Globalizations Of Capital Markets

E. Han Kim’s article is in pursuit of an important question that arises with the Asian crisis “Are open capital markets good for emerging economies?”. The recent Asian currency problems brought in the discussion that emerging markets should resist the temptation of easy money, or at least place regulatory restraints on capital inflows and outflows. For emerging nations, the inflow of foreign capital is essential for building infrastructure and making other investments necessary for economic progress. Thus, before emerging economies reverse their recent liberalization measures and implement further regulatory restraints on capital flows, it would be useful to reexamine the opportunity cost of a closed market and the risk associated with open markets. To reach a sound answer Kim concentrates on three basic topics in this article: (1) the impact of open capital markets on the economies of host countries; (2) the causes of the Asian financial crisis; (3) the effects of South Korean government’s recent attempts to restructure its corporate sector. Although the recent Asian financial crisis has led some to question the merits of open capital markets and to call for regulatory restraints on capital flows across international borders, the scientific evidence suggest that the opening of stock markets to foreign investors has been largely beneficial for emerging economies.

First of all, a market that is open to global investors reduces the cost of capital for local companies by allowing stockholders to achieve efficient diversification, thereby increasing the probability that promising new ventures will attract funding. Also, stock markets lower the cost of capital by increasing the liquidity of investments. Greater liquidity not only reduces the required rate of return demanded by investors, it encourages companies with promising growth prospects to retain and reinvest earnings as long as investors remain confident in their own ability to convert the retained earnings into cash by selling shares in the market. A lower cost of capital leads in turn to greater investment and employment as domestically produced goods and services become more competitive in the global marketplace. More efficient use of capital in turn leads to the value creation (EVA) in the corporate sector that is necessary for sustainable economic growth.

Furthermore, opening the stock market to foreign investors serves as a catalyst for achieving greater efficiency in the domestic market such as improved financial technology. Additionally foreign investor will demand the transparency and improved disclosure rules that enable them to monitor corporate performance and capital allocation. They will also demand greater accountability of management to shareholders in order to protect themselves against expropriation of wealth by the controlling investors.

Finally, the cost of foreign capital tends to be lower because foreign portfolios can be more broadly diversified across national boundaries and therefore are more “efficient” in managing “country-specific” risks, resulting lower risk premium.

The results of empirical studies that were undertaken on 20 emerging economies over a 10-year period by Kim, Vijay and Singal supports the positive effects of financial liberalization. On average, stock market liberalization has been accompanied by increases in stock prices and reductions in stock return volatility, reductions in inflation (excluding Turkey, Pakistan and Thailand) and reductions in the rate of currency depreciation.

There are enormous gains that can be realized by uniting foreign investors and host countries through stock market openings. But these gains provide no guarantee against the possibility of sudden outflows. International flows of funds are highly sensitive to differences in interest rates, perceived economic growth rates, and expected returns from holding securities. Due to the sensitivity of these investments, even a small shock to the economy or revision in expectations may lead to volatile change in fund flows, which further exacerbates the shock and destabilizes the domestic economy. Often the blame for the crashes goes to the hot money or hedge of funds as in Asian crisis. However, foreign investors are more likely to be the “patient money”. As sophisticated investors, they are aware of the volatility, instability and risk of the emerging stock markets. They are accordingly enter these markets with a relatively longer investment horizon. Therefore, host countries can ensure that they retain foreign capital by using that capital productively and treating investors fairly.

Whether accomplished by foreign or domestic investors, capital flight is merely a symptom not the cause of the Asian crisis. Much of the blame for the Asian currency crisis is assigned to Asian policymakers’ futile attempts to defy market forces by trying to maintain their currencies at artificially high levels. But a more fundamental cause of the crises is corporate sector value destruction through chronic overinvestment with little regard to earning a rate of return adequate to compensate the supplier of capital. In the pursuit of growth and expansion, the cost of capital was often underestimated or ignored altogether in making investment decisions. This resulted in inefficient allocation of capital and destruction of corporate value. This has lead to a lower value for the overall economy and weakened the banking sector.

The government-directed banking system and weak corporate governance structures (including managerial incentives to increase size and market share at the expense of shareholders) that characterizes most Asian economies have resulted in systematically overinvestment, bloated payrolls, and sharp declines in corporate profitability.

Corporate value destruction is a basic cause of the crisis in Korean case as well. Rather than trying to realize government-directed restructuring of the chaebol, Korea should streamline its efforts towards increasing the productivity of capital. Asian companies should seek to realign managerial with shareholder interests by trying compensation to measures of value creation like EVA.