Assessing the Role of the Invisible Hand in Stock Market Liberalizations
Firms experience investment booms following the removal of foreign ownership restrictions in emerging-market stock exchanges.
ANN ARBOR, Mich. Firms experience investment booms in the aftermath of stock market liberalizations in developing countries that are undergoing economic reforms, according to a University of Michigan Business School researcher.
In a study of 369 firms in five emerging nations, Anusha Chari, assistant professor of finance at the Michigan Business School, and economist Peter Blair Henry of Stanford University found that in the three-year period after stock market liberalization, the investment growth rate of the typical firm increased by an average of 5.4 percent.
"The return to capital rose in the post-liberalization period, suggesting that the investment boom did not constitute a wasteful binge," Chari says.
The firms used for the study were located in India, Jordan, Korea, Malaysia and Thailand, which opened their stock markets to foreign investment during the late 1980s and early 1990s.
Removing restrictions on the stock market is often part of broader reform efforts to institute capital-account liberalization in developing countries. Some economists believe such reforms permit financial resources to flow from capital-abundant developed countries, where expected returns are low, to capital-scarce developing countries, where expected returns are high. The flow of resources into the developing countries, they say, reduces their cost of capital, increases investment and raises output.
Other economists disagree, taking the position that liberalization does not produce a more efficient international allocation of capital. Instead, they insist that liberalizations in emerging nations generate speculative capital flows that are unrelated to business fundamentals and have no discernible positive effects on investment, output and the real economy.
Against this background of competing views, Chari and Henry find evidence confirming the typical firm's post-liberalization investment decision does reflect a rational response to the signals embedded in the stock price change that occurs when a country liberalizes.
These signals may reflect changes in the firm's expected future cash flow and/or its cost of capital. On average, the larger the impact of liberalization on the firm's stock price, the larger its post-liberalization increase in capital stock growth tends to be.
"The firms in our sample increased investment when future growth prospects improved," Chari says. "But these companies also increased investment when they had a lot of cash (even in the absence of financial constraints)."
Chari and Henry report that a 1 percent increase in the growth rate of a firm's expected future cash flow predicts a 2.9 percent to 4.1 percent increase in the growth rate of its capital stock.
In their study, post-liberalization changes in investment also were significantly related to changes in the firms' overall cost of capital. The researchers report that the country-specific shock to the cost of capital predicts a 2.3 percent increase in annual investment. However, firm-specific changes in risk premia do not appear to impact decisions about the post-liberalization allocation of resources, they say.
Variation in changes in investment may be due to other factors.
"Firms in industries that are more dependent on external finance may show the largest post-liberalization increases in investment," Chari says. "Companies that receive preferential government treatment may be better positioned to raise stock market financing than other firms. Likewise, preferential treatment may determine which firms are opened up to foreign investment in the first place."
Their paper, "Is the Invisible Hand Discerning or Indiscriminate? Investment and Stock Prices in the Aftermath of Capital Account Liberalizations," was presented at the Michigan Business School's recent Mitsui Life Symposium on Global Financial Markets: Microanalysis and Emerging Markets.
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