Foreign portfolio investment, and inflation in emerging stock markets

This dissertation examines the factors which explained the exceptional growth of emerging stock markets in the 1980-95 period. In particular we examine the role liberalization of foreign investment and reduction in inflation can play. We develop a theoretical model of a stock market in which the interaction of portfolio allocation and participation decisions made by local and foreign investors, as well as the funding decisions of firms determine the equilibrium pricing and level of activity in the market. We show that strategic complementarities exist which give rise to possibility of multiple pareto rankable equilibria. Conditions are derived under which foreign investment can 'crowd in' domestic investors and firms, moving the stock market to equilibria with higher activity levels. The predictions are shown to match the empirical record of emerging stock markets in the last two decades. We also show that liberalization to foreign institutional investment is more efficacious than liberalization to individual investors.;The dissertation also examines the impact of inflation on the distribution of real returns to shares, on stock prices, and consequently on the participation decisions of investors and firms in a stock market. We model the manner in which inflation raises the variance of real returns to each share and the covariance between them. Inflation lowers diversification opportunities and stock prices. We then derive a threshold condition, corresponding to recent empirical work, whereby inflation beyond a certain level has a discrete negative effect limiting stock market growth, but little further marginal effect. We show empirically that the covariance effect can be substantial, and an obstacle to stock market development.;We then examine the implications of inflation for exchange rate variability and foreign investment. Exchange rate variability limits the potential benefits of foreign investment liberalization for stock market growth by substantially increasing the risk of foreign investors. We show that under inflationary conditions, nominal exchange rate hedging can actually increase risk in foreign investment.