By Patrick Imam
The growing appetite for emerging market financial assets (such as equity or bonds) by local and foreign investors has not been met by a commensurate increase in the supply of these assets. This is because an economy’s ability to produce output is only imperfectly linked to its ability to generate financial assets.
With the start of the new millennium, a “golden decade” of macroeconomic stability and economic growth has put emerging markets back on the map for investors. Following the 1980s debt crisis in Latin America and Asian crisis of the 1990s, most emerging markets undertook bold reforms, encompassing orthodox fiscal policies, a predictable monetary stance, and other measures that led to strengthened balance sheets in both the public and private sectors. These economies-with the exception of those in Eastern Europe-managed to maintain this newfound economic stability through the 2008 global credit crisis.
Paradoxically, however, the growing appetite for emerging market financial assets (such as equity or bonds) by local and foreign investors has not been met by a commensurate increase in the supply of these assets. This is because an economy’s ability to produce output is only imperfectly linked to its ability to generate financial assets.1
Many countries-such as communist countries in the past, or oil-producing nations today-have been able to grow rapidly without issuing substantial amounts of financial assets. This explains why, since the 1990s, asset issuance as a share of GDP in emerging markets has not increased in parallel with GDP (see Figure 1). While emerging markets accounted for roughly 30 percent of global GDP in 2010, they accounted for only about 15 percent of global financial assets.
Despite high equity returns, a stable macroeconomic environment, and increasing assets under management by institutional investors, the primary market in most emerging markets has not taken off. Stock market capitalization-that is, the total value of the tradable shares of companies on the stock market-has increased due to valuation changes from price increases, not because new companies have come to the stock market. Not only are equity issuances and initial public offerings (IPOs) still infrequent in emerging markets, but most domestic fixed-income markets also remain highly underdeveloped and dominated by public debt. Outside of short-term public debt, most fixed-income products remain illiquid.
Why isn’t there greater expansion in the supply of domestic financial assets in these countries? The answer is partly related to market size. Outside of the BRICs-Brazil, Russia, India, and China-corporations tend to be small, limiting the scope for equity and bond issuance, which requires a minimum scale to make it worthwhile. Most emerging markets do not have many large companies able to issue bonds on a scale large enough to create a vibrant stock market. Moreover, capital markets in these countries would not find it easy to simultaneously absorb several IPOs or large bond issuances without disrupting prices.
In addition to size, the corporate culture also plays a part in explaining why entities and controlling shareholders are reluctant to issue shares. Family-owned entities, for example, are often unwilling to give up control of their company in this way.
Asset shortages and economic imbalances
With emerging markets producing too few financial assets relative to rising demand-both foreign and domestic-the result is a shortage of assets.2 Not only are there fewer investment opportunities, but the lack of domestic financial assets, if not addressed, could potentially lead to large macroeconomic imbalances that threaten financial stability.
These include:
• Low real interest rates. With too much savings chasing too few investments, real interest rates are kept low. Low interest rates in turn push investors to search for higher yields by moving into higher-risk assets, thereby bringing real interest rates down further.
• Illiquid capital markets. The mismatch between buyers and sellers leads to investors adopting buy-and-hold strategies that dry up liquidity. In turn, fewer transactions limit price discovery in domestic capital markets (and lend themselves to market misconduct, price manipulation, or price volatility from noise traders).
• Misalignment in the valuation of assets, leading to bubbles in extreme cases. Market efficiency is impaired if a mismatch between asset supply and demand leads to sustained misalignments in asset valuation relative to economic fundamentals. In a world of imperfect capital mobility, distortions in asset valuation relative to the economic fundamentals can be long lasting. The recurrent speculative bubbles observed in emerging market economies are a reflection of these misalignments.
• Capital flows from emerging markets to advanced economies. Classical economic theory predicts that capital should flow from rich countries to poor countries. But according to the “Lucas Paradox,” capital does not flow from advanced economies to emerging markets-despite the fact that the latter group has lower levels of capital per worker and should logically be seen as profitable places in which to invest. The Lucas Paradox is a symptom of asset shortages in emerging markets. With a limited pool of domestic assets, savers in emerging markets invest their savings overseas instead. Sovereign wealth funds are an extreme manifestation of this phenomenon, with massive savings in emerging markets not being absorbed by the domestic economy because of the dearth of financial assets.
Why have asset shortages arisen?
Dramatically improved economic fundamentals on the one hand and regulatory restrictions on the other have led to rising imbalances in the supply and demand for financial assets. For policymakers, the challenge is to maintain economic stability while tackling the distortions that have curbed the supply of financial assets. Let us look at these two issues in turn.
First, improved macroeconomic fundamentals have raised the demand for financial assets.
There is a dwindling supply of financial assets due to orthodox fiscal policy. Government fiscal policy is a key source of the supply of financial assets in emerging markets. According to the so-called “Original Sin” line of reasoning, most emerging market governments and corporations are unable to borrow in local currency. This is because the domestic capital markets are shallow and investors are unwilling to fund large investments in an emerging market currency, leading to an insufficient supply of domestic financial assets. Although the issuance of domestic debt has recently increased, the original sin has declined only marginally, and only in a few countries. Abstinence from debt has instead become the strategy of choice for emerging markets. Improved fundamentals are occurring in parallel with relatively lower issuance of financial assets in the form of government bonds.
There is an increased supply of domestic savings. With rising income per capita in emerging markets, one might have expected rising consumption levels and falling savings. However, this has not been the case, as pension reforms in Latin America, increasing commodity prices in the Middle East and Africa, and limited consumption growth in East Asia have contributed to an increasing supply of domestic savings in emerging markets that needs to be invested.
The advanced economies have an increasing appetite for emerging market assets. To diversify their holdings, portfolio managers in advanced economies have been increasingly investing part of their portfolios in emerging markets, thereby reducing the supply of domestic financial assets available to emerging market investors. The home bias in advanced economies is evaporating quickly as investors turn their attention toward emerging markets-which only worsens the asset shortage problem.
At the same time, financial frictions are curbing the supply of financial assets.
Regulatory restrictions are limiting the supply of financial assets. A substantial portion of the world’s savings are put to work by governments, central banks, and financial institutions such as insurance companies. Many of these agents are ordered by law to buy fixed-income products, such as domestic government bonds, and face constraints on investing in certain asset classes, including (private) equity or foreign assets. Moreover, many emerging markets (e.g., China) do not allow the issuance of high-yield debt or other financial assets outside of the plain-vanilla types. This prevents the development of a whole asset class, which restricts the supply of financial assets and holds back the country’s financial deepening.
Institutional uncertainty inhibits investment. Emerging markets have undergone severe and repeated shocks in the past few decades, making investors increasingly risk averse. As a result, banking systems in Asia and Latin America have become highly regulated and are forced to keep high liquidity buffers and capital ratios. While these regulations have created stable banking systems, they have also turned them into more conservative systems that often constrain credit growth. In addition, poorly defined property rights, weak contract enforcement, and judicial arbitrariness are just a few problems that, by keeping uncertainty elevated, have constrained investment and led to lower private rates of return. While policymakers in these countries have made great strides in addressing these concerns, their efforts have not been sufficient to increase the supply of financial assets.
Political factors have discouraged investment in advanced economies. While investors in emerging markets are often keen to invest their assets overseas to diversify their portfolios, the worsening macroeconomic conditions of advanced economies in recent years have made it increasingly risky to invest there. In addition, Middle Eastern and Chinese investors wanting to invest in advanced economies are being increasingly scrutinized (as epitomized by the failure of Dubai World and CNOOC to acquire Western assets owing to political opposition). The combination of these two factors has made overseas investment less attractive.
Policy prescriptions
Policymakers could take three key steps to help solve the asset shortage problem in emerging markets.
Deepen capital markets.
To spur growth in the supply of financial assets, it is crucial to deepen capital markets further. More efficient capital markets would increase access to financing for the private sector, lower the cost of financing, distribute risk, and support long-term growth. Many countries have developed alternative markets for mid-cap companies in the early stages of development. Inspired by the success of AIM (Alternative Investment Market) in London, which allows smaller companies to float shares with a more flexible regulatory system, some emerging markets have, with varying degrees of success, managed to develop such markets. For example, Peru recently simplified the issuance of securities by establishing a “fast track” registration process for public offerings by accredited investors. However, in order for this to work, the country has to have an investor base willing to take risks and a critical mass of companies with the potential to grow rapidly.
Improve regulation.
Authorities in emerging markets should clarify legislation and modify regulations to spur the growth of new financial assets. In Latin America, for instance, regulatory restrictions on the investment of pension funds in nontraditional instruments (private equity, real estate, lower-rated fixed income products, etc.) and illiquid assets in the stock market have limited the opportunities for growth in such non-traditional assets. Liberalizing these investment restrictions would encourage companies to issue more non-traditional financial assets, thereby widening the investment universe.
Regulations should address not only the demand side but also encourage the supply side of financial assets. With a rising rate of urbanization and growing income levels, the demand for housing – and financing for it – is rising rapidly. In most emerging markets, however, the market for covered mortgage loans is underdeveloped, given the vague legal and regulatory framework with regard to the collateral and matching requirements for covered bonds, valuation issues, and their treatment of in the case of bankruptcy. Addressing these issues could pave the way for the growth of covered bond markets.
Similar reforms may be needed to create an asset-backed securities (ABS) market for mortgages. A successful ABS market for mortgages could open the door for other assets such as credit cards and auto loans to become securitized, thus expanding the list of financial assets.
Governments should also develop comprehensive policies to support new companies by fostering private equity and venture capital industries. This could take the form of tax incentives to invest in high-risk asset classes, or it could complement private investment through public sector co-investment in some ventures targeting earlier stages of development. Such policies have been successfully implemented in Brazil and South Africa.
The business environment for publicly listed companies should likewise be improved. Encouraging entrepreneurs to expand by using capital markets is an important step in increasing asset supply. Too often, companies are discouraged from going public because of the regulatory hurdles and increased costs that inevitably result.
In addition, rules could be set in place to enforce a minimum amount of assets that must be listed on a stock exchange. In 2010, India’s Finance Ministry announced new rules for companies listed on Indian bourses, requiring them to make available, within 5 years, a minimum of 25 percent of equity, as opposed to the existing 10 percent. Such a move also raises liquidity, and thereby reduces volatility.
Countries with many state-owned enterprises could also launch a program to list and privatize, as Malaysia is doing. While privatization per se is not a panacea that will necessarily improve the productivity of state-owned enterprises, it does tend to improve the governance and profitability of companies. And privatization has the added benefit of increasing the supply of financial assets.
Finally, regulators could remove or reduce the limit on how much institutional investors are allowed by law to invest overseas. This would allow the system to lessen the excessive exposure to domestic systemic risk and the risk of domestic security prices moving too far from the fundamentals. Local markets tend to be uncorrelated with international markets, and thus diversification is likely to pay off.
Reduce savings.
Partly because individuals behave in a precautionary manner, emerging markets have large national savings rates. High saving rates in China, for instance, are said to reflect high individual risk related to the cost of health, retirement, and education. Consequently, one way of reducing savings-and helping correct the asset shortage problem-is to strengthen the social safety net. This is why in 2008, China expanded the Chinese state health care system ‘Yi Bao’ to 229 cities.
In countries where the fiscal position is strong and infrastructure needs are acute, raising infrastructure investment, financed through issuing financial assets, is another way of reducing national savings. Such a strategy would have obvious positive spillovers for the rest of the economy.
No magic bullet
There is no magic bullet that will correct asset shortages. The comprehensive set of reforms described here will certainly help reduce macroeconomic imbalances and financial instability. But tackling the problem of asset shortages will also further stimulate the broader development of emerging markets by spurring investment, perfecting the allocation of resources, and reducing the likelihood of bubbles.
About the author
Patrick Imam is an economist in the Monetary and Capital Markets Department at the IMF, with a PhD in economics from Cambridge University. He was worked on Africa, the Western Hemisphere region, Middle East and Asia. His research interest encompasses capital markets and financial stability. Prior to the Fund, he worked as an investment banker at Credit Suisse First Boston.
References
1.While the recent literature has emphasized the lack of safe financial assets as a store of value (e.g. Caballero, Ricardo, 2006 “On the Macroeconomics of Asset Shortages” MIT mimeo), we argue that, within EMs, the issue is less one of safe assets (as a store of value), and more about there simply not being enough assets to invest in.
2.Chen, Jiaqian and Patrick Imam, 2011, “Causes of Asset Shortages in Emerging Markets” IMF Working Paper No.114
