Emerging Markets Research Now and in the Future Campbell R. Harvey Duke University and NBER Valuation in Emerging Markets Batten Institute and AIMR Darden at University of Virginia May 28-30, 2002

2 Materials in my presentation are largely drawn from my past and on-going collaborations with Geert Bekaert at Columbia University. Emerging Markets Research

3 Emerging Markets Research Program Bekaert and Harvey JFE97 Emerging Market Volatility Bekaert WBER95 Investment Barriers Harvey RFS95; WBER95 Predictable Risk Bekaert and Harvey JF95 Time-Varying Integration Bekaert and Harvey NBER98 Capital Flows Bekaert and Harvey JF2000 Foreign Speculators Bekaert, Harvey & Lumsdaine JFE2002 Dating Integration Bekaert, Harvey & Lumsdaine JIMF2002 Dynamics of Capital Flows Bekaert, Erb, Harvey & Viskanta BOOK, JPM97 Behavior of Returns and Asset Allocation Bekaert, Harvey & Lundblad JDE2002 Finance and Growth Econometrics Bekaert, Harvey & Lundblad WP2002 Liberalization and Growth Bekaert, Harvey & Lundblad WP2002 Liberalization and Growth Volatility Bekaert, Harvey & Lundblad WP2002 Emerging Mrt Liquidity & Expected Returns

4 My first look at the data Data through June 1992 Published in RFS 1995 What has happened since? Emerging Markets Research

5 Average Annual Geometric Returns Through June 1992

6 Average Annual Geometric Returns Through June 1992 – What Happened After?

7 Average Annualized Standard Deviation Through June 1992

8 Average Annualized Standard Deviation Through June 1992 –What Happened After? Data through April 2002

9 Correlation with World Through June 1992

10 Correlation with World Through June 1992 – What Happened After? Data through April 2002

11 Beta with World Through June 1992

12 Beta with World Through June 1992 – What Happened After? Data through April 2002

13 Evolution of World Correlation Five-Year Rolling Window: 20 Countries Data through April IFC Composite Average of 20 Emerging Countries

14 Evolution of World Beta Risk Five-Year Rolling Window: 20 Countries Data through April IFC Composite Average of 20 Emerging Countries

15 Why is the picture different? Financial liberalizations Emerging Markets Research

16

17 Prices High Expected Announcement Implementation Low Expected Returns of Liberalization Returns PIPI PSPS Time Segmented Integrated Asset Prices and Market Integration Return to Integration

18 Average Annual Geometric Returns Pre and Post Bekaert-Harvey Official Liberalization Dates Data through April There are no pre-liberalization data for Indonesia.

19 Average Annualized Standard Deviation Pre and Post Bekaert-Harvey Official Liberalization Dates Data through April There are no pre-liberalization data for Indonesia.

20 Correlation with World Pre and Post Bekaert-Harvey Official Liberalization Dates Data through April There are no pre-liberalization data for Indonesia.

21 Beta with World Pre and Post Bekaert-Harvey Official Liberalization Dates Data through April There are no pre-liberalization data for Indonesia.

22 Implications Lower cost of capital More investment, employment More economic growth  Current research with Geert Bekaert and Chris Lundblad explores the relation between equity market liberalization and the real economy Emerging Markets Research

23 Geert Bekaert, Campbell Harvey and Chris Lundblad, Does Financial Liberalization Spur Growth? Working paper 2002 Emerging Markets Research

24

25

26 Financial Development Growth Financial Liberalization Relaxing Fin Constraints Investment Growth Opportunities Efficiency of Investment Cost of Capital

27 Controversial exercise Liberalization implies consumption booms and inefficient investment (crisis literature) Liberalization may lead to reduced savings (endogenous growth literature) Liberalization may lead to “hot speculative capital” and induce capital flight (Stiglitz & others) Financial Liberalization and Growth

28 Financial Liberalization and Growth What we already know (too many references to list!): Financial/banking development associated with higher growth Cost of capital decreases Investment increases

29 Financial Liberalization and Growth Outline: 1. Did liberalization spur growth? –Large panel of data –Cross-sectional growth regression with temporal dimension 2. How did liberalization spur growth? 3. Accounting for the liberalization effect –Is is macro-economic reforms? –Is it financial development? –Other simultaneity biases? 4. Conclusions

30 Financial Liberalization and Growth Caveats: Not much guidance from theory. As a result, it is important to conduct extensive robustness experiments

31 Financial Liberalization and Growth Econometric Framework: where y i,t+k,k is real per capita GDP growth between t and t+k Q i,1980 is initial GDP, X i,t represents control variables Lib i,t is a Liberalization indicator variable

32 Financial Liberalization and Growth Econometric Framework:

33 Financial Liberalization and Growth Econometric Framework: S T is the variance covariance matrix of the sample orthogonality conditions

34 Financial Liberalization and Growth Key issues: Temporal dimension Different weighting matrices Liberalization variable Choice of “k” Endogeneity of the liberalization decision

35 Financial Liberalization and Growth Data: Four samples determined by availability of data Sample I: 95 countries Sample II: 75 countries [macroeconomic and demographic data]

36 Financial Liberalization and Growth Data: Four samples determined by availability of data Sample III: 50 countries Sample IV: 28 countries [add financial development indicators] As data requirements become more stringent, the variance of GDP levels across countries in the sample decreases.

37 Financial Liberalization and Growth Liberalization dates: Use Bekaert and Harvey (JF 2000) “official liberalization” dates These dates are based on a detailed chronology of important regulatory events Augmented with IFC frontier markets and three developed markets, Spain, New Zealand and Japan

38 Financial Liberalization and Growth Liberalization dates: Robustness of our results checked by examining Bekaert and Harvey (2000)’s “First Sign” dates These dates based on the earliest date of {official liberalization, first ADR and first closed-end fund} Example: Thailand –“Official” 1987:09 –“First Sign” 1985:07

39

40 Financial Liberalization and Growth Liberalization dates: Capturing “intensity” or “comprehensiveness” of the liberalization –Ratio of IFC investable market cap to global stocks (Bekaert (1995) and Edison and Warnock (2001)) –U.S. holdings of domestic market capitalization Is it just a proxy for capital account openness? [See Rodrik-Edwards debate]

41 Financial Liberalization and Growth Are the dates exogenous? Counter examples Spain in the EU Some countries cannot liberalize their financial markets

42 Financial Liberalization and Growth Findings so far: We document a liberalization effect on growth with certain "standard control variables"

43

44 Financial Liberalization and Growth Findings so far: The liberalization effect is robust to –different definitions of liberalization dates –to business cycle or interest rate controls –allowing for intensity of liberalization...and independent of capital account liberalization

45

46

47 Financial Liberalization and Growth Channels of increased growth: Both: »increased investment, partially through a cost of capital effect and »increased productivity (which is different from the financial development literature)

48 Financial Liberalization and Growth On the mechanism... »Liberalization does not lead to consumption binge –investment increases –trade balance decreases

49

50 Financial Liberalization and Growth On the mechanism... »Investment increases - but you need a minimum “country quality level” to see effect –decreased cost of capital associated with more investment

51

52 Financial Liberalization and Growth On the mechanism... »Productivity increases –and this is not just a banking development effect

53

54 Financial Liberalization and Growth Accounting for the liberalization effect: We investigate whether part of the effect can be ascribed to »macroeconomic reforms »financial development »other regulatory reforms

55 Financial Liberalization and Growth Accounting for the liberalization effect: Macroeconomic reforms... »Liberalization not spuriously reflecting macroeconomic reforms –we control for trade openness, inflation, black market premiums, and government deficits

56

57 Financial Liberalization and Growth Accounting for the liberalization effect: Financial development... »Degree of banking and equity market development is important but independent boost from liberalization –we examine the size of private credit, equity market activity, and equity market size

58

59

60 Financial Liberalization and Growth Accounting for the liberalization effect: Other regulatory reforms... »The financial liberalization/growth effect is not a post-banking crisis effect »The enforcement of law and institutions are important

61

62

63 Financial Liberalization and Growth Conclusions Financial liberalization spurs growth by 1% per annum over the five years Survives a battery of robustness experiments We understand better the channels whereby growth impacted by financial liberalization Liberalization effect not spuriously accounted for by a host of other events such as macro- economic reforms

64 Financial Liberalization and Growth Conclusions Financial liberalization has a very important economic effect

65 Total Growth = 3.02% Financial Liberalization and Growth Conclusions Financial liberalization has a very important economic effect Consider economic impact of improvements plus a equity market liberalization Liberalization

66 Financial Liberalization and Growth On going research What about growth volatility? Geert Bekaert, Campbell Harvey and Chris Lundblad, Growth Volatility and Equity Market Liberalization, Working paper 2002

67

68

69