Opening markets raises share prices and increases investment

November 1, 2000

Free Market Foundation

When Latin American and Asian countries opened their stock markets to foreign investors in the late 1980s, capital investment surged and economic growth rates climbed.

According to a recent study, opening up these markets increased the supply of foreign capital and allowed greater risk sharing between domestic and foreign partners.

These factors lowered the cost of equity and boosted private investment.

During the eight months preceding the liberalisation of stock markets, stock prices rose by an average of 3 percent per month in anticipation, surging a total of 25 percent due directly to liberalisation.

The 20 percent cost of equity typical of a closed market was likely to drop to 15 percent once foreign investment flowed in.

Following liberalisation, the average growth rate of private investment was 23 percentage points higher in the first year, with 27 percentage points and 17 percentage points in the second and third years.

The author notes that the surge in capital and private investment is temporary. After about 4 years, private investment returns to pre-liberalisation rates. Nevertheless, the three years of strong investment growth is extremely valuable in previously stagnant economies.

Source: “Liberalizing Emerging Stock Markets,” Economic
Intuition, Summer 2000. Based on Peter Blair Henry, “Stock Market Liberalization, Economic Reform, and Emerging Market Equity Prices,” Journal of Finance, April 2000.

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