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Stock anxiety

The public image of stock markets in Latin America took a beating in October. After a decade of impressive gains, the region's stock indexes had come to be seen as encouraging barometers of domestic and international confidence in Latin America's economic prospects.

But when a string of currency crises in South East Asia provoked a global stock market "correction," Latin American bourses took a wrenching dive, losing more than a quarter of their value in a few days. Despite some early signs of recovery, most of the region's stock indexes are still far from regaining their pre-October highs.

In the aftermath, shell-shocked investors and ordinary citizens throughout the region were left wondering if securities markets have become too much of a good thing. Have Latin America's economies been taken hostage by their volatile markets? Are these markets just complicated casinos where rich speculators and foreigners place bets? And more fundamentally, do these markets actually provide benefits to the real economy of people, products and jobs?

As the market crisis was unfolding on Oct. 27, financial and stock exchange officials from several Latin countries were meeting at the IDB's headquarters in Washington, D.C., to consider some of these very questions. Indeed, the two-day conference, "The Development of Securities Markets in Emerging Economies: Obstacles and Preconditions to Success," offered a timely opportunity to assess the extraordinary evolution of Latin America's securities markets in recent years.

A decade ago, securities markets were a barely noticeable part of the financial sector of most Latin American countries, which has always been dominated by banks. Consider the example of Argentina. Although the Buenos Aires stock exchange has existed for over a century, as recently as 1989 its market capitalization (the total value of the stocks, bonds and other securities listed on the exchange) was a trivial $172 million, according to Guillermo Harteneck, president of Argentina's Comisión Nacional de Valores.

But over the next few years things changed dramatically. A package of market-oriented trade and financial reforms stabilized the economy, renewed investor interest in Argentina and facilitated foreign direct investment. An ambitious privatization plan gave ordinary investors access to something they had rarely had before: the opportunity to buy shares in a list of premium industrial companies. Millions of dollars of Argentine savings that had been parked in foreign banks were repatriated to buy these shares, and European and U.S. investment funds soon followed suit. The result was a spectacular run-up in the stock market. Despite a serious downturn following the Mexican peso crisis in 1995, the market capitalization of the Buenos Aires exchange had reached $60 billion by October 1997.

Although securities markets in Latin America's other major countries were at significantly different stages of development in the late 1980s, their experience during the 1990s has been broadly similar to Argentina's. According to the International Finance Corporation, the total market capitalization of the region's principal exchanges hovered around $37 billion in 1987. By October 1997 it stood at $515 billion, after peaking at $680 billion in July.

Less than meets the eye. Yet these figures are not as impressive as they seem on the surface. To begin with, Latin America's capital markets are still very small when measured against their underlying economies. In 1996, the region's total market capitalization amounted to around 30 percent of its gross domestic product. Claudio Loser, director of the Western Hemisphere Department at the International Monetary Fund, reminded conference participants that in many Asian developing countries, such as Thailand and the Philippines, that ratio stood at 100 percent in 1996.

Moreover, Latin America's stock market boom is primarily benefiting a handful of recently privatized utilities and blue-chip industrial firms. Although the region's larger exchanges boast several hundred listed companies, the bulk of their market capitalization and trading volume are accounted for by a handful of giant telecommunications and energy firms. In Brazil and Mexico, around half of the market's trading volume on a typical day corresponds to the stock of each country's dominant telephone company.

In other words, the vast majority of Latin America's companies are still not obtaining capital from stock markets. "Despite the very impressive gains in capital market development, the region's banks are still the overwhelmingly dominant source of financing for the private sector," said Liliana Rojas-Suárez, principal advisor in the IDB's Office of the Chief Economist. Bank loans account for well over 90 percent of all corporate financing in the region, according to Rojas-Suárez. By contrast, banks in the U.S. meet only 20 percent of overall corporate financing needs. Companies obtain cheaper and more flexible financing by issuing stocks, bonds and commercial paper directly to investors, through various securities markets and exchanges.

Rojas-Suárez said the underdevelopment of Latin America's securities markets is partly due to the fact that many companies are still unwilling to meet the requirements for listing on an exchange. Although many companies have gone public, and some have even met the rigorous requirements for listing on the New York Stock Exchange, the ownership of most large Latin American firms is still concentrated in small groups that prefer not to relinquish even partial control of their companies to shareholders. Many companies are also unwilling to disclose their earnings and assets, as required of publicly traded firms, because they believe disclosure will increase their tax liability, aid their competitors, or even make them targets of kidnappers by revealing executives' salaries. So while the market value of a handful of premium companies has grown exponentially, the total number of newly listed companies in the region has only slightly increased. In Mexico, Brazil and Argentina, which together account for around two thirds of the region's market capitalization, the number of listed companies has remained essentially flat since 1987.

As a result, "there is a keen demand for new placements , and very little supply," said Argentina's Harteneck. "Companies don't understand the benefits of going public, and a lot of education is needed in this area."

Deeper is better. The real problem with Latin America's securities markets is not that they have grown too fast, but that they have not grown deep enough. Economists refer to the "depth" of capital markets to describe the number and variety of securities that investors can choose from, the quantity and quality of information about companies that investors can use to make decisions, and the liquidity of the markets in terms of trading volumes. By these measures, Latin America's stock markets remain very "shallow."

These deficiencies can have a very tangible effect on the real economy. In addition to providing an alternative to bank financing, well-functioning securities markets offer a different and more productive destination for domestic savings. This was an academic point during the hyperinflationary 1970s and 1980s, because most Latin Americans were saving very little. But with the monetary stability that has accompanied structural reforms, domestic savings rates have begun to tick up. In most of the region's largest countries, social security reforms are providing additional incentives to save by letting workers place all or part of their pension contributions in privately managed funds.

According to Solomon Brothers Inc., the New York investment bank, Latin American private pension assets will have swelled from just over $50 billion in 1993 to an estimated $130 billion in 1997, and they are increasing by around $1 billion per month. Government regulations require that much of that money be invested in government bonds, but in order to diversify their portfolios and improve rates of return, fund managers are eager to buy corporate stocks and bonds as well. That is where the "shallowness" of Latin America's stock markets presents a real obstacle to economic growth: lacking a plentiful supply of new securities, pension fund assets and individual savings languish in government bonds instead of fueling the growth of local companies.

There are signs of improvement, however. Cash-rich domestic pension and mutual funds are snapping up an increasing proportion of new securities that used to be bought up entirely by foreign investors. Based on interviews with several investment banks that underwrite public offerings of securities in the region, The Wall Street Journal recently reported that the portion of debt and equity issues sold to local investors has in many cases increased to an average 20 to 30 percent, from 10 to 15 percent two years ago, "with some companies opting to raise capital entirely in the local markets." The newspaper reported that local fund managers are also beginning to invest in smaller domestic companies--the kind that foreign investors have traditionally overlooked.

Should this trend continue, the true benefits of a flourishing stock market could be felt by millions of working people. "This kind of investment complements foreign capital and ultimately helps to reduce the vulnerability of local economies to foreign shocks," said the IDB's Rojas-Suárez.

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