Latin American Capital Markets

128 KAREN GOLDSTEIN ROSSOTTOEnhanced Market LiquidityThe primary way institutions contribute to the ability of capital markets to affect economicgrowth is by creating liquidity. Liquidity exists in deep, actively traded marketswhere securities may be sold quickly, cheaply, and with little price impact. Liquidity isfundamental to capital market development because it allows for stock valuation,thereby reducing investment risk and the cost of capital. Liquid markets also contributeto economic growth by providing financing on favorable terms. Levine (1997)argues that if investors are able to sell their shares at any time, they are more likelyto commit to longer-term and potentially more profitable investments. In this way, liquidityimproves capital allocation and allows firms to rely on financing that is neededfor long-term development.In Latin America and the Caribbean, liquidity may also be a mechanism toimprove the competitiveness of regional markets. In table 5-2, two common metsures of liquidity—the total value of shares traded as a percentage of GDP and thtturnover ratio, showing trading activity relative to market size—indicate that the region'smarkets are relatively illiquid compared with larger OECD markets. This hasprompted larger local companies to seek cheaper and more abundant sources of capital outside Latin American and Caribbean markets. As companies delist from localexchanges, markets become less liquid and the cost of capital increases. With greaterliquidity, markets may be more efficient and attractive to large local issuers. In addi-Table 5-2 | Institutionai Investor Growth and Market LiquidityCountryBrazilChileColombiaMexicoPeruVenezuelaItalyjapanUnited KingdomUnited StatesFinancial assets ofinstitutional investors(percentage of GDP)245746428076203192Value traded(percentageof GDP)11.610.20.87.54.40.844.319.582.5133.7Turnoverratio44.69.53.832.512.78.810469.966.6200.8Copyright © by the Inter-American Development Bank. All rights reserved.For more information visit our website: www.iadb.org/pubSource: World Bank (2001); S&P (2001 b); SIA (2000).