Version: September 11, 2002

Research in Emerging Markets Finance: Looking to the Future

Geert Bekaert a,c,, Campbell R. Harveyb,c*
a Columbia b Duke c

University, New York, NY 10027,USA

University, Durham, NC 27708, USA

National Bureau of Economic Research, Cambridge, MA 02138, USA

Much has been learned about emerging markets finance over the past 20 years. These markets have attracted a unique interdisciplinary interest that bridges both investment and corporate finance with international economics, development economics, law, demographics and political science. Our paper focuses on the research areas that are ripe for exploration.

JEL classification: Keywords: Emerging equity markets, market integration, market segmentation, diversification, market liberalization, portfolio flows, market reforms, economic growth, contagion, capital flows, market microstructure, cost of capital.

This paper is based on a presentation made to the conference on Valuation in Emerging Markets at University of Virginia, May 28-30, 2002. We have benefited from discussions with and the comments of Chris Lundblad and Bob Brunner. *Corresponding author. E-mail address: [email protected]

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The designation emerging market is associated with the World Bank. A country is deemed emerging if its per capita GDP falls below a certain hurdle that changes through time. Of course, the basic idea behind the term is that these countries emerge from lessdeveloped status and join the group of developed countries. In development economics, this is known as convergence. History is important in studying these markets. Paradoxically, many complain about the lack of data on emerging markets. This is probably due to the fairly short histories available in standard databases. The International Finance Corporations Emerging Market Database provides data from only 1976. Morgan Stanley Capital International data begins ten years later. However, many of these markets have long histories.1 Indeed, in the 1920s Argentina had a greater market capitalization than the United Kingdom. More fundamentally, even the United States was, for much of its history, an emerging market. For example, in the recession of the 1840s, Pennsylvania, Mississippi, Indiana, Arkansas and Michigan defaulted on their debt. Even before this time, most Latin American countries had defaulted on their debt in 1825.2 So, many of the important topics of today, are issues that we have been dealing with for hundreds of years. Our paper provides a high level review of some important research advances over the past 20 years in emerging markets finance. While some country level historical data reach back to the 19 th century, the work of the International Finance Corporation made firm-level data widely available for researchers. In addition, care was taken in data collection so that the data were deemed to be more reliable than what had been available in the past. We then explore some of the most interesting challenges for the future. While most of our analysis focuses on 20 countries with the longest history in the EMDB (countries with data from at least 1990), many more countries have been added and many more countries will be added in the future. Indeed, part of what makes emerging markets research so interesting is that there is an immediate out of sample test of new theories as new markets migrate to the status of emerging. In addition, one cannot do emerging markets finance research in a vacuum. Emerging markets finance research is touched by many different disciplines. That is, it is very difficult to conduct meaningful research in emerging markets finance without having some knowledge of development economics, political science and demographics to name a few. Finally, this article is not meant has a comprehensive review article. [A more comprehensive review can be found in Bekaert and Harvey (2003)]. Indeed, we purposely relegate most of the citations to footnotes. While we do not intend to minimize the importance of the hundreds of research papers that have studied emerging markets over the past 20 years, we have decided to emphasize the big picture. We apologize in advance to the researchers not cited.
1 2

See Goetzmann and Jorion (1999) See Chernow (1990).

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The paper is organized as follows. The first section presents a number of statements that reflect research advances that have been made in recent years. We supplement this with data analysis that contrasts the behavior of emerging market returns pre-1990 and post-1990. This analysis focuses on those countries that have the longest samples of emerging market returns. We break our analysis in 1990 because many of the capital market liberalizations are clustered around 1990. The study of the impact of these liberalizations is one of the important research advances in recent years. The second section details a research plan for the future. Some concluding remarks are offered in the final section.

I. How much have we learned about emerging markets? While much has been learned, our knowledge is incomplete on a number of major issues. Below we characterize the progress that has been made in understanding these markets.

THE THEORY OF MARKET SEGMENTATION AND MARKET INTEGRATION Considerable research has focused on the evolution of a country from segmented to integrated with world markets. There are at least two levels to this evolution. Economic integration refers to decreased barriers to trading in goods and services. Financial integration refers to free access of foreigners to local capital markets (and local investors to foreign capital markets). Some of the early work in international finance tries to model the impact of market integration on security prices.3 A simple intuition can be gained from looking at asset prices in the context of the Sharpe (1964) and Lintners (1965) capital asset pricing model (CAPM). In a completely segmented market, assets will be priced off the local market return. The local expected return is a product of the local beta times the local market risk premium. Given the high volatility of local returns, it is likely that the local expected return is high. In the integrated capital market, the expected return is determined by the beta with respect to the world market portfolio multiplied by the world risk premium. It is likely that this expected return is much lower. Hence, in the transition from a segmented to an integrated market, prices should rise and expected returns should decrease.

DATING MARKET INTEGRATION IS COMPLICATED Market integration induces a structural change in the capital markets of an emerging country. Hence, for any empirical analysis, it is important to know the date of these structural changes.

Stulz (1981a,b), Errunza and Losq (1985), Eun and Janakiramanan (1986), Alexander, Eun and Jankiramanan (1987), Errunza, Hogan and Senbet (1998), Bekaert and Harvey (1995).
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We have learned that regulatory liberalizations are not necessarily defining events for market integration. Indeed, we should be careful to distinguish between the concepts of liberalization and integration. For example, a country might pass a law that seemingly drops all barriers to foreign participation in local capital markets. This is a liberalization but it might not be an effective liberalization that results in market integration. Indeed, there are two possibilities in this example. First, the market might have been integrated before the regulatory liberalization. That is, foreigners might have had the ability to access the market through other means, such as country funds and depository receipts. Second, the liberalization might have little or no effect because either foreign investors do not believe the regulatory reforms will be long lasting or other market imperfections exist that keep them out of the market. Hence, a number of different strategies have been pursued in an attempt to date the integration of world capital markets. There are four main approaches to this dating exercise: event association, inference from the behavior of financial assets and inference from the behavior of key economic aggregates and market infrastructure. The event association strategies include: (1) the regulatory reform date, (2) the date (preferably announcement) of the first country fund, (3) the date (announcement) of the first local equity listing or American Depositary Receipt on a foreign exchange.4 The finance strategies involve looking for changes in the behavior of asset returns and linking the change date to market integration. For example, if dividend yields are associated with expected returns, a sharp drop in dividend yields could be associated with an effective market liberalization reflecting the permanent price increase associated with the liberalization.5 The economic strategies involve the analysis of key economic aggregates that might be impacted by liberalization.6 For example, a sharp increase in equity capital flows by foreigners would seem to be evidence of an effective liberalization.7 Finally, market infrastructure refers to the degree of investor protection and the quality of the accounting standards. For example, some have looked at the date of the enforcement of capital market regulations, such as insider trading prosecutions as market integration.8

MARKET INTEGRATION IS OFTEN A GRADUAL PROCESS We have learned that market integration is surely a gradual process and the speed of the process is determined by the particular situation in each individual country. When one starts from the segmented state, the barriers to investment are often numerous. Bekaert (1995) details three different categories of barriers to emerging market investment: legal barriers, indirect barriers that arise because of information asymmetry, accounting standards and investor protection and risks that are especially important in emerging markets such as liquidity risk, political risk, economic policy risk and currency risk. These barriers discourage foreign investment. It is unlikely that all of these barriers disappear at a single point in time.
See Miller (1999). Other literature relevant for ADRs includes Karolyi (1998), Karolyi and Foerster (1999) and Urias (1994). 5 See Bekaert, Harvey and Lumsdaine (2002a) and Basu, Morey and Kawakatsu (1999). 6 See Kim and Singal (2000), Bekaert, Harvey and Lumsdaine (2002a) and Basu, Morey and Kawakatsu (1999). 7 See Bekaert and Harvey (2000b), Bekaert, Harvey and Lumsdaine ( 2002b) and Stulz (1999). 8 See Bekaert and Harvey (2000a), Henry (2000a) and Bhattacharya and Daouk (2002).
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Empirical models have been developed that allow the degree of market integration to change through time. This moves us away from the static segment/integrated paradigm to dynamic partial segmentation/partial integration paradigm.9 Whereas these models are indirect, relying on a model and econometric estimation to infer changes in the degree of integration, there are more direct measures available. For example, sometimes the ratio of investable market capitalization to global market capitalization, as defined by the International Finance Corporation, is used as a proxy for the degree of integration.10 This realization is particularly useful because many countries are in the process of liberalizing their capital markets. Often the relevant question is how fast should this occur.

MARKET INTEGRATION IMPACTS EXPECTED RETURNS The theory suggests that expected returns should decrease. We have learned that this is, indeed, the case. Fig. 1 contrasts average annual average geometric returns for twenty emerging markets, the IFC composite portfolio and the MSCI world market portfolio, pre1990 and post-1990. We choose this cutoff because a number of liberalizations are clustered around this point. The graph shows a sharp drop in average returns which is consistent with the theory. However, this type of summary analysis ignores other factors that might simultaneously affect the cost of capital in both individual emerging markets and in global capital markets. Recent research attempts to control for other confounding economic and financial events, allows for some disagreement over the date of the capital market liberalization, introduces different proxies for expected returns, and allows for the gradual nature of the liberalization process. The bottom line is that expected returns still decrease.11

MARKET INTEGRATION HAS AN AMBIGUOUS IMPACT ON MARKET VOLATILITY We have learned that there is no obvious association between market integration and volatility. While some have tried to argue that foreigners tend to abandon markets when risk increases, leading to higher volatility, the empirical evidence shows no significant changes in volatility going from a segmented to an integrated capital market. Fig. 2 shows the annualized standard deviation of 20 emerging market monthly returns with the split point of 1990. While it is true that some countries have seen a dramatic decrease in volatility (Argentina), there is no obvious pattern. In the 19 countries, 9 experience decreased volatility and 10 have increased volatility. Again, the summary analysis in Fig. 2 makes no attempt to control for other factors that might change volatility. For example, the decreased volatility in Argentina was partially
See Bekaert and Harvey (1995, 1997), Adler and Qi (2002). See Bekaert (1995) and Edison and Warnock (2003). 11 See Bekaert and Harvey (2000a), Henry (2000a) and Kim and Singal (2000).
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due to the economic policies that eliminated hyperinflation. Recent research attempts to model the volatility process carefully. For example, it makes sense to allow for time-varying expected returns and to allow for the volatility process to change as the country becomes more integrated into world capital markets. For example, as a country becomes more integrated into world capital markets, more of its variance might be explained by changes in common world factors (and less by local factors). When models are estimated that incorporate these complexities and that try to control for the state of the local economy, equity market liberalizations do not significantly impact volatility.12

MARKET INTEGRATION LEADS TO HIGHER CORRELATIONS WITH THE WORLD Theoretically, it is not necessarily the case that market integration leads to higher correlations with the world. A country with an industrial structure much different than the worlds average structure might have little or no correlation with world equity returns after liberalization. However, we have learned that correlations do, on average, increase. Fig. 3 shows that 17 of 20 markets experience increased correlation with the world. The correlation of the IFC composite with the world return has doubled over the past 12 years. The evidence also suggests that the correlation among emerging markets has increased. Fig. 4 shows that the average correlation has nearly doubled over the past 12 years. Association can also be measured by the beta with respect to the world market return. In Fig. 5, the picture is very similar to the correlation analysis. In the overwhelming majority of countries, the beta increases. The beta of the IFC composite with the MSCI world increases from 0.36 in the pre-1990 period to 0.90 in the post-1990 period. Again, it is important to control for other events. As with the analysis of expected returns and volatility, both correlations and betas increase after liberalizations even after introducing control variables. When correlations increase, the benefits of diversification decrease. However, we have learned that the correlation of emerging market returns are still sufficiently low to provide important portfolio diversification.13

CAPITAL FLOWS INCREASE AFTER LIBERALIZATION

See Bekaert and Harvey (1997, 2000a), Richards (1996), Kim and Singal (2000), De Santis and Imrohoroglu (1997) and Aggarwal, Inclan and Leal (1999). 13 DeSantis (1993) and Harvey (1995) detail the initial portfolio diversification benefits, Bailey and Lim (1992), Bekaert and Urias (1996, 1999) and Errunza, Hogan and Hung (1999) evaluate the diversification benefits of country funds and ADRs. De Roon, Nijman and Werker (2001) and Li, Sarker and Wang (2003) reexamine the diversification benefits in the presence of transactions costs and short-sale constraints.
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As barriers to entry decrease in emerging equity markets, foreign capital flows in. We have learned that the initial foreign capital flows bid up prices and help create a return to integration. While there is an initial increase in flows, in general, these flows level out in the three years post-liberalization.14 While most countries welcome foreign equity investment, many are concerned about the potentially disruptive impact of capital flight during a crisis. Indeed, during the recent Asian crisis, Malaysia imposed capital controls aimed at eliminating the possibility of foreign capital flight. However, the evidence with respect to the Mexican crisis suggests that foreign investors reduced their holdings in Mexico but they were preceded by local investors that had advance information. While most of the research on capital flows has relied on the U.S. Department of Treasury data, some of the most exciting research follows from tracking either individual or institutional investors.15

CONTAGION HAPPENS Contagion refers to the abnormally high correlation between markets during a crisis period. For emerging markets, there have been many crises in the last 10 years: Mexico in 1994-1995, East Asia 1997-1998, Russia 1998, Brazil 2000 and Argentina in 2002. We have learned that some part of the increased correlation is expected. One naturally expects higher correlation when volatility increases.16 However, one must be careful about defining abnormal correlation. In other words, we need a model to define what is expected in terms of correlation. Suppose that a world factor model governs returns. If the volatility of a particular world factor increases, then the returns with the highest exposures to this factor will be more correlated. Furthermore, it is possible that the exposures themselves are dynamic. As exposure increases, so will correlation. Hence, it makes sense to define contagion in terms of correlation over and above what one would expect from the factor model. In defining contagion this way, there is substantial evidence of contagion during the Asian crisis but no evidence of contagion during the Mexican crisis.17

EMERGING MARKET RETURNS ARE NOT NORMALLY DISTRIBUTED In many applications in finance, we simplify the world by imposing the assumption of normality for log returns distributions. We have learned that emerging market returns are not normally distributed.18 Furthermore, both post and pre-liberalization returns are not normally distributed. That is, while the liberalization event impacts expected returns and
See Bekaert, Harvey and Lumsdaine (2002b), Stulz (1999) and Griffin, Nardari and Stulz (2002). The country level data is studied in Tesar and Werner (1995). Research on flows includes Warther (1995) and Edelen and Warner (2001). Research that examines high frequency data, particular investors or particular securities is Choe, Kho and Stulz (1999), Froot, O'Connell and Seasholes (2001), and Clark and Berko (1997), Griffin, Nardari and Stulz (2002), and Kim and Wei (2002). 16 See Forbes and Rigobon (2002) and Bae, Karolyi and Stulz (2002). 17 See Bekaert, Harvey and Ng (2003) and Tang (2002). 18 See Harvey (1995).
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correlations, it does not change the fact that emerging market returns are skewed and have fat tails. Figs. 6 and 7 show the skewness and excess kurtosis of emerging market log returns in the pre and post-1990 period. Notice that the considerable variation in the skewness of the individual country returns. The excess kurtosis is almost always greater than zero indicating fatter tails than the normal distribution. There are a number of implications. First, this impacts the way that we model volatility in emerging markets. The standard distributional models are rejected by the data for many countries.19 Second, the existence of higher moments means that we need to consider alternative models for risk.20 Third, portfolio decisions need to incorporate information about these higher moments.21

EMERGING MARKETS ARE RELATIVELY INEFFICIENT While it is common for informational efficiencies to exist in new and smaller equity markets, we have learned that many emerging equity markets do not behave like developed markets. Emerging market equity returns have higher serial correlation than developed market returns. This serial correlation is symptomatic of infrequent trading and slow adjustment to current information. 22 Emerging market returns are less likely to be impacted by companyspecific news announcements than developed market returns. The evidence suggests that insider trading occurs well before the release of information to the public.23 Finally, there is a literature on stock selection in emerging markets that suggests that relatively simple combinations of fundamental characteristics can be used to develop portfolios that exhibit considerable excess returns to the benchmark.24 While none of these findings prove that these markets are inefficient, the preponderance of evidence suggests that these markets are relatively less informationally efficient than developed markets.

THERE ARE IMPORTANT LINKS BETWEEN THE REAL ECONOMY AND FINANCE Market integration is associated with lower expected returns. Effectively, the cost of capital decreases. It makes sense that investment should increase as more projects have a

See Bekaert and Harvey (1997). See Harvey and Siddique (2000), Harvey (2000) and Estrada (2000). 21 See Bekaert, Erb, Harvey and Viskanta (1998). 22 See Harvey (1995), Morey and Kawakatsu (1999). 23 See Bhattacharya, Daouk, Jorgenson and Kehr (2000). There is also work that examines the informativeness of domestic versus foreign investors, see Choe, Kho and Stulz (2002). 24 See Achour et al. (1999), Fama and French (1998), Rouwenhorst (1999) and Van der Hart, Slagter and Van Dijk (2003).
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positive net present value. We have learned that this is indeed the case.25 Finance also impacts other aspects of the real economy. In addition to investment increasing, evidence shows that the trade balance worsens after equity market liberalizations suggesting that the additional investment is indeed financed by foreign capital. Interestingly, personal consumption does not increase there is no evidence that a consumption binge occurs when new capital enters the market. Finally, real GDP growth increases. The evidence suggests that real economic growth increases, on average, by 1% per year over the five years following the opening of equity markets. Indeed, there is a considerable literature on the linkage between finance and growth. Much research has focused on banking liberalization and capital account liberalization26 or on how better developed markets help relax financing constraints and improve the allocation of capital.27 Only recently have we learned about the relative importance of equity market liberalization. Of course, the impact on the real economy is an average effect some countries grow faster than others. Research has suggested some ingredients for faster growth. If the economy has a good infrastructure, for example a high level of secondary school enrollment, it is more likely to benefit from an equity market liberalization.28 It is also the case that possible GDP growth gains are negatively influenced by the state of development of the countrys financial markets. For example, if the bank loan market is active and robust, this will mute the impact of opening an equity market on GDP prospects.29 While it is difficult to attribute causality from the financial sector to the real economy, the evidence points to the important role of equity capital markets in the economic growth prospects of less-developed countries.

FOREIGN PORTFOLIO INVESTORS DO NOT CAUSE HAVOC IN EMERGING MARKETS While there is no robust evidence that the volatility of equity returns increases on average after liberalizations the volatility of the real economy may ultimately be more important. Recent economic sharp economic declines during the Asian crisis, for example, have led some to argue that liberalization may lead to increased volatility of a countrys economic growth.30 We have learned that this is not the case. In tests that exclude the Asian crisis, there is evidence of a significant decline in economic growth volatility. When the

See Bekaert and Harvey (2000a) and Henry (2000b). See Demirg-Kunt and Levine (1996b), Levine and Zervos (1996, 1998a,b), Levine, Loayza and Beck (2000) and Laeven (2001). 27 See Love (2002), Rajan and Zingales (1998), Wurgler (2000), Galindo, Schiantarelli, and Weiss (2001) and Lins, Strickland and Zenner (2001). 28 See Bekaert, Harvey and Lundblad (2001). 29 See Bekaert, Harvey and Lundblad (2002a). 30 For example, see Stiglitz (2000).
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Asian crisis is included, this evidence is weakened. However, there is no evidence of significantly increased volatility.31 The volatility of economic growth is related to the concept of globalization leading to improved risk sharing. When the predictable components of consumption growth are stripped out, the evidence weighs in favor of risk sharing (decreased idiosyncratic consumption growth volatility after liberalizations).32

II. Future research directions THEORETICAL MODELS OF THE INTEGRATION PROCESS Our theoretical models are best characterized as static models of integrated/segmented economies. The true process is dynamic and much more complicated that our current models. For example, policy makers in emerging markets may strategically set the opening of their markets to maximize the revenue from privatization programs.33 While some empirical models have tried to characterize the degree of openness of capital markets, they are lacking a theoretical framework.

WHAT IS THE COST OF CAPITAL IN EMERGING MARKETS? It is particularly interesting to examine the state of the practice of finance in estimating the cost of equity capital in emerging markets. Most realize that the assumptions of the CAPM are violated. Numerous ad hoc attempts have been made to add something to the CAPM-based cost of capital because the CAPM yields an expected rate of return that is deemed too low to be reasonable. One of the more popular attempts is to supplement the CAPM required rate of return with the addition of the yield spread between the emerging markets U.S. dollar denominated government bond yields and the U.S. Treasury yield of the same maturity. Another method redefines the beta as the ratio of local to world standard deviations (rather than the usual definition of covariance divided by world variance). Both of these attempts are without theoretical foundation.

WHAT IS THE RELATION BETWEEN DIFFERENT TYPES OF REFORMS? There are many different categories of financial reforms: the banking sector or equity market may be opened up to foreign investment and foreign exchange restrictions may be lifted. Many of these reforms relax restrictions on payments for capital account transactions defined by the International Monetary Fund which is the 0/1 variable
See Bekaert, Harvey and Lundblad (2002b). See Lewis (1996, 1999, 2000) and Athanasoulis and van Wincoop (2000, 2001) for tests of international risk sharing. Bekaert, Harvey and Lundblad (2002b) link international risk sharing directly to equity market liberalizations. 33 Megginson and Netter (2001) provide a survey of the privatization literature.
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underlying the capital account openness measures used frequently.34 There are legal reforms regarding the domestic financial system as well as macroeconomic reforms. Most studies have focused on one particular type of reform without reference to the others. We need a better understanding of the relation between the different types of reforms.

THE SEQUENCING OF REFORMS The plethora of reforms begs an important policy question: What is the optimal sequencing of reforms? 35 For example, should banking liberalization precede equity market liberalization? The issue of sequencing is complicated because of the small number of observations from somewhat heterogeneous markets. However, the stakes are high. Given the relation between economic growth and financial liberalization, the correct sequencing of reforms could make a substantial difference for the economic prospects of any particular country.

MICROSTRUCTURE IN LESS THAN IDEAL CONDITIONS Much of the important work on market microstructure has focused on U.S. equity markets. Emerging equity markets provide special challenges and a diverse range of opportunities.36 Many countries are setting up exchanges and struggling to decide the best structure. Indeed, the type of exchange may be dependent on the characteristics of the particular emerging market. While the goal is to maximize the chance of fair prices, microstructure alone cannot provide these answers. The institutional structure, legal and regulatory environment (e.g. accounting disclosure rules) all impact the outcomes. On the boundaries of market microstructure and asset pricing there is much interest in the effects of (time-variation in) liquidity on expected returns and asset prices.37 Emerging markets constitute ideal laboratories to test predictions regarding liquidity and asset prices.38

FIRM LEVEL ANALYSIS Most of the work on emerging markets has focused on country level aggregate indices. Relatively little work has focused on the behavior of individual companies.39 For example, it would be interesting to examine the reaction of a particular company to liberalization measures. Is it the case that local firms become more specialized? In the
Eichengreen (2001) reviews the literature on capital account liberalization; Beim and Calomiris (2001) discuss the domestic financial reforms that are often part of a financial liberalization. 35 Edwards (1987) examines the sequencing of economic reforms. 36 See Domowitz, Glen and Madhavan (1998), Cherkaoui and Ghysels (2003) and Lesmond (2002). 37 See Jones (2000) for example. 38 See Bekaert, Harvey and Lundblad (2002c). 39 Chari and Henry (2002) examine the change in risk of individual firms after liberalizations. The ADR literature also examines the behavior of individual firms, see, for example, Foerster and Karolyi (1999).
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segmented state, firms have the incentive to inefficiently diversify in order to reduce their volatility to attract local equity investment.40 This could be tested. In addition, it would be interesting to follow firms investment policies after market integration decreases the cost of equity capital. Finally, it would be interesting to examine the impact, at the firm level, of different types of liberalizations, e.g. banking versus equity market.

AGENCY AND MANAGEMENT ISSUES In some respects, corporations in emerging markets provide an ideal testing ground for some important theories in corporate finance. For example, it is often argued that the existence of a sufficient amount of debt helps mitigate the agency problems that arise as a result of the separation of ownership and control. In a number of emerging markets, the existence of cross-ownership provides an environment where there is an acute separation of cash flow and voting rights. Given the possibility of severe agency problems, emerging markets provide an ideal venue to test these theories. That is, powerful tests of these theories can be conducted in samples that have large variation in agency problems.41

CORPORATE GOVERNANCE AND THE LEGAL ENVIRONMENT In order to compete in world capital markets, a number of countries are grappling with setting rules or formal laws with respect to corporate governance. There is a growing realization that inadequate corporate governance mechanisms will increase the cost of equity capital for emerging market corporations as they find it more difficult to obtain equity investors.42 Research needs to adapt our current knowledge of best practice in corporate governance to the unique characteristics of individual emerging markets. There are also important issues with respect to the legal environment. What is the optimal level of securities regulation in these countries? Trying to replicate the U.S. Securities and Exchange Commission may cause firms to list on other exchanges with less stringent regulations. Of course the existence of regulations or the establishment of a regulatory body does little, unless it is supplemented with credible enforcement.

INFRASTRUCTURE AND GROWTH OPPORTUNITIES Many emerging countries have extremely modest infrastructures. In addition to important questions such as the legal, regulatory and microstructure of the equity market, important choices need to be made on basic infrastructure needs of a country. It is not clear what the best choices are and there is very little research on this topic. For example, how
See Obstfeld (1994). See Harvey, Roper and Lins (2002). 42 See Klapper and Love (2002), Dyck and Zingales (2002), Denis and McConnell (2002) and Pinkowitz, Stulz and Williamson (2002).
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much capital should be allocated to education versus transportation infrastructure? These are important policy choices.

POLITICAL SCIENCE AND FINANCE We have learned that political risk is priced in many emerging markets.43 One difference between emerging and developed markets is the much more prominent role of politics in emerging markets. These markets tend to have larger public sector. An interesting course for future research is to examine the relationship between politics (e.g. the degree of democratization), financial reforms and future economic growth.44

CONVERGENCE AND DEMOGRAPHICS Are there social costs, in terms of greater income inequality, that follow financial liberalization?45 What is the relation between demographics and the probability of success (measured in terms of economic growth) of capital market reforms? The field of demographics is virtually untrodden with respect to finance.46

III. Conclusions Much of the research in finance focuses on the most efficient markets in the world, in particular, the U.S. and other G-7 markets. The conditions of these markets are most likely to be consistent with the assumptions of our theoretical models. Rich empirical tests can be carried out using data as granular as individual transactions. This luxury does not exist in emerging markets. Emerging equity markets provide a challenge to existing models and beg the creation of new models. While the data is not nearly as extensive, it is better for the empiricist to use what is available than to use nothing. Such work demands extensive robustness tests given the limited nature of the data. Nevertheless, the stakes are high. Given the relation between finance and the real economy, the research we do in emerging markets has a chance to make an impact beyond the particular equity markets that we examine. For example, in many of the emerging markets, the impact of a lower cost of capital (and its subsequent impact on economic
See Bekaert, Erb, Harvey and Viskanta (1997) and Perotti and van Oijen (2001). See Quinn (1997, 2001) and Quinn, Inclan and Toyoda (2001). 45 See Das and Mohapatra (2003). 46 Erb, Harvey and Viskanta (1997) relate demographic characteristics to expected returns. Stulz and Williamson (2002) examine the role of culture.
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growth) can be measured not just in dollars -- but in the number of people that are elevated from a desperate subsistence level to a more adequate standard of living.

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References
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Fig. 1

Average Annual Geometric Returns

0.80 0.70 0.60 0.50 0.40 0.30 0.20 0.10 0.00 -0.10 -0.20
o a e a d n l zil e a n a na ra hil bi ec di sia da ore sia xic eri tan es ga a nd key ela we ite orl nti B C lom Gre In one Jor K alay Me Nig akis ippin ortu Taiw haila Tur nezu bab pos W e g m P hil P T M Co Ind Ar Ve Zim Co P

Pre-1990

Post-1990

Data through April 2002

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Fig. 2

Average Annualized Standard Deviation

1.20

Pre-1990
1.00 0.80 0.60 0.40 0.20 0.00

Post-1990

il e ce dia a an rea ia ico ria n s al an d ey la e e rld az il ia a tin Br Ch omb Gree In nesi Jord Ko lays ex ige kista pine rtug aiw ailan urk ezue abw posit Wo n l a M N Pa ilip Po T Th T en mb m o ge M Co Ind Ar V Zi Co Ph

Data through April 2002

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Fig. 3

Correlation with the MSCI World Market Return

0.70 0.60 0.50 0.40 0.30 0.20 0.10 0.00 -0.10 -0.20
na nti rge A il ce dia a l an d ey la e te an rea ia ico ria n s az ile ia Br Ch omb Gree In nesi Jord Ko lays ex ige kista pine rtuga aiw ailan urk ezue abw posi l a M N Pa ilip Po T Th T en mb m o M Co Ind V Zi Co Ph

Pre-1990

Post-1990

Data through April 2002

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Fig. 4

Correlation with the IFC Composite Return

0.80 0.70 0.60 0.50 0.40 0.30 0.20 0.10 0.00 -0.10 -0.20
na nti ge Ar

Pre-1990

Post-1990

il e ce dia a l an d ey la e an rea ia ico ria n s az ile ia Br Ch omb Gree In nesi Jord Ko lays ex ige kista pine rtuga aiw ailan urk ezue abw erag v l a M N Pa ilip Po T Th T en mb A o M Co Ind V Zi Ph

Data through April 2002

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Fig. 5

Beta with the MSCI World Market Return

1.60 1.40 1.20 1.00 0.80 0.60 0.40 0.20 0.00 -0.20 -0.40 -0.60
na nti rge A

Pre-1990

Post-1990

il ce dia a l an d ey la e an rea ia ico ria n s az ile ia rld Br Ch omb Gree In nesi Jord Ko lays ex ige kista pine rtuga aiw ailan urk ezue abw Wo l a M N Pa ilip Po T Th T en mb o M Co Ind V Zi Ph

Data through April 2002

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Fig. 6

Average Monthly Skewness

1.00 0.50 0.00 -0.50 -1.00 -1.50 -2.00 -2.50 -3.00 -3.50 -4.00

Pre-1990

Post-1990

a d e a y a o ia n l n zil le na ra Chi mbia reec Indi esia rda Kore aysia exic iger istan ines tuga iwa iland urke zuel abwe osite orl nti B W lo G e al M N Pak ilipp Por Ta Tha T ene mb mp on Jo g M Co Ind Ar V Zi Co Ph

Log returns. Data through April 2002

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Fig. 7

Average Monthly Excess Kurtosis

10.00 8.00 6.00 4.00 2.00 0.00 -2.00
e zil le na ra Chi mbia reec nti B o G l ge Co Ar ia a an ea ia co ria n s al an d ey la e e rld Ind nesi Jord Kor lays exi ige kista pine rtug aiw ailan urk ezue babw posit Wo a M N Pa ilip Po T en m m o T Th M Ind V Zi Co Ph

Pre-1990

Post-1990

Log returns. Data through April 2002