Key Trends in Emerging Stock Markets in 1996

The words "survival" and "revival" might sum up best what 1996 meant for emerging stock markets. First, the markets survived a period of international turbulence created by the 1994-95 Mexican peso crisis and its "tequila effects" which were dissipating as the year began. During 1996, most emerging markets revived on continued low international interest rates, bull markets for stocks in most developed economies, expanding international trade, generally smooth growth conditions in most developed economies (with the exception of Japan), and continued progress in most emerging markets' economic liberalization programs.

Domestic and foreign investors sought opportunities in 1996 to review emerging markets in light of specific market circumstances, and generally they liked what they saw.

Emerging stock markets posted their first positive collective return since the boom of 1993, as measured by the IFC Global (IFCG) and Investable (IFCI) Composite indexes. The IFCG Composite Index rose about 5.8% during 1996. It is the broadest indicator of emerging stock market performance available, covering 1,779 stocks in 27 markets during 1996. The IFCI Composite Index, with 1,224 stocks in 26 markets, is the broadest index available, designed to measure returns on emerging market stocks that are legally and practically open to foreign portfolio investment, and is a widely-used benchmark for international portfolio management purposes. The IFCI Composite gained 6.7% in 1996.

On a regional basis, the largest gain came in Latin America. The IFCI Latin America Index was up 14% in 1996, followed by an 8.9% gain in the IFCI Asia Index, and a loss of about 5.2% in the IFCI Europe/Mideast/Africa Index.

While share price performance in most emerging markets was positive, individual performance among the emerging markets in 1996 was as diverse as the features of the markets themselves. As in many years past, emerging markets could be found both at the top and bottom of a list of the world's best performing stock markets.

For instance, emerging markets swept the top 15 spots for annual performance measured in dollar terms, from a list of 76 world stock markets. Only Spain and Sweden from the developed markets made the top 20 on this list, which included 54 markets from developing countries and 22 from developed countries. The top five performers for 1996 were Bangladesh (up 196%), Russia (156%), Venezuela (132%), Hungary (95%), and China (89%). It is noteworthy that the largest gains tended to come from some of the smaller, less-known emerging markets not contained in any index producer's composite index, though the relatively large Taiwanese market made 18th on the list with a 36% increase.

The worst performing markets were also concentrated in emerging markets. Twenty-one world equity markets dropped in price in 1996, of which 19 were emerging markets. Bulgaria was nearly wiped out as stock prices continued to post losses in dollar terms after trading was suspended from September, in light of a radical currency devaluation. As a consequence, the IFCG Bulgaria Index lost nearly 83% over the course of 1996, making it the world's worst performing stock market in 1996. Large emerging markets like Korea, Thailand, and South Africa also suffered heavy losses, with their IFCI indexes falling 39%, 38%, and 19% for the year in reaction to domestic economic problems.

The term "emerging stock markets" most often is intended to mean stock markets based in developing economies. But even by this simple definition, emerging stock markets vary tremendously in size, liquidity, and sophistication.

Many emerging markets have come into existence only in the last few years-witness the rapidly growing list of markets in economies making the transition from communism. Others are even more new-born, and still others are expected to debut, for example, Vietnam. Another category are the reborn markets, such as Egypt, which existed in principle for a century but only recently began operating again as a real marketplace for capital. Others have been around for decades and form the core of today's emerging market portfolios.

Stock markets currently categorized as "emerging" include some of the largest and most liquid markets in the world, several long-established markets where trading still takes place over tea, and many markets where the latest technology has been installed to expedite trading, settlement, portfolio management, market supervision, and information dissemination.

In short, this group of markets is so diverse that no generalities apply. Still, some useful insights about their progress in becoming developed marketplaces for capital can be inferred from aggregate figures on listing activity, trading activity, and new issue activity.

The standard quantitative indicators of stock market development were up in most emerging markets in 1996, and also up in the aggregate. The number of companies listed in the 27 constituent markets of the IFC Composite indexes rose 7.5%, for instance, due largely to a dramatic increase of listings in the People's Republic of China (up 67% in 1996, to 540 companies) and Malaysia (up 17% to 621 firms). Markets that saw a decline in the number of listed companies typically did so for good reasons; Czech Republic, Egypt, and Peru are among those that delisted shares of companies that had not traded for years or that did not comply with listing requirements. The trend to overall increases in listings is illustrated by the small gains in listings evidenced by Korea (5% more listings) and Thailand (9% more), despite the generally poor market conditions these markets experienced throughout 1996.

The net increase in market capitalization of emerging stock markets-up 16% over the end of 1995 to $2.1 trillion-was generally in line with the increase in listings, new issues by already-listed companies, and share price increases registered during the year. Despite the net increase in new listings over 1995 figures, fewer companies are estimated to have raised capital via stock offerings in 1996 than in 1995 (2,385 vs. 2,700), and the estimated aggregate amount of capital raised fell to $35.8 billion from 1995's $43.8 billion. The decline is due almost entirely to decreases in new issue activity in Korea and India during 1996.

Trading of shares within emerging markets rebounded strongly in 1996, up 49% in value terms, to almost $1.5 trillion, from 1995's figure. Though this is still below 1994's record $1.6 trillion in "home market" trading, it is remarkable for a number of reasons.

First, the increase in home market trading occurred at the same time as an 11% increase in the trading of exchange-listed American Depositary Receipts (ADRs) for emerging market stocks. This rose to almost $108 billion from $97 billion traded in 1995, according to figures published by Citibank. The fact that trading in emerging market stocks' home markets increased in 1996, even as more companies chose to issue ADRs and as substantial amounts of trading activity likely shifted to U.S. and other international money center exchanges, indicates an increase in emerging market stocks' liquidity on a global basis.

In addition, few emerging markets in 1996 suffered from a decline in liquidity (as measured by value traded) that exceeded the general decline in share prices. This indicates that for these markets, at least, overall trading volumes remained equal to last year.

These simple indicators of market development-increased breadth as measured by new listings, increased size as measured by market capitalization and new issues, and increased liquidity as measured by value traded-all point to 1996 as a year of progress.

Indicators more difficult to determine, but which may be even more important, are the "soft," qualitative matters of improved market efficiency in terms of transaction costs; clearing, custody and settlement procedures; corporate governance and disclosure standards; accounting and auditing standards; and standards of company and economic research. Progress here is very sensitive to individual market conditions and thus difficult to generalize. But the apparent trend on the part of emerging market companies, brokerage firms, stock exchanges, and regulators is toward increased accommodation to the legitimate demands of domestic and international investors.

Other indicators of market development are the increasing range of financial products and services available in emerging markets and from international sources. Examples include a growing list of financial futures and options in the emerging markets themselves, stock options and index futures trading at international exchanges, and an active international over-the-counter index swaps market. Index funds for emerging markets have captured an estimated $10 billion of international capital, and the technique-managing a basket of stocks to provide the return posted by an index-is spreading to domestic fund management, as evidenced by the launch of a Greek mutual fund based on the IFCI Greece Index.

International portfolio flows to emerging markets and emerging market stocks picked up in 1996, according to many sources. The World Bank's Global Development Finance (formerly, World Debt Tables), provides preliminary estimates of approximately $45.7 billion of new foreign money for emerging stock markets. This represents the first increase in annual flows since 1993. In addition, 1996's estimated flow set a new record in this regard, easing past 1993's $45 billion. While other sources differ as to the amounts of the flows, they agree that 1996 saw a major increase after two years of no growth in net new cash flows.

Looking at allocations on a regional basis, Latin America received the most ($16.5 billion), followed by East Asia and the Pacific ($12.9 billion), Europe and Central Asia ($6.7 billion), South Asia ($5.4 billion), Sub-Saharan Africa ($3.6 billion), and Middle East and North Africa ($0.7 billion).

The World Bank estimates that almost $177 billion of foreign portfolio capital has moved into emerging markets' stocks over the course of the 1990s. The total amount of foreign portfolio investment in emerging stock markets (directly and indirectly through depositary receipts and other vehicles) at the end of 1996 is estimated by IFC at around $230 billion, with dedicated emerging market funds accounting for about two-thirds of the total. The balance comes from global/international equity funds, hedge funds, and institutions and retail investors via direct purchases.

The motivations behind the increased portfolio flows of 1996 can be summarized as:

Interest in emerging markets as relatively high-growth economies. Real GDP growth in 1996 for major emerging markets has been estimated by the Institute for International Finance at 4.7%, and forecast for 1997 at 5.7%, double the average for the G-7 countries. Many economists expect this differential in growth rates to persist for years, if not decades.

Perception of decreasing risk in emerging market economies as a group. Formal credit ratings were upgraded in many cases during 1996, while many markets received ratings for the first time. In addition, spreads on yields of emerging market debt versus developed country sovereign debt tended to narrow over the period, even in the absence of formal re-ratings. In part, the improved ratings were due to greater opening of local financial markets and evidence that privatization programs and other economic reforms were taking hold. These were all confidence-building factors for foreign portfolio investors.

Interest in emerging markets as a means of diversifying opportunities at relatively attractive valuations. With many developed stock markets setting highs on a daily basis in 1995 and 1996, many investors in U.S. and European stocks wished to shift some of their gains and new cash flows into emerging markets. Japanese institutions, on the other hand, began to more actively invest in emerging markets to improve returns and diversify out of Japanese financial assets under liberalized investment regulations, particularly after the Japan Pension Fund Association sanctioned emerging markets as a distinct asset class in mid-1996.

Greater access to emerging market stocks, particularly through Depositary Receipts. During 1996, 144 additional ADR programs were launched by companies from emerging markets, bringing the number of ADR programs from emerging markets to 556 from 42 countries. In 1996, such programs raised $8.9 billion in new capital, according to Citibank's 1996 DR Market Review. The increasing availability of emerging market securities on "approved exchanges" (stock exchanges approved by regulators of pension funds or mutual funds), such as New York or London, allows many investors to own stocks they might otherwise have been prohibited from buying. It also makes such stocks available to the interested retail investor.

Growth of domestic capital accumulation. The shift in emerging markets from pay-as-you-go pension systems to funded pension schemes that invest in a variety of asset classes is seen as offering a firm underpinning for long-term growth in emerging stock markets, especially in light of the relatively young labor forces of most emerging markets. In addition, many of the new pension plans offer international money managers new business opportunities to participate in the fund management business in a domestic context. Their presence as local participants with enhanced knowledge of the emerging markets contributes to a sense of confidence by the international investor community.

The upturn that started in 1996 accelerated through the first quarter of 1997-the IFC Investable Composite Index, for example, was up 12% over its December 1996 close. Fund managers are reporting significant increases in new money for emerging market exposure, pension funds are widely reported to be expanding their base allocations to emerging markets, and demand is rising for access to the "frontier markets" of the emerging market category. On the international side, the long-term trends favoring emerging markets are clearly gathering strength.

The same is true in emerging markets themselves. The secular trend is for greater listing, issuing, and trading activity in existing markets; more sophistication in these markets in all aspects of securities dealings; and, where markets currently do not operate, to start-up or reactivate them. Foreign portfolio investment is not a prerequisite for this to occur, or even necessarily a compelling factor.

Consider China's stock market. In spite of being largely closed to foreign investment, by the end of 1996 it had more than 600 listed companies with a market value of $130 billion, and trading of shares worth $256 billion over the year. The evolution of China's stock market so far is driven almost exclusively by the domestic forces of the savings' supply and demand dynamic.

The growth of other emerging markets is similarly driven by domestic forces, though perhaps to a lesser degree. There is no prospect that this will change soon. While foreign portfolio and direct investment acts as catalysts to accelerate developments, and in an increasingly integrated world economy these catalytic agents are becoming more active, the real impulse for the development and growth of emerging capital markets is "home grown." Therein lies their attraction.

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