The agenda for the G-20 finance ministers and central bank governors meeting in Sydney this weekend focuses on two themes: promoting stronger economic growth and employment and making the global economy more resilient. The G-20 leaders have recognized that expanding and strengthening capital markets in developing countries is crucial to both these goals and member countries have identified this as a priority issue for their deliberations.
Why? It’s widely understood that stronger and deeper capital markets can help to mobilize domestic savings and support the efficient allocation of resources, increasing investment and growth. Moreover, greater availability of domestic capital, at longer maturities and denominated in local currency, makes emerging economies less vulnerable to external financial shocks. But while there has been some progress, capital markets remain illiquid and underdeveloped in most emerging markets and developing economies.
There is plenty of research on the factors that facilitate the growth capital markets, including by the G-20 itself. But there are two crucial points that the G20 should not miss. First, the preconditions for capital market development, which I group into four pillars in a recent BIS paper, are interdependent: fragilities in any single pillar weakens the others; all pillars are equally important and necessary. Second, even if all the necessary conditions are in place, this may not be sufficient for developing countries to achieve the desired resilience against adverse external shocks; as these economies still lack the capacity to issue internationally recognized safe assets.
The Necessary Conditions for Capital Markets Development
The four pillars for capital markets development are: 1) macroeconomic stability, 2) sound banking systems, 3) solid institutional frameworks, and 4) adequate regulation and supervision. These examples show why all four pillars are interdependent:
Regulations for capital markets development (pillar 4) cannot be effective if they lack the support of a solid institutional framework that protects the rights of investors and creditors (pillar 3). South Asia, the Middle East and North Africa, and Latin America, which trail other parts of the world in measures to resolve insolvent firms also have the least developed capital markets.
In countries with economic instabilities (pillar 1), weak judicial systems (pillar 3) and/or fragile banking systems (pillar 2), even a well-designed bankruptcy law (pillar 4) will not allow for the orderly restructuring of firms in distress. Firms’ liquidation—even at fire sale prices— will be the creditors’ preferred choice, as they assign a very low probability to the recovery of their investments, perhaps due to lack of trust in the country’s macroeconomic management or institutional framework.
No capital market regulation, even if effective (pillar 4), can ensure the availability of liquidity (very much needed for the operations of capital markets) provided by sound banks (pillar 2).
Liberalizing the foreign-investment rules of private pension funds (pillar 4) in countries lacking macro stability (pillar 1) and financial stability (pillar 2) might exacerbate capital outflows in case of an adverse shock. In my view, Chile followed the right sequence: controls on investments in foreign securities were gradually lifted as the economic, regulatory and institutional environments gained strength.
A Longer-Term Constraint for Domestic Capital Markets’ Resilience
However, the four pillars while strictly necessary, are not sufficient. International experience has shown that even if all the pillars are in place countries that lack the ability to issue internationally recognized safe assets tend to have shallower and less-resilient local capital markets. Investors naturally prefer assets that maintain liquidity in bad times. There are just a handful of these safe assets in the world: government securities from countries that issue hard (e.g. highly liquid, internationally traded) currencies; US Treasuries top the list. During the global financial crisis, equity and bond instruments in emerging markets lost liquidity and prices collapsed.
Here’s where the G-20 comes in. Given the crucial importance of the ability to issue safe assets—and the limited number of such assets available—attaining fully functional, deep and stable local capital markets in developing countries will require more than just policy actions at the country level. Multilateral arrangements are needed to provide liquidity to these markets when needed. While some initiatives such as the IMF Flexible Credit Line can somehow help (although in an indirect way), they are insufficient. Much more needs to be done. The G-20 is uniquely positioned to begin the process, through instructions to the IMF and other multilateral institutions where the G-20 countries’ effectively call the shots.