sector, several studies have investigated the linkage between financial markets integration and economic growth, with some finding no relationship (e.g., Rodrik, 1998); some suggesting that financial integration is favorable to economic growth (e.g., Edwards, 2001); yet others failing to find any robust linkage between economic growth and international financial integration(e.g., Edison et al., 2002). More recently, Imbs (2006) showed that greater capital account openness or assets cross-holdings (financial integration) tend to be associated with high business cycle synchronization (GDP correlations) across countries. He finds that the channel of transmission from the financial to the real sector is policy reforms, which tend to bundle because trade and financial liberalizations often happen simultaneously. Although Imbs (2006) draws data from several emerging and developed markets, the study does not address the potential impacts of integration-induced synchronization in consumption and output cycles on asset prices. News announcements provide an important source of information that may affect asset prices. If financial markets are integrated, it is reasonable to expect that domestic asset prices would react to material domestic and foreign announcements. Some interestingly designed studies have sought to examine the nature of domestic price reactions in emerging equity markets to news in major, foreign, economies. In the Nikkinen et al (2006) study, results show that developed countries and emerging Asian countries are closely integrated with respect to the US macroeconomic news, while Latin America and transition economies are not affected by US news. Hanousek, et al. (2009) study the reaction of stock prices of Hungary, Czech Republic and Poland to fifteen different classes of macroeconomic announcements in the EU and US and find that Czech stock market is impacted more by the US macroeconomic announcements while Hungarian and the Polish stock markets are more affected by EU macroeconomic news. However, later studies find that the impact of the EU macroeconomic news dominates over the impact of US news on the Czech (Buttner et al.,2012) and on Hungarian, Czech and Polish equity markets (Hanousek and Kocenda, 2011). To a large extent, these findings merely suggest evidence of integration. Our interest goes beyond this as we seek to establish the nature of reaction of emerging markets stock prices to such news. That is, we seek to understand whether, as a result of increased integration, equity price volatility, for instance, is quelled or worsened by developments in foreign markets. An important corollary of financial integration is stock market liberalization, discussed later in this chapter under “Liberalization, cross-border capital 5

flows and emerging markets finance”. When countries liberalize, publicly listed firms that become eligible for foreign ownership (investable firms), experience a significant firm-specific revaluation in the price of their stock while firms that remain non-investable get no such revaluation; since a reduction in systematic risk is usually occasioned by risk sharing availed by liberalization, integration reduces the required rates of return for investable companies and is therefore beneficial (Chari and Henry, 2004). Similarly, Bekaert and Harvey (2000) find that the cost of capital declines after capital market liberalization, again implying that financial integration is good for emerging markets. Yet, not all empirical evidence paint a rosy picture of liberalized emerging equity markets. According to Lucey and Zhang (2006), corporate financing choices respond asymmetrically to financial integration: leverage is positively related to credit market integration but negatively related to equity market integration, high-growth firms tend to obtain more debt than low-growth firms, and large firms tend to obtain more debt and issue more equity than small firms at higher levels of integration. By these results, financial integration appears to distort capital allocation efficiency. Similarly, Cakan et al. (2015), whose analysis employs asymmetric GJR-GARCH4 model, find that news announcements induce persistent and asymmetric volatility shocks: increasing with bad news on US inflation and unemployment but reducing with good news. Thus, these results suggest that financial integration causes instability in the cost of capital, hence making the capital allocation function of emerging equity markets less efficient. To recap, the integration of capital markets, a goal consciously pursued by regulatory agents everywhere in the emerging markets, might be a good way of attracting foreign capital to support economic growth. However, foreign flows to equity markets occur either in the form of the less stable, highly speculative portfolio investments or in the form of the more stable, longer-lasting direct investments (see Kodongo and Ojah, 2012b). While foreign direct investments (FDI) have some calming effects on equity markets and may potentially stabilize cost of capital in the short run, it might distort real exchange rates and make equity markets susceptible to contagion in the long-run. International portfolio flows, which move across national borders in search of better return prospects, are, on the other hand, unconducive to equity markets stabilization. The next section delves deeper into cross-border capital flows and the provisioning of finance to enterprise.

Liberalization, cross-border capital flows and emerging markets finance Since the 1980s, multilateral development agencies, led by the International Monetary Fund (IMF), have steered the reforms agenda in developing economies on a number of fronts. The reform drive has affected the financial sector through, among others, the liberalization of the capital account, whose edict has increased foreign investor access to domestic asset (interest rates, exchange rates, equities etc.) markets and increased domestic investor access to foreign asset markets. Whether these reforms have been useful to emerging financial markets is, however, an unresolved empirical question. 6

In the 1990s when the emerging markets were becoming an important research topic, some studies appeared to suggest that stock markets benefited from liberalization as they became larger, more liquid, and more integrated after relaxation of restrictions on international capital and dividend flows and that stock market liquidity tended to rise following the lifting of capital controls (Levine and Zervos, 1998a). High liquidity is associated, in the literature (see Levine and Zervos, 1998b), with improved real GDP growth. These findings are supported by many early studies (e.g., Bekaert and Harvey, 1997; De Santis and Imrohoroglu, 1997) whose results support the interpretation that equity return volatility decreases after market liberalization. Many studies reporting higher volatility following liberalization would cleverly ascribe it to ‘other domestic variables’. For instance, Aggarwal et al. (1999) seem to attribute higher return volatility to local events although they find that liberalization processes might have induced changes in asset return variance whose magnitudes and impacts are, however, country-dependent. Cuñado et al. (2011) find that changes in volatility, when present, are associated with financial liberalization but the results are mixed, with some countries reporting reduced volatility and others reporting increased volatility. Overall, their study concludes that liberalization reduced volatility, subject to the possibility of occasional large shocks. Like Aggarwal et al. (1999), they attribute changes in the structure and level of volatility to local events, which in most cases were, however, associated with financial liberalization. The supposed calming effect of liberalization on emerging equity prices also finds support from Umutlu et al. (2010), who attribute it to the broader investor base that liberalization provides. Asset pricing theory suggests that a country’s aggregate cost of equity capital should fall when it liberalizes its equity markets because, assuming that liberalization increases integration, the world market equity portfolio replaces the domestic market equity portfolio in the standard pricing theory and individual stock returns are less correlated with the world market than with the domestic market. The implication of this view is that impending equity market liberalization should elicit an increment in the country’s stock market index, holding expected future cash flows constant. Henry (2000) investigates this prediction in several emerging markets and finds that a substantial revaluation of aggregate share prices occurs in the months leading up to the implementation of a country’s initial stock market liberalization and a modest appreciation occurs in the implementation month. However, the study fails to infer causality between liberalization and cost of capital. In the light of such findings, one would be interested in understanding the channels through which liberalization impacts stock price volatility. To try to comprehend the transmission mechanism, Chari and Henry (2004) design an interesting study hypothesizing that firm-specific risk sharing (arising from liberalization) might partly explain some of the liberalization-induced stock price appreciation. Their tests find evidence that firm-specific risk-sharing characteristics account for roughly two-fifths of the liberalization-induced revaluation. Several years later, Umutlu et al. (2010) seem to confirm this


hypothesis in a study that finds that the effect of liberalization on aggregate volatility is transmitted through aggregated idiosyncratic and local volatilities. However, the relaxation of capital controls in emerging markets has not been without setbacks. Many studies have found a link between stock market liberalization and potentially disruptive volatility, of prices and cash flows, and contagion in emerging stock markets. For instance, Jaleel and Samarakoon (2009) find that stock market liberalization is strongly associated with increased volatility on the Colombo Stock Exchange (CSE), a market without other potential volatility-inducing factors such as derivatives, shortselling, cross-listings, and outward-bound portfolio flows. They show that volatility is significantly higher in the liberalization window period relative to the pre-liberalization period and that positive shocks to the market induce greater volatility than negative shocks. The adverse effects of liberalization are, by no means, confined to aggregate volatility. It has been demonstrated that volatility transmission and fragility in international capital markets are reinforced when capital controls are relaxed (Phylaktis and Ravazzolo, 2002; Rejeb and Boughrara, 2015). Indeed, as Rejeb and Boughrara (2015) explain, interdependencies between emerging and developed markets, which appear to be responsible for transmission of volatility, are amplified by more enhanced levels of integration. In an earlier work in the same subject, however, Rejeb and Boughrara (2013) put up a strong argument for financial liberalization, finding in their study, that liberalization can bolster market efficiency and reduce the odds of financial crises. Based on these findings, Rejeb and Boughrara (2013) plainly recommend financial liberalization to emerging markets. Yet, they caution that the effect of financial liberalization on efficiency depends on, among others, ‘the level of development, the degree of liquidity and the quality of investment that, themselves, draw from the evolution of financial liberalization process’ (p.206). Rejeb and Boughrara’s (2013) caveat is the cue that we need to pose a more fundamental question: what role does financial liberalization play in aiding financial development of emerging economies? The importance of this question can be seen in the light of our thesis that financial development is the channel through which financial liberalization must transmit tranquility and efficiency to emerging equity markets. If financial liberalization does not underpin financial development, then it might not enable equity markets to build the wherewithal to attenuate volatility transmission or the capacity to transform into a more efficient mechanism that can effectively serve its capital allocation function. Inefficient capital allocation inhibits economic growth. Luckily, several studies have, directly, examined the nexus between financial liberalization and the development of the financial system. We begin our survey with Arteta et al. (2001), who, using innovative approaches, record evidence that liberalization has positive economic growth effects in countries with strong institutions; however, evidence in support of the hypothesis that liberalization is more useful for economic growth with financial depth and development is weak. They suggest that countries should eliminate major macroeconomic imbalances before liberalizing their capital accounts. With this finding, Arteta et al. 8

(2001) introduce an important issue for the functioning of financial markets and which potentially holds the key to comprehending the linkage between financial liberalization and financial development – institutional quality. Expectedly, many subsequent studies have taken up the issue. One of the early studies to examine the relationship, in the empirical sense, between capital controls and financial development is Chinn and Ito (2002). Their results essentially suggest that higher levels of institutional and legal quality are necessary for the link between financial development and financial openness to be scientifically detectable. For the emerging markets, they find that shareholder protection and accounting standards constitute the most important element of the legal environment. Similar results are reported by Chinn and Ito (2006) who are emphatic that financial openness does not contribute to equity market development unless a threshold level of legal systems and institutional development has been attained. Interestingly, they do not, unlike Chinn and Ito (2002), find that finance-specific legal institutions are an effective catalyst in the nuanced relationship; rather, emerging markets development minders should focus their energies on improving their general levels of legal and institutional development to realize financial development benefits from financial openness. In their study, Klein and Olivei (2008) appear to suggest that a clear link exists between financial depth (development) and capital account controls in which restrictiveness discourages development. However, the full benefits of payoffs of capital account liberalization can only be realized by countries with adequate institutions and sound macroeconomic policies. The study adds that it is difficult to fully appreciate the importance of economic policy and institutional quality that is required for successful liberalization (and integration into the world economy) until a complete understanding of the manner in which openness alters the economic structure and performance is achieved. One can discern potential alterations, induced by capital account openness, to the economic structure and performance from the lens of a monetary economist. Thus, the question as to whether the real economy is better off with equity markets liberalized is germane. In particular, relaxation of capital flows controls has been associated with real exchange rates disequilibria and monetary policy management complexities. Theoretical modeling by Bailey et al. (2001) traces the linkage between capital flows and real exchange rates to productivity shocks. According to the model, each economy is endowed with two sectors, one whose goods are tradable with the rest of the world, and one whose goods are not tradable. A shock that raises the productivity of the tradable sector increases the country’s capital inflows causing real exchange rate appreciation in both the short and the long runs. Empirically, many studies have investigated capital flows–real exchange rates linkage using emerging markets data, many of them finding that capital flows and the real exchange rate are closely interrelated (e.g., Calvo et al., 1993; Buffie et al., 2004). However, Saborowski (2009) provides strong evidence that the real exchange rate appreciation effect of foreign direct investment is significantly mitigated in economies with deep financial sectors and large and active stock markets; the study does not find similar 9

evidence for other types of capital inflows. The latter result is supported by Jongwanich (2010) who finds that the composition of capital flows matters for the real exchange rates effect. Specifically, portfolio inflows bring in a faster speed of real exchange rate appreciation than foreign direct investment inflows although the magnitudes of the appreciation among capital flows are close to each other. Jongwanich (2010) also finds that capital outflows bring about a greater degree of exchange rate adjustment than capital inflows for all types of capital flows. Consistency exists in the capital flows-real exchange rates nexus literature in respect of the composition of capital flows, with many studies finding that foreign portfolio investment (FPI) and foreign direct investment (FDI) flows have different responses to, or induce different responses on, real exchange rates. In their study, Kodongo and Ojah (2013) find that depreciations in real exchange rate ‘lead to improvements in the trade balance and net inflows of foreign direct investment flows while international portfolio investors react to real exchange rate depreciations by taking short positions in capital assets’ of African countries (p. 44). The differences in the reaction of FDI and FPI could be explained by differences in the key characteristics of the two flows: as Kodongo and Ojah (2012b, 2013) explain, portfolio flows of major developing African countries are non-persistent and volatile, relative to those of advanced markets and relative to trade and FDI flows (see also Chapter 8 of this volume). It should be clear, by now, that we have a more-or-less circular relationship in which the real economy and the financial system interact with each other in a complex fashion with institutional and legal quality and capital account openness intervening and/or moderating the complex relationship. Consequently, it is unclear the manner in which the cost of capital, an important construct with huge implications for corporate financing and economic output, is informed by capital account openness. However, some issues emerge. First, emerging economies must think carefully about the sequencing of implementation of economic/financial policies with, preferably, institutional and legal reforms preceding financial openness. Secondly, financial openness must be approached cautiously to mitigate the destabilizing effects of the (relatively volatile) portfolio flows and contagion (volatility transmission) on real exchange rates and equity required rates of return (prices). It is to the latter issue that we turn next: the determination of equity required rates of return in globalized emerging markets and its potential implications for the financing of business entities.

Equity required rates of return and corporation finance in emerging markets In “A Theory of Economic Development,” Schumpeter (1911) argues that entrepreneurship and innovation play an important role in economic growth. Further, he argues that a developed financial sector eases the mobilization of productive savings, efficient allocation of resources and risk management, all of which enable innovation and entrepreneurship to thrive. Based on this logic, he presents the case for finance as the mechanism through which entrepreneurial orientation informs economic growth. 10

Empirical tests of Rajan and Zingales (1998) and Beck et al. (2000), among others, have supported Schumpeter’s viewpoint. As we have argued in the previous sections, the important role finance plays in resource mobilization and allocation can be more effectively achieved if required rates of return on financial assets: (i) reflect all the sources of risk that impact the performance of those assets; and, (ii) are low enough to incentivise private production. Low required rates of return can be attained if the sources of variability in returns on securities are, themselves relatively stable, and the systematic ones of them less correlated with asset returns. Thus, we raise two fundamental questions in this section. First, has globalization helped to reduce the variability of factors impacting required rates of return on emerging markets equities? Second, which key factors enter the pricing calculus of emerging markets equities? The two issues are clearly interrelated and our attempt, below, to respond to them treats them as such. An important aspect of the emerging markets reform drive has been the review of restrictions on assets holdings that once characterized these markets. This included various forms of floatation of countries’ foreign exchange rate regimes. Prior to the currency floatation era, international asset pricing models (IAPMs) were used to estimate required rates of returns on internationally-held securities and portfolios in their traditional sense – without controlling for currency risk. Under the floating currency regimes, it is believed that currency fluctuations constitute an important factor that might drive international asset returns. As such, IAPMs have been developed (e.g., Adler and Dumas, 1983; Ikeda, 1991) that give a role to currency returns as a priced factor. Empirical asset pricing tests generally estimate an IAPM of the form (see Kodongo and Ojah (2011) for a detailed exposition): 𝑟𝑡 = 𝛼 ⊗ 𝜄 + (𝑓 + 𝜆 ⊗ 𝜄)𝛽 + 𝜀𝑡


where 𝑓 are the returns on factors such that 𝐸(𝑓) = 0 for each 𝑗 = 1, 2, . . . , 𝑘; 𝜄 is a vector of ones; ⊗ is the Kronecker product; 𝐸(𝜀𝑡 ) = 0; 𝛼 (intercept terms), 𝛽 (factor loadings) and 𝜆 (factor risk premia) are parameters to be estimated. The key factors included in Eq. (12.1) are the world market equity portfolio and exchange rate returns. In the emerging equity markets and some advanced markets that are not fully integrated with the rest of the world’s equity markets, a segmentation variable (liquidity, home bias, sovereign risk, etc.) is often included in the model following revisions to the standard IAPM by Stultz (1981), Errunza and Losq (1985), Solnik and Zuo (2014) and others. Eq. (12.1) can be estimated using the unconditional asset pricing or conditional asset pricing principles. Under the unconditional asset pricing framework, the model is estimated on the unrealistic premise that asset returns depend only on innovations in the priced factors. Whilst unconditional asset pricing tests done in advanced equity markets generally provide evidence of weak or no pricing of currency risk (e.g., Jorion, 1991; Choi et al., 1998; Iorio and Faff, 2002), the story is different for the emerging equity markets where high levels of currency risk premia are typically reported (e.g., Claessens and Rajan, 1997; Tai, 1999; Carrieri and Majerbi, 2006; and Kodongo and Ojah, 2012a).


Even more striking results are obtained when Eq. (12.1) is estimated through the conditional asset pricing framework, which works on the more realistic premise that asset prices are determined not only by innovations in priced factors but also by incorporating the influence of variables with proven ability to inform investment decisions of investors. Based on this logic, several studies, among them, Drobetz et al. (2002), Phylaktis and Ravazzolo (2004), Poghosyan (2010), Poghosyan and Kočenda (2009) and Huang et al. (2014) have found strong evidence of currency risk pricing in emerging equity markets. Even for the relatively young African equity markets where currency risk is unconditionally not priced (Kodongo and Ojah, 2011), incorporating additional (conditioning) information yields findings reminiscent of high levels of currency risk pricing in equity returns (Kodongo and Ojah, 2014). Thus, it is not tenuous to conclude that equity risk premia have increased following currency market liberalization, making external equity financing dearer for enterprises. We pointed out in our earlier discussion that globalization’s main achievement should be the integration of equity markets across the world. When equity markets are integrated, domestic market risk factors become less important and equity required rates of return are more informed by their covariance with developments in the world markets. In such a situation, IAPMs should find global factors and currency risk priced, whereas domestic factors should command zero risk premia in equity returns. Empirical studies proxy the world equity market by a global index such as the MSCI world equity portfolio. Using this as the world market risk factor and including a local market factor (typically an index of local market equities) jointly with the exchange risk factor, the model in Eq. (12.1) is estimated, unconditionally or conditionally. Full integration implies that the domestic risk factor premium equals zero (𝜆𝐷 = 0) while the world market factor premium is different from zero (𝜆𝑊 ≠ 0). The findings of several of these studies do not make us confident that emerging equity markets are fully integrated with the rest of the world several years after reform measures were initiated. For instance, Abid et al. (2008) finds that the degree of market integration changes frequently over time and markedly across markets. Their findings that speak directly to integration, however, leaves globalization policy proponents of yesteryears with egg on their faces – the premium for global risk factors appears to be only a small component of the total equity premium for several of the markets. Based on these findings, Abid et al. (2008) advice, contrary to what several years of reform drive would suggest, that ‘asset pricing rules for emerging equity markets should reflect a state of partial integration’ (p. 415). Several other studies have shown that emerging equity markets are mostly partially segmented. These include Saleem and Vaihekoski (2008) who show that the local market risk factor is significantly priced in the Russian stock market; Bailey and Jagtiani, (1994) who provide evidence for the Thai equity market and Kodongo and Ojah (2011, 2014) who find a significantly priced local market factor and infer partial segmentation in Africa’s emerging markets. In contrast, Gerard et al. (2003) earlier found little support for the hypothesis that exposure to residual country risk is rewarded across major East Asian equity markets and proceeded to reject market segmentation. 12

With the preponderance of the literature pointing to lack of full integration in emerging equity markets, it is not clear if empirical findings suggest that emerging equity markets regulators, in a bid to achieve greater integration, could do more than just opening up of their capital accounts for increased foreign investment flows, or that the efforts to this end should be gradual and in sync with equity markets maturity, liquidity and efficiency. What is clearer, especially from the partial segmentation findings, is that, in addition to local factors, global factors (and, from our earlier review, currency risk factor) are now priced factors affecting emerging equity returns. This not only avails international investors of the benefit of diversification (that enables them to reap superior returns through their emerging markets equity investments), but, complicates emerging markets’ ability to effectively use the relatively abundant capital to improve economic output through lower cost of external capital for corporations.5 Having addressed the key pricing factors that feed into the international asset pricing models and hence determine the cost of international capital for corporations, it is only fair that we attempt to unravel the domestic market risk factor in order to appreciate why it could be priced in spite of the overt attempts at the policy level to make it irrelevant. We address this using a key potential sub-factor of the domestic market factor – liquidity. Liquidity is important because it is an enabler of the price discovery process, which frequently manifests itself through volatility. In this regard, we should examine volatility as well: however, in globalized markets, volatility takes on an elevated significance because it often is the face of contagion effects of other markets. In Table 12.1, we saw that emerging equity markets are less liquid and smaller in size than the average advanced equity market. In the context of the cost of capital, we try to establish whether lower liquidity in emerging equity markets is so important to international investors that it impacts their required rates of return. We get some answers in recent studies (e.g., Amihud et al., 2015; Bai and Qin, 2015; Hearne and Piesse, 2015) which report evidence that illiquid stocks generate significantly higher risk-adjusted return than liquid stocks; amenable to the interpretation that illiquidity premium is significant in emerging (and advanced) equity returns. Not surprisingly, Amihud et al. (2015) find that illiquidity premium is higher in the emerging markets than in advanced markets, confirming that emerging equity markets still exhibit a great deal of segmenting influences with the ability to impact the cost of capital. The stakes get even higher for liberalization aficionados in the emerging markets policy arena: a novel and informative finding of Amihud et al. (2015) is the existence of strong positive covariation in the illiquidity premia across countries, which tends to increase as countries’ equity markets become more integrated with each other or in countries whose equity markets are more open to foreign investments. We interpret this finding to imply that the relatively high illiquidity premia in emerging markets can be a bane to capital hungry private enterprises as the implementation of capital account liberalization achieves greater success in integrating markets. That is, higher covariation in liquidity premia across markets would reduce the diversification benefits (currently a great pull-factor in the attractiveness of emerging equity markets) and reduce equity inflows of emerging markets. Although increased inflows have not been effective in 13

reducing the cost of capital, decreased inflows might reduce the supply of funds, in turn, driving up required rates of return. The importance of this interpretation can be viewed against the insights of Bai and Qin (2015) that illiquidity risk can be diversified away through the construction of global portfolios.

Conclusions and recommendations In this chapter, we have reviewed the literature on globalization and emerging equity markets. Through the review, we make a number of observations. First, firms that become investible following liberalization experience a significant firm-specific revaluation in the price of their stock while firms that remain noninvestible get no such revaluation; implying that integration reduces the required rates of return for investible companies and is therefore beneficial. However, certain characteristics of equity markets, such as size and liquidity, might distort required rates of return on equity and result in failure to achieve optimal capital allocation. We show, through summary statistics, that emerging equity markets are indeed smaller in size and less liquid than advanced equity markets. We also establish that there is a cross-causality relationship in which the real economy and the financial system interact with each other in a complex fashion with institutional and legal quality and capital account openness intervening in the complex relationship, making it unclear how the cost of capital is ultimately impacted by capital account openness. Following from this, we recommend that emerging economies must carefully sequence the implementation of financial policies with, preferably, institutional and legal reforms preceding financial openness. In this regard, we echo sentiments suggesting that emerging market countries should eliminate economic imbalances and asset price distorting environment or factors before liberalizing the capital account. Second, financial openness must be approached cautiously to keep to a minimum the destabilizing effects of the relatively volatile portfolio flows and volatility transmission on real exchange rates and cost of equity capital. Third, there is higher covariation in liquidity premia across markets that might potentially reduce diversification benefits to international investors and diminish equity inflows of emerging markets. Although increased inflows have not been effective in reducing the cost of capital, decreased inflows might reduce the supply of funds, in turn, driving up required rates of return. This is one potential drawback of globalization that must be carefully thought through as more reform policies are implemented in emerging markets.


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Table 12.1: Some characteristics of emerging and advanced equity markets, 2012 Value of Stocks traded Market Number of stocks traded turnover ratio capitalization listed domestic (% of GDP) (%) (% of GDP) firms A: Emerging equity markets Brazil 34.58 67.88 50.96 353 China 68.86 164.44 43.70 2494 India 33.98 54.63 68.97 5191 Israel 26.18 45.90 57.71 532 Korea 123.80 139.22 96.54 1767 Malaysia 40.82 28.57 156.20 921 Mexico 9.96 25.31 44.25 131 Russia 36.32 87.64 43.38 276 South Africa 78.46 54.93 154.08 348 Turkey 44.18 136.51 39.14 405 B: Advanced equity markets Australia 68.54 84.65 83.84 1959 Canada 65.91 61.58 110.01 3876 Japan 60.55 99.85 61.82 3470 UK 95.17 84.04 115.47 2179 USA 132.25 124.60 115.50 4102 Data source: World Bank’s World Development Indicators


Borrowers still have to incur security floatation costs, such as auditing, advisory, and legal fees charged by professional firms and listing and registration fees imposed by securities exchanges and market regulators. 2 One of the major roles of private equity (such as venture and angel capital) is to shepherd enterprises to financial self-sustainability; this role necessitates a high-level involvement by the financier in the management of the financed entity, with a view to taking the entity to an initial public offering (or other exit mechanism) within a specified duration of time. The private equity financier exits the financed entity at the point of the IPO or gradually thereafter. 3 The law of one price states that a commodity should trade at the same price in different locations otherwise there will be arbitrage opportunities that will force it to do so. 4 GJR in the model refers to Glosten, Jagannathan and Runkle (1993), who developed the particular Generalized Autoregressive Conditional Heteroscedasticity (GARCH) process. 5 Juxtaposing this against conventional economic wisdom, one finds it intriguing that relative abundance in the supply of a resource (capital) fails to provide the resource at a lower price to consumers (firms). 1


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