Comparison between Emerging and Developed Economies - Literature review Example

? An essay reviewing the literature relating to Investment opportunities and risks in stock markets: A comparison between emerging and developed economies Introduction Trend of investment in the developing countries has increased in magnitude over the past few years. Analysts have found that higher incidences of investment are being found in the emerging countries. The concentration of the Equity Portfolio Flows (EPF) is the highest among a cluster of emerging economies, Latin America being the biggest destination for foreign investors (Claessens, 1993). With the EPFs emerging as a vital source of capital inflow for the developing countries, an array of issues arises regarding this pattern of investment. It is of prime importance to understand the diversification benefits accruing to an investor from investing in the developing countries and the returns to stocks of these emerging markets. Investors and researchers are concerned about the level of integration of these markets with the financial markets of the industrially advanced countries. Several research works have been conducted in the past to investigate about the process of integration between these markets and to understand the changes appearing in the risk-return features of emerging markets. This helps in the understanding of the individual investor’s reaction to the changes in organization of financial markets and the changes in her behaviour in favourable and unfavourable economic conditions. Sufficient research papers are available, that present their findings related to the developed industrial countries. It has been found that there is a lack in recent researches concerning the stock market scenario and market returns in the emerging economies. This essay focuses on reviewing the existing literature on the risks and benefits accruing from investment activities in the developing economies and comparing it with the risks and benefits associated with investing in the advanced stock markets of the world. The diversification benefits are investigated and the correlation between the advanced and emerging stock markets is studied through this literature review. Review There are several reasons that provoke investors to seek diversified and long-term exposure to the emerging financial markets. Social as well as demographic trends are fundamental to the growth of emerging economies and the development of investment prospects in those markets. Recent researches show that the influence of the financial crisis of the US and the Euro zone has been felt more severely in the developed nations rather than on the developing countries. As a matter of fact, a few emerging financial markets are demonstrating a high degree of stability that is historically associated with the mature economies. This is an outcome of rapid evolution, which shows that the investment conditions are also evolving at a fast pace. Many investors of the developed countries such as the United States consider the emerging economies, like, Brazil, India, Russia and China to offer good investment opportunities. In fact, some other smaller markets, such as, Philippines and Indonesia, are emerging that put forward noteworthy opportunities to equity investors. But while choosing the market in which to invest, the investor require the understanding of the differences and parity among the emerging markets, and must not group them together. The investors have to weigh the currency strength of the country in which they are deciding to invest along with the stability of the country’s government (TIAA CREF, 2013). Rationale behind investing in developing countries According to Henry and Kannan (2008), two rationales emerge out of conventional theories pertaining to investment in risky assets, such as stocks, in developing countries. The first rationale relates to the low level of risk involved in the investments made in the emerging economies and the second rationale concentrates on the high growth rates in the developing countries. There is a low correlation between returns to stock in developed countries and developing countries. This happens due to the differences in growth rates of developed countries and the developing countries. Such differences lead to varying rates of profits and the returns to stocks are diversified. This provides a golden opportunity to diversify investment decisions by investors. Diversification opportunities available in the less developed countries allow investors to reduce risk, since investment condition in these countries are comparatively more stable than the highly fluctuating stock funding investment in the developed countries. Hence these investors increase their expected return on portfolio. These advantages of diversification have also been demonstrated by I. Meric and G. Meric (1989); Divecha, Drach and Stefek (1992); Michaud et al. (1996), and De Fusco et al. (1996). The second rationale states that high rates of economic growth in emerging economies favour large scale investment. The emerging economies are different from the developed economies because enough investments have not been made in these countries and therefore provide great investment opportunities. Since the emerging economies have huge latent scopes for development they can sustain high rates of economic growth. In the near future the growth rates in these countries are expected to become higher than the rate at which the developed countries grow. Analysts forecast that returns to stock in the long run are also going to exceed the rate of return in the developed countries (Malkiel and Mei, 1998; Mobius, 1994). Henry and Kannan (2008) have focussed on this second aspect in their paper. The discussion presented above reveals that the return to stock in an economy reflects the performance of the real economy and captures the growth rate of GDP in that particular economy. The paper presents the outcome of the investigation that whether return to capital in emerging markets is related to the growth of the economy. The paper emphasises that although it is an obvious fact that countries that are growing very fast would give higher return on stock than that one can earn in a slow-growing country, there is not an obvious positive relationship between return to stock and growth of the emerging economies. Henry and Kannan (2008) have depicted this fact by using data from the last thirty years. In order to understand what drives the rate of return in an emerging economy the researcher has to study the reasons that lead to the points of difference between developed and developing countries. The return to stock in a country is associated to the returns to the real assets in that economy. If one witnesses “a falling rate of return to capital in a country” (Henry and Kannan, 2008) one cannot infer that the level of return to capital in that country is lower than other countries. This comparison does not hold true between developed countries and developing countries. The emerging economies have a lower capital-labour ratio than their developed counterparts. These economies have the inherent tendencies to grow more rapidly and provide high rates of return to capital. The developing economies in East Asia had initially started with a low capital labour ratio, but have exhibited rapid growth of capital over labour. Capital accumulation leads to high productivity level of the factors of production thereby increasing the level of return to capital (Krugman, 1994; Young, 1995). Return to capital is therefore quite high and might appear to be higher when compared to that received in the developed nations (Henry and Kannan, 2008). The emerging markets Innumerable countries in the globe are still in the developing phase. These are recognized as the emerging markets or economies. However, due to the diverse geographical characteristics, variation in cultures and the initial endowment of resources of these countries, they cannot be defined by a single definition. In simple words “emerging economies are low income, rapid-growth countries using economic liberalization as their primary engine of growth” (Sauvant, 2008, p. 333; Hoskisson et al, 2000, p. 249; Tina, Jerry and Richard, 2002, p.45). The developing economies are putting efforts to become market oriented economies by making changes in their food sector, agricultural sector, and the rural commercial zones in the country (United States Department of Agriculture Foreign Agricultural Service, 2010). Significant structural changes are being brought within the emerging economies (Lou, 2002). The big emerging economies of the world include China, Brazil, India, Argentina and Indonesia. Certain factors make these economies strategically important to investors. Some of these factors are, favourable and evolving consumer markets, increasing purchasing power of the people with rising per capita disposable income, increasing credit facilities, increasing productivity that leads to attractive prices in the world market. Big companies, such as, GE, expects to gain almost “60 percent of its revenue growth from the emerging markets over the next decade” (Czinkota and Ronkainen, 2007, p. 116). According to the International finance corporate (IFC) the emerging market must belong to a developing country and must be highly dynamic. Such a market must have a high contribution level in stock exchange market and act as an attractive destination for the domestic as well as foreign investors. The stock exchanges in these economies might be in the embryonic stage, or moderate old or quite comparable to the developed countries (Bekaert and Harvey, 2003). Hence all emerging economies cannot be classified as a homogenous group of markets. Derrabi and Leseure (2002) explain the different activities involved into the investment process in the emerging markets. Investment activities in emerging economies encompass activities, such as, buying and selling of financial assets. Domestic entrepreneurs or foreign investors can directly buy financial assets from stock markets. Some deposit institutions possess funds through which these investors can make investment on buying the stocks. Comparison between emerging and advanced financial markets Investment activities in developed markets are highly institutionalized. Investments therefore cannot be done directly by the investors. In contrast, one of the striking features of emerging economies is that individuals predominantly hold financial assets in these economies. In these economies investment is made directly into shares. This form of investment is preferred in the developing countries. Derrabi and Leseure (2002, p. 1) shows that “return on investment in emerging markets is much higher than the returns on investment in developed markets.” On this same note the researchers also claim that emerging markets pose riskier challenges to the investor than the developed markets. Emerging economies are not well integrated with the global economy and hence do not behave in a coherent manner with the international financial market. The authors have used the Capital Asset Pricing Model to show that the specific risk involved with investment decisions in the developing countries in the world is higher than the specific risk related to the developed economies. Advantages of investing in the emerging markets The most significant advantage of this market is the amount of potential returns yielded from these markets. The second advantage is risk cutting by diversification of investment options. Low correlation found between returns to stock in less developed markets and the returns to stock in advanced markets allow investors to reap benefits from the diversified opportunities offered by the emerging markets. Measurement of diversification benefits yielded from emerging stock markets can be made using the data available on closed-end funds at both regional and national levels (Derrabi and Leseure, 2002). The results obtained from research show that when investors hold closed-end funds they lose out a substantial portion of the benefits arising from diversification of investments in foreign economies. For the measurement of diversification benefits some researchers take into account transactions costs that investors directly face by investing in new budding markets (De Roon, Nijman and Werker, 2001). Their findings show that investors do not reap the entire benefit arising due to diversification of investment if the transaction costs are considered, especially the short-sale constraints. The low degree of association between returns to stock in these markets might be attributed to various factors, such as, differences in time zones, opening hours and also geographical factors. Results obtained from research confirm that high correlation exists between those markets that are located in some particular area with similar geographical features. Countries such as Singapore/Indonesia, Argentina/Brazil and Honk Kong/Indonesia exhibit high correlation. Markets positioned in places that are geographically distant from one another exhibit low correlation coefficients between stock market returns. Examples of such markets are Taiwan /Colombia, Korea/Colombia or Malaysia/Argentina. Such low coefficients are a signal of potential diversification profits that can be enjoyed by investing in emerging economies. According to Mullin (1993), low correlation coefficients arise due to low frequency transactions in the developing markets. However, the research by Derrabi and Leseure, 2002 has eliminated all low frequency transactions and still finds low correlation coefficient between geographically distant areas. This result had already found prior establishment in research results obtained by Harvey in the 1990s (Harvey, 1995). Derrabi and Leseure (2002) support this result by showing high levels of correlation between /Singapore, Indonesia/Honk Kong and Indonesia/Singapore. This results points towards the fact that reduction of risk is not apparently obvious if investment is made in the emerging markets. Various factors play decisive roles in determining the level of benefit and risk associated with particular markets in the developing countries. The advantages associated with investment activities in the emerging markets have also been discussed explicitly by Derrabi and Leseure (2002). The level of advantage or disadvantage accruing to an investor is dependent on the return/risk ratio. The behaviour of the markets has to be studied explicitly for making a reliable estimate of this ratio. The characteristics of risk associated with investment in these markets can be determined by a thorough study of the organization of the markets and the precise regulations binding these markets. Level of integration among financial markets Evaluation of the integration level of equity markets is important for a transparent understanding of the risks and benefits of investing in the emerging markets. A critical precept of theory of investment states that a majority of situations of economic instability are specific to the country in which it has occurred. International diversification therefore provides a good opportunity to shrink portfolio risk while increasing expected proceeds. However, if the risk is contagious the negative shock would spread across other countries. Market correlation would increase correlation between the stock market returns across different economies. This would damage the rationale behind international diversification. Many institutions and international policy makers are concerned over the fact that the negative shock affecting one country is capable of casting a negative shadow on the financial activities of another country although the activities in the other country might be healthy. Besides, most of the models theorizing investor behaviour assume that different investors produce different reactions when faced with a big economic shock. In order to understand the changes in individual investor’s behaviour in good economic conditions and poor states, understanding of the process of transmission of financial shocks across markets is important (Vo and Daly, 2005). Vo and Daly (2005) has investigated into the stock market scenario of the Asian countries and the advanced stock markets of the United States, United Kingdom, Australia and Germany. The paper depicts the relationship between these stock markets and the interdependence has been verified by checking the correlation among these markets. The time period selected for the study is the period before and after the Asian Financial Crisis of 1997. Vo and Daly (2005) has focused on the issue whether the Asian Crisis of 1997 has affected the equity markets in the Asian countries and whether it has altered the level of expected benefits from making investments in these markets. With the countries overcoming the financial crunch, significant changes have been made in the capital markets of the Asian countries. The question that crops up following this situation is related to the risk factor of these markets and the benefits arising out of investment in these markets. This paper delves deep into the research pertaining to the integration of the capital markets in the Asian countries. The financial crisis has led to an economic convergence among the countries in Asia. The paper studies whether such integration has led to increased correlation among these markets which might effectively reduce the benefits earned by investors on investing into these markets. It has been empirically proved that no significant co-integration exists between the stock markets of Asian countries and the US. Since there is no common stochastic tendency within the Asian markets the effect of diversification benefit is quite high for foreign investors in the period post financial crisis. However, with the rising pace of international financial integration, correlation of equity returns must be considered in making future decisions regarding allocation of resources. Relationship among the global stock markets Majid and Kassim (2009) have explored the effects of the US financial crisis of 2007 on the stock market conditions of the emerging economies. The paper supports the common opinion that a greater extent of integration among the stock markets is evident during the period of crisis. Hence investors spending resources in the markets of emerging economies yield lesser benefit from diversification than in pre crisis period. The subprime financial crisis that ripped the US economy in the 2007 brought about significant changes in the situation of stock markets from the pre crisis period and the benefits arising due to diversification across emerging stock markets in the long-run shows a diminishing trend. The stock markets of the advanced as well as the emerging economies have been affected largely by the trough in the US financial condition. Studies show that the financial crisis has had severe impact on the integration of the stock markets in both advanced and emerging countries and the co-movements among these markets. These reports reveal practical information regarding the global opportunities for investment diversification (Ibrahim, 2005). Stock markets that are well integrated offer narrow diversification benefits since they are highly inter-correlated and “tend to move together” (Majid and Kassim, 2009, p. 342) thereby depicting a stable relationship in the long run. Such economies share strong financial and economic ties due to similarity in macroeconomic environment between these countries. The paper by Majid and Kassim (2009) shows that the long run relationships between the stock markets that was not present in the pre crisis period was found to be existent after the co-integration test was conducted using the period during the financial crisis. Justification of international diversification It is a long debated argument that emerging economies are highly risk prone and investment activities in these countries are lined with hazards. There is a strong general notion that the developing economies are politically unstable, often due to military intervention or unwarranted capital influx or out flux, and suffer from currency risk that arise due to strict control over the flow of capital. The other reason that support the argument is that there is higher incidence of thin trading in these countries than in the developed ones. Besides, there is a persistent problem of low liquidity in these markets (Sinclair et al, 1996). All these contribute to the perception of risk associated with investing in equities that are traded in the emerging economies. Besides, the fund managers in these countries are not well versed in the procedures of accounting and share trading. In some cases these countries do not have a standard accounting procedure that would match the global standards. Asymmetry in available information, accounting standards, transaction costs, legal barriers and governmental regulations are some of the micro level barriers that are specific to these developing countries and pose a threat to investing decisions (Claessens, 1993). Returns to capital are volatile in these individual emerging markets that pose the most dramatic threat to investment in emerging equity markets. International diversification of portfolio can be justified only when it is a gainful investment. With the increase in integration of global equity markets, diversification benefits tend to demur with the occurrence and strengthening of positive correlation between markets. This is a well known concept and has been enumerated upon by various researchers since the last century. Lucey and Voronkova (2006) have demonstrated this statement and showed a number of interesting facts. Firstly, the phase in which benefits from diversification depict highest level of potential, due to low level of correlation among the international indices, is the period in which investors face the greatest amount of trouble in diversifying. These periods are characterized by international tension in the financial markets. The next phase is that of highest correlation among the international markets thereby offering low diversification benefits. The period of Great Depression has been such a period of low diversification benefits. In this period the market generally shows a sluggish tendency. The final phase is that of inconsistent diversification benefits. In this phase diversification benefits are needed the most but are available scarcely. Interestingly, Lucey and Voronkova (2006) suggest that the factors that develop correlations between markets in long run and their linkages are not clearly understood. While some researchers believe that the economic conditions and national cultures dominate such market tendencies, some others are of the opinion that want for integration among the emerging markets develops such correlation among financial markets. Summary It has been established from the discussion presented above that the emerging markets offer a lucrative investment opportunity although it is laden with high risks. Although various barriers are present in the emerging financial markets, diversification benefits are stronger in case of investment activities “across international financial markets than within domestic markets” (Claessens, 1993, p. 4). Two contrasting factors act simultaneously that help in overcoming the risk associated with investment in equities of emerging markets. These factors favourably affect the position of equities of the emerging economies in the diversified portfolios of the global investing institutions. On one hand, the emerging markets are characterized by economically liberal markets and the effect of globalization is increasing the correlation between returns to stock of these markets. On the other hand, there still exists a low coefficient of correlation between the market returns of the developed countries and the developing countries (Sinclair et al, 1996). International equities endow investors with diversification benefits at times of financial crises (Patel and Sarkar, 1998). Participating in these emerging economies is likely to reduce the “overall unconditional portfolio risk” (Claessens, 1993, p. 4). References Bekaert, G. and Harvey, C. R., 2003. 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