2 1659 DEVELOPMENT BRIEF Number 15 The World Bank April 1993 R i s i n g po rtf o l i o flI ow s: source country regulations, and in- vestor information. Changes in all Short-lived or sustainable? these factors suggest that access to these flows should prove to be sus- Portfolio investments reduce the cost of capital in tainable to a reasonable degree. developing countries, making it important to sustain Benefits of portfolio flows their recent fivefold expansion The primary benefit conferred by equity portfolio flows on a host P rivate portfolio flows, both in 1992. Much of these flows have country is a reduction in its cost of bonds and equity, have represented repatriated flight capi- capital (in addition to the presumed grown explosively in the tal, some high risk and high return benefit of efficient employment of past four years. These flows, which funds, and a small part institutional resources by the most creditworthy averaged less than US$6 billion a investment. Since these flows grew corporations in the private sector). year during 1982-88, were esti- at a time of falling U.S. dollar inter- Prices in developing country stock mated at US$34 billion in 1992.* est rates and recession in the United markets typically have jumped The revival of portfolio flows to States, an issue is whether access to higher upon opening to foreign in- developing countries was led ini- these flows will be sustained. vestors, indicating that removal of tially by a sharp expansion in bond The potentially huge supply of market segmentation has permitted financing (see the chart). Several portfolio equity flows to developing the domestic rate of return to fall. countries that had previously been countries is motivated not only by But the benefit is not realized by all absent from international capital source country conditions but by types of these flows. International markets reentered this market in host country creditworthiness, a de- stock trading (through American 1989. Equity flows through closed- sire for diversification, host and depository receipts-ADRs) and di- end country and regional funds, which until recently had been the mainhvhicle fre participao in he- Gross portfolio flows to developing countries, 1989-92 main vehicle for participation in de- veloping country stock markets, 35- were fairly modest during 1989-90. Direct In the past two years, the use of in- 30 equity ternational share offerings by sev- eral major middle-income countries Country to privatize public sector firms and 25-- funds the opening of many developing country stock markets to direct par- 20 s ADRs, ticipation by foreign investors have l 9 GDRs boosted equity portfolio flows. The increase has gone largely to a 15 cps few countries in Latin America, where gross equity portfolio flows 1- have grown more than tenfold in CDs four years-from US$434 million in - 1989 to an estimated US$5.6 billion -~-| _ Bonds 'For more details, see Global Economic Prospects and the Devel- Bonds oping Countries. 1993, Washington, DC, World Bank, April 1989 1990 1991 1992 1993. Soutrce: World Bank staff estimates. FILE COPY rect purchases on domestic stock 1992 were more than 30, up from 18 from 26.1 in September 1989 to 30.4 markets appear to be much more in 1986. Following the liberalization in September 1992. beneficial than are country funds in Brazil, the P/E ratio increased A second factor is the array of (comprising largely closed-end 40% in 1991 alone, and direct for- regulatory and other impediments mutual funds), because they alter eign equity purchases in 1991 and in the markets. Developing-country the way in which stocks are priced 1992 exceeded $1 billion. For the investment regulations vary from domestically. group of emerging countries as a placing no significant restrictions The companies in developing whole, the P/E ratio is now 17, up on the purchase of stocks and repa- countries that have listed ADRs have from 10 in 1986. triation of income and capital to se- seen their costs of capital decline. For Despite considerable variation in verely restricting access. Nine Tel6fonos de M6xico, the cost of capi- returns across emerging stock mar- emerging markets permit free en- tal has fallen by some 10 percentage kets, these markets have on average try, and a further 12 permit rela- points (relative to Mexican rates of performed strongly in recent years, tively free entry, while six others return generally) since the offering of although less well in the second and are restricted. its ADRs in May 1991. Evidence from third quarters of 1992. The Interna- A third factor is source country industrial countries also indicates tional Finance Corporation's (IFC) regulation, both fiduciary and institu- that dual stock listings lead to a composite index of total returns for tional. German institutional investors lower cost of capital-for Canadian 20 emerging markets rose 148% have the most stringent controls, firms by 0.71 percentage point and during 1987-92, exceeding returns while Japanese investors are subject for Australian firms by close to 2 per- on the U.S. stock market (Standard to nonbinding ceilings on foreign as- centage points. and Poor's 500) of 119%. The IFC's set size. If outward portfolio flows The issue of ADRs has lowered Latin America regional index rose from all source countries behaved the costs not only for individual 321% during this period, and its like those from the United States, firms but also for other domestic Asia regional index posted a gain of portfolio flows to developing coun- firms through spillover effects. 153%. tries would increase by an estimated Contrast this with country funds, Rates of return over the five-year US$3 billion a year. which are unlikely to have the period 1987-91 for the U.S. and A fourth factor is the economic same spillover benefits because emerging stock markets show that if situation of the source country, there are not the same direct price U.S. investors had held up to 20% of such as low interest rates and poor linkages. Country funds can, how- their portfolio in emerging markets growth prospects. These conditions ever, be useful in promoting inves- (compared with actual holdings of a are an important but by no means tor familiarity with an emerging fraction of 1%), they would have in- decisive determinant of equity port- stock market if direct purchases are creased their average return by folio flows. If U.S. dollar real inter- difficult or if a country is concerned about 1% a year and decreased the est rates rose by 100 basis points-a about large foreign ownership. variability of their returns. large rise-the net flow of portfolio The cost of equity capital has also equity to developing countries come down as a result of large capi- Determinants of equity would decline by an estimated tal inflows and associated increases portfolio flows US$2 billion a year. in stock prices, in part driven by a Undoubtedly, a main factor deter- A fifth factor is the potential for perception of improved earnings mining the destination of equity diversification. Investing in emerg- prospects. After significant capital portfolio capital is developing coun- ing stock markets potentially low- gains on most local stock markets, try creditworthiness. The recent ex- ers portfolio risk for the global local price/earnings (P/E) ratios perience in Latin America shows investor. Emerging stock markets are now at their highest levels in that markets are willing to recog- are weakly, and in some cases nega- most developing countries with a nize and reward improvements in tively, correlated with stock mar- well-developed stock market, indi- creditworthiness quickly. Institu- kets in industrial countries, so these cating lower required rates of re- tional Investor's average credit rating markets provide substantial poten- turn on equities. In India, the for the emerging market countries tial risk reduction benefits to inter- average P/E ratios at the end of of Latin America rose impressively national investors. De..lop,espet Briefs are issued by the World Bank to inform the media, business, academic, and government policy communities about development policy analyses and results from the Bank's research activities. They are drawn from the work of individual Bank researchers and do not necessarily represent the views of the World Bank and its member countries-and should not therefore be attributed to the World Bank or its affiliates. Briefs are issued periodicallyby the Research Advisory Staff, Development Economics Vice Presidency, The World Bank, 1818 H Street, NW, Washington, DC 20433. Tel: (202)473-3984, Fax: (202)477-0955. Brefs are not copyrighted and may be reproduced with the appropriate attribution.