ADRs bring the advantages of liquidity, transparency, and ease of trade of the US markets to emerging markets. As investors (both foreign and local) choose ADRs, local exchanges, brokers, and regulatory authorities come under pressure to modernize operations, enhance disclosure standards, and strengthen enforcement in order to make the local market more liquid, transparent, and efficient.
Through these activities, the local market becomes more developed. We would then expect that, in addition to increased participation by local companies and investors, the more sophisticated US investors would increasingly buy and sell in the home markets of foreign shares rather than through ADRs. Thus, many foreign companies would use the US markets as a temporary mechanism to access US funds and gain international investor credibility and visibility. The development of the ADR market would then result in the further development of the local market, as more local investors and companies enter this more efficient market.
This dynamic product-development interaction between intermediaries and markets can be interpreted as part of a “financial innovation spiral” (Merton (1993)) pushing the financial system towards an idealized target of full efficiency. That is, as products such as ADRs become commonplace, the proliferation of new trading markets in these instruments makes feasible the introduction of competing products by local intermediaries. Trade in these new products and volume expands, driving down marginal transactions costs. This makes possible further implementation of more new products and trading strategies by intermediaries, which in turn leads to still more volume. Success of these trading markets encourages investment in creating additional markets and products, and so on, spiralling towards the theoretically limiting case of zero marginal transactions costs.
Under this model, we might view the migration of local companies to the ADR market as the first step in the competitive dynamic between a deep market (the US market) and the local financial intermediaries, including the local stock and bond markets. Local companies, which were used to dealing with opaque financial intermediaries (such as banks or private equity investors) for their sources of capital, and had bypassed or neglected the local stock market, would turn to the ADR market for capital. Additionally, as firms are able to access foreign equity capital, they might also be able to exploit foreign debt capital, putting the foreign debt markets in direct competition with both the local debt market and with local financial intermediaries.
The second step in the innovation spiral would predict that the ADR market would serve as a catalyst for the local intermediaries to develop in order to compete effectively with the ADR market. This would lead to growth in both the ADR and local markets, and to continued financial innovation by local intermediaries. However, there is an alternate hypothesis. In this scenario, the diversion of activity away from the local market might lead to the opposite effect: As local market firms look abroad to the US market, there would be a reduction in appeal (and hence trading volume and liquidity, and the incentive to innovate) in the local market participants, leading to a downward spiral for local market development. The end result is that the local market would contract and become less relevant.
In this exploratory paper, using a sample of 28 stock markets, I empirically explore the effect of ADRs on emerging market development, and determine if the ADR market has helped or hindered the development of local markets. I study the role of ADRs on three aspects of market development: openness, which proxies for the degree of market transparency and reliability, liquidity, which is a measure of market activity, and growth, which attempts to measure the market’s ability to foster the formation of new enterprises and encourage economic growth.
The preliminary evidence from this study is mixed. Using a set of proxies for these measures of market development, I find that ADRs appear to be instrumental in increasing openness, but negatively impact both liquidity and the ability of the local market to foster economic growth.
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