Emerging Financial Markets Prof. Zhiwu Chen Lecture 1: The Big Picture

The Rise & Fall of Historical Powers u u 3000 BC, Kingdom of Egypt

Then u u 2500 BC, The Greek Civilization u u 2000 BC, Shang Dynasty in China u u 500 BC, The Roman Empire

Then u u Middle Ages: China, Aztec in Mexico and the Incas of Peru u u 1500 AD, Spanish Adventurers u u AD, British Empire u u 1900 AD - ?, The United States of America

Financial Markets also emerge, submerge and re-emerge u Argentina’s stock market: –Founded in 1872 –Submerged in 1965 –Re-emerged in 1975 u Peru: , 57-77, 88-

3 The IFC Definition: Income less than $9,000 21% GDP, 85% Population, 76% Area, And 11% Market Capitalization in the World (1995) Higher growth rates & high avg returns in many countries Time Taken to Double Per capita Output (10 years but unstable) What is an Emerging Market?

The Emerging Markets

Annual Real GDP Growth

Average Annual Returns for the Twelve Years Ended December 1998 Source: International Finance Corporation. Returns include capital gains and dividends.

Why Do Countries Differ?

The Puzzles of Economic Growth u u Why growth differs across countries? u u Why growth does not always translate into stock returns? u u Why capital flow is so small?

Why Good Opportunities in Emerging Markets?

4 Privatization and Incentives u u Have shown a high correlation between economic freedom and growth. u u Privatization of SOEs leads to great improvement in efficiency and profits. u u Low Tax Rates provide more incentives for entrepreneurs. u u Free trade and market opening allows multinationals to leverage their strength, outsourcing production, and expand their markets.

Effective Corporate Tax Rates Data Source: Goldman Sachs

5 An Educated And Low Cost Labor Pool u u High Literacy Rates Make Training Less Costly. u u Young and Energetic u u Cost Of Labor Is Low u u Technology Leap-frog Allows for Dramatic Improvement in Efficiency.

Domestic Savings And Foreign Capital Flow (FDI) u u People are thrifty (high saving rates) in many markets. But high domestic savings cannot fully cushion the flow of foreign capital. u u The composition of capital flows is healthy (more private than public flows) but there is a problem of duration mismatch. 6

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Economic Impact On Developed Countries u u Raising demand of baby boomers in EM vs. falling demand in many western countries u u Rising demand for western technology u u Badly needed infrastructure projects create huge demand for capital and expertise. 7

Comparison of Population Growth Data Source: United Nations Over the last five years, Japan’s population grew only at a miniscule 0.2% a year. In comparison, the population of other Asian grew at much higher rates, with some growing at over 2% a year.

Annual GDP Growth Projection Data Source: “Asia’s Bright Future” (Steven Radlelet and Jeffrey Sachs ), United Nations, and Financial Times

Of course, what can go wrong? u u Past Success has little persistence (Brazil & Asian Tigers). u u Excessive public and private borrowing increase the risk of financial crisis. u u Currency instability resulted from week financial system. u u Overbuilding of production capacity leads to low returns. (Real estate speculation)   Strong special interest groups can block badly needed reform. 8

Nobody says it is easy to invest in EMs! Can you handle it?