strengthening of latin american capital markets

Latin American Capital Markets Strengthening 1

Examination of the Strengthening of Latin American Capital Markets

Ryan Flynn

August 24, 2011

INT 750

Dr. Aysun Ficici

Southern New Hampshire University

Abstract:

Latin America is a rapidly emerging economic region. As such, it is competing with Asian

markets for attention and attractiveness. For decades, news about Latin America was not

promising. However, in recent years, the major nations of Argentina, Brazil, Chile, Colombia,

and Mexico have made great efforts to improve their economic conditions and stabilize their

markets. One fault of many Latin American countries in the past has been a high perceived level

of corruption. Another fault of many Latin American countries has been a low perception of

their ability to maintain stable capital markets and service their external debt. This paper intends

to examine and compare the relationship between the stabilization of perceived corruption and

country credit risk and increases (improvements) in market capitalization, levels of external debt,

and foreign direct investment in nine emerging markets in two regions, Latin America and Asia.


Introduction

Latin American capital markets have been subject to extreme volatility through the past

several decades, 1970 – 2010. And, during this time, Latin American countries, primarily Chile,

Brazil, Colombia, Mexico and Argentina have been the focus of foreign direct investment in the

region. However, the capital markets have never seemed to stabilize, despite efforts to liberalize

the economies of the aforementioned countries and develop stable capital markets. The approach

of liberalization and market reform was undertaken over the past 30 years in the hopes of

developing stable capital markets, intended to drive economic development and establish an

economic center of gravity that would attract, nurture, and development investors in the region.

According to a research effort, Capital Market Development Whither Latin America, published

in 2008 by de la Torre, Gozzi and Schmukler, it claims capital markets in Latin America are

underdeveloped compared to other emerging markets, i.e. East Asia, and that stock markets are

below expected levels, despite the presence of the necessary economic and institutional

fundamentals that facilitate stock market usage. The study also identifies a shortfall in domestic

stock market activity when considering per capita income, macroeconomic policies, and legal

and institutional provisions. Using research from their peers, de la Torre, Gozzi and Schmukler

(2008) arrived at a “de facto measure of openness by using both equity flows from portfolio

equity flows and foreign direct investment (FDI) flows relative to GDP” (de la Torre, p. 6, 7).

According to them, this variable reflects the degree of openness of the stock market and

its “effective integration with international capital markets” (de la Torre, p. 7). Moreover, the

team identified and compensated for the factor that “local market development is affected by the

growth opportunities that firms face…” which may be, “particularly relevant for explaining

capital raising behavior” (de la Torre, p. 13). The claim here is that the better growth


opportunities will require larger stock markets to develop a cycle of attracting, maintaining, and

expanding increasing demand for foreign funds. The research by this team also indicates that

size of an economy, measured by GDP, leads to efficiency gains in securities markets by

expanding volume and participants; in turn, leading to increasing development of liquid,

operating securities markets.

But, the most important thing to establish is a stabilized market that facilitates domestic

and foreign investment. The research indicates that this requires an open stock exchange, the

issuance of public/external debt securitized in local currency, and the presence of foreign direct

investment. Most of the research collected for this particular examination stopped its exploration

of data with the year 2005. This is a slightly more progressive study seeking to evaluate

developments in Latin American capital markets up through 2010, while providing a quantitative

comparison to corresponding data for Asian markets. The years of observation are 2001 through

2010, as the last half of the decade created some very interesting activity in world markets, and

at least chatter in the news indicated Latin America was a place to observe. Chile has long been

the darling of Austrian School liberal economists, while Brazil has been a very intriguing market

for investment and economic development. Argentina and Mexico have had their share of

turbulent activity through the years, and have made great strides in the past decade, as has

Colombia. The developments in these markets are significant and have added depth to the

capital markets in the region through stabilization of their economies.

This paper will contribute to the world of International Business by investigating the

development of Latin American capital markets over the past decade, most importantly in the

years 2005 – 2010. The evaluation will draw a correlation between the stabilization of


perception of corruption and country and credit risk to increases in market capitalization,

issuance of external debt and foreign direct investment.

Literature Review

Supporting and expounding on the research of de la Torre, Gozzi and Schmukler (2008)

is a 2007 effort undertaken by Ananchorikul and Eichengreen1 (2007), while showing a different

and more promising picture that reflects the buzz in the international news, a medium which

measures by rates of change, rather than comparable levels. It is noted that the seven large Latin

American markets experienced dramatic growth in capitalization of domestic bond markets in

the ten year period between 1995 and 2005, wherein it more than doubled (See Appendix A,

charts). Additionally, in the five year period between 2000 and 2005, those seven countries

experienced over 60% increase, while capitalization of the stock market 1 jumped by 52%;

complemented by an 86% rise in trading value, averaged across countries. However, in reality,

Ananchorikul and Eichengreen show stagnant movement in the Latin American capital markets.

The study cites a lack of current price quotes as a limit for institutional investors to invest as

required to sustain the markets, limiting liquidity and creating what they indicate is a

“destructive loop” (Ananchorikul and Eichengreen, p. 2, 3).

Part of the problem, as indicated, is that Latin American equity markets are controlled by

a relatively small number of companies. When reviewing charts presented in the research, it is

clear that the number of listings in Latin American stock markets is nearly flat over the fifteen

year period of 1990 through 2005. Citing that only Chile and Brazil are home to successful

1 Important to note, Ananchorikul and Eichengreen did reference the de la Torre, et al. 2007 unpublished

manuscript from the World Bank, which was published in 2008, as a basis for their research. The value is that Ananchorikul and Eichengreen’s points are further substantiated and substantiating the research efforts of de la Torre, et al.


capital markets, but even they lag behind other emerging markets. Ananchorikul and

Eichengreen are quick to point out that as of 2007, there are fewer than twenty five percent as

many companies listed in Latin American exchanges as there are in East Asia, but that Latin

American markets are starting behind other regions. Widespread regional macroeconomic

instability has played a heavy role in the depressed development of capital markets as an

extension of the lack of institutional provisions needed to provide security to markets in the

forms of corporate debt, stock market capitalization, and regional stock market turnover, as

indicated in the literature.

Debt Issuance: Progress and Breaking Procyclical Financial Cycles

Tovar and Qulspe-Agnoli (2007) acknowledge the difficulties facing Latin American

markets, but are optimistic that shifts in financing trends, primarily away from cross-border

flows and towards domestic investment. While Tovar and Qulspe-Agnoll (2007) agree that Latin

American capital markets are depressed, their literature indicates domestic policies in the region

are improving, which enable citizens to increase their marginal savings, in turn making available

capital for investments. The article points out that Latin American policies are trending towards

reduced debt ratios, current account surpluses, and increasing international reserves. This type of

activity is what it will take to put Latin American markets on par with other emerging markets,

as indicated in the Ananchorikul and Eichengreen literature. Tovar and Qulspe-Agnoli point out

that Chile, Brazil and Peru have implemented fiscal responsibility laws aimed at reducing

“procyclicality” of fiscal policies (Tovar and Qulspe-Agnoli 2007 ). In other words, set the

fiscal policies on a track that is more linear in nature, and works in tandem with debt


management policies to improve prospects and debt profiles. Additionally, exchange rate

regimes have been called in to question as a source of instability. Restructuring those regimes

alongside financial reforms is working to improve the picture and prospect of deepening and

strengthening Latin American capital markets. These policies improve the competitive stance

and reduce the risk and uncertainty discussed as a set-back in the Ananchorikul and Eichengreen

literature.

Tovar and Qulspe-Agnoli (2007) also provides examples of how LAC’s are emerging

with tools to help squelch fears of currency risk coupled with country risk. Brazil, Colombia,

Peru, and Uruguay are issuing sovereign (country) bonds in local currency as one measure to

attract investors with diversified portfolios. According to the literature, this action enables these

countries to extend the yield curve and limit currency and country risk entanglement because

investors will not be subject to the quirks of investing in local markets. The critical drawback,

however, is that issuing country bonds could have the negative side-effect of segmenting

investors. Yet, the positives, as outlined in the literature are that the domestic currency bonds can

help break the procyclical fiscal pressures of foreign currency denominated bonds, which also

has the effect of improving sustainability in markets. Moreover, as the paper points out,

“Sovereign global bonds in local currency also improve the depth of private domestic debt

markets by (1) allowing the expansion of the longer part of the yield curve in local currency (as

in Brazil and Peru); (2) setting benchmarks for domestic markets, which can be relevant for

domestic credit markets if longer-term credit in local currency is nonexistent; (3) creating

incentives for the expansion of derivative markets; and, finally, (4) by diversifying the investor

base” (Tovar, p.5). This is further enhanced by the ability of global bonds issued in sovereign

currency afford to effectively predict inflation. However, the main problem of limited private


sector debt issuance remains. Hindered in part because it is overshadowed by better securitized

public debt, and also because there is a deep lack of corporate governance, yet another issue

discussed in the Ananchorikul and Eichengreen (2007) literature. While long term debt issuance

still favors international markets, short-term debt is being issued domestically, and there is a rise

in asset-backed securities (ABS), particularly in Brazil and Mexico. The caveat is that most of

the ABS are in fact, mortgage backed securities (MBS). The significance of ABS development

is that it signals a sign of confidence in the domestic capital markets, enough at least, to

securitize debt domestically. This finding was uncovered in Scatigna and Tovar (2007).

Supporting Tovar’s concept of ABS indicating strength in markets is a research

conducted observing herding mentality. Hsieh, Yang, and Vu (2008) research indicates two

interesting things. First, interest rate differentials actually act as a magnet for attracting investors

to a particular market. This is reflected in ABS’s when bond yield curves are projected to

stabilize on an increasing trend. Second, this research indicates, “This finding also amplifies the

point that, before their respective crisis, it was more profitable to invest in most of the selected

Latin American countries than in the Asian ones” (Hsieh, et. al, p.24).

Macroeconomic Controls: Policy Considerations for the Attraction of Investment

The research on Latin American capital markets continually reverts back to the

importance and effects of macroeconomic policies on the flow of investments to the various

Latin American capital markets. Chile is a stand out example of a country with a strong and

deep (comparative) capital market, and with strong macroeconomic policies designed to attract

foreign and domestic investment. Pablo E. Guidotti (2007) indicates that the emerging market


economic crises of the 1990’s actually derailed any momentum Latin American markets had

developed coming out of the 1980’s and into the 1990’s during their initial exposure to

globalization. As the Latin American economies moved to protect their markets from the havoc

created by capital flow stoppages, most Latin American markets began “deleveraging” (Guidotti,

p. 284).

Rocked by two major recessions stemming from global activity – the Asian financial

crisis and the Russian default crisis – Latin America was hit especially hard by an evaporative

effect on capital inflows. Guidotti (2007) indicates that the near wholesale loss of capital inflows

left Latin American countries over extended in public services, and the fear of inflation took over

as the most significant target of domestic policy. Aiming to keep inflation in check, yet tied to a

variety of rigid currency regimes, much of the Latin American region found itself at odds with

public versus private sector concerns. Policy shifts targeted the private sector in order to retain

the public obligations, leaving public debt and deficit relatively high.

According to a Fostel and Kaminsky (2007), Latin American governments in need of

some relief to prevent default of their own were saved, in large part by the graces of the Brady

Plan. The problems were not entirely based on capital flows. In fact, Fostel and Kaminsky

argue that measuring value of the market based on capital flows is a misnomer. Their paper

argues that fundamentals are the reason at least Brazil, Chile and Argentina performed well in

capital markets during the 1990s. But that strong performance in the 2000’s was more a result of

the dramatic increase in global liquidity. Also, the research focuses on “international primary

gross issuance” (Fostel and Kaminsky, p.1).


Lane and Milesi-Ferreti (2006) describe financial globalization as, “the accumulation of

larger stocks of gross foreign assets and liabilities.” Bond issuance is the benchmark of strength

of a nation’s capital markets and a litmus test of investor confidence in the market. By receiving

debt relief from the Brady Plan, Latin American markets were enabled to refocus on

fundamentals, and were thereby enabled to begin to lift out of the crisis. Because the Brady Plan

effectively restructured defaulted loans into debt collateralized by U.S. Treasury Bonds, it

facilitated the development of a syndicated loan market (Fostel and Kaminsky (2007)). Latin

American markets had issued only $1 billion USD in bonds in 1990; but after the restructuring,

Latin American markets had issued $54 billion USD in bonds by 1997. Fostel and Kaminsky

(2007) also point out that the side-effect of the Brady Plan securitization and rise in investor

confidence in emerging markets, particularly Latin American markets, was the “forceful

development of an international equity market.” This period of the late 1990’s and early 2000’s

saw an increase in Latin American private corporations accessing unregulated bond markets and

syndicated loan markets to raise capital, but these same types of corporations were also reaching

out to the regulated equity markets of various financial sectors for capital (Fostel and Kaminsky,

p.7) Using a supply and demand model, Fostel and Kaminsky expound on their findings,

claiming that, “the effect of shocks in world capital markets on the supply of funds to emerging

economies is quite intuitive” (Fostel and Kaminsky, p. 9). Low world interest rates increase

supply, assuming emerging market assets and world assets are substitutes. Furthermore, risky

emerging-market assets supply will decrease as risk aversion increases and will increase with

world liquidity. Contagion literature, such as Kaminsky and Reinhart, 2000, indicates that crises

may rapidly spread, limiting emerging market access to international capital markets, having


negative effects in their domestic capital markets. Moreover to that point, certain market and

economic fundamentals of the emerging market countries can be signals to the impact and reach

of the financial crises. Fostel and Kaminsky (2007) claims that while stability in macroeconomic

policy reduces the probability of crises, low political risk raises the likelihood of

repayment/decreased chance of default. This dynamic creates confidence, and will lead to

increased capital flows. Conversely, it argues that from the demand side, there is an almost

“Fisherian” effect when there are currency mismatches; suggesting the more open an economy,

the more able it is to generate foreign currency denominated assets (Jeanne, 2003). Declining

currency mismatches increase demand for foreign currency denominated assets. However, as

currency mismatches increase alongside real exchange rate volatility, domestic firms will limit

exposure to foreign markets by pulling back on foreign investments.

Capital Account Liberalization Results in Uncertain Capital Inflows

Ferreiro, Correa, and Gomez (2008) undertook the task of understanding the effects of

capital account liberalization on capital inflows. What was discovered and supported by

Eichengreen and Voth (2003) and others is that current account liberalization have no conclusive

impact on economic growth, size and stability of capital flows, and financial and banking

development. Ferreiro, et al. states that the, “lack of consensus also raises concern about the

kind of economies that would benefit from financial liberalization” (Ferreiro, et al., p.32). This

questions the very premise of the Chicago Boys school of thought. Though, it does indicate that

the effectiveness of current account liberalization rests totally on the institutional framework of

the country in which it is enacted. “Capital account liberalization should be the final step in the

more general liberalization processes once product markets have been liberalized and the


domestic financial and banking system has been successfully transformed, thereby ensuring an

efficient resource allocation mechanism” (Ferreiro, et al., p.33).

Securitization as Policy in Latin American Markets

One component of macro and microeconomic policy that has significant ramifications on

capital markets is the effectiveness of securitization. As securitization is a method of reducing

the risk associated with an asset, securitized assets can attract investors to the market. As

Scatigna and Tovar (2007) indicates, “Structured finance can have a positive influence on the

financial system because it can transform ordinarily illiquid or risky assets into more liquid or

less risky ones. It thus offers an alternative source of long-term funding in both domestic and

cross-border markets, and can foster the development of domestic bond markets. In turn, this

could promote greater bank and financial market efficiency, as it implies greater competition to

meet customer financing needs” (Scatigna and Tovar, p.71). Consequently, structured

transactions have expanded rapidly in Latin America. New securitized transactions in 2006

rocketed from $6 Billion in 2002 to $20 Billion. Only $3.6 Billion of that was in cross border

transactions, indicating a rapid increase in domestic transactions. However, compared to Asia,

this is still a relatively small amount of securitized products (Gyntelberg and Remolona (2006)).

Scatagna and Tovar (2007) explain the added value of use of securitization in the region can add

depth to financial markets. This is accomplished by largely improving the resilience of the

markets by mitigating sovereign risk, and providing a source of funding for the housing finance

system.


The article makes the important distinction that securitization can create liquid assets

from relatively illiquid assets; things such as mortgages, credits, and receivables. And, more

importantly, it can improve the credit quality of the structured asset using credit enhancement

techniques. This is a means to offer investors more attractive products. Yet, it remains limited

with only such instruments accounting for, “3%, 10% and 6% of total assets in Argentina, Brazil

and Mexico, respectively,” in 2006 (Scatagna and Tovar, p. 77). As a means of mitigating

sovereign risk, securitized products enabled many firms to open to international markets using

products such as future flow securitizations (FFSs). Traditionally, FFSs have been a means for

evading domestic regulation. As the use of these products declines, it indicates an expansion and

deepening of domestic bond markets and attractiveness to both domestic and foreign investors.

Interdependence of Markets and the Resulting Successes and Failures

Pimenta and Fama (2002) presents a unique research in the interdependence of markets.

Using impulse response functions (IRF) models show that the despite liberalization of the

boundaries in Latin American countries, there was little difference between market

interdependence in 2002 than earlier periods with greater market barriers. The importance of

interdependence stems from Eun and Shim (1989) research on the U.S. stock market’s effects on

other markets. Intuitively, the largest market at that time, was the gravitational center,

influencing developments in other large markets. Eun and Shim (1989) showed the influence of

the U.S. Stock market expanding rapidly after the Black Monday crash. In no cases was it

shown that the other large markets, or any of the middle, i.e. Latin markets and Asian markets,

had any effect on the U.S. market. What is interesting, however, is the limited impact the middle

markets have on each other. Counter-intuitively, as Pimenta and Fama (2002) finds, despite


barriers or lack thereof, that there is limited, inconsequential, interdependency between Latin

American markets themselves, and Asian markets.

Hypotheses

Research up to year end 2005 indicates the top five Latin American capital markets are

not as strong as their Asian counterparts, as shown by Ananchorikul and Eichengreen (2007) and

Tovar (2007). And, Pimenta and Fama (2002) shows there is little, if any, interdependence

between the two markets. Previous research points to a multitude of reasons for the disparity and

lack of depth and strength in Latin American markets. While Ananchorikul and Eichengreen

(2007) does accept measures of market depth by increases of capitalization, it claims the

faltering macroeconomic policies of Latin American economies through the 1990’s and prior

have been significant setbacks in this regions’ capital market development. While economic

policy plays a significant role in the development of capital markets, the issuance of sovereign

debt adds depth to capital markets, breaking the “destructive loop” (Scatigna and Tovar, 2007;

Fostel and Kaminsky, 2007). Tovar and Qulspe-Agnoli (2007) indicates the issuance of

sovereign debt issuance in local currency has a deepening effect on private capital

markets. What is not shown in previous research is the effects strengthening macroeconomic

policy has created through stabilization of the perception of corruption, measured using the

corruption perception index (CPI) from Transparency International. And, more importantly,

stabilizing and improving OECD Knaepen Package scores over the period from 2000 to 2010 has,

in fact, facilitated an overall deepening of Latin American capital markets.


It is intuitive to assume that low perceived corruption will lead to investments and

increased capitalization, as that also indicates an increase in transparency. It is also intuitive to

assume that a Knaepen Package score (scores rank between 0 – 7, the lower number, the lower

risk) between zero and three might attract investment in capital markets. Yet, what isn’t

considered is a stabilization of these factors in the capitalization of markets. This investigation is

related to the stabilization of perceived corruption and the stabilization of Knaepen Package

scores as a reflection on the level of capitalization of a particular market.

Hypothesis one:

Stabilization of CPI scores, despite some consistently low scores, has increased

attractiveness of Latin America’s five key markets, Argentina , Brazil, Chile, Colombia,

and Mexico measured by increases in market capitalization, compared to the top four

performing Asian markets, Singapore, China, Taiwan, and Republic of Korea (S. Korea).

Corruption levels are measured against the Transparency International criteria and the

scores are taken directly from the Transparency International data base. Scores range

from 0 to 10, the lower the score, the higher the perceived corruption.

Hypothesis two:

Intuitively, the stabilization and decrease of World Bank Knaepen Package scores of

Latin American markets has been a co-contributor to the steady capitalization of markets,

increases in external debt, and increases in FDI compared to the top four Asian markets.


The expectation is that just stabilizing Knaepen Package scores will bode well for a

market. As the market stabilizes, and expectations are built around the stability,

investments will increase in a particular market as there is an increased level of

predictability. Lower scores, or countries displaying a move toward lowering scores

should experience further increases in market capitalization, as the Knaepen Package

measures country risk for repaying and servicing external debt using eight criteria.

Because the index has only been in existence since 1999, it does not have a long enough

history to have been used to assess previous research.

The criteria for which the Knaepen Package is scored is as follows:

The Country Risk Classification Method measures the country credit risk, i.e. the likelihood

that a country will service its external debt.

The classification of countries is achieved through the application of a methodology comprised

of two basic components: (1) the Country Risk Assessment Model (CRAM), which produces a

quantitative assessment of country credit risk, based on three groups of risk indicators (the

payment experience of the Participants, the financial situation and the economic situation) and

(2) the qualitative assessment of the Model results, considered country-by-country to

integrate political risk and/or other risk factors not taken (fully) into account by the Model.

The details of the CRAM are confidential and not published.

The final classification, based only on valid country risk elements, is a consensus decision of

the sub-Group of Country Risk Experts that involves the country risk experts of the

participating Export Credit Agencies.

The sub-Group of Country Risk Experts meets several times a year. These meetings are

organised so as to guarantee that every country is reviewed whenever a fundamental change

is observed and at least once a year. Whilst the meetings are confidential and no official

reports of the deliberations are made, the list of country risk classifications is published after

each meeting.

A number of Multilateral/Regional Financial Institutions are also classified in relation to Article

26 of the Arrangement.

(http://www.oecd.org/dataoecd/59/4/1910218.pdf)

Data

The data in this study is associated with nine countries, five Latin American countries

and four Asian countries. The Latin American countries are Argentina, Brazil, Chile, Colombia,

and Mexico. The four Asian countries are China, Korea, Singapore, and Taiwan. There are five

http://www.oecd.org/dataoecd/59/4/1910218.pdf


sets of data collected for each country. The data collected for these countries includes the

Transparency International Corruption Perception Index (CPI) for the years of 2001 through

2010 as published on the Transparency International website list. Next is the Knaepen Package

Index, taken directly from the Organization for Economic Cooperation and Development (OECD)

listings, used as a measure of country credit risk and worthiness using the unique 7 level criteria

and ratings for establishing credit worthiness. This data is for the same 2001 through 2010 time

period. The next data sets come directly from the World Bank catalog of market capitalization,

foreign direct investment, and external debt levels for the ten year period.

Method

First, there is a scatter plot comparison of all data correlated between year and data set –

CPI Index score, Knaepen Package score, market capitalization, external debt, and FDI. There

are five charts showing the relationship between the data, in many cases it is near linear. This is

in response to the great work of Ananchorikul and Eichengreen (2007), Tovar and Scatigna

(2008), and Tovar and Qulspe-Agnoli (2007). While previous research indicates that the five

major Latin American markets are not as well capitalized as the four major Asian markets, these

relationships show otherwise, but account for a more recent time period. Important to note in

these relationships is that the Chinese data set returns values of market capitalization and FDI

significantly higher than others. This is to be expected for the time period 2001 through 2010,

but it also includes the data for Taiwan, as that is not separated by the World Bank.


Corruption Perception Index Scores – Transparency International

Chart 1

CPI Scores are a scale of 0 – 10. Zero is the lowest possible score. Ten is the best possible score

indicating a near complete transparent system. Scores appear to be stable over the ten year period of

observation. There is no significant movement in scores by any one country. Interestingly,

China, Brazil, Mexico, and Colombia have very closely connected scores. Argentina rides on the

low edge of the group, while South Korea rides on the high edge, and has the most noticeable

increase of all observed countries. Singapore is the most transparent nation in the survey, with

Chile as the second most transparent. According to hypothesis one, this should indicate

increased capitalization for countries with high CPI scores. However, this was not the case. In

direct comparisons, the CPI score had a minimal effect on a correlation between overall market

capitalization and CPI.


Knaepen Package Scores – Transparency International

Chart 2

Knaepen Package scores are fairly consistent. However, in 2004 – 2005, Brazil,

Columbia, and Mexico all made improvements in that pushed their Knaepen package scores

lower, and closer to those of Chile and China and the other Asian countries. These moves

translated to improvements in those countries market capitalization. For example, between 2005

and 2010, Brazil increased its market capitalization by 325%, from $474.64mn to $1.545bn.

Chile increased market capitalization by 250.35% in the five year period, from $136.445mn to

$341.584mn. Colombia may be the most impressive, increasing market capitalization by 453%

while lowering its Knaepen Package score by one point and stabilizing that score for five years.

And, Mexico increased its market capitalization by 190% while stabilizing its Knaepen Package

and CPI scores.

The Asian markets, on the other hand did not show such success, save China. Singapore

only increased its market capitalization by 116.8% from $316mn to $370mn, South Korea

increased its market capitalization by 151.6% from $718mn to $1.089bn. And, China, the

0

1

2

3

4

5

6

7

8

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

Argentina

Brazil

Chile

Columbia

Mexico

Singapore

China

Taiwan

S. Korea


complete outlier, and whose data set also includes Taiwan’s figures, grew by 609.96% in the

same period.

Market Capitalization

Chart 3

With the exception of China, which only spiked in 2005 – 2006 years, market

capitalization of all nine emerging markets is fairly closely related, despite the reduced number

of listings in Latin American markets Ananchorikul and Eichengreen (2007) highlights. Market

capitalization seems rather closely related in all markets, with a few obvious exceptions. Not

accounting for any of the factors that will be used in a fixed effects regression analysis, this

particular scatter plot seems to have little-to-no preference for CPI or Knaepen Index rankings

when viewed as group, even though the Asian countries appear to have stronger relative ratings

in charts 1 and 2 than their Latin American counter parts. However, on a case-by-case basis as

previously described, each country, particularly the Latin American countries, have shown

significant improvements in market capitalization.

0

1,000,000,000,000

2,000,000,000,000

3,000,000,000,000

4,000,000,000,000

5,000,000,000,000

6,000,000,000,000

7,000,000,000,000

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

Argentina

Brazil

Chile

Columbia

Mexico

Singapore

China

Taiwan


External Debt

Chart 4

Numbers for 2010 are not available at the time of writing. Singapore has no external debt

to report, and the Taiwanese data is bundled with the Chinese figures. The missing Taiwanese

data skews the comparison as that may have some effect on the level of Chinese external debt.

Interesting to note is that despite the lower CPI scores and higher Knaepen Package scores, Latin

America has, on the whole, a higher issuance of external debt. This is an important factor for

assessing market depth and strength, addressed by Tovar and Qulspe-Agnoli (2007). As

described in the section titled Debt Issuance difficulties facing Latin American markets are

methods for breaking procyclacilty. Tovar and Qulspe-Agnoli indicate Chile, Brazil and Peru

have implemented fiscal responsibility laws aimed at reducing the phenomenon of

“procyclicality” of fiscal policies (Tovar and Qulspe-Agnoli 2007 ). The government efforts to

set the fiscal policies on a track that is more linear in nature, and works in tandem with debt

0

20,000,000,000

40,000,000,000

60,000,000,000

80,000,000,000

100,000,000,000

120,000,000,000

2000 2002 2004 2006 2008 2010

Argentina

Brazil

Chile

Columbia

Mexico

Singapore

China

Taiwan

S. Korea


management policies to improve prospects and debt profiles seems to be the case as indicated in

charts 3 - 5.

The issuance of external debt is one way in which Tovar and Qulspe-Agnoli (2007)

explain how LAC’s are emerging with tools to help squelch fears of currency risk coupled with

country risk. Perhaps the reason Latin American countries have experienced an upward trend in

external debt is because CPI and Knaepen Package scores, these countries are able to extend the

yield curve and limit currency and country risk entanglement.

As indicated previously, the critical drawback is that issuing country bonds could have

the negative side-effect of segmenting investors. However, market capitalization in Latin

America appears consistent and on a growth or expansion track, as does foreign direct

investment as evidenced in chart 5.

Foreign Direct Investment

Chart 5

0

20,000,000,000

40,000,000,000

60,000,000,000

80,000,000,000

100,000,000,000

120,000,000,000

140,000,000,000

160,000,000,000

2000 2002 2004 2006 2008 2010

Argentina

Brazil

Chile

Columbia

Mexico

Singapore

China

Taiwan

S. Korea


Numbers for 2010 are not available at the time of writing. The interactive chart will show

the precise value for foreign direct investment. There appears to be a very stable trend in FDI in

Latin America, with Brazil experiencing the most noticeable movement in investment. China, as

is the case in charts 3 and 5 is a complete outlier. For future reference it would be interesting to

distill the Chinese data to extrapolate the Taiwanese contribution. However, considering China

its’ own unique circumstance, the remaining FDI trends slightly favor Latin America. This

supports the Tovar and Qulspe-Agnoli (2007) research. For a three year period between 2005

and 2008, FDI levels appear to be increasing in Latin America. However, the global financial

crisis of 2008 seems to have immediate and noticeable effects in the 2009 FDI levels which have

decreased, with the exception of Singapore.

Finally, an initial and simple two-way-fixed-effects regression provides a quantitative

examination of the data appears to lend some credibility to the hypothesis that depth of capital

markets, as measured by market capitalization in each of the nine countries is affected by

perception of sovereign stability and credit worthiness, as measured by the OECD’s Knaepen

Index. Using a selection of data spanning the years 2001 through 2010 and including the five

major Latin American markets, Argentina, Brazil, Chile, Colombia, and Mexico and the four

major Asian markets, China, Korea (South), Singapore, and Taiwan, I have compiled a two way

fixed-effects regression, controlling for levels of FDI, external debt, and CPI with the following

basic logarithmic formula:

The dependent variable, measured as a logarithmic transformation for ease of

interpretation and due to the heavy rightward skew in the data, is highly statistically significantly


associated with the Knaepen Index. As Table 1 shows, without any controls, every unit increase

in the Knaepen Index is associated with a 67.1% decline in Market Cap size. Controlling for FDI,

external debt, and CPI, Knaepen Package Index is still significant at the 1% level and associated

with a 60% decrease in investment for every unit increase in the index. As one would expect,

levels of FDI are also significantly associated with levels of investment (at the 1% level), albeit

in extremely small magnitude2. Holding the other covariates constant, neither CPI nor levels of

external debt appear to be associated with Market Cap size in any statistically significant manner.

Table 1: Full Regression

Table 2 includes only the Latin American countries run with the same regression, and we can

see the same relationship emerge between the Knaepen Index and Market Cap size, with every

2 Every one million dollar increase in FDI associated with a 1.89e

11 % increase in Market Cap size.

Dependent Variable: ln(MarketCap)

(1) (2) (3) (4)

VARIABLES logMktCap logMktCap logMktCap logMktCap

Knaepen Index -0.671*** -0.569*** -0.607*** -0.600***

-0.106 -0.0948 -0.117 -0.117

FDI 1.91e-11*** 1.88e-11*** 1.89e-11***

4.22E-12 4.67E-12 4.69E-12

External Debt 6.71E-12 7.54E-12

9.45E-12 9.54E-12

CPI -0.288

-0.358

Constant 28.13*** 27.36*** 27.38*** 28.48***

-0.315 -0.313 -0.75 -1.556

Observations 80 72 54 54

R-squared 0.362 0.527 0.544 0.551

Robust standard errors in parentheses

*** p<0.01, ** p<0.05, * p<0.1


unit increase in the index associated with a 74.1% decline in Market Cap size. Within Latin

American countries, neither FDI, CPI, nor external debt are associated with Market Cap in any

significant manner, holding each of the others constant.

Table 2: Latin America

Table 3 shows the same regressions run with only the Asian countries in the sample.

Given the lack of sovereign debt issuance among those nations, a control for external debt was

not possible. Holding constant levels of FDI, a 1-point increase in the Knaepen Index is

associated with a 48.2% lower market cap value at the 5% level of significance. However, some

of this appears to have been due to inflation, as adding a control for CPI dissipates the

statistically significant relationship.

Latin America


(1) (2) (3) (4)

VARIABLES logMktCap logMktCap logMktCap logMktCap

Knaepen Index -0.707*** -0.723*** -0.742*** -0.741***

-0.104 -0.132 -0.13 -0.132

FDI -5.96E-12 -1.26E-11 -1.17E-11

1.60E-11 1.63E-11 1.71E-11

CPI -0.524 -0.525

-0.34 -0.344

External Debt 1.84E-12

8.92E-12

Constant 28.58*** 28.66*** 31.04*** 30.92***

-0.443 -0.708 -1.691 -1.813

Observations 50 45 45 45

R-squared 0.511 0.543 0.571 0.572


*** p<0.01, ** p<0.05, * p<0.1


Table 3: Asia

Caveats: While the tables and regression analysis is useful to the discussion of

strengthening Latin American markets, in that it provides a level of quantitative support to the

ideas discussed here, it must be understood the data presented is limited. For one, the sample size

of countries (9) is relatively small, and spread across a short period of time (2001 through 2010),

for which some 2010 data was unavailable. Although, going any further back than 1999 is

impossible considering the Knaepen Package is so new. Second, compounding the issue, data

availability is spotty in the case of China and Taiwan. Many of the statistical inferences drawn

from these regressions are undoubtedly overstated (while supportive of my hypothesis, it is

basically absurd to think that every one unit increase in the Knaepen Index corresponds to a 60%

Asia


(1) (2) (3)

VARIABLES logMktCap logMktCap logMktCap

Knaepen Index -0.529* -0.482** -0.264

-0.279 -0.203 -0.232

FDI 2.07e-11*** 2.02e-11***

-4.49E-12 -4.31E-12

CPI 0.658*

-0.382

Constant 29.13*** 27.26*** 24.60***

-0.601 -0.57 -1.638

Observations 30 27 27

R-squared 0.605 0.796 0.821


*** p<0.01, ** p<0.05, * p<0.1


decrease in market capitalization. However, future research will show that the correlation exists,

just in more reasonable associations).

Conclusions

This study has examined and evaluated two important factors on the success of markets:

perceived corruption and country credit risk. The previous research up through 2005 suggested

that Latin America’s economic problems had been so deep rooted that Latin American markets

were not going to offer the same depth of be as well capitalized as their Asian counterparts.

Perceived corruption levels and transparency in Latin American countries are clearly higher, on

average, than those of their Asian counterparts, while the average Knaepen Package score of

Latin America is higher than that of Asia. Yet, this does not appear to have a negative impact on

success of capital markets after 2005.

The data in the charts clearly indicates that Latin America, and the Asian countries for

which data was available, are relatively equally matched in capitalization levels and FDI flows,

with the obvious exception of China. However, as the literature indicated, “Sovereign global

bonds in local currency also improve the depth of private domestic debt markets by (1) allowing

the expansion of the longer part of the yield curve in local currency (as in Brazil and Peru); (2)

setting benchmarks for domestic markets, which can be relevant for domestic credit markets if

longer-term credit in local currency is nonexistent; (3) creating incentives for the expansion of

derivative markets; and, finally, (4) by diversifying the investor base” (Tovar, p.5). This research

has showed that if external debt is any measure of capital market depth, then Latin America, on

average is exceeding its four Asian counterparts.


The study certainly is not a complete examination, and is missing data sets that could

strengthen the study. However, as a preliminary investigation of the strengthening of Latin

American markets shows that the five major markets are, in fact, showing signs of strengthening

at a macro level. Future research can dissect the micro elements of market capitalization, but for

the purposes of understanding what most effects a country’s market capitalization, it is clear that

the factors incorporated in measuring country credit risk are the factors most important in

understanding the strength of a market. The reason for this is any movement in Knaepen

Package score can have strong impacts on the level of market capitalization for a particular

country.

In response to the hypotheses, the study concludes that stability is favored with regard to

perceived levels of corruption and country credit risk, not just favorable scores in either index.

Contrary to the first hypothesis, lowering perceived corruption (raising the scores) has a minimal

effect on levels of market capitalization. However, lowering the Knaepen Package score

(increasing attractiveness) has a dramatic effect on the level of market capitalization. This is

perhaps due to the strengthening of economic and trade policy aimed at servicing external debt.

Overall, Latin American capital markets appear to have the same relative strength as their Asian

counterparts, despite the lack of interdependency and the slower start and hiccups Latin America

had in developing world class markets. The scatter plots, save China, show a tight grouping of

the 8 countries, and a slight incline in favor of Latin American markets as corruption scores are

improved, and especially as country credit risk is reduced vis-à-vis Knaepen Package scores.

Latin American markets have, in deed, made great progress in the past decade, and

appear to be every bit as stable and strong as their Asian counterparts. Latin American markets

will most likely continue on a path of strengthening given the trends presented in the data.


REFERENCES

Ananchorikul, Sudurat & Barry Eichengreen (2007); Plumbing for Latin American capital

markets; BIS Papers retrieved from http://www.bis.org/publ/bppdf/bispap36g.pdf

de la Torre, Gozzi & Schmukler, (2008); Capital Market Development Whither Latin America,

retrieved from http://www.nber.org/chapters/c4776.pdf

Eun, Cheol S., and Sangdal Shim (1989). “The International Transmission of Stock

Market Movements,” Journal of Financial and Quantitative Analysis, Vol. 24, No.

2, pp. 241-255

Ferreiro, Jesus & Eugenia Correa, and Carmen Gomez (2008); Has Capital Account

Liberalization in Latin American Countries Led to Higher and More Stable Capital

Inflows?; International Journal of Political Economy, vol. 37, no. 4, Winter 2008–9, pp.

31–63.

Fostel, Ana and Kaminsky (2007); Latin America’s Access to International Capital Markets:

Good Behavior or Global Liquidity?; Tenth Annual Conference of the Central Bank of

Chile: Current Account and External Financing.

Guidotti, Pablo E. (2007); Global Finance, Macroeconomic Performance, and Policy Response

in Latin America: Lessons from the 1990’s; Journal of Applied Economics. Vol X, No. 2

(May 2007),279-308

Hsieh, Meng-Fen; Yang, Yu-Tai; Vu, Tam Bang (2008); Do Herding Behavior and Positive

Feedback Effects Influence Capital Inflows? Evidence from Asia and Latin America; The

International Journal of Business and Finance Research, Volume 2, Number 2

Jeanne, Olivier (2003); Why do Emerging Market Economies Borrow in Foreign Currency?;

IMF Working Paper

Lane, Philip and Gian Maria Milesi-Ferreti (2006); The External Wealth of Nations Mark II:

Revised and Extended Estimates of Foreign Assets and Liabilities, 1970 – 2004; IMF

Working Paper

Pimenta and Fama (2002); Interdependence Between the Major Capital Markets of the Emerging

Countries of Latin America and Southeast Asia; Latin American Business Review, Vol.

3(3) 2002

http://www.bis.org/publ/bppdf/bispap36g.pdf

http://www.nber.org/chapters/c4776.pdf


Qulspe-Agnoli, Myriam & Diego Vilan (2006); Financing Trends in Latin America; BIS Papers

retrieved from http://www.frbatlanta.org/filelegacydocs/er08no3_tovar.pdf

Scatinga, Michela and Camilo Tovar (2006); Securitization in Latin America; BIS Quarterly

Review, September 2007

Tovar, Camilo and Myriam Qulspe-Agnoli (2007); New Financing Trends in Latin America: An

Overview of Selected Issues and Policy Challenges;

http://www.frbatlanta.org/filelegacydocs/er08no3_tovar.pdf


http://www.transparency.org/

http://data.worldbank.org/indicator/CM.MKT.LCAP.CD/countries?page=1

http://data.worldbank.org/indicator/DT.DOD.DPPG.CD/countries

http://data.worldbank.org/indicator/BX.KLT.DINV.CD.WD?page=1




http://www.transparency.org/

http://data.worldbank.org/indicator/CM.MKT.LCAP.CD/countries?page=1

http://data.worldbank.org/indicator/DT.DOD.DPPG.CD/countries

http://data.worldbank.org/indicator/BX.KLT.DINV.CD.WD?page=1

strengthening of latin american capital markets

Documents