Emerging Financial Markets

Prof. Zhiwu Chen

Lecture 1: The Big Picture

The Rise & Fall of Historical Powers

3000 BC,

Kingdom of Egypt

Then 2500 BC, The Greek Civilization

2000 BC, Shang Dynasty in China

500 BC, The Roman Empire

Then

Middle Ages: China, Aztec in Mexico and

the Incas of Peru

1500 AD, Spanish Adventurers

1700-1900 AD, British Empire

1900 AD - ?, The United States of America

Financial Markets also emerge, submerge and re-emerge

Argentina’s stock market:Argentina’s stock market:

–Founded in 1872Founded in 1872–Submerged in 1965Submerged in 1965–Re-emerged in 1975Re-emerged in 1975

Peru: 1941-52, 57-77, 88-Peru: 1941-52, 57-77, 88-

3

•The IFC Definition: Income less than $9,000

•21% GDP, 85% Population, 76% Area, And 11%

Market Capitalization in the World (1995)

•Higher growth rates & high avg returns in many

countries

•Time Taken to Double Per capita Output (10 years

but unstable)

What is an Emerging Market?

The Emerging Markets

Emerging19%

Developed81%

Share of World GDP, 1996Share of World Population, 1996

Emerging84%

Developed16%

Share of World Equity market Capitalization

Emerging9%

Developed91%

Annual Real GDP Growth1987-1996

9.9%

8.5%

7.7%

5.1%

3.1% 3.0%

2.3%

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

12.0%

China Tiger Cubs Four Tigers India Latin

America

Japan United

States

Average Annual Returns for theTwelve Years Ended December 1998Source: International Finance Corporation. Returns include capital gains and dividends.

-1.3%

2.1%

5.1%

8.9%

10.4%

15.8%

16.6%

17.1%

19.1%

23.5%

25.4%

27.0%

-5.0% 0.0% 5.0% 10.0% 15.0% 20.0% 25.0% 30.0%

Korea

Malaysia

Thailand

Singapore

Brazil

Taiwan

US

Hong Kong

Mexico

Greece

Chile

Argentina

Table. PRODUCTIVITY GROWTH

Time Taken to Double Per-capita Output (Selected periods)

Country Period Years

China 1977-1987 10

South korea 1966-1977 11

Brazil 1961-1979 19

Turkey 1857-1877 20

Japan 1855-1919 34

U.S. 1839-1886 48

U.K. 1780-1838 59

Sources: For U.K., Crafts 1981; for Japan, Moddison, for others, World Bank data

Why Do Countries Differ?

The Puzzles of Economic Growth

Why growth differs across

countries?

Why growth does not always

translate into stock returns?

Why capital flow is so small?

Which Countries Prosper?Per-capita GDP is expressed in terms of Purchasing Power Parities

(Source: Heritage Fountation)

-0.32%

-1.44%

0.97%

2.88%

-2.00%

-1.50%

-1.00%

-0.50%

0.00%

0.50%

1.00%

1.50%

2.00%

2.50%

3.00%

3.50%

Free Mostly Free Mostly Not Free Repressed

Why Good Opportunities in Emerging Markets?

4

Privatization and Incentives Have shown a high correlation between economic

freedom and growth.

Privatization of SOEs leads to great improvement in

efficiency and profits.

Low Tax Rates provide more incentives for

entrepreneurs.

Free trade and market opening allows

multinationals to leverage their strength,

outsourcing production, and expand their markets.

Effective Corporate Tax RatesData Source: Goldman Sachs

0% 10% 20% 30% 40% 50% 60%

Hong Kong

Singapore

Thailand

China

US

Japan

5

An Educated And Low Cost Labor Pool

High Literacy Rates Make Training

Less Costly.

Young and Energetic

Cost Of Labor Is Low

Technology Leap-frog Allows for

Dramatic Improvement in Efficiency.

World Labor Costs in U.S. Dollars per HourManufacturing Sector

1995 1997Cost (US $) Cost (US$)

Germany 31.88 27.80Japan 23.66 19.08France 19.34 16.91United States 17.20 18.17Italy 16.48 15.81Canada 16.03 16.24Britain 13.77 14.08Spain 12.70 n/aSouth Korea 7.40 4.29Singapore 7.28 7.05Taiwan 5.82 4.98Hong Kong 4.82 5.31Brazil 4.28 n/aChile 3.63 n/aPoland 2.09 n/aArgentina 1.67 n/aMalaysia 1.59 1.81Mexico 1.51 n/aCzech 1.30 n/aRussia 0.60 n/aThailand 0.46 0.39Indonesia 0.30 0.22China 0.25 0.33India 0.25 0.26

Source: Morgan Stanley Research (End of Year Estimates)

Bulge BrackAsian countries, % of population aged 25-59

(source: Higgins and Williamson; * represents forecast)

25

30

35

40

45

50

55

Indonesia Malaysia Thailand Bangladesh Pakistan

1990-1992 2005* 2025*

Domestic Savings And Foreign Capital Flow (FDI)

People are thrifty (high saving rates) in many

markets. But high domestic savings cannot fully

cushion the flow of foreign capital.

The composition of capital flows is healthy (more

private than public flows) but there is a problem

of duration mismatch. 6

6

Foreign Investment

$-

$20

$40

$60

$80

$100

$120

$140

86 87 88 89 90 91 92 93 94 95 96 97

EQUITY

FDI

Economic Impact On Developed Countries

Raising demand of baby boomers in EM vs.

falling demand in many western countries

Rising demand for western technology

Badly needed infrastructure projects create

huge demand for capital and expertise. 7

Comparison of Population GrowthData Source: United Nations

Over the last five years, Japan’s population grew only at a miniscule 0.2% a year. In comparison, the population of other Asian grew at much higher rates, with some growing at over 2% a year.

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

Japan U.S. China Thailand Indonesia Mexico Brazil Hong Kong India Malaysia

Po

pu

lati

on

Gro

wth

Series1

Annual GDP Growth Projection 2000-2025Data Source: “Asia’s Bright Future” (Steven Radlelet and

Jeffrey Sachs ), United Nations, and Financial Times

7.0%

6.7%

6.3%

5.3%

4.2%4.4% 4.5%

4.1%

2.2%

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

7.0%

8.0%

China Indonesia Malaysia Thailand HongKong

SouthKorea

Singapore Taiwan Japan

Of course, what can go wrong?

Past Success has little persistence (Brazil & Asian Tigers).

Excessive public and private borrowing increase the risk of financial crisis.

Currency instability resulted from week financial system.

Overbuilding of production capacity leads to low returns. (Real estate speculation)

Strong special interest groups can block badly needed reform. 8

Nobody says it is easy to invest in EMs!

Can you handle it?Can you handle it?