Developing Deeper Capital Markets in Emerging Market EconomiesRemarks by John Lipsky
First Deputy Managing Director, IMF
at the U.S. Department of the Treasury
February 2, 2007
It's a pleasure to see so many old friends gathered around the room at this seminar to discuss the development of deeper, more liquid, local capital markets in emerging economies. I'm happy to be able to emphasize the word "deeper" because a lot has been accomplished since the crisis years of 1997-98-reasonably well-developed capital markets are now in place in many emerging economies. Indeed, at end-2005, the stock of domestically issued bonds in emerging market countries amounted to US$3.9 trillion, constituting an important global asset class, as you are aware. So what we are speaking of today is deepening these markets-making them more liquid, sounder, and more resilient.
That the key role of financial markets in emerging market economies is widely recognized is particularly gratifying to me. When I was a graduate student, I had the good fortune of serving as a teaching assistant to Professor Ed Shaw, the author of the path-breaking book "Financial Deepening 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 emerging markets is that international investors are increasingly purchasing securities denominated in local currency. To quote a few figures: Dedicated emerging market U.S. mutual funds have been growing rapidly, from US$27 billion in late 2000 to about US$230 billion as of mid-2006; and the stock of domestic securities in emerging market economies increased by some estimates from 26% of GDP to 40% between 1996 and 2006.
Thus, many emerging markets have seemingly managed to atone, in investors' eyes, for what some experts had typically characterized as their "original sin." I mean, of course, that they are beginning to overcome the structural weakness and lack of market credibility that many experts assumed was more or less permanent, and which it was claimed relegated these economies to borrowing internationally only in foreign currencies.
The overcoming of "original sin" is an important development, even if its implications are not yet fully evident. Some see it as a risky development, arguing that it may reflect only an overly exuberant "search for yield" in an environment of low interest rates and ample liquidity. Of course, investors and officials need to be aware of potential risks. At the same time, however, overemphasizing these risks could obscure what I hope are the more important implications of these developments.
My own view is that the growing internationalization of emerging market securities reflects important structural changes taking place in the global economy and in global markets. These include, notably, the growing integration and new role of emerging market countries in the global economy, and the growing sophistication of financial markets and risk management. In addition, it also represents the unexpectedly benign economic and financial environment of the past few years. We've had the fastest five-year period of global growth in recent times. The more forthcoming stance by international investors signals an important vote of confidence in future economic and financial stability. With the prevailing environment of macroeconomic stability in OECD economies expected to continue in the coming year and probably beyond, emerging market countries are being offered a tremendous opportunity. It is essential that they fully capitalize on this unusual moment.
Many emerging economies, happily, have been taking the right steps. They have substantially improved their macroeconomic performance by strengthening their monetary and budget policies and by developing more complete and stable domestic financial markets. They have also taken advantage of the generally favorable environment to build cushions against external shocks-through such measures as improved debt structures, expanded regional reserve pooling arrangements (for example 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 of emerging market countries into world capital markets. An important priority in this regard is to preserve the combination of steady growth and low inflation in mature markets. In addition, work is needed to better understand the financial market trends that are driving globalization-including, for example, by helping to insure the healthy development of credit 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. For example, the aggregate capital of the hedge fund industry has grown tremendously-from US$30 billion in 1990 to over US$1.3 trillion as of end-2005-while the number of hedge funds has multiplied from only 530 in 1990 to over 6,700.
These instruments provide obvious benefits-they have added to market liquidity, and they have helped to transfer risk to a much wider variety of willing investors. In that sense, they've contributed to stability. They've also helped reduce market inefficiencies. At the same time, the knowledge and practices of regulatory and supervisory authorities will need to keep up with these developments. The basic goal is to have as much oversight as necessary, but not more. Beyond that, we need a comprehensive and systemic approach to deal with potential market stress. We need to have crisis prevention and crisis resolution methods that 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 financial intermediation. Certainly, the experience of the emerging economies underlines the fundamental importance of deepening and broadening financial sectors in underpinning growth. In fact, new Fund research indicates that, over the last 30-35 years, emerging markets economies on average have grown close to three times faster than the group of developing countries that have not actively participated in financial globalization.
Nevertheless, there is still potential for additional substantial growth of financial markets in these economies. At 43 percent of GDP, emerging market outstanding bond market capitalization is still nascent, compared to 140 percent of GDP for mature markets. Moreover, the development of domestic debt markets remains still very uneven across the emerging market universe. The largest six markets (South Korea, China, Brazil, India, Mexico, and Turkey) account for about 70 percent of domestic outstanding bonds in emerging markets. And corporate bond markets in most emerging market countries remain very underdeveloped. At end-2005, emerging market non-sovereign debt issued in domestic markets amounted to $1.2 billion compared to $2.7 trillion of sovereign debt.
So what are the key issues that emerging market authorities need to consider? Some of these are being addressed during this conference so I will mention them only briefly. They include:
- Strengthening public debt management and submitting to market discipline in domestic markets;
- Strengthening the investor base and improving regulation and consistency of treatment of institutional, foreign, and other investors;
- Developing financial derivatives such as repos and swaps, as well as asset-backed securities markets, improving access by foreigners to domestic hedging services. This must be matched by suitable regulation of equity derivatives markets, as well as increased market surveillance and improved risk management at the firm level;
- Bringing trading, settlement, custody, and delivery mechanisms up to world standards, where necessary through regional linkages, and opening up to foreign investment in these services;
- And, finally, developing and refining regional solutions that can bring greater efficiency and scale to smaller capital markets.
What can the IFIs and advanced economies do, for their part, to facilitate deeper domestic capital markets in emerging economies? Let me first state how the IMF is helping; second, how it is collaborating in this effort with 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 of excellence in understanding the role of financial markets and their impact on the global economy. In a world of integrated financial markets and large-scale capital flows, the IMF cannot fulfill its key responsibility of promoting international monetary and financial stability and efficiency of the international system unless Fund surveillance is underpinned by a solid analysis of macro-financial linkages and cross-country spillovers.
The IMF's Medium-Term Strategy (or MTS) sets out the framework under which we are 'raising our game' in this regard. It calls, in particular, for improved analysis of financial sector issues, and the effective integration of this analysis into country work-namely in the context of in our Article IV consultations, our regular bilateral checks of members' economies. This work is also supported, of course, by the global analysis of risks contained in the IMF's semiannual Global Financial Stability Report (GFSR).
A recent internal reorganization should help us to deliver better on these initiatives. A new department-the Monetary and Capital Markets Department-has been created by merging the work of two previous departments, one responsible for international capital markets, and the other for monetary policy and financial sector issues. The underlying message is that it is no longer appropriate to view internal and external markets as separate, and that financial and macroeconomic developments are increasingly intertwined at both the national and international levels.
One of the key tasks of this department is to work precisely on the issue of capital market development you are discussing today. Through this work, we expect to strengthen the Fund's ability to give advice on the development of local capital markets. We know that diagnostic and technical assistance work must reflect country demand and priorities, but the IMF's advice on sovereign debt management also is becoming more comprehensive in scope, taking into account not only debt management but overall sovereign asset-liability management. Our advice also recognizes the interface between sovereign debt management, monetary policy operations, inter-bank and money markets, and proper capitalization of central banks. We also expect to undertake more diagnostic and technical assistance work relating to nonsovereign bond markets and emphasize such work in a multilateral or regional context. In short, we expect to be aggressive in promoting the development of local capital markets.
In conducting this work, it is of critical importance that we work closely with the World Bank. The sister institutions have been very active in developing best practices, standards, lessons, and appropriate adaptations to emerging market environments. As you know, we have developed data dissemination standards, and introduced the Financial Sector Assessment Program (FSAP) and Reports on the Observance of Standards and Codes (ROSCs). This work plays an important role in informing the IMF's surveillance at the national, regional, and global levels.
Coordination with other IFIs and with bilateral agencies has also been good. Regulatory agencies-such as the Basel Committee and the International Organization of Securities Commission-have helped prepared standards, while the IMF helps implement them through its work with individual countries and gives these agencies valuable feedback. In fact, the IMF played an important role in helping to improve the Basel and International Association of Insurance Supervisors' core principles on banking and insurance supervision. That said, the markets are moving continuously, so this collaboration will always be a work in progress.
More could be done by the IFIs and other institutions, however, to research and disseminate knowledge on select topics. These could include:
- studies on best practice on themes of common interest (e.g. tax treatment of foreign investors, responsibility and accountability of debt management offices);
- analyses and case studies of key drivers of intermediation costs in local currency bond markets;
- steps needed to develop the institutional investor base (something on which one of our staff already presented some analysis this morning);
- linkages and role of bond markets with interbank, money, and derivative markets; and
- a more complete coverage of statistics on emerging market debt.
We welcome initiatives by advanced economies, notably the G-7, and other partners to facilitate these efforts. With their familiarity with well-developed local capital markets, they can be an important source of advice and help to emerging market policy makers and regulators. They can help to propagate good practices and the identification of specific policy actions to foster local capital market liquidity and development. Other initiatives could involve leading and supporting seminars or training; funding or providing experts to support IFI technical assistance; hosting of emerging market sovereign debt managers, securities regulators, or staff of securitization conduits seconded to G-7 counterparts. Advanced economies should have a direct incentive to support such initiatives, given increasing institutional and retail investment by mature markets in emerging local capital markets. These are 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 emerging markets that has most contributed to the explosion of lending to emerging economies and the unprecedented increase we have seen in cross-border capital flows. In turn, these flows provide strong discipline on borrowing governments to continue to perform well. We should all help to underpin these dynamics by supporting further reforms.
The overall message should be clear: Good policies should and will be rewarded.