The share of foreign trading activity in total stock market volume increased tremendously during the last decade. Today, the amount of gross cross border flows in stocks and bonds is spectacular, exceeding 7 times the GDP (IMF(1998) p.186). The internationalization of capital markets is reflected not only in the addition of foreign securities to otherwise domestic portfolios, but also in active trading in foreign markets. There is surprisingly little evidence, however, on the impact of foreign trading activity on local equity markets. The purpose of this paper is to establish the empirical relationship between foreign trading, the volatility of returns and the correlation of local and world returns.
The motivation for this exercise is straightforward. Despite the benefits of free capital mobility, there are growing concerns that international capital flows are destabilizing. The perception is that by opening capital markets, countries expose themselves to the fickle sentiment of foreign investors. In addition, this sentiment is not only volatile but is also highly dependent on returns in other countries. The required rate of return, which is the cost of capital, depends on the variance of returns and the correlation with world returns. If the impact of liberalization is that the variance and the correlation increase, expected returns must increase. When returns increase, the cost of capital also increases. A higher cost of capital reduces investment and growth, and in this case the opening of the capital account may not be a good idea. The effects of capital account liberalization have been the subject of much recent research. However, the existing literature focuses primarily on the effects of the lifting of restrictions, the introduction of country funds, ADRs, and structural breaks in net capital flows. The impact of foreign trading activity on return volatility and co-movement has not been previously studied. This paper tries to fill in the gap.
Limited access to finance is a serious barrier to entry and growth for less established, new or smaller firms. Adequate funding enables entrepreneurs to overcome generic barriers or constraints to expansions. A broad range of evidence has shown that financial underdevelopment and limited bank competition hinder new firm creation and economic growth (Rajan and Zingales 1998; Levine 1999; Beck, Levine, and Loyaza 2000; Black and Strahan 2002; Cetorelli and Strahan 2006; Aghion, Fally and Scarpetta 2006). As poor investor protection limits access to finance (La Porta et al, 1997, 1998), it also has the effect of reducing competition. Thus any factor which fosters financial development, such as common law (La Porta et al, 1997, 1998), or voters preferences (Pagano and Volpin, 2005; Perotti and von Thadden, 2006) may indirectly favor competition.
Rajan and Zingales (2003a, 2004) have extended Stigler’s theory of regulatory capture to finance, and argued that limited financial development may be the result of political influence of established producers seeking to reduce competition. This paper shows how the ability of incumbents to affect investor protection and thus competition depends on the degree of political accountability. In our model, wealthier entrepreneurs need less external finance and thus lobby for weak investor protection, to limit access to funding to competitors. Reduced competition lowers welfare and makes politicians less popular, so the lobby needs to offer compensating political contributions (“bribes”).
Recent evidence suggests that financial development, in particular the amount of credit to the private sector, is correlated with subsequent economic growth (Levine, 2004). This is particularly true in sectors relying on external finance (Black and Strahan, 2002; Rajan and Zingales, 1998), and appears essential for new entry (Perotti and Volpin, 2004).
This evidence supports reforms which encourage financial development. While lack of funding is not the sole obstacle for potential entrepreneurs (Johnson et al, 2002), access to external financing provides resources to overcome generic entry barriers. Policies promoting financial development, such as improved investor protection and financial liberalization which in principle increase the quantity and quality of external finance, appear therefore well justified.
