Ramana Ramaswamy, Jorge Roldos, Donald Mathieson, and Anna Ilyina
Published Date:
April 2004
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One of the key issues in developing local securities markets as a stable source of funding for corporates is the development of an adequate domestic and international investor base. The scale and stability of that investor base will be influenced fundamentally by the nature of the returns and portfolio diversification benefits associated with holding local securities. This chapter therefore analyzes emerging market equities from two perspectives. First, it looks at the performance of this asset class from the perspective of global investors and considers how this performance may affect the scale and volatility of equity-related capital flows. Second, it examines emerging market equities as an alternative source of finance for the corporate sector, and analyzes how equity issuance in emerging markets has fared in relation to bank financing.

Emerging Market Equities as an Asset Class for Foreign Investors

The global investor base for emerging market equities includes dedicated emerging market funds, global or international funds that allocate a portion of their assets to emerging market equities in order to track either a world or regional equity index, and tactical investors, such as hedge funds. While the emerging market allocations of global equity funds are typically small—around 4 percent of total assets—the absolute amounts of these allocations can be sizable in relation to the market capitalization of emerging stock markets; for instance, the emerging market exposure of global equity funds (both dedicated and nondedicated) is estimated to have reached over a $100 billion in 2002 (about half the size of total market capitalization in Korea). For tactical investors in emerging markets, the objective is to achieve high absolute returns through market timing, given the high volatility of this asset class. For global equity funds, emerging market equities could provide a diversification play. Adding emerging market equities to portfolios dominated by mature market equities can at times provide a more favorable risk-return profile than investing exclusively in mature market equities, particularly when returns between the two assets are not closely correlated.

The global investor’s perspective on emerging market equities is somewhat different from that of the local investor, in part because the alternative investment opportunities facing the two are often rather different. Despite the strong drive toward financial market liberalization and integration, a number of emerging markets continue to have capital controls, and prudential and regulatory restrictions on the portfolio choices of institutional investors may constrain both local and global investors in different ways. The international investor is typically interested in the foreign currency returns available from investing in emerging market equities, and has access to several other classes of equities as alternatives; dedicated international emerging market funds, in particular, expect to obtain an equity premium on this asset class over longer periods. Local equity investors are mainly interested in local currency returns and risks, and for many of them the assets available for investment are much more restricted than for the global investor. Until recently, for example, retail investors in many emerging markets have had little access to fixed-income instruments; the alternatives in practice have involved the decision of whether to place money in a bank, to buy government bonds, or to invest it in stocks. As local fixed-income instruments become a more viable asset class in emerging markets in the future, the existence of an equity premium that compensates for the additional risk is likely to become an important issue for the investment strategy of local investors.

In any event, the global investor’s decision to invest in emerging equities is driven by risk-adjusted returns and by the potential portfolio diversification benefits associated with the extent of the correlation of these returns with the rest of his/her portfolio. In the next sections, the performance of emerging equity markets is reviewed, with a view to inferring how this performance affected the investment behavior of global investors as the asset class matured during the past decade.

Emerging Equity Market Performance

Emerging market equity returns have been relatively poor—both in absolute and relative terms—during the past decade. Between 1990 and 2002, the average annual return on the S&P/IFCI Composite53 was about 3.9 percent—less than half of the returns available from investing in the S&P 500 index or the NASDAQ. The returns on the Asian component of the IFCI Composite have, in fact, been in borderline negative territory; Latin America accounts for the bulk of the positive returns that this asset class has provided during the decade. In contrast to emerging market equities, emerging market international bonds have provided high returns. Indeed, investors tracking J.P. Morgan’s emerging bond index, EMBI+, could have obtained average annual returns of almost 15 percent between 1990 and 2002. Comparison with other “riskier” asset classes provides much the same story—U.S. high-yield instruments generated almost twice the return of emerging market equities in this period.

Not only have returns on emerging market equities been low, but volatility has been high, with Sharpe ratios for emerging market equity returns being significantly lower than those for both the S&P 500 and the EMBI + (Table 8).54 The cumulative impact of the underperformance of emerging market equities over the decade is illustrated starkly in Figure 4. One hundred dollars invested in January 1990 in a fund tracking the IFCI Composite would have grown to $166 at the end of 2002. The same investment tracking the S&P 500 index, in contrast, would have grown to $356. Investors tracking the EMBI +, however, would have been rewarded by asset growth of almost six times over the period.

Table 8.Equity and Bond Returns
ReturnsStandard deviationSharpe ratioReturnsStandard deviationSharpe ratio
S&P/IFCI Composite1−1.1326.0−0.2316.022060.42
Latin America−12.6832.2−0.5427.4029.20.69
MSCI EAFE2−19.8919.6−1.260.3119.4−0.36
S&P 500−18.8120.1−1.178.3412.40.09
EMBI+ Brady Broad313.6512.90.6814.4314.00.51
Merrill Lynch U.S. High Yield2.4311.1−0.2111.326.40.63
Sources: Bloomberg L.P.; and Datastream.

Asia: China, India, Indonesia, Korea, Malaysia, Pakistan, The Philippines, Sri Lanka, Taiwan, and Thailand. EMEA: Czech Republic, Greece, Hungary, Poland, Russia, Slovakia, Turkey, Egypt, Israel, Jordan, Morocco, South Africa, and Zimbabwe. Latin America: Argentina, Brazil, Chile, Colombia, Mexico, Peru, and Venezuela.

EAFE stands for Europe, Australia, and Far East.

EMBI+ Brady Broad started in 1991.

Sources: Bloomberg L.P.; and Datastream.

Asia: China, India, Indonesia, Korea, Malaysia, Pakistan, The Philippines, Sri Lanka, Taiwan, and Thailand. EMEA: Czech Republic, Greece, Hungary, Poland, Russia, Slovakia, Turkey, Egypt, Israel, Jordan, Morocco, South Africa, and Zimbabwe. Latin America: Argentina, Brazil, Chile, Colombia, Mexico, Peru, and Venezuela.

EAFE stands for Europe, Australia, and Far East.

EMBI+ Brady Broad started in 1991.

Figure 4.Equity and Bond Performances

(January 1990 = 1000)

Sources: Bloomberg L.P.; and Standard and Poor’s.

1 December 1990 = 100.

Splitting the last 10 years into the pre- and post-Mexican crisis phases—a benchmark often used to delineate the start of the increasing internationalization of emerging market crises—offers interesting insights. Between 1990 and 1994, the average annual returns on the benchmark emerging market equity index was about 16 percent—twice that of the returns available from tracking the S&P 500, and even somewhat higher than that of EMBI+. The Sharpe ratio for the IFCI Composite was also higher than that for the S&P 500, associated with a relatively lower volatility of returns for emerging market equities in this period. All that changed dramatically during 1995–2002. The returns on the IFCI Composite averaged a negative 3.75 percent, in contrast to about 10 percent returns on the S&P 500 and about 15 percent for EMBI+. Volatility of equity returns also increased significantly in emerging markets in the post-Mexican crisis period.

The performance of emerging equity markets during the 1990s stands in sharp contrast to that of mature market equities. On the one hand, for advanced economies, the existence of an expost equity premium—that is, higher returns available over the long run from holding stocks compared to the yields on a risk-free rate, usually a benchmark treasury bond—is generally accepted as a stylized fact; the premium is perceived as the higher compensation required for holding the riskier asset. The debate on the equity premium has essentially centered on whether it is “rational” for the premium to be as high as the realized 6 to 7 percent for holding stocks rather than bonds. Some have argued that the equity premium in the United States indeed has been historically high, but that the run-up in U.S. stock prices in the latter half of the 1990s, and the accompanying higher valuations and lower implied expected returns, has reduced the equilibrium equity premium, as investors have gradually adapted to the idea of holding stocks as a longer-term asset.55 In emerging markets, however, the equity premium has been negative over the period 1990–2002—the return on the IFCI Composite being almost 2 percentage points lower on average than that from holding the 10-year U.S. treasury bond.

ReturnsStandard deviationSharpe ratioReturnsStandard deviationSharpe ratio

Portfolio Diversification and Emerging Equity Markets

The negative equity premium on emerging market equities raises the issue of why a global investor ought to have an exposure to this asset class. It also raises concerns about the future viability of this asset class. As noted above, another determinant of foreign investor interest in emerging market stocks is their potential return enhancing and/or risk reducing function in broader equity portfolios. How much of that has materialized?

Figure 5 illustrates the historic risk-return trade-offs available for different portfolio combinations of emerging market and U.S. stocks, with a focus on international investors willing to allocate up to 10 percent of their assets to emerging market equities. During the period from January 1990 to December 2002, a portfolio consisting only of emerging market stocks was expost inefficient, as it returned the lowest possible annual average return (3.9 percent) for the highest possible risk (23.4 percent). In contrast, a portfolio that included only U.S. stocks would have provided a return of about 9 percent, the highest possible portfolio return. Hence, U.S. stocks were clearly more attractive than emerging market stocks from a tactical perspective—that is, when the focus is exclusively on returns. Moreover, emerging market stocks did not offer much in the way of diversification benefits in this period, as a 10 percent allocation to emerging markets did little to change portfolio risk, while providing a lower annual return of about 8.5 percent. For the investor wanting to minimize risk, the minimum variance portfolio would have consisted of only a 2 percent allocation to emerging market stocks.

Figure 5.Risk-Return Trade-Off for Combinations of Emerging Market Stocks and U.S. Stocks1

Sources: S&P/IFC EMDB; Bloomberg L.P.; and IMF staff calculations.

1 IFCI Composite total return index is used for emerging market stocks and S&P 500 total return index for U.S. stocks. Risk (in percent) is calculated as the annualized standard deviation of monthly returns and return (in percent) as the annualized geometric average of monthly returns.

In contrast to the experience of the decade as a whole, the first five years of the 1990s proved rewarding for global funds willing to hold emerging market stocks. A portfolio fully allocated to emerging market stocks not only experienced the highest return (about 16 percent annually), but also offered diversification benefits to international investors. A portfolio of exclusively U.S. stocks was ex post inefficient, returning 8.4 percent for a risk of 12.5 percent, whereas a 10 percent allocation to emerging markets would have provided about a 9 percent annual return for a marginal risk reduction. Such an allocation would have also been the minimum variance portfolio. The post-Mexican crisis period has been a troubling one for emerging market equities. Between 1995 and 2002, a portfolio composed exclusively of emerging market stocks would have been inefficient—negative 3.7 percent return for the highest portfolio risk (24.7 percent). In contrast, U.S. stocks experienced the highest portfolio return for the lowest risk. Portfolio diversification by inclusion of emerging market stocks offered no benefits to global investors in this period.56

Explanatory Factors

What accounts for the underperformance of this asset class from a longer-term perspective? The general inclination when seeking explanations of stock market weakness is to search for indicators of overvaluation. But unlike Japan, where long-term stock market weakness has been lied to the Overvaluation associated with the bubble in equity prices in the late 1980s, valuations do not appear to be the key factor for explaining the longer-term performance of emerging equity markets. Figure 6 indicates that while the price/earnings ratio for the IFCI Composite has been high during certain episodes, it has on the whole been significantly lower than that of the S&P 500 for much of 1990–2002. Other valuation indicators such as the price-to-book ratio and dividend yields also do not indicate the picture of a structurally overvalued emerging equity market for the entire period.

Figure 6.Valuation Indicators in Emerging Equity Markets

Sources: Bloomberg L.P.; and Standard and Poor’s.

1 EAFE stands for Europe, Australia, and Far East.

Market participants argue that the key factor generating both the poor returns on emerging market equities and the reduced diversification benefits has been the experience with financial crises during the second half of the 1990s. A siring of financial crises, starting with Mexico in 1995, Asia in 1997–98. Russia in 1998, Brazil in 1999, and, more recently, in Turkey and Argentina, culminated in prominent currency depreciations and severe contractions in the level of economic activity in emerging markets. The downturn in economic activity and currency depreciations that accompanied these crises severely weakened both the income and balance sheet position of local corporates, especially in situations where the corporate sector had large foreign currency exposures. Moreover, the restructuring of corporate balance sheets at times involved lengthy negotiations and legal complications that further affected corporate performance. Such poor corporate performance was readily reflected in sharp declines in equity prices, over and above the decline in the value of many emerging market currencies.57

The large depreciations associated with these crises also had a strong impact on the returns earned by foreign investors, especially for many emerging equity market funds that tended not to fully hedge their currency exposures. As a result of this experience, foreign investors, whose holdings account for between ¼ and ½ of the market capitalization of some of the largest emerging equity markets, appear to have become more averse to currency risks.

As noted earlier, the second half of the 1990s witnessed a decline in the diversification benefits associated with holding emerging market equities. In part, this reflected the higher correlations between the equity returns in the various countries affected by the emerging market crises. However, this period also saw a trend increase in the correlation between emerging and mature stock returns (Figure 7). This higher correlation related in part to the global effects of some mature market crises (such as the one associated with the failure of Long-Term Capital Management) and the sectoral investment strategies adopted by many global equity investors in connection with the sharp rise and subsequent decline of equity prices in the technology, media, and telecommunications (TMT) sector in the latter part of the 1990s (see Brooks and Catao, 2001).

Figure 7.Correlations Between Returns in Emerging and U.S. Equity Markets

Sources: Bloomberg L.P.; and IMF staff calculations.

While crises in emerging and mature markets affected the relative performance of emerging equity markets in the first and second halves of the 1990s, there are certain structural weaknesses that influenced equity market performance throughout the decade, although they became more evident to investors during periods of weak performance. In particular, liquidity, asymmetric information, and corporate governance considerations have had a dampening effect on the performance of emerging market equities. In many emerging markets, a few prominent companies constitute the bulk of the market capitalization of country indexes put out by the IFC and MSCI, and quite often the free float constitutes a small fraction of the companies’ market capitalization. Firms included in these indices often tend to be privatized utilities, natural resource and transportation-related companies, or banks, which continue to maintain direct or indirect links to the state and have limited opportunities for future growth. Also, foreign investors worry that adjustments in their holdings of these stocks will lead to large price movements, as the size of the free float is quite small relative to total market capitalization. Generating high returns in emerging equity markets therefore requires going beyond these companies, and picking out-of-index companies with good growth prospects. Market participants argue that many such publicly listed companies do exist, and have attractive valuations, particularly in Asia, where price/earnings ratios on the IFCI index are often much higher than that of the corresponding local index.58 However, foreign investors do not generally invest in out-of-index stocks either because of liquidity considerations or simply because they are unaware of the potential of these stocks, since international investment banks do not include them in their research coverage.

Issues of transparency and corporate governance have also weighed negatively on emerging market equity performance. In many emerging markets, analysis have concerns about the accuracy and transparency of corporate earnings reports—especially for the case of closely held companies—and asset managers distrust analysts’ research. Indeed, in a recent survey (Montagu-Pollock, 2001), a large majority of fund managers (76 percent of the sample) responded that they were not happy with the independence of the research they got from investment banks. Poor corporate governance has been identified as one of the causes of the recent Asian financial crises (see, for instance, Claessens, Djankov, and Lang, 1998), with ownership largely concentrated in the hands of families and the state, in part through the use of pyramid structures, deviations from one-share-one-vote rules, cross holdings, and the appointment of managers and directors who are related to the controlting family. Also, the need to attract strategic investors during the privatization processes of the 1990s in some European and Latin American countries was accompanied by weak minority rights that contributed to abuses from controlling shareholders. Over the past few years, several emerging markets have approved capital market laws that include measures aimed at strengthening minority rights and improving corporate governance and transparency.

The migration of the listings of top-quality emerging market corporates to major mature market financial centers has also taken a toll on the liquidity of emerging equity markets, A common way of raising equity capital in international markets is to issue depository receipts that trade in the United Slates (American Depository Receipts or ADRs) or in the rest of the world (Global Depository Receipts or GDRs).59 In general, companies list on a local exchange initially and then offer part of their equity to international investors through depository receipts. During the 1990s emerging market issuers raised on average $7 billion a year through ADRs, but issuance levels in recent years have averaged around $22 billion—though that includes the peak year of 2000. Latin America entities were the most active issuers of ADRs in the early 1990s, but more recently the focus has shifted to Asia. In the early 1990s, about 60 percent of international equity issues took the form of ADRs; this has risen to almost 80 percent in the past three years, with Latin American issues being almost exclusively in the form of depository receipt programs. Market participants argue that lot some prominent Latin American stocks, price discovery is done in New York rather than in the local markets.60

Along with ADRs, the delisting of stocks from local stock exchanges in emerging markets has also had a negative impact on the asset class. Delisting has been a significant problem in Central Europe, Latin America, and South Africa. In Hungary, for instance, a number of companies have delisted from the local stock exchanges because they have been taken over by multinationals—in 1999, FDI firms accounted for 50 percent of book value added in the nonfinancial business. Similarly, a large number of delistings by foreign companies of their Argentine subsidiaries accounts for a large fraction of the fall in the country’s stock exchange market capitalization. In South Africa, some local companies decided to migrate and list abroad to take advantage of the larger investor base and overcome the size limitations of the local market. Delistings have been less of an issue in Asia. A number of prominent companies listed in the local stock exchanges are state-linked, and even in the case of purely private companies, the urge to delist from the local stock exchanges has been precluded by a mixture of nationalism and subtle political pressure.

Implications for Capital Flows

The sustained poor performance of local emerging market equities has sharply altered the global investor base for emerging market equities. For example, dedicated emerging market mutual funds have in some cases witnessed declines in assets under management of one-half. The role of crossover investors, such as pension funds and insurance companies, and tactical investors, such as hedge funds, has increased, and their focus is on opportunistic trading. As noted earlier, the robust performance of emerging equity markets since early 2002 has attracted investor focus on this asset class once again, with a number of global investment banks recommending their clients to go overweight on emerging market equities (see Salomon Smith Barney, 2002; and Goldman Sachs, 2002). As tactical investing in emerging equity markets gains in relative importance, it is likely to accentuate the already volatile net inflows into emerging equity markets. And such a prospective increase in volatility is also likely to have spillover effects into other emerging asset markets, particularly to the currency markets.

Domestic Equity as an Alternative Source of Funding

In response to the emerging market crises of the late 1990s, a number of analysts and policymakers recommended the development of local securities markets as an alternative source of funding for the corporate sector to ameliorate the impact of a banking or external funding crisis. While the emphasis has been largely on the development of local bond markets, the need to reduce the leverage of several large corporates in Asia, combined with the desirability of having more flexible financial structures in volatile environments, has raised the issue of the stock market as a source of finance.

The value of stock market capitalization has been approximately equal, on average, to the value of outstanding bank credit over the last decade in emerging markets (Figure 8). Although this constitutes only a rough approximation of the pattern of corporate finance in emerging markets, it shows the relative importance of equity financing. There are significant differences, however, across time and regions, bank credit is much larger than equity market capitalization in Asia, while the opposite applies to Latin America and Central Europe. The collapse in equity prices in Asia in 1997 and 1998 accounts for a large share of the fall in market capitalization during these years, and the TMT-led rebound in valuations across the whole spectrum of emerging markets in 1999 explains the reverse phenomenon during that year. Outstanding bank credit grows steadily during the decade in Central Europe and Asia (with the exception of Asia only in 1997), while it flattens out in Latin America after 1994.

Figure 8.Stock Market Capitalization and Bank Credit

(In billions of U.S. dollars)

Sources: International Monetary Fund, International Financial Statistics; and IMF staff estimates.

In contrast to the similar orders of magnitude in the stocks of debt and equity, bank lending has dominated domestic equity issuance in emerging markets. Between 1990 and 2002, the size of bank flows has been approximately 10 times the size of the equity flows (Figure 9, upper panel). However, volatility has also been substantially greater. This is explained in part by the fact that bank lending is short term and hence needs to be rolled over, while equity is, generally speaking, a permanent source of finance. Nevertheless, the flow data show that, while relatively small in absolute size, equity finance was a relatively resilient source of finance during the Asian crisis. The sharp fall in domestic equity issuance between 2000–02 raises doubts, however, about the long-term prospects of initial public offerings in local markets going forward, an issue that is related to the internationalization of equity markets. As Figure 9 (lower panel) shows, international equity issuance has dominated local equity issuance over 2000–02. Despite that, international equity issuance in emerging markets itself has declined in recent years, with the decline being particularly precipitous in Latin America, related in part to the slowing down of the privatization process (Figures 10 and 11).

Figure 9.Valuation Indicators in Emerging Equity Markets

(In billions of U.S. dollars)

Sources: International Monetary Fund, International Financial Statistics; and IMF staff estimates.

Figure 10.International Equity Issuance by IPO and Privatization

(In numbers)

Sources: Dealogic; and IMF staff estimates.

Figure 11.International Equity Issuance by IPO and Privatization

(In billions of U.S. dollars)

Sources: Dealogic; and IMF staff estimates

While the internationalization of equity markets has helped top-quality emerging market corporates to raise capital at a lower cost, it may thwart efforts to develop local equity markets as an alternative source of finance. The trend toward the internationalization of equity markets is a result of the dramatic reduction in transaction costs associated with improvements in information and computation technologies.61 The associated reduction in the cost of raising capital in the most advanced exchanges, combined with the integration of capital markets, has made evident the inefficiencies existent in several local emerging equity markets. Several of these markets are reducing listing requirements and other costs associated with initial public offerings, and they are establishing alliances with other exchanges to increase the investor base for local issues (see below for a more detailed discussion). It remains unclear if these local efforts could compensate global trends toward the consolidation of equity market activity in the most efficient financial centers. However, the poor performance of local emerging equity markets during the second half of the 1990s is not necessarily a harbinger of future performance. A more stable macroeconomic environment and improved corporate governance and transparency would nonetheless be key elements in furthering the development of these markets. In this regard, the ADRs and GDR programs of emerging market corporates are also likely to play important roles in helping improve corporate transparency and governance.

Stock Exchanges: Developments and Issues in Emerging Markets

Stock exchanges worldwide have been under pressure in recent years. The bear market in equities has shrunk trading volumes literally everywhere and reduced the earnings potential of many exchanges. Moreover, the growth of large automated trading platforms known as electronic communications networks (ECNs) have also put pressure on floor-based trading exchanges. Their capacity to process large quantities of information faster has meant that they have offered less expensive access to buyers and sellers of financial assets than traditional exchanges do. In many industries, pressures of this kind usually lead to a spate of mergers and acquisitions, as firms try to consolidate to compete better in a difficult environment. In stock exchanges, however, mergers and acquisitions have been less prominent, for reasons discussed at greater length below, and the industry has continued to face turmoil.

The pressures faced by stock exchanges in emerging markets (which is the focus of this chapter) have been even more acute in recent years. In addition to the bear market in equities, a drop in IPOs associated with the reduction in privatization and a spate of delistings have called into question the viability of many stock exchanges in emerging markets. Moreover, the drying up of liquidity associated with these developments has meant that the role of the stock market in intermediating finances for economic development has been dented to some extent, which has the potential to create difficulties of a systemic nature in many emerging market economies. This is particularly important, given the findings of recent research that the combined financial intermediation effects of stock markets and banks have a statistically and economically large positive impact on economic growth—with the extent of the development of stock markets having a positive effect on economic growth that is independent of the impact due to banks.62

In view of the favorable impact that deep and liquid stock markets can have on economic growth, it becomes particularly important to have a proper understanding of the forces that have put pressures on stock exchanges in emerging markets. This section carries out such an analysis, and also discusses the response of the various stock exchanges to the difficulties that they face.

Stock Exchanges Under Pressure

As discussed in the previous sections, emerging market equities have not only underperformed mature market equities in recent years, but also posted negative returns. Moreover, global equity portfolios that include emerging market equities have offered little in the way of diversification benefits over the past five years. Given this difficult environment, it is not surprising to find that stock exchanges in emerging markets have faced acute pressures on profit margins.

The underperformance of the equity market by itself need not necessarily have to compress profit margins of stock exchanges, however. If trading volumes are sufficiently high, because investors resort to reshuffling their portfolios frequently to deal with an environment of low or negative returns, then the stock exchange as an entity should be less adversely affected than holders of equities. But as can be seen from Figures 12-14, trading volumes in many prominent emerging markets have declined sharply in recent years, with the decline being particularly precipitous in countries such as Malaysia, Argentina, Brazil, Hungary, and Poland.

Figure 12.Monthly Dollar Trading Volume for Selected Asian Countries

(In billions of U.S. dollars)

Sources: Standard and Poor’s.

Figure 13.Monthly Dollar Trading Volume for Selected Latin American Countries

(In billions of U.S. dollars)

Sources: Standard and Poor’s.

Figure 14.Monthly Dollar Trading Volume for Selected European Countries

(In billions of U.S. dollars)

Sources: Standard and Poor’s.

While the decline in trading volumes has provided the essential backdrop for the pressures faced by the stock exchanges in emerging markets, other factors have accentuated these pressures. The deregulation of brokerage commissions has increased the competitive pressures on the exchanges, particularly where profit margins were maintained through a mixture of barriers to entry and antiquated trading and governance structures. The fact that many of the exchanges in emerging markets tend to be member owned has been a factor that has obstructed the technological evolution of electronic trading. Many of the members of these exchanges came from small brokerages and could not afford the fixed costs involved in instituting ECNs, but resisted takeovers by bigger players who had the capacity to restructure. Notable exceptions to this pattern have been the stock and derivatives exchanges of Hong Kong SAR, which merged and demutualized, and the stock exchange of Singapore, where shares were offered not only to the existing members of the exchanges but also to banks and other institutional investors. These developments allowed a radical restructuring of these exchanges and made possible a more flexible and efficient organizational structure for trading. As a result, these exchanges are now playing the role of regional hubs with many prominent companies in Asian countries preferring to list in the exchanges of Hong Kong SAR and Singapore. While there has been consolidation of the stock exchanges in many emerging markets (through, for instance, the merging regional exchanges within a country, as in Brazil), the process of demutualization and instituting ECNs has been somewhat patchy when compared with the changes that have taken place in Hong Kong SAR and Singapore.

As noted briefly in the earlier sections, stock exchanges in emerging markets have also been buffeted by declines in the number of IPOs, the increasing tendency of some prominent companies to take the ADR/GDR route, and the delisting of companies altogether from local markets as they gel acquired by multinationals. These developments, which have been largely confined to Latin America and Central Europe, but which have also cropped up in Asia more recently, are discussed immediately below. The steps taken by the various stock exchanges to respond to these pressures is explored later in this chapter.

The stock market and the exchanges in Central Europe were kept buoyant by a wave of privatizations during 1995–97 (see Box 5 for the Russian experience). Once the initial privatizations were completed, a number of smaller companies came on stream and issued IPOs, particularly during 1999–2000. The IPO market has dried up, however, particularly in Hungary and Poland during the last two years—for instance, there were no IPOs issued in Hungary in 2001. A number of companies have preferred to take on a strategic investor rather than go through the IPO route. In addition to the paucity of IPOs, liquidity in the exchanges of Central Europe has been reduced by delistings than by local firms taking the ADR/GDR route. In Hungary, in particular, multinational participation in the economy is substantial, and a number of local firms have delisted from the local exchanges as they have been taken over by multinationals. All of this has raised the issue of the viability of the stock exchanges in Central Europe.

In Latin America, the string of financial crises since the mid-1990s has constituted the essential backdrop under which the stock exchanges have found themselves under pressure. As in Central Europe, the local equity market has not served as an important source of funding for corporates in Latin America during the past few years. For instance, there have been only 10 primary equity issues in Brazil between May 2000 and May 2002, fewer than the number of delistings during this period. However, the pressures on the stock exchanges in Latin America have owed more (in the relative sense) to firms taking the ADR/GDR route than due to delistings. A number of securities taxes in Brazil and capital controls in Chile, For instance, have made listing and trading ADRs in New York more attractive for many firms than listing and trading in the local exchanges.

Stock exchanges in Asia have been under much less pressure than those in Central Europe and Latin America. While the IPO process has slowed in Asia in 2000–02, it has not been battered in the way that it has been in the other emerging market regions. Delisting of companies from the local market and the issue of ADRs/GDRs have also been a less prominent feature of the Asian equity landscape. In Malaysia and Singapore, for instance, many of the listed companies are state linked and are unlikely to be taken over by multinationals and delist from the local market. But even in the case of purely private companies, the urge to delist from the local exchanges is and will be precluded by a mixture of nationalism and subtle political pressure; stock exchanges in Asia are perceived as national symbols, much in the way that national airlines are, and are likely to be bolstered by the state as they face pressures. While private companies in these countries can take the ADR route, they are in general too small for this to be a systematically profitable option.

Factors Driving Companies to take the ADR/GDR Route

Delisting and taking the ADR/GDR route are phenomena that are not just confined to emerging market stock exchanges, but are also pervasive in the case of mature market stock exchanges. While one may expect that as capital market integration proceeds, geography could become increasingly irrelevant to the process of raising finance, that does not seem to have happened in practice. The number of companies seeking a foreign listing has increased throughout the 1990s both in emerging markets and the mature markets of Europe. Exchanges in the United States have been the main beneficiaries of this trend. Companies tend to cross list in the more liquid and larger markets, and in markets where companies from their industry are already cross listed, and this makes the exchanges of the United States a natural destination for many firms. In response to this business opportunity, U.S. exchanges and regulators have made a concerted effort to reduce regulatory costs and facilitate foreign listings. For instance, in the early 1990s the Securities and Exchange Commission in the United States became significantly more cooperative toward non-U.S. companies trying to register in the United States; this change in attitude was apparently prompted by stock exchange officials who regarded the listings of foreign companies as an attractive business Opportunity for themselves.

Box 5.The Equity Market in Russia

The Russian equity market has been one of the best performing stock markets in recent years. Over the last two years the RTSI dollar index has returned about 50 percent annually. Its five-year performance has been even more impressive—returning about 58 percent annually. This rapid growth in stock prices has raised the issue of whether there has been an “irrational exuberance” for Russian stocks. This box offers a brief overview of the institutional framework of the Russian stock market, and provides an analysis of whether the run-up in Russian stock prices is sustainable in terms of fundamentals.

The Structure of the Russian Stock Market

There are two main organized exchanges for trading equities in Russia—the Russian Trading System (RTS) and the Moscow Interbank Currency Exchange (MICEX). The RTS currently includes 386 stocks representing 244 listed companies. The RTS dollar-denominated index, consisting of 59 stocks, is viewed as the benchmark Russian equity index, both locally and internationally. The MICEX, which originally specialized in currency and debt trading, began trading equities in 1997. There are about 200 stocks listed on MICEX, and it is the favorite trading platform of local investors. There is reportedly a high level of leverage used in trading stocks listed on MICEX and pervasive day trading. However, since the price discovery process for stocks takes place in the better managed RTS (with MICEX market makers often using RTS prices as indicative quotes), the high leverage used by MICEX brokers, by itself, has not impinged on valuations in those stocks that are traded in both exchanges.

There are very few restrictions on foreign ownership of Russian equities, and there is no general regulation that limits foreign investor participation in the local equity market. However, there are several special cases. The most prominent example is Gazprom, where nonresidential holdings of the company’s share cannot exceed 20 percent of its charter capital. However, the effective ceiling is even lower, as foreign investors can only buy Gazprom ADRs and not the local shares (the total value of ADRs is less than 4 percent of the company’s market capitalization). The presence of such restrictions largely explains the sizable ADR premium for Gazprom shares, which does not exist for other Russian stocks. In addition, Gazprom shares can be traded on four exchanges only—the Moscow Stock Exchange, St. Petersburg Stock Exchange, and two other small regional exchanges. Other special cases include shares of UES and Sberbank. The limit on foreign ownership of UES shares is 25 percent, while for Sberbank it is 12 percent.


The run-up in Russian stock prices, by itself, does not indicate whether there is a bubble or not. Conceptually, this can be viewed as the obverse of the situation in Japan, or for that matter in the NASDAQ—where stock prices have fallen by about 75 percent from peak levels, but they are still considered by a number of market participants to be overvalued. A straightforward way of looking at the issue of whether the run-up in equity prices in Russia is a source of concern is simply to look at valuations. The price-earnings ratio for the RTSI is currently only about 8–9. The price-earnings ratio for the IFCI (Russia) and MSCI (Russia), indexes that represent investibility for foreign investors is even less—in the range of 6–7. In contrast, the price-earnings ratio for the IFCI Composite, the benchmark dollar based index for emerging market equities is about 15; for the S&P 500 it is about 28. That is, in terms of the price-earnings ratio of the broad stock indexes, the Russian equity market does not look overvalued despite the dramatic run-up in equity prices.

Given that almost 70 percent of the market capitalization of the RTSf is oil related, it is necessary to go beyond macro-valuation measures, such as the price-earnings ratio, and look more closely at sectoral valuation measures. In particular, it is necessary to evaluate if Russian oil companies are fairly valued or not. The price-earnings ratio has certain limitations as a valuation measure—it does not take the financing structure of companies into account, and also fails to take account of accounting idiosyncrasies, making relative value comparisons difficult. An alternative valuation measure preferred by many analysts for making revalue value comparisons is the ratio of the enterprise value to earnings before interest, taxes, dividends, and amortization (EV/EBITDA); enterprise value is defined as the sum of a company’s market capitalization and debt.

On an EV/EBITDA measure, Russian oil companies appear cheap on both absolute and relative grounds. Russian oil companies, on average, have an EV/EBITDA of about 2.5, compared to about 4 for some of the prominent oil companies in emerging markets and about 6 for the major oil companies in mature markets. Market participants argue that doing relative value analysis for oil companies is a lot easier than is the case with some other industries—the oil industry produces basically a homogenous commodity with a well-defined production process, and fuzzy concepts such as goodwill do not enter into the valuation process. Market participants also offer other anecdotal evidence to indicate that Russian oil companies, and by implication the stock market as a whole, is still cheap despite the run-up in equity prices; for instance, it has been estimated that Yukos, one of Russia’s largest oil companies, has a market capitalization that is about one-third of Chevron Texaco despite producing half its output, having oil reserves that are larger and production costs that are significantly lower. Moreover, market participants note that Russian oil companies are in the process of entering into strategic agreements with foreign oil companies—the recent strategic alliance between BP and TNK, which is expected to ratchet up significantly the inflow of foreign direct investment into Russia, is the most prominent example, Russia is also planning to enhance the pipeline structure with collaboration agreements with both China and Japan, and these developments are expected to add significantly to export capacity of the oil industry and the earnings potential of the Russian oil companies.

Russian metals and telecoms are also evaluated to be cheap when looked at in relation to EV/EBITDA measures for comparable sectors in other emerging markets. Wimm-Bill-Dann’s (the food company) successful IPO last year sparked a tremendous interest in Russian consumer good stocks. But market participants note that Wimm-Bill-Dann as well as the other prominent Russian consumer goods companies are not cheap on a relative value basis. Thus, the attractiveness of the Russian equity market essentially appears to be an oil and metals story.

Investor Base

The investor base for Russian equities appears to have evolved and stabilized in a form that is likely to offer support to the stock market. A combination of local investors and foreign dedicated emerging market funds slowly began to increase their exposure to Russian stocks in the first half of 2000, stabilizing a market that had been badly affected by the events of August 1998. In the second half of 2001, a new type of investor—global equity funds with sectoral allocations—started buying up several Russian stocks as part of a relative value play on the global oil and gas sectors—for instance going short on Shell and BP and going long on Yukos and Sibneft. Traditional global equity funds with country allocations have also started to evince an interest in the Russian market. These are typically conservative equity funds—their mandates warrant a time-consuming approval process before they can enter a new market—but once they enter the market it tends to be a relatively longer-term commitment. While hedge fund activity in Russian equities picked up last year, they have been late comers into the stock market, unlike in the case of eurobonds where they got in early and made considerable gains.

The entry of the global equity funds, along with MSCI’s decision to increase Russia’s weighting in its Emerging Market Free index, has been another factor supportive of the Russian equity market. As a result of the MSCI index rebalancing, the weight of Russia in the EMF index has risen to about 4 percent, roughly the same weight as India. Market participants expect MSCI to broaden the set of companies that it includes in its Russia index (primarily with additions from the telecoms sector), and this is expected to draw in more foreign investors into the Russian equity market. Investor interest is also likely to be perked up by a number of IPOs coming on stream in the years ahead.

Divestment of state shares in Russia is not expected to weigh down on the stock market in the way that it has in China, for instance. Unlike in China, where the state owns about two-thirds of the market capitalization in the equity market, the ownership structure of the Russian equity market is more diverse. Except in the case of notable exceptions such as Gazprom, UES, and Sberbank, radical privatization was essentially completed by 1996 in Russia. Ownership in many of the important companies are distributed among management, employees, strategic owners, and foreigners. Moreover, Russia does not have to privatize for fiscal reasons, and divestment in companies where the state has significant ownership can be done in a more controlled way by taking into account market timing. Nevertheless, despite the favorable fundamentals for Russian equities, concerns about corporate governance issues are likely to cap the upside potential for the stock market.

A number of recent academic studies have used panel data for identifying the driving forces of cross listing, and their conclusions throw important light on why many firms in emerging markets choose to take the ADR/GDR route (see, in this context, Pagano and others, 2001). The need for greater liquidity appears to be one of the most important factors in the decision to cross list, and explains why the exchanges of the United Slates have become the popular destinations for firms in emerging markets to list in. The larger size of the stock market not only provides access to a larger pool of potential investors, but being listed on a large stock market can confer greater visibility and reputation for a company.

Cross-listing decisions also appear to be influenced by informational cascades—i.e., by wanting to be where the peers are. If a company’s managers observe many competitors listing on a particular stock exchange, they are likely to infer that there might be advantages from imitating them, and are likely to cross list in a bigger and more liquid stock exchange, even when there may be no pressing economic requirement to do so. This competitive pressure to issue ADRs/GDRs may in part explain the extent of the pressures that stock exchanges in emerging markets have been confronted with in recent years. The discrepancy in accounting standards between the home country and the host country also appears to play a role in the decision to cross list. Listing in a country with better accounting standards allows the company to precommit to greater transparency and reduces the monitoring costs of its shareholders and their required rate of return. However, if the discrepancy in accounting standards between the home and the host country is too large, then the discrepancy may actually negatively affect the decisions of some firms to cross list. Another possible benefit of cross listing is to expose the company to the attention of additional financial analysts, and thereby to a wider investor base. However, in practice, academic studies do not find analyst coverage to be a significant explanatory factor of the decision to cross list.

The Response of the Stock Exchanges

Stock exchanges (both in emerging and mature markets) have responded in a variety of ways to deal with the pressures that they have been subjected to in recent years. For instance, some stock exchanges have decided to go public. Prominent examples are the London Stock Exchange and the Deutsche Borse. Going public has allowed these exchanges to mobilize funds for upgrading their ECNs and acquiring the capacity to compete better with rival exchanges. In other cases stock exchanges have sought alliances with each other to enhance liquidity. Prominent examples of this are Euronext—which is an alliance of the Paris, Amsterdam, and Brussels exchanges; Newex—which is an alliance of the Deutsche and Vienna Borses; and Norex—which is an alliance of the exchanges in Copenhagen, Stockholm, Oslo, and Iceland. The process of forming alliances to survive appears to be still in its infancy among emerging stock exchanges. Particularly in the case of the Asian exchanges, where stock exchanges tend to be local monopolies, the pressure to consolidate in response to technological innovation has been much less than for exchanges in the United States; it has been estimated, for instance, that the number of stock exchanges in the United States came down from over a 100 in the nineteenth century to about live major stock exchanges currently in response to the competitive pressures exerted by technological innovation (see Shy and Tarkka, 2001).

In Central Europe, the Warsaw stock exchange has taken strides to restructure. The Warsaw stock exchange, which is the biggest in the region, is now a fully electronic order driven market and has instituted a number of new rules to make trading transparent. The exchange has been in talks with Euronext to form a loose alliance and has aspirations to become a regional hub in Central Europe for Hading equities. The Budapest stock exchange has put in place plans to demutualize and list as a public company. To make mergers and acquisitions possible, the Hungarian administration has abolished the rule that limits individual ownership to no more than 10 percent of the exchange. The Budapest stock exchange has also recently instituted talks with both Euronext and the London Stock Exchange for forming a loose partnership; it intends, however, to maintain its independence. The Czech stock exchange has also come up with plans to demutualize.

Local stock exchanges in Latin America have also taken a number of steps to revive activity and make themselves viable entities. In Brazil, the Sao Paulo Stock Exchange (BOVESPA) has introduced a new market—O Novo Mercado—available only to companies meeting stricter rules on corporate governance. The Novo Mercado is a listing segment designed for trading shares issued by companies that voluntarily undertake to abide by good practices of corporate governance and disclosure requirements that go beyond those already requested by Brazilian legislation. It is hoped that this would reduce the pressure for companies wanting to delist for “reputational” reasons. In Chile, the Stock Exchange of Santiago has recently launched the Mercado Emergente, a new segment for “emerging enterprises.” Recently established firms with innovative business plans and a potential for strong growth can receive financial assistance for the registration of costs and list in the local stock exchange. Despite the measures taken by the stock exchanges in Latin America, many analysts consider the liquidity problem to be serious, particularly in Chile, where the reforms are viewed as having come too late to bring liquidity back into the stock markets.

As already noted, the stock exchanges in Asia have been under relatively less pressure than those in other emerging markets. In particular, the exchanges of Hong Kong SAR and Singapore have already completed the process of demutualizing and going public and are in relatively good shape to face the challenges ahead. The stock exchanges in Singapore and Australia have recently formed an alliance that allows them to trade in each other’s exchanges. A full-fledged merger of these two exchanges is seen as being unlikely for nationalistic reasons; moreover, a merger is not seen as necessary for developing the equity asset class in these two countries. The Thai stock exchange perceives cross-border trading of stocks between it and the other regional exchanges, rather than cross-border listing, as a preferred option. This is also true of the Malaysian stock exchange. Here, there is an essential asymmetry between Singapore and the other countries in the region—whereas Singapore would like to function as the regional hub, its neighboring stock exchanges are less interested in losing their distinctive identities. The stock exchanges in China are relatively new, and despite the fact that a number of Chinese companies have been listing in Hong Kong SAR and Singapore, they have not been subject to the same kind of pressures seen in other emerging markets (see Box 6). In fact, with firms queuing up to list in the Shanghai exchange, the exchange can afford to be sanguine about Chinese firms listing abroad; the Shanghai stock exchange foresees a situation in which dual listing becomes the norm for many Chinese firms. The Korean stock exchange, which is currently run as a sell-regulating nonprofit organization that provides a trading platform for stocks, bond index futures, and options, also appears to have no immediate plans to demutualize.


Emerging market equities can provide global investors with attractive absolute returns as well as an avenue for diversifying their portfolios. The evidence indicates that investors reaped such benefits in the first half of the 1990s, but that the gains disappeared between 1995 and 2001. This deterioration in the performance of emerging market equities gave rise to tactical investors, whose opportunistic behavior is likely to increase the volatility of capital inflows into emerging markets. The underperformance of emerging market equities from a longer-term perspective does not appear to be primarily due to overvaluation, though price/earnings ratios in emerging market equities have been high in some years. Some of the main factors in this underperformance are (1) a string of financial crises, starting with Mexico in 1994, that has drastically pruned the U.S. dollar returns on emerging market equities; (2) concerns about corporate transparency and governance; and (3) the growing importance of American Depository Receipts (ADRs) and delistings, which has also reduced the universe of liquid stocks in emerging markets and has thinned both the domestic and global investor base. While the stocks of debt and equity are of similar sizes, bank lending has dominated domestic equity issuance in emerging markets. Between 1990 and 2001, the size of bank lending has been approximately 10 times the size of domestic equity issuance, but the volatility of bank lending has also been Substantially greater. Moreover, while relatively small in absolute size, equity finance was a relatively resilient source of finance during the Asian crisis. The sharp fall in domestic equity issuance in 2000 and 2001 raises doubts, however, about the long-term prospects of initial public offerings in local markets as an alternative financing mechanism going forward, an issue that is largely related to the increasing internationalization of equity markets.

Box 6.The Equity Market in China

The stock market in China has grown rapidly since the mid-1990s, with market capitalization rising dramatically from less than 10 percent of GDP in 1995 to about 40 percent currently (see Figure). This rapid growth reflects the greater role in China’s reform process given to capital markets by the Chinese authorities since the 15th Party Congress in September 1997. Beginning at that time, the authorities decided to increase listings on both the domestic and international stock markets to help finance the cost of enterprise restructuring, impose greater market discipline on state-owned enterprises, and develop a market for allocating savings to the most productive uses. Domestic investors with ample savings and relatively few investment opportunities responded enthusiastically to official efforts to encourage stock ownership, and currently a sizable segment of households in China have some stake in the stock market. The institutional structure of the Chinese stock market is complex, given the multifaceted objectives involved in developing it, and a brief description of this structure is provided below.

The Structure of the Equity Market

The stock market in China is highly segmented. The A share market was initially open to Chinese residents only. In 2002 it was also open to qualified investors abroad. It consists of about 1,200 listed companies currently, and is investible in local currency only. The B share market began in 1992 to allow foreigners to participate in the Chinese equity market by investing in foreign currency only. There are currently about 111 companies listed on the B share market. In practice, the B share market has been dominated by Chinese nationals, who have in the past used regulatory loopholes to invest part of their considerable holdings of foreign currency in this market. Chinese nationals have officially been allowed to invest in the B share market since February 2001 and they account for almost 95 percent of share holdings in this market currently. There is also the H share market, which trades shares of Chinese companies listed in Hong Kong SAR and other stock exchanges outside of China. Almost 80 percent of the IPOs in Hong Kong SAR in 2001 came from China. The links between the Chinese and Hong Kong SAR equity markets are, in fact, much deeper than indicated by the importance of H shares. “Red Chips” are companies incorporated in Hong Kong SAR, but whose substantial shareholders and production bases are in China—the combination of H shares and “Red Chips” now constitutes about 30 percent of the Hong Kong SAR stock market.

Performance of the Stock Market

After experiencing rapid growth in the latter half of the 1990s, equity prices witnessed a sustained decline, starting in mid-2001 (see the Figure). Despite the pickup in recent months, the A share market is down by about 20 percent and the B share market by about 40 percent from the highs of mid-2001. What are the factors weighing on the Chinese stock market currently? Is the decline a rational response to unsustainable valuations, or are we witnessing a bout of irrational panic?

Valuations in the A share market currently reflect price-earnings ratio of 30 to 40; this is almost twice the price-earnings ratio in the B share market. The substantial divergence in valuations between the A and the B share markets is due to segmentation—the driving forces of equity prices in the two markets are different and arbitrage between the two is highly imperfect. Many market participants argue that even these high valuations do not fully capture the extent to which the market is overvalued. For example, many of the companies initially listed in the A share market were state-linked enterprises, a number of them in “sunset sectors,” with limited prospects for a significant improvement in earnings potential. Moreover, a part of the earnings of some companies listed in the A share market comes from profits obtained from stock market speculation. And this type of profit will disappear as the market subsides.

China Equity Market Indices

Sources: Bloomberg L.P.; and Standard and Poor’s.

Investor Base

Almost 90 percent of the investor base for equities in China is retail. Households in China have been confronted with limited opportunities available for investment, other than to hold deposits in banks. Consequently, a sizable part of household savings was placed in the stock market, and these investments have been a key factor driving stock prices. The unease over high valuations among retail investors appears to have been mitigated partly by the fact that many companies are state-linked, generating plausible expectations of a bail-out in the strategically important companies. The institutional investor base has developed only recently, largely as a consequence of official action to promote it. Mutual funds in China are not strictly equity-based or bond-based, but instead invest in a mixture of equities and fixed-income products. In contrast to the retail segment of the market, institutional investors have been more wary of current valuations and are at present largely in bonds or cash. Foreign investors wanting an exposure to the Chinese equity market have traded primarily H shares rather than B shares, because of the more stringent transparency requirements in the former market. Foreign investors appear to be even more concerned than local investors about both the high valuations in the Chinese equity market and the prospects of an increase in the supply of shares (the concerns about the supply-side effects appear to have been mitigated somewhat after the announcement in June 2002 that the divestment process is likely to slow—see below for details), and this in turn has depressed the equity market in Hong Kong SAR.

The Primary Market—the Initial Public Offering (IPO) Process

Market analysts argue that the IPO process in China was initially focused on generating revenues through privatization for the state. More recently, a number of what market participants regard as more viable companies have been brought to the market. Nevertheless, the idea of an IPO as a fund-raising process for the state rather than as a resource allocation mechanism continues to find resonance in China. After a decline of about 30 percent in the value of IPOs in 2001, about 55 billion yuan of IPOs came on stream in 2002—a slight increase over 2001. In contrast to early IPOs, which were mainly in the manufacturing sector, the next batch of IPOs are likely to also involve banks and insurance companies, which need to be strengthened ahead of the competitive challenges linked to WTO accession.

An IPO in China can be a complex and lengthy process. Companies intending to issue IPOs should in the first instance have been in existence for at least three years and should have generated profits in the three years prior to listing. They have to accept guidance from local investment banks on the modalities of functioning as publicly listed, and the entire process from the intention to list publicly to the beginning of secondary trading can take up to a year to complete. Moreover, until the restrictions were removed recently, there was a quota system for IPOs, with each province being offered a choice of four to five companies to list on an initial public offer waiting list. This policy was cancelled recently. A number of companies have chosen to take the quicker route of listing in Hong Kong SAR and Singapore.

Some technical requirements of the IPO process in China have resulted in the building up of speculative pressures in the equity market. When companies list in the local stock market, a “rule-of-thumb” is applied to cap the price of the stock to generate a historical price earnings ratio of about 20 to 25. Given that the average price earnings ratio in the A share market is about 40, those with access to the IPOs can generate substantial profits when secondary trading in the newly listed shares begins. To minimize abuse of the system, the IPO allocations are made according to a formula, whereby the allocation is a function of the holding period—that is, those willing to hold on to the IPOs for longer periods get more stock allocated.

Regulatory Initiatives

The authorities have taken a number of steps recently to strengthen the functioning of the stock markets in China. The China Securities Regulatory Commission has embarked on a broad initiative to improve transparency by cracking down on fraud and market manipulation, issued tighter rules to delist loss-making enterprises, and imposed more stringent disclosure and accounting requirements on listed companies. They have also required listed companies to have at least one-third of their boards composed of independent directors by 2003.

The biggest challenge for the authorities, however, is to find a way of divesting state shares—both for revenue generating and corporate governance reasons—without disrupting the market. Given that two-thirds of the listed shares in China are currently owned by the state and not traded actively on the secondary market, the expectation of an increase in the supply of shares when restricted shares are freed up is one of the main factors that have roiled markets over the past year. Creating a tracker fund as in Hong Kong SAR to sell state shares is less of a viable option in China, given the magnitude of the delisting needed. The authorities have, however, been cognizant of the delicate supply-demand balance in the stock market, and announced in June 2002 that the plans to divest state shares would be put off for the near future. Instead, the plan is to transfer part of the state’s equity holdings to strategic investors through agreement transfers.

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