Stock Markets as a Foreign Direct Investment Transmission Mechanism

Introduction

Stock markets in developing economies mainly in the Far East, Asia, Latin America and Africa are no longer mere shadows of stock markets in developed economies such as the London Stock Exchange or the New York Stock Exchange. According to Claessens, Klingebiel and Schmukler (2001), high economic growth supported by enhanced macro stability, structural reforms and policy changes have aided economic growth in developing countries, a fact that is reflected in the vibrant stock markets. Over the years, profitable and promising companies in the developing countries have listed their shares in the stock markets and besides attracting local investors, have managed to catch the attention of foreign investors aiming at enhancing their portfolios (Hauser, Marcus and Yaari, 1994, p. 76).

With globalisation becoming predominant in the 21st century, investors are on a constant search for more effective means of conducting cross-border capital flows (Claessens, Klingebiel and Schmukler, 2001, p. 1). More so, developing countries knowledgeable of the fact that it may take more than domestic capital to develop their respective economies keep sourcing for external resources. While borrowing was a preferable way of obtaining capital in the beginning of the 21st century, developing economies find it more advantageous to encourage foreign investors to venture into the local markets due to a number of reasons (Adam and Tweneboah, 2009, p. 178). First, foreign investors inject capital into developing economies at their own risk; second, foreign investors bring expertise and knowledge to the domestic markets; and third, unlike borrowing which has to be repaid as agreed with the lenders, all the developing country does for the foreign investor is provide a viable investment environment. In cases where the foreign investor wants to buy into existing enterprises, the stock market is always the best place to target. The stock market gives foreign investors the chance to vet listed companies for good performance and a promising financial future.

Adam and Tweneboah (2001, p. 6) argue that FDI inflow is best represented as the difference between inward-flowing FDI and outward-going FDI. Enhanced FDI inflows into emerging markets signify good times for both governments and private business people (Yartey and Adjasi, 2007, p. 180). This can be explained by the fact that emerging economies usually lack the capital capacity required to finance all the targeted development projects. As a result, such economies seek external financing, either through loans of external investors.

Literature Review

The role of the stock market as a mechanism for transmitting FDI capital into emerging markets has not received much attention from scholars. A search through literature reveals limited coverage of the topic therefore indicating that a lot more research needs to be done. Piecemeal information gathered regarding the subject however succeeds in conjuring an image where stock markets are portrayed as either complementary or supplementary entities to FDI.

In a research article based on Ghana’s scenario, Adam and Tweneboah (2009) investigated the interrelation between increased FDI and the stock market. In their findings, they observe that “stock market development is embodied in the general financial sector development” (p. 179). In most developing countries like Ghana, FDI is regarded as an essential source of development capital (Adam and Tweneboah, 2009, p. 179). With domestically generated capital falling below the minimum requirements needed to fund developments in the emerging economies, governments are cognizant of the fact that foreign capital, which can be acquired either through external borrowing or through foreign investments, is essential. The role played by the stock market as a transmission mechanism of FDI in Ghana is well captured in the willingness of external investors to buy shares and equity listed in the Ghana Stock exchange (Adam and Tweneboah, 2009, p. 180). This observation is also supported by Yartey and Adjasi (2007, p. 11), who argues that the Stock markets in emerging markets (especially in Africa) play a major role in corporate financing. This is especially so because foreign investors buy into existing listed companies through the stock markets, thereby providing the much needed to finance development in such firms.

Citing South Africa, Ghana, Zimbabwe and Mauritius, Yartey and Adjasi (2007) observe that equity financing attained through respective stock markets in all the four countries were “the single most important source of long-term external finance” (p. 11). Most notably, a huge percentage of the financing came from external investors, with countries like Zimbabwe registering 75.4 percent external investor financing through the stock exchange in the 1990-1999 period (Yartey and Adjasi, 2007, p. 11). In emerging markets in Asia, the situation is no different. According to Prasanna (2008, p. 40), foreign institutional investors from the mature markets are on a constant hunt for viable investment opportunities in developing countries. Most such investors evaluate firms listed in the stock exchange market, to gauge whether they (firms) qualify as good investment choices.

The fact that the world is experiencing some sort of transnational capitalism has enhanced stock markets’ role as a transmission mechanism of FDI into emerging markets. As Prasanna (2008, p. 41) observes, the zeal and zest through which foreign institutional investors commit their capital into portfolio investment is a testament to the trust they have in the stock exchange markets located in different emerging markets across the world. Like every prudent investor, foreign direct investors scout for the most promising stocks in the emerging markets. This has earned them accusations of being inclined to growth, especially considering that a significant percentage focus on buying stocks that have short-term financial success (Prassana, 2008, p. 41).

Analysis and Discussion

It is rather obvious that most emerging markets intent on attracting foreign investors into their respective economies are well aware of the stock exchange’s potential. According to Prasanna (2008, p. 41) foreign capital acquired through the stock exchange market not only creates liquidity for the firms that the investors commit their capital into, but also allows such firms to compete in the global marketplace. Consequently, economies in the emerging markets earn benefits accruing from tax remittances and foreign exchange earnings resulting from the trade.

One of the preferred method of investing through the stocks markets as identified by Kambhato (1998, p. 116) is the use of depository receipts (DRs). DRs are negotiable certificates, which act as evidence that an investor owns shares in a specific company. As such, they are perceived as a direct alternative to the shares they represent. The DRs allow the investor “to trade in the equity of an emerging market using the custody and settlement of the major international markets” (Kombhato, 1998, p. 117). More so, the DRs happen to be more liquid than the shares they represent thus allowing international investors to trade in them more easily. Kambhato (1998, p. 116) further observes that firms in emerging markets, which are yet to achieve a listed status, but hopes to stage an initial public offering in future, can use the going-public bond to raise capital from external investors. Such an act indicates that both the firms and the investors acknowledge the stock market’s usefulness in raising foreign capital. This aside, the depository receipts have gained currency in the world financial markets because as Kambhato (1998, p. 116) notes, they give foreign direct investors an effective mechanism through which they can indulge in equity investments in the emerging markets.

The depository notes also play a role in enhancing the stock market’s function as an FDI transmission mechanism. According to Kombhato (1998, p.116-117), nowhere is this more evident than in the exposure of emerging markets to large pools of investors. Explaining the concept, the author argues that even public listed companies that hadformerly captured the attention of global fund managers usually have a new lease of life once they start accepting depository notes.

Overall, the stock market provides international investors with a relatively secure investment avenue into emerging markets. Most notably, as stock markets in the emerging markets establish themselves “as the primary market for issuers’ shares” international investors’ confidence in the markets increases thus enhancing their willingness to invest more in the emerging economies (Kombato, 1998, p. 117). Still, as stock markets improve in the emerging markets, they attract more foreign direct investors, thus increasing competition. With competition comes enhanced value for local stocks, which consequently amounts to economic growth for both the beneficiary firms and the host economies.

Observably, stock markets not only attract foreign investors into emerging economies, but also affect the valuation of listed companies positively. According to Kombahto (1998, p. 117) foreign investors apply “international valuation benchmarks” while trading in the stock markets in emerging markets. The application of developed markets’ stock exchange practices introduces stability in the emerging markets. As a result, the stock markets in the recipient countries experience less price volatility and, more often than not, higher valuation for local stocks.

Notably, transmission of FDI to the emerging markets through the stock exchange is not without limitations. In African countries like Zimbabwe and Kenya, foreign investors can only purchase a maximum of 40 percent shares in any public listed company. The rest of the stocks are reserved for local investors. Ghana on the other hand allows foreign investors a maximum of 74 percent equity ownership in listed companies (Yartey and Adjasi, 2007, p.26). Such investment caps are put in place for security reasons. In an example provided by Prasanna (2008, p. 41), it is evident that in as much as stock markets bring in foreign direct investments into emerging economies, they can also act as venues of capital flight. Negative sentiments about the Indian economy in 2006 for example led to massive withdrawals by foreign investors from India’s stock exchange amounting to $2.061 billion (Prasanna, 2008, p. 41). Consequently, there was a major crash in the Bombay stock exchange. Regardless of the caps put in place by different regulatory bodies in the emerging markets however, it is quite clear that most emerging markets give foreign direct investors a wide-enough access to the stock markets.

In addition to acting as a channel through which FDI is transmitted to emerging markets, Claessens, Klingebiel and Schumukler (2001, p.3) also holds the opinion that both the stock market and the FDI play complimentary roles. The authors argue that foreign investors with local investments in emerging markets may still want to seek financing through the stock markets. In such cases, the investors have to abide to the respective regulations set by different emerging countries concerning listing their investments in the stock exchange market (Baker, Foler and Wurgler, 2004, p. 5; Claessens, Klingebiel and Schumukler, 2001, p.3).

Conclusion

In the globalised financial markets, no economy regardless of its financial strengths and capabilities can survive alone. The emerging markets no doubt understand the implication of opening up their markets to foreign direct investors, and while FDI especially through the stock market is not without its risks, it is rather obvious that the advantages outweigh the risks. As has been established in this paper, stock markets in emerging economies, just like is the case in developed economies, provide firms with a viable way of raising capital from both the external and internal markets. Investors from developed markets do on the other hand realise that the emerging markets have untapped potential, which is hard to find in the matured developed economies. The stock market usually acts as the catalyst needed to bring the investors, and the capital-seeking firms together.

With the advent of depository receipts, the foreign investors now purchase equity into listed firms from the emerging markets with a lot more confidence due to the lower risks associated with the DRs. Overall, foreign direct investors can choose to use DRs or simply purchase shares from listed companies in the emerging markets’ stock markets. Whatever the case, investors commit their capital to such firms on either long-term investment missions, or short-term speculative reasons. Without the strategic role played by the stock markets, investors would need to adopt other FDI measures, which could be more risky.

References

Adam, A.M. & Tweneboah, G. (2009) Foreign direct investment (FDI) and stock market development: Ghana evidence. International Research Journal of Finance and Economics, 26(1), 176-185.

Baker, M., Foler, C.F., & Wurgler, J. (2004) The stock market and investment: Evidence from FDI flows, NBER working papers, 10559, 1-31.

Claessens, S., Klingebiel, D. & Schmukler, S. L. (2001) FDI and Stock market development: Complements or substitutes? World Bank Working Papers, 01 (09), 1-59.

Hauser, S., Marcus, M. & Yaari, U. (1994) Investing in emerging stock markets: Is it worthwhile hedging foreign exchange risk? Journal of Portfolio Management, 20(3), 76-81.

Kambhato, P. (1998) American depository receipts, global depository receipts, and other new financing instruments. In: Lieberman, I.W. & Kirkness, C.D. (eds) Privatization and emerging equity markets. New York, World Bank Publications. pp. 116-130.

Prasanna, P. K. (2008) Foreign Institutional Investors: investment preferences in India. Journal of Administration and Governance, 3(2), 40-49.

Yartey, C.A & Adjasi, C. K. (2007) Stock market development ion the Sub-Saharan Africa: critical issues and challenges. IMF Working Paper, WP/07/209, 3-29.