Ebook The Role of ADRs in the Development of Emerging Equity Markets
This paper examines the impact of the growth of international cross-listings of shares on the stock market development of emerging economies. Specifically, we ask whether the large increase in the number of companies from emerging markets that have chosen to cross-list their shares on U.S. markets, typically in the form of American Depositary Receipts (ADRs), has facilitated the development of the domestic stock market or has hindered it. The study encompasses twelve Latin American and Asian emerging markets that had a wide variety of experiences in the growth of their ADR programs during the 1990s in terms of pace, breadth and trading activity. Overall, we find that the expanded ADR presence in these markets has fostered stock market development, which we measure as greater cross border equity flows, higher market capitalization, more listed companies and greater turnover. But, these benefits accrue primarily to those firms that can and do pursue ADR programs, while the size, scope and liquidity of the non-ADR segment of the domestic markets diminish.
Understanding how ADRs and other financial innovations in global capital markets affect stock market development is important for several reasons. First, stock market development is a catalyst for overall economic development. Many notable economists have argued that vital financial markets can lead to greater economic growth by increasing the productivity of capital through greater liquidity, enhanced portfolio diversification opportunities and better information on the profitability of risky projects (Schumpeter, 1911; McKinnon, 1973). Indeed, there has been an abundance of empirical evidence that stock market development is positively correlated with current and future economic growth (King and Levine, 1993; Levine and Zervos, 1998a, 1998b; Wurgler, 2000; Rajan and Zingales, 2003). Second, in the case of emerging economies which were rapidly liberalizing their markets during the 1980s and 1990s, this positive correlation has been shown to be even stronger. Market liberalization events, such as the easing of regulatory restrictions on foreign ownership or foreign exchange convertibility, have led to greater integration of emerging equity markets with global markets. Greater integration, in turn, has led to improved risk-sharing benefits (Obstfeld, 1992, 1994; Lewis, 1996, 2000), greater investment activity, higher stock market returns, lower return volatility and higher real per capita GDP growth (Bekaert and Harvey, 1995, 2000; Bekaert, Harvey, and Lundblad, 2001, 2002; Henry, 2000a, 2000b; Kim and Singal, 2000; Edison, Levine, Ricci, and Sloek, 2002; and Martell and Stulz, 2003).
Third, the impact of international cross-listings and ADRs for domestic stock market development can be unlike many other forms of government-sponsored market liberalization, however, because they are actions initiated by the firms themselves and not mandated by regulatory authorities. As such, they are likely to be made in the best interests of their shareholders and not necessarily the markets,as a whole. There is general agreement on the benefits that accrue to the listing firm in terms of improved access to global capital markets, a broader shareholder base, and enhanced visibility before analysts, media and even consumers and also to the current and prospective investors in terms of increased transparency, better liquidity and greater ease of trading. But, there is little understanding to now of how these cross-listings, in aggregate, impact the local markets. Several possible scenarios could arise and it is their study that is the focus of this paper.
One possible scenario is that the expansion of the ADR market in a country facilitates stock market development by acting as a “catalyst” toward greater efficiency. In this view, as more local firms pursue U.S. listings, local stock exchanges, their brokers and regulatory authorities feel increased competitive pressure to modernize operations, improve standards of disclosure and strengthen enforcement of trading regulations. These improvements spur on greater liquidity of trading, increased transparency and efficiency of markets and market intermediaries, which, in turn, attracts more firms to list their shares for trading and more global investors to those markets enhancing liquidity, efficiency and overall development.
Another possible scenario, however, is that the expansion of ADR programs “hinders” stock market development by diverting investment flows and trading activity away from the local market. In this alternative view, there is no competitive response from local market participants leading to further deterioration of operations, diminished trading volume, and fewer new listings and investors. As the quality of the local market declines, increasingly more firms look abroad to opportunities in more developed markets, such as in the U.S. But not all firms can seize upon these opportunities because the stringent foreign listing, registration and reporting requirements imposed by these established exchanges ensure that only the largest and most liquid firms can pursue listings. The result of these ADR issuances is a breakdown of a pooling equilibrium in favor of a signaling equilibrium in which the larger firms with better opportunities signal their higher quality to local and global investors relative to the smaller, marginal firms in the local market, which suffer lower valuations, reduced liquidity and diminished numbers. Instead of acting as a “catalyst” to greater local market development, the ADRs act more as a “hindrance” or “diversion” by driving investment flows and trading activity away from those markets.
A third possibility, and one that we uniquely explore in this study, is that ADRs act as neither a catalyst nor a hindrance for local stock market development, but represent an outcome of it. In this scenario, there are economic, political or institutional forces at work that are the fundamental cause of poorly functioning markets. As a result, the deteriorating quality of the market creates stronger incentives for existing firms to escape by way of international cross-listings. In general, it is difficult to determine the actual direction of causality. After all, even if there is an acceleration of ADR issuances that precede the decline in a local market, it does necessarily imply that this event caused this decline, as these firms may simply have had better information about the future trends toward lower valuations, diminished
numbers of new listings and decreased liquidity of the domestic market. Nevertheless, in this paper, we argue in favor of this third scenario over the “hindrance” or “diversion” scenario above and provide empirical evidence in support of it. Specifically, we show that not only is the growth of ADR programs negatively associated with local stock market development, it is so regardless of the type of ADR program. What are shown to be adverse effects on local-market turnover and valuations arise are just as large when large, high profile ADR listings occur on the major U.S. exchanges as with the smaller, less-actively-traded over-the-counter listings and private-placement issues, even though the latter types have only limited liquidity in the U.S. The similarity of these results across types of ADRs is surprising because it is very unlikely that OTC ADR listings and private placements divert in any significant way economic activity away from the home market.
Studying the impact of ADRs on stock market development is also important because it has grown so rapidly in many emerging markets of Latin America and Asia during the past decade and because it has stoked a controversial policy debate as a result. According to the International Federation of Stock Exchanges, there were just over 700 foreign companies cross-listed on the six largest exchanges in 1986 (New York Stock Exchange, Nasdaq, London, Tokyo, Paris and Frankfurt), but, as of 2002, this number has almost tripled to just under 2,000. The fastest growth over this time took place among non-U.S. companies listing their shares on the U.S. markets in the form of ADRs. According to the Bank of New York, there are now over 1,500 ADR programs for companies from 85 countries around the world, including more than 600 programs trading around $20 billion annually on the major exchanges.
Our paper is related to, but distinct from, a large and growing literature on international cross-listings that argues that the benefits stem from a lower global cost of capital (Alexander, Eun and Janakiramanan, 1987, 1988; Foerster and Karolyi, 1999, 2000; Miller, 1999; and Lins, Strickland and Zenner, 2002). By listing shares abroad, the firm makes its shares more accessible to non-resident investors who would otherwise find it less advantageous to hold the shares because of investment barriers.4 Empirical support for this market segmentation hypothesis relies on firm-level, event-study tests that show that the announcement of a particular U.S. listing is accompanied by significant positive abnormal returns averaging around 1 percent on the announcement date itself (Miller, 1999) and cumulatively around 12 to 15 percent in the year of listing (Foerster and Karolyi, 1999). But, a number of recent studies have proposed alternative explanations for these findings. Foerster and Karolyi (1999) argue, for example, that the U.S. listing is not necessarily related to investment barriers and segmented markets, but is associated with the benefit of an expanded shareholder base, which reduces the risk premium in the cost of capital all investors require to hold the shares regardless of the barriers that were in place. Noronha, Sarin, and Saudagaran (1996), Sofianos and Smith (1997), Foerster and Karolyi (1998, 2000), Hargis (1998), Domowitz, Glen, and Madhavan (1998), and Pulatkonak and Sofianos (1999), by contrast, demonstrate significant improvements in liquidity due to increased competition for order flow across multiple markets trading the shares, which could also account for the benefits of listing. Cantale (1996), Fuerst (1998), and Moel (1999) assume widespread information asymmetries among investors, particularly in emerging markets, and suggest that the benefits of a lower cost of capital stems from a signaling equilibrium in which firms that list on markets with high disclosure standards (like the U.S.) can establish their quality relative to their peer firms before global investors and experience significant revaluation of their shares. Finally, Coffee (2002), Stulz (1999), Reese and Weisbach (2002), Tribukait (2002), and Doidge, Karolyi, and Stulz (2003) argue that a U.S. listing enhances the legal protection of a firm’s investors and reduces the agency costs of controlling shareholders.
Whatever the sources of the cost-of-capital benefits of international cross listings to the firms themselves, there are several studies that have demonstrated that these listings in aggregate facilitate greater integration of international capital market (Bekaert and Harvey, 1995; Errunza, Hogan and Hung, 1999; Errunza and Miller, 2000; Hargis, 2002; and, Bekaert, Harvey, and Lumsdaine, 2002). Errunza, Hogan, and Hung, for example, estimate an international asset-pricing model that allows for time variation in market integration and show that a number of factors are statistically related to higher degrees of integration including the number and composition of international cross-listings. Bekaert, Harvey, and Lumsdaine estimate a reduced-form model for a number of financial time-series, like stock returns, dividend yields, cross-border capital flows, to search for a common, endogenous break in the process generating the series around market liberalizations. They uncover such common breakpoints and show that events related to the introduction of the first ADR listing from a country are more closely related to those breaks than official market liberalization or other capital-market event dates.7 These studies, like the current one, are country-level investigations, but they focus primarily on the diversification benefits of ADRs for investors and for the integration of capital markets as a whole, and not on the spillover effects on the development of the stock markets.
Our study is most closely related to a select few studies of the “spillover effects” of ADR listings on the domestic stock market development. Most of these studies focus on the impact of trade diversion and migration of order flow to the U.S. markets on the liquidity of ADRs and non-ADRs in the domestic market (Domowitz, Glen, and Madhavan, 1998; Hargis and Ramanlal, 1998; Claessens, Klingebiel, and Schmukler, 2002; Levine and Schmukler, 2003), but some focus on the impact on stock returns and valuations of non-ADR firms (Lee, 2002; Melvin and Valero-Tonone, 2003) while only one examines broader measures of development (Moel, 2001). Moel, in particular, examines the effects of ADR growth for three different proxies of stock market development (market openness, liquidity and the growth in listings) in 28 emerging markets. Unfortunately, his results are mixed across these different indicators. Hargis and Ramalal focus on liquidity in only four Latin American markets and make the case for a net positive effect from international cross listings due to expansion of the global shareholder base for local equities and in spite of order-flow migration following listings. Levine and Schmukler, however, examine a broader sample of 55 countries to show that the migration of trading of “international firms” (which include not only ADRs but also firms that issue equity or debt overseas) to major exchanges has led to a significant diversion of trading away from purely-domestic firms into international firms on the local markets. Claessens et al. show that this diversion of activity is concentrated in those countries with lower incomes per capita, less efficient legal systems and less liquid markets in the first place. Consistent with these broad-based findings, both Lee and Melvin and Valero-Tonone uncover negative “spillover” stock returns for “rival” or “peer” firms with three days around ADR listing announcements.
There are two major contributions of the current paper. First, with the exception of the Moel (2001) study, we evaluate a broad array of measures of stock market development, including the ratio of market capitalization to Gross Domestic Product (GDP), the number of publicly-listed firms, overall cross-border equity flows (relative to GDP) and trading activity (measure as the dollar value of trading relative to market capitalization). However, unlike Moel, we measure these development proxies at the firm level and, most importantly, separately for ADR firms and non-ADR firms. This firm-level analysis allows us to isolate the direct effects of the ADR firms themselves from the indirect effects on the other non-ADR firms in the local market. The analysis is also different because it is conducted at monthly (not just annual) horizons in order to be able to better capture the dynamics of the changes in the ADR and domestic markets.
To this end, we construct our development proxies by aggregating firm-level data on the number, market capitalization, and dollar value of trading of different firms each month and compile it with information on listing dates for the ADRs from the various exchanges and depositary banks. Unlike the results of the Moel study, our results are consistent across all development proxies identifying adverse spillover effects on market capitalization-to-GDP, the number of listed firms and turnover activity for non-ADR firms. Moreover, the results are robust to a number of controls including official market liberalizations, other capital-market events (like country fund introductions) and even the influence of events like the Asian financial crisis.
The second major contribution of this study is that, unlike all other “spillover” studies to date, we distinguish among the different types of ADR listings from the various emerging markets. That is, we measure the scope, size and trading activity in the larger, high-profile ADRs that list on the major U.S. exchanges (New York Stock Exchange, NYSE, and Nasdaq) from those smaller ADRs that list and trade as over-the-counter and as private-placement (by means of Securities Exchange Commission Rule 144a) issues. This distinction is important because over-the-counter listings are typically illiquid and Rule 144a issues trade only among qualified institutional buyers on the PORTAL system. Our central premise is that these alternative vehicles for listing in the U.S. are unlikely to effect as large a diversion of trading activity away from the home market. Yet, we find surprisingly that increasing numbers of Rule 144a and over-the-counter listings are associated with statistically significant effects on ADR and non-ADR firm numbers, valuations and trading that are as large, if not larger, than the impact of exchange listed ADRs. We offer new interpretations in light of these findings and discuss their policy implications.
The remainder of this paper is organized as follows. In the next section, we describe and summarize the data on the growth and expansion of ADR programs in our twelve emerging markets. Section 3 presents the stock market development proxies and conducts simple univariate tests for significant changes around official liberalization and major capital-market event dates, including the first major ADR listings. Section 4 presents the main results of the paper and conclusions follow.
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