IV Institutional and Regulatory Framework for Developing Country Finance

International Monetary Fund
Published Date:
September 1995
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An open foreign exchange regime and appropriate macroeconomic policies atone are not sufficient conditions for developing countries to be able to sustain private capital inflows. Efforts by developing countries to establish reliable domestic financial markets are also needed to facilitate the flow of foreign capital, while at the same time improving overall economic efficiency. This section examines recent measures taken by developing countries to improve the efficacy of their regulatory frameworks and to broaden their investor bases both at home and abroad. It also reviews recent changes in regulations in creditor countries that have facilitated developing countries’ access to international capital markets. In addition, the section includes a preliminary empirical analysis of the relationship of various factors, including the institutional setting and the state of market development, to integration of developing countries’ domestic markets into global financial markets.

Reform of Domestic Capital Markets

Regulatory Structures

In response to international market conditions and the growing sophistication of their own domestic markets, developing countries have continued to broaden their regulatory control and refine existing systems in line with international standards. In April 1995, Russia announced that the Federal Commission on Securities and the Stock Market will oversee the development of securities commissions for the autonomous regions. Guidelines have been issued that ensure that stock market participants observe federal laws and that issuers register and distribute securities in accordance with their prospectuses. In September 1994, India delegated new powers to the Securities and Exchange Board to oversee the activities of the country’s stock exchanges and to allow the Board to recognize new exchanges. Similarly, in Chile the three stock exchanges and the Superintendencia de Valores, the country’s securities regulator, put into practice in October 1994 a self-regulatory mechanism to prevent market manipulation. Pakistan’s Corporate Law Authority, the government entity responsible for regulating the nation’s securities markets, amended the national securities law in November 1994 to recognize insider trading as a criminal, rather than civil, offense.

With the development of derivative instruments in several of the larger developing country markets, the authorities have responded by broadening their surveillance powers to oversee these markets. Singapore in May 1995 passed amendments to its Futures Trading Act to widen control of the Monetary Authority of Singapore (MAS) over the regulation of leveraged foreign exchange and futures trading. Under these amendments, all trading institutions will need to be licensed and are subject to capital adequacy standards, business conduct, and prudential requirements. In March 1995, the Thai Securities and Exchange Commission established a subcommittee to examine the regulatory structure necessary to establish a futures and options market. In the same month, India removed a long-standing ban on options contracts, opening the way for a wide range of new financial instruments to be traded; contracts are to be regulated by the Securities and Exchange Board.

Equally, a number of the authorities in smaller developing countries are taking measures to reinforce their regulatory environment to support their fledgling stock exchanges. With the help of the Inter-American Development Bank (IDB), a number of Caribbean countries (Barbados, the Dominican Republic, Jamaica, and Trinidad and Tobago) intend to standardize their regulatory regimes and modernize and unify clearance and settlement procedures between their respective stock exchanges over the coming year. Panama’s new securities market law broadens control to cover initial public offerings, secondary market transactions, stock exchanges, brokers, clearance and settlement organizations, and mutual funds. It also defines and prohibits insider trading and fraud. In July 1994, Romania passed legislation to institute a legal and regulatory framework to establish the country’s first stock exchange and a securities commission. Similarly, in Latvia, the Riga Stock Exchange (in collaboration with the Union of French Stock Exchanges and the French Central Depository) has drafted regulations to establish a legal framework to bring the exchange into line with international standards and open the market to international investment.

With growing market integration and globalization of financial markets, countries increasingly are working toward greater international cooperation and harmonization of regulatory issues as a means of strengthening their own domestic institutions. This process has been particularly evident in the Western Hemisphere, with members of the Council of Securities Regulators of the Americas (COSRA)26 agreeing to a multilateral resolution on cooperation to combat fraud. The resolution requires member countries to assist in providing standardized financial information from sources that come under their jurisdiction to other member countries in order to ensure full compliance with the respective securities laws. In addition, member countries agreed to establish and maintain a multilateral mandatory system for corporate disclosure as laid out in a recent document (COSRA (1994)). The standardized financial information to be provided by corporations includes an income and cash-flow statement; a balance sheet; and information on revenues, operating profits, assets, and export sales by industry and geographic area. Separately, in August 1994, members of the Federación Iberoamericana de Bolsas de Valores27 agreed to work toward standardizing clearance and settlement practices and requirements for a central depository. The move is designed not only to stimulate cross-border transactions within the region, but also to encourage investment from industrial countries.

In addition, bilateral cooperation agreements under memorandums of understanding (MOUs) to share market and regulatory information have grown rapidly. The United States Securities and Exchange Commission has signed several MOUs in recent years, in particular with several Latin American countries (most recently with Paraguay, in October 1994). These agreements provide for the sharing of intelligence on share price movements, clearing and settlement data, and other regulatory information. In general, they are designed to promote the development of cross-border trading and the regional harmonization of regulatory practices.

Market Reforms

There has been a continued expansion in the establishment of new securities markets in developing countries over the past year, especially in the transition economies. Romania enacted a securities law in 1994 and launched the Bucharest Stock Exchange in 1995. In Latvia, the Riga Stock Exchange began trading operations in 1995, and a stock exchange is scheduled to begin operations in Estonia in 1996. In March 1995, Uzbekistan passed a decree providing for the creation of a securities market. Similarly, African countries, which until recently have been slow to establish stock markets, are seeking to create equity-based instruments. Sudan opened its first stock exchange in January 1995, and Uganda plans to open a stock market in early 1996. In Zambia, the first equity listing on the Lusaka Stock Exchange took place in 1995, following the opening of the market in 1994. Both Tanzania and Cameroon also have announced plans to establish stock exchanges.

In a move to expand and deepen existing markets, several developing countries have introduced second-and third-tier boards. These make it easier for smaller companies to raise equity capital by simplifying listing and disclosure requirements. In October 1994, Colombia’s Superintendencia de Valores (the national securities regulatory authority) created a second board on the domestic stock exchange for small companies. In Turkey, the Istanbul Stock Exchange opened a “young companies” market in April 1995 to provide newly established companies with greater access to funds.

Developing countries have continued to take actions to improve and modernize securities trading systems in individual exchanges over the past year. By enhancing the functioning and reliability of markets, computerized trading systems help to promote investor confidence, increase market liquidity, and facilitate effective market surveillance. Since October 1994, stock exchanges in Ecuador, Peru, and Venezuela have introduced electronic order systems. In October 1994, the Philippine Stock Exchange initiated a new trading surveillance system designed to curb potential price manipulation. The Jakarta Stock Exchange in Indonesia launched an automated trading system in May 1995. India’s Bombay Stock Exchange, the country’s largest exchange, launched a screen-based trading system in March 1995. In a step likely to promote the integration and orderly development of its large over-the-counter trading activities. Russia is beginning to introduce a national, electronic over-the-counter market with an automated quotation system based on the National Association of Securities Dealers Automated Quotation (NASDAQ) system in the United States.

In a similar vein, a number of developing countries—notably in Latin America—have taken steps to achieve greater uniformity of trading practices among their domestic markets over the past year. In Argentina, the two major exchanges, the Buenos Aires Stock Exchange and the Electronic Open Market, agreed in August 1994 to harmonize trading hours and trading and settlement practices, In Peru, the IDB is financing a technological modernization and merger project for the country’s tow largest stock exchanges.

Developing countries have continued to take steps over the past year to improve clearance and settlement systems in their securities markets. The speed and reliability of these systems can be a critical determinant in international investors’ willingness to place funds in developing country markets, since uncertainties and delays regarding delivery of securities and settlement can substantially reduce the effective liquidity of local investments. Brazil’s Comissao de Valores Mobiliarios (CVM) introduced in December 1994 a settlement period of three business days in order to bring the local exchanges into line with international standards. In the Philippines, the country’s securities settlement system is to be upgraded by the end of 1995 to require settlement in three business days. The International Securities Markets Association (ISMA) and the Emerging Markets Traders Association (EMTA) in June 1995 recommended that the settlement period for transactions in the international bond markets be reduced to three business days.

Improvement of settlement facilities and efficiency often necessitates the establishment or strengthening of centralized depository or registry facilities for securities, and many developing countries have taken steps in this area over the past year. Venezuela established a central securities depository in December 1994. In Poland, the Krajowy Deposzyt Paierow Wartosciowych, the national securities depository, expanded its storage, registry, and clearance functions in November 1994. In Russia, the European Bank for Reconstruction and Development (EBRD) and a U.S. bank have established an independent share registry with the aim of overcoming irregularities in share registration that have occurred under the current system of company-specific share registries.

During 1994 and the first half of 1995, there has been a significant expansion in the range of instruments traded on developing country securities markets through the introduction of derivatives, notably futures, options, and warrants. These instruments allow investors to hedge interest rate, foreign exchange, and price risks more effectively. Thus, by introducing the trading of standardized derivatives, developing countries can widen their potential investor base and promote the deepening of market liquidity. However, the inherent risks of these instruments underscores the need for adequate regulatory control.

Development of hedging instruments and markets, together with regulations covering their use, has proceeded apace in numerous developing country markets. Thailand’s Securities and Exchange Commission announced in March 1995 the establishment of a futures and options market. In Singapore, the range of stock index futures and options traded on the International Monetary Exchange (SIMEX) was extended in early 1995. In March 1995, India removed a 38-year ban on options contracts, opening the way for a wide range of new financial instruments. Chile introduced stock options trading on the Santiago exchange in August 1994. In Europe, Poland signed an agreement with the Chicago Board of Trade in November 1994 to develop a new commodity futures exchange. In Brazil, the CVM approved rules in December 1994 to permit local stock exchanges to list covered-call securities warrants, an option-like derivative product. In Russia, the Moscow financial and futures exchange is scheduled to begin operations in July 1995 and will trade currency futures and equities.

Broadening the Investor Base

Liberalizing Access to Capital Markets

During 1994 and early 1995, developing countries took further steps to liberalize foreign investors’ and foreign brokers’ access to domestic markets and to remove or reduce obstacles to domestic companies’ ability to raise capital in international markets. In January 1994, Taiwan Province of China liberalized limits on foreign direct investment and on investment in securities. The previous ceiling for foreign holdings of equities has been replaced with a ceiling of 12 percent of total market capitalization, while the limit on the maximum holdings of any one foreign investor in an individual company’s shares has been increased to 6 percent. In Kenya, a 30-year ban on foreign investor participation in the Nairobi Stock Exchange was lifted in January 1995, allowing foreign investors to hold up to 20 percent of the quoted shares in listed companies. In Korea, the ceiling on foreign investors’ holdings in individual domestic companies was raised to 15 percent in July 1995, with a further increase planned for 1996.

Some developing countries have also liberalized rules concerning domestic companies’ access to international capital markets. Chile in December 1994 eased rules applying to banks wanting to trade their shares in international markets. In January 1995, Korea relaxed restrictions on domestic companies’ ability to raise foreign loans for certain purposes and announced much wider liberalization of companies’ access to international capital markets beginning in 1997. The Bank of Israel in May 1995 liberalized rules regarding domestic enterprises’ ability to invest abroad. Companies are now permitted to invest, within certain limits, in recognized foreign securities, Israeli stocks traded abroad, and offshore bank deposits.

Some liberalization of foreign brokers’ access to developing country markets has also occurred. In April 1994, Thailand liberalized laws regarding the ownership of securities companies, allowing foreigners to own up to 49 percent of these companies. Under the national treatment provisions of the North American Free Trade Agreement (NAFTA), Mexico authorized 16 U.S. brokerage houses to begin operations in Mexico in early 1995.

Introduction of Contractual Savings Schemes

Regulatory authorities in a number of developing country markets have also moved to encourage domestic fund management industries in order to increase the depth of liquidity in local capital markets and to broaden the range of investment possibilities available to domestic investors. During 1994, Singapore liberalized the rules governing the investment of funds held in savings and pension funds to allow investment in foreign securities. From 1997, fund managers will be permitted to invest in regionally traded securities and, from 1999, to place funds in markets outside Asia. In July 1994, Argentina introduced a private pension fund scheme, authorizing 25 funds to commence operations. Approximately 1.7 million people elected to join the scheme at the time of inception. Investments are limited to domestic financial instruments only. In September 1994, Brazil liberalized rules regarding domestic investments by the country’s pension funds and authorized the creation of foreign investment funds that will enable Brazilians to invest in foreign securities. In an effort to encourage the expansion of domestic mutual funds, Peru amended its capital taxation law in October 1994 to exempt from tax all capital and interest earned on locally issued funds. In December 1994, Chile increased the foreign investment limits for institutional investors, including pension and mutual funds; the latter can now invest up to 30 percent of their assets abroad. Thailand’s Securities and Exchange Commission approved in January 1995 the creation of more domestically based mutual fund management companies, as well as broadening the type of funds offered.


Privatization of public sector corporations was a major influence on activity in developing country equity markets during 1994 and the first half of 1995; in many smaller markets, it provided the dominant source of equity listings and trading activity. Peru privatized nearly $3 billion in assets in 1994 and during the final quarter of the year expanded its wide-ranging privatization program to allow individual investors to purchase shares. In the wake of its financial crisis, Mexico announced plans in January 1995 to privatize much of its electricity sector, and both Argentina and Brazil have announced plans to accelerate privatization efforts in 1995. In May 1995, Bolivia’s “capitalization” program got under way, with formal bids completed for the first of six state enterprises in which 50 percent controlling stakes are to be sold. The program is based on the sale of 50 percent of shareholdings to foreign investors, with the proceeds to be injected as capital into the enterprises, together with the distribution of the remaining 50 percent of shareholdings to domestic residents through private pension funds. Colombia plans to undertake an ambitious privatization program over the next four years and has established a commission to investigate further development of Colombia’s capital markets to facilitate the process. In Venezuela, the Government is planning to list shares in several major state-owned companies on the stock exchange in preparation for privatization. This follows moves in late 1994 to allow the direct sale or auction of public assets through the Caracas Stock Exchange.

In Africa, Zambia successfully completed a first sale under its privatization program in May 1995. Of the 18 companies listed on the Ghana stock exchange, 8 are the result of privatizations, and the Government is planning sales of its shareholdings in several banks, a diamond mining company, and the telecommunications company. Côte d’Ivoire expects to privatize 15 more companies in 1995 and is aiming to have sold a total of 50 state enterprises by mid-1996. Egypt’s privatization program has attracted a high level of investor interest, underpinning activity on the Cairo Stock Exchange. The Government has announced plans to privatize another 65 companies in 1995.

The predominant method of privatization used by transition economies over the past year has been that of mass privatization by means of the distribution of privatization vouchers. One benefit of this form of privatization in economies with a long tradition of state ownership is that vouchers provide the wider population with a stake in the process of transformation and privatization of the economy, bolstering domestic support for the process. Because privatization programs may initially result in highly fragmented ownership of privatized entities, and thereby dilute potential monitoring and control benefits of the transfer of resources to the private sector, many countries have introduced investment funds simultaneously with privatization. By providing a mechanism for the aggregation of individual shareholdings, investment funds can result in more effective ownership control over privatized companies.

In May 1995, the Czech Republic completed its privatization program, with shares in a third round of companies privatized by vouchers that became tradable on the Prague Stock Exchange. In May 1995, Romania’s parliament approved a privatization program that aims to sell off 3,000 state companies by year’s end in a voucher and coupon scheme. Poland in July 1995 launched its privatization program to sell 400 state companies through the issuance of participation certificates in national investment funds to individual citizens and enterprise employees. Bulgaria plans to launch its own privatization scheme in late 1995, and legislation approved in March 1995 provides for privatization vouchers and other privatization instruments to be traded on the stock exchange. In Mongolia, the Government has almost completed its privatization program using vouchers, with companies accounting for close to 70 percent of the country’s output being transferred to private ownership. Russia is also continuing with its privatization program. The large energy producer, Gazprom, which in 1994 sold 34 percent of its shares domestically for privatization vouchers, announced plans in January 1995 to sell 9 percent of its shares to foreign investors.

Regulatory Changes in Creditor Countries

Several changes in creditor countries’ securities markets have been designed to facilitate and promote investor interest in developing countries. In August 1994, the London Stock Exchange (LSE) announced new regulations that enable foreign-listed companies to list sterling-denominated depositary receipts on the exchange (previously only LSE-listed firms were allowed to issue receipts); this is expected to be of particular interest to a number of developing countries. At the same time, the LSE established a “country sector” for Mexico on SEAQ International, the electronic price information system for international equities trading for companies from Asia, Eastern Europe, and Latin America. This is the first time a group of stocks on SEAQ’s Developing Markets Sector has been placed in a separate country sector. The change provides easier registration procedures for Mexican stocks to be quoted, by requiring just two market makers to post prices (previously, each issuing institution required approval from the exchange, as well as market-maker sponsorship).

The U.S. Securities and Exchange Commission has assigned “recognized custodian status” to Costa Rica. This allows a foreign custodian service to handle securities deposited by U.S. investors (a policy modification introduced in 1994) and, therefore, simplifies clearance and settlement procedures. Other countries with the same status include Mexico and Thailand.

Following the decision of Mexico’s central bank to lift its restrictions on trading futures and options on the Mexican peso, the Chicago Mercantile Exchange introduced futures and options contracts on the Mexican peso in May 1995, the first such contracts traded on a developing country currency. The Chicago Mercantile Exchange also announced the intention to broaden traded futures and options over the next year to cover a number of additional developing country currencies.

Importance of the Institutional Setting to Market Integration

Various studies have found strong evidence that capital mobility and integration among developing countries have been increasing over time. In particular, one recent study finds that most developing country markets were substantially more integrated over the period 1985-91 than during the years 1977-84 (Buckberg (1993)). Markets that tended not to be “integrated” were smaller and subject to substantial illiquidity risk. Similarly, in reviewing developing countries in the Pacific Basin, estimates support a general trend toward increased capital mobility in the region over the 1980s (Faruqee (1992)).

An exploratory analysis using an equity return-based measure of market integration and indicators of the institutional environment and market maturity in selected developing countries suggests the importance of the institutional setting and market development for the integration of developing country stock markets into global markets.28 Market integration was proxied by the correlations of developing country equity returns with returns in the U.S. stock market based on the Standard and Poor’s (S&P) 500 index (Table 10). A rank correlation analysis was then done, using these correlations and measures of regulatory control, disclosure and accounting information, stock market development, and macroeconomic information proxied by credit ratings, the variability of inflation and the exchange rate, and import cover of international reserves. A ranked survey of the efficacy of investor protection and accounting standards, availability of information, and pertinent disclosure was compiled using information provided by the IFC (1994). A comparison and ranking of market maturity was then prepared based on capitalization, value traded indicators, and the number and average size of listed companies. Ability to repatriate capital and income was also taken into account.

Table 10.Correlations of Equity Indices with the Standard and Poor’s 500 Index
Global Total Return Weekly (January 1992-November 1994)Investable Total Return Weekly (January 1992-November 1994)
Taiwan Province of China0.070.07
Sources: IFC; and IMF staff estimates.
Sources: IFC; and IMF staff estimates.

Results of the rank correlations are shown in Table 11, based on weekly total return indices over the period January 1992 to November 1994. As can be seen, the rank correlation of returns between individual developing country markets and the U.S. stock market and measures of the institutional setting and stock market development are high and statistically significant. The importance of macroeconomic information appears much less robust, both in terms of credit ratings applied and indicators of inflation and exchange rate variability. The correlations between equity returns in individual developing country markets and returns on the S&P 500 index are weak, suggesting that there is not a high degree of integration between these markets. Nonetheless, the strong preliminary results associated with both the quality of the institutional environment and the level of market development support the premise that investors are reluctant to participate in thin, poorly regulated markets.

Table 11.Rank Correlation Results1
Equity Return Index (January 1992-November 1994)Rank Coefficientt-Value
Institutional setting0.81880.76293.172.95
Market development0.73900.70742.862.74
Repatriation of income and capital0.52280.59712.022.31
Credit ratings0.52060.37132.021.44
Reserve to import cover0.50290.40071.951.55
Exchange rate variability20.15880.20960.620.81
Inflation variability20.11050.08600.430.33

The rank correlation coefficient is defined as:

where D is the difference between the ranks of equity returns and the corresponding ranks of the determining variables and N is the number of observations.

Inflation and exchange rate variability are defined as the standard deviation of monthly rates over the period.

The rank correlation coefficient is defined as:

where D is the difference between the ranks of equity returns and the corresponding ranks of the determining variables and N is the number of observations.

Inflation and exchange rate variability are defined as the standard deviation of monthly rates over the period.

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