Latin American Capital Markets

THE IMPACT OF THE MACROECONOMIC ENVIRONMENT ON CAPITAL MARKETS 93Prices represent a critical variable in determining scarcity and signaling wherethe resource flow should go. The interaction between supply and demand sets theprice signals for traded assets in capital markets. If these signals are efficient, productionand growth should be maximized. In theory, in developed capital markets, allavailable information is embedded in the prices of individual stocks. In a world whereinformation is a scarce resource, this function is by no means trivial.The macroeconomic environment and the quality of macroeconomic policiesare interrelated with the functions of capital markets. When capital markets are affectedby macroeconomic instability, their microeconomic functions are impaired. At the sametime, some microeconomic distortions have macroeconomic implications; for example,subsidized credit may have fiscal and monetary implications. Moreover; many countrieswith macroeconomic stability have underdeveloped capital markets.This is the case insome countries in the region, where the lack of efficient market infrastructure or thesmall size of the market does not allow for capital market development. Therefore,taken separately, macroeconomic stability and an adequate structural environment arenecessary but not sufficient conditions for the development of capital markets.From a macroeconomic perspective, there is significant interaction betweeneconomic growth and financial depth. Some countries have achieved economic growthwith strong debt markets and weak equity markets (for example, Germany andJapan); for others (including the United States), the opposite is true. It is generally acceptedthat countries with high growth rates have either well-developed or developingcapital markets.There is less agreement regarding causality.The functions of capital markets are quite important, but they may be criticalor accessory depending on the existence of bad or good substitutes. Garcia(1987) puts forward the hypothesis that changes in the demand for or supply ofmoney will cause changes in the availability of credit Garcia analyzes and accepts, witha high degree of confidence, the hypothesis that private sector credit was a significantvariable in the aggregate production function of Argentina in 1946-70. Exogenousmovements in the real quantity of private sector credit significantly affected Argentina'sgross domestic product (GDP).Can the results for Argentina be generalized? The situation in Mexico after the"tequila" crisis seems to contradict them. After 1995, Mexico's banking system practicallyshut down. No meaningful credit flowed to the private sector. Nevertheless, afterthe sharp 1995 downturn, the country recovered and experienced high growth. Howcould it produce high growth with a closed banking system? A significant part of theexplanation relies on the commercial credit provided by U.S. business firms to theirsubsidiaries and to large Mexican firms. Subsequently, the North American Free TradeAgreement (NAFTA) generated growth in foreign investment and external demand,Copyright © by the Inter-American Development Bank. All rights reserved.For more information visit our website: www.iadb.org/pub