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The Usual Suspects:A Primer on Investment Banks
Recommendations and Emerging Markets
Javier Santiso
Chief Economist and DeputyDirector
OECD Development Centre
ConferenceOpening and Innovation on Financial Emerging
MarketsBeijing - China March 28 2007
Sebastin Nieto Parra
Chaire Finances Internationales
Sciences Po Paris
tp://www.financesinternationales.sciences-po.fr/
http://www.financesinternationales.sciences-po.fr/http://www.financesinternationales.sciences-po.fr/ -
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Objective of the paperI
Overview of the literatureII
Description of the dataIII
Investments banks business and research publicationsIV
Emerging markets capital flows and research publicationsV
ConclusionsVI
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Two core questions
Do recommendations given by investment banks havean impact on the allocation of portfolio flows in theemerging markets?
That reveals the influence of analysts
recommendations on investors behaviour. Above all, do recommendations are related with the
business of investment banks?
Information provided by banks to investors could be
biased depending on their own objective thatsometimes could differ from those of investors.
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Objective of the paperI
Overview of the literatureII
Description of the dataIII
Investments banks business and research publicationsIV
Emerging markets capital flows and research publicationsV
ConclusionsVI
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Investment banks recommendations
The impact of investments banks recommendations on capital
markets has been concentrated in OECD countries.- Womack (1996), Jackson (2005), Boni and Womack (2002), Barber et al
(2001), Asquith et al (2005),
Variety of results:
- analysts are confronted by a trade-off between sending true signals and
optimistic signals.- Larger number of buy recommendations than sell recommendations.
- Market reaction to upgrades is less pronounced than the market reaction todowngrades by analysts.
- Impact of the measures introduced by the NYSE and NASDAQ, but also the
sanctions established by the SEC in 2002.
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Investment banks recommendations
Research literature on emerging markets is scarce and
concentrated in the equity market:- Seasholes (2000), Bae et al (2005): Accuracy of local vs foreign
forecast analysis.
- Bacmann and Bollinger (2001): Boom of the stocks covered byanalysts between 1993 and 2000.
Empirical studies of the relationship between therecommendations and underwriters are scarce andconcentrated to OECD countries:
- Womack and Michaely (1999). Results suggest that there is a conflictof interest between investment banking and research department.
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Capital Flows to Emerging Countries
A large body has studied the determinants of capital flows:
- Push factors or global factors literature: First half of the 90s Fernandez-Arias (1996) andCalvo et al (1993)
- Pull and Push factors : Taylor and Sarno (1997), World Bank (2001), Alfaro et al (2005),
Most of the results conclude that local factors combined with external factors explain capitalflows (FDI, foreign banks lending, bond and equity flows,).
- In addition to pull and push factors, recent empirical literature has studied the impact ofinformation and distance on capital flows:
Ghosh and Wolf (1999), Savastano (2000), Papaioannou (2004) and Portes and Rey (2005).
In particular Portes and Rey (2005) develop an empirical model in which internationalinformation flows are a significant aspect to explain international equity flows.
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Our research
By using untapped and rich dataset, the purpose of this study:
First, it is an attempt to analyse the determinants of the recommendations given by investmentbanks in the sovereign emerging bond market.
Second, it allows to determine the impact of information on capital flows. For that we take into
account investment banks recommendations as an additional factor to explain capital flows.
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Objective of the paperI
Overview of the literatureII
Description of the dataIII
Investments banks business and research publicationsIV
Emerging markets capital flows and research publicationsV
ConclusionsVI
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Investment banks recommendations
We have taken the recommendations given by 10
investment banks. All of them important players in theemerging bond markets.
Instit
ABN AMRO
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Investment banks recommendations
Main aspects concerning the recommendations given by investment banks:
- Composed only by sovereign emerging debt.
- We have classified three types of recommendations: Overweight (1), neutral (0) andunderweight (-1).
- These recommendations are assimilated to the cases of buying, maintaining andselling with respect to a portfolio (the index EMBI+ calculated by JP Morgan)
Given portfolio restrictions a buying recommendation must be compensated by aselling advice.
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Investment banks recommendations
Example: Average of the recommendations given to
Brazil by the investment banks with respect to theweight of Brazil in the EMBI Global index.
Brazil: recom me ndations
(1:overwe ight, 0:neu tral, -1:underw ei
-1
-0.5
0
0.5
1
J ul-97 J ul-98 J ul-99 J ul-00 J ul-01 J ul-02 J ul-03 J ul-04 J ul-05
So urce:The authors based on banks publications ,
AVERAGE
To tal Average:0.3
Variance: 0 .29
EMBI Global
(Index weigh t, %
10
15
20
25
30
J un-97 J un-99 J un-01 J un-03 J un-05
Source: J P M organ, april 200
Brazil
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Investment banks recommendations
We have taken 11 Latin American countries that
represent nearly 95% of the GDP of the region. Thetotal number of recommendations is over 3,000.
Argentina
INVESTM
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Objective of the paperI
Overview of the literatureII
Description of the dataIII
Investments banks business and research publicationsIV
Emerging markets capital flows and research publicationsV
ConclusionsVI
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Investment banks business
Banks are faced with a trade-off concerning recommendations:
- While sell side business could have the incentive to build reputationby giving accurate information in the long term .
- . in the short term recommendations could be biased in order to
obtain short term profits.
- Additionally, investment banking activities could be motivated torecommend optimistically the assets which they are participating asunderwriters in an IPO.
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Underwriters recommendations Recommendations given by banks that have been
underwriters for Latin American sovereign bond issues.
- 90% of the underwriters recommend to investors at theannouncement date of the issue to buy or to maintain in theirportfolio the bonds issued by the countries where they areacting as underwriters.
Underwriters'
Jan. 1999 - Jul
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Size of the market and recommendationsObjective of the sell side business: to sell portfolios to a large variety of
financial intermediaries. The percentage invested in these portfoliosincreases relative to the size of each country.
High correlation between recommendations and size of the market: toobig to underweight
Credit risk is not a relevant variable to determine the recommendations
Argentina
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Objective of the paperI
Overview of the literatureII
Description of the dataIII
Investments banks business and research publicationsIV
Emerging markets capital flows and research publicationsV
ConclusionsVI
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Determinants of capital flows
In order to test the impact of recommendations on capital flows (Bond flowsand Equity flows respectively), we have used the following two panel data
regressions models:
(i)
(ii)
where and : percentage allocated by funds in country i with respect to
the total amount invested in emerging economies.
: the average of theinvestment banks recommendations given to country i .
: Pull variables defined by capital markets (exchange rate, spread of sovereignbonds and rate of return of equity).
ittitititit PushalMarketcBond +++++= ReRe
ittitititit PushalMarketcEquity +++++= ReRe
itBond itEquity
itcRe
itMarket
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Determinants of capital flows
: Pull variables that are strongly influenced by real sector (economic activity,
inflation rate and interest rate).
: country invariant variables which capture global factors (US nominal ratesand US industrial production).
Period of the analyses: 1997-2005 for equity flows
2002-2006 for bond flows Frequency: Monthly
Countries: Argentina, Brazil, Chile, Colombia, Mexico, Peru and Venezuela
OLS and FE estimation. Since OLS estimation are known to deal inadequatelywith time series and cross-section heterogeneity, we reported also Fixed
Effects estimates (FEM estimators).
tPush
italRe
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Determinants of capital flows
In order to determine if a Random Effects Model (REM) was an adequate econometricmodel for this analysis we realised the Hausman Test. The null hypothesis underlyingthe Hausman Test (FEM and REM estimators do not differ substantially) was rejected.
In order to avoid problems of endogeneity between independent and dependentvariables we have also taken into account the first lag of each of the explanatoryvariables in the regressions. In fact, by taking the lagged explanatory variable wecould solve causality problems which are common to capital flows analysis.
We present only the results of FE estimators with lagged explanatory variables (seeannex for the others results)
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Determinants of bond flows
Dependent vari
Impact of R
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Determinants of equity flows
Dependent varia
Impact of R
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Objective of the paperI
Overview of the literatureII
Description of the dataIII
Investments banks business and research publicationsIV
Emerging markets capital flows and research publicationsV
ConclusionsVI
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Determinants of capital flows
3 conclusions concerning the determinants of capital flows:
1. The impact of investment banks recommendations oncapital flows is positive and significant.
2. The impact of the recommendations given to external publicdebt goes beyond sovereign bond flows. Indeed, althoughtheir influence is minor, these recommendations also affectprivate equity flows.
3. This new microeconomic variable improves the fit of capitalflows regressions more than some traditional
macroeconomic variables such as interest rates, economicgrowth and inflation rate.
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Business and Investment banksrecommendations
We can not reject the hypothesis that the information transmitted to
investors could be biased with the purpose to obtain short term profitsand to recommend optimistically the assets which banks are
underwriters in an IPO.
Further research:
The results are preliminary. We have in part neglected the role of therecommendations in the sell side long term business.
Indeed, further research must be done concerning the performance ofthese recommendations in terms of investment value and tocontrast them with the underwriting activity.
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Policy Lessons
1. There is a need for more detailed informationdisclosure by investment banks in order todetermine if past recommendations are related tomacroeconomic variables and financial variablesor whether they are associated with their
business in emerging economies.
2. Given that banks recommendations and portfolioflows are related, an international co-operationmust be established in order to encourage
investment banks to cover more countries.
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ANNEXES
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Investment banks recommendations
An example of the weight of some Latin American
countries in the EMBI index (depends on the amountoutstanding of sovereign debt).
EMBI Global Marke t W eight (%)
10
15
20
25
30
jun-97 jun-98 jun-99 jun-00 jun-01 jun-02 jun-03 jun-04 jun-05
Source: J P M organ, 2006
0
2.5
5
7.5
10
Brazil
Mexico
Venezuela (rhs.)
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Underwriters recommendations
415 underwriters or Lead managers and 215 sovereign
issues. Almost 75% of the underwriters are located inBrazil, Argentina, Colombia and Mexico.
1
U d it d ti
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Underwriters recommendations:Argentinean case
The Argentinean case is very useful, interesting and special case
- 67 per cent of the recommendations were to maintain the positions in Argentinean
External Debt (prior 2001)
- Some of the comments given by banks months before the crisis were unrealistic:
Morgan Stanley: We are maintaining our Market Perform recommendation on Argentinebonds.Relaxation of fiscal targets and an innovative IMF-led financial package from creditors bothimprove Argentinas credit outlook. Argentina needs to raise an estimated $2.6 billion to fulfil its firstquarter financing requirements. New issues are expected to total $5.6 billion in 2001. Growth andfiscal performance are becoming the focus of investors attention. January 26, 2001.
Salomon Smith Barney (Citigroup): The successful implementation of the IMF support package withthe associated debt management transactions and the change in the global outlook probablyincreases the chances that economic activity will pick up in the second half of the year. We thereforerecommend a neutral position in external bonds and local currency instruments. January 17, 2001
U d it d ti
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Underwriters recommendations:Argentinean case
Source: Nieto Parra (2006) from Bloomberg
0
0.5
1
1.5
2
2.5
3
3.5
0 100 200 300 400 500 600 700 800
Turkey July 2000
Turkey August 1999
Hungary 99 Turkey 2000
Argentina 1999
Argentina 2000
Argentina 2000
FEE
SPREAD
Argentina 2000
Jamaica 2000Colombia 2000Colombia 2001
Argentina 1999Philippine 1999Tunisia 2000
Philippines 2006
Emerging Markets: fee vs spread primary market (1999-2006)
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Underwriters recommendations
Underwriters recommendations vs. Recommendations given by other investment banks
- 75% of the Lead mangers advice was higher than or equal to that made by other investment banks.
Underwriters'
Other invest
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Underwriters recommendations
Underwriters recommendations vs.Recommendations given by other investment
banks during the announcement date of the issueof a bond.
- On average underwriters recommendations are morefavourable than no-underwriters recommendationsUnderwriters vs No-Underwriters' recommendations
(Announcement date, Average 1999-2006)
-0.6
-0.4
-0.2
0
0.2
0.4
0.6
0.8
Arg.
Brazil
Chile
C
olombia
Dom.Rep.
E
cuador
Mexico
Panama
Peru
Uruguay
Venez.
To
t.Aver.
Weigth.Aver.
Source: The authors, 2006
Underwriter
No underwriter
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Underwriters recommendations
What is the incentive that no-underwriters could have to give an equal or higherrecommendation than underwriters?
For most of the Latin American countries 90% of the issues were realised by 10investment banks
# Issu
Part
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Underwriters recommendations By calculating the HHI we obtained the same results:
Theoretically, this market could be characterised by an imperfect competitive market inwhich underwriters are playing a repeated game.
By taking investment banks recommendations as a marketing product, it is thenadvantageous to investment banks to recommend a country even if at that periodthey have not been underwriters.
1999
Argentina 0.14Brazil 0.18Chile 0.50Colombia 0.28Dom. Rep.
Ecuador
Concentration (Herfinda
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Determinants of bond flows
.
Dependent varia
Impact
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Determinants of bond flows
.
Dependent varia
Impact o
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Determinants of bond flows
.
Impact of Re
Dependent varia
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Determinants of equity flows
.
Dependent varia
Impact
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Determinants of equity flows
.
Dependent varia
Impact o
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Determinants of equity flows
.
Dependent vari
Impact of R