NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

Financial Reform Changed Stock Markets in Latin America

"Financial opening has helped make Latin American markets more stable and more similar to markets in rich nations."

During the late twentieth and early twenty-first century, many emerging markets experienced severe financial crises. These episodes led some economists to argue that financial markets in poor nations are poorly developed and differ in fundamental ways from those in advanced economies. As a result, they maintained, emerging nations should not fully open their capital markets like rich nations; they should impose some controls on the flow of capital that moves across their borders.

But do financial markets in emerging nations operate differently from those in other regions? In Stock Market Cycles, Financial Liberalization, and Volatility (NBER Working Paper No. 9817), co-authors Sebastian Edwards, Javier Gomez Biscarri, and Fernando Perez de Gracia attempt to answer that question. They examine stock market cycles from 1975 to 2001 in four Latin American economies (Argentina, Brazil, Chile, and Mexico) and two Asian economies (South Korea and Thailand), and compare them with market cycles in the United States and Germany during the same period. After identifying the bull and bear phases of market cycles in each economy, they focus on several key aspects of cyclical behavior, including the duration of market expansions and contractions, their amplitude, the volatility of the cycle, the synchronicity of cycles across countries, and whether these characteristics have changed following periods of market liberal ization in emerging markets. (This final point is particularly relevant from a policy perspective, since some analysts have argued that "Washington Consensus"-style liberalization policies have resulted in increased market instability.)

Using monthly data on stock returns for the six emerging markets in the study, the authors find that after the market liberalization of the late 1980s and early 1990s, the average duration of bear markets declined in all countries except Korea, while the duration of bull markets declined in all countries except Argentina and Mexico. The authors also find that the amplitude of bull as well as bear markets -- that is, the total return from the trough of the market to the peak, or the total loss from the peak to the trough -- is significantly higher in emerging markets than in the two benchmark advanced economies. "Emerging stock markets seem to offer a significant premium, or excess return, during expansions," the authors find, "that compensates for the big losses during contractions." For example, average annual gains during bullish periods in Argentina reached 142 percent, whereas average losses during Argentina's bearish times totaled 123 percent.

The authors identify some striking differences between the Latin American economies and the Asian markets. For instance, the amplitude of market cycles in the Latin American countries declined in the post-reform period, but not in the Asian cases. Also, the volatility of market cycles -- the average size of market returns in bull and bear periods -- is indeed much higher in emerging markets than in advanced economies, but that volatility generally declined in Latin America following the period of market reform. By contrast, in Thailand as well as South Korea, market volatility actually increased in both bull and bear periods following market openings.

The degree of synchronicity (concordance) among the markets also varies after periods of market liberalization. Before liberalization, different emerging markets did not appear to move together or to track the U.S. market. However, after liberalization, three groups appeared to emerge: Argentina, Brazil, and Mexico showed high concordance; Chile and Korea became more concordant with each other but less with other countries; and Thailand did not fit into any other group." These findings suggest that liberalization processes have indeed contributed to a much stronger co-movement of the stock markets in the emerging countries," the authors explain, both in the long and short term.

The authors also study the shape of bull and bear phases of the market cycles. Prior to market liberalization, the shape of the cycles in the six emerging economies displayed "significant predictabilities," by which the returns accelerated depending to their proximity to the peak or trough of the cycle. These patterns were more marked than in the benchmark, advanced economies (thus suggesting possible inefficiencies). After liberalization in the developing countries, however, those markets began to display patterns much more similar to those of advanced markets. Bear markets still show some acceleration, but the difference was significantly reduced.

Overall, the authors conclude that even while stock market behavior in emerging economies differs in important ways from behavior in advanced markets -- bull phases are shorter, bear periods longer, and amplitude and volatility of both phases is greater -- financial opening has helped make Latin American markets more stable and more similar to markets in rich nations. Asian economies, for their part, have not shown the same evolution, as "they seem to have been affected too intensely by the financial crisis of late 1997."

-- Carlos Lozada


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