Banco de Espa

1
Banco de España Investment Banks
Recommendations and Emerging Markets The Usual
Suspects
Javier SantisoChief Economist and Acting
Director OECD Development Centre
? Madrid - January 2008?
2
Overview
Objective
1
Capital Flows and Research Publications
2
Determinants of Banks Recommendations
3
Conclusions and Policy Lessons
4
3
Two core questions

• Do recommendations given by investment banks have
  an impact on the allocation of portfolio flows in
  the emerging markets?
• What is behind investment banks recommendations?
  A work in process
• - Recommendations and the business of
  investment banks (i.e. bond issuances by
  sovereigns).
• - Financial Markets analysts and political
  events in emerging democracies.

4
Overview
Objective
1
Capital Flows and Brokers Publications
2
Determinants of Banks Recommendations
3
Conclusions and Policy Lessons
4
5
Recommendations Database

• Construction of a unique database containing the
  recommendations given by the major investment
  banks to the Latin American bond markets
• - Over 3 800 observations.
• - 12 Major Investment Banks.
• - Covering the period 1997-2007.
• - Direct and strict link between financial
  intermediaries and investors (not public
  information).

6
Recommendations Database

• We have taken the recommendations given by 12
  investment banks. All of them important players
  in the emerging bond markets, i.e. market makers.

7
Recommendations Database

8
Recommendations Database

• Example Average of the recommendations given to
  Brazil by the investment banks (lhs) with respect
  to the weight of Brazil in the EMBI Global index
  (rhs).

9
Recommendations Database

• We have taken 11 Latin American countries that
  represent nearly 95 of the GDP of the region.
• The total number of recommendations is over
  3,800.

10
Capital Flows to Emerging Countries

• A large body has studied the determinants of
  capital flows
• Push factors or global factors.
• Fernandez-Arias (1996) and Calvo et al (1993).
• Pull factors or local factors.
• Taylor and Sarno (1997) and Alfaro et al
  (2005).
• Information and distance.
• Savastano (2000), Papaioannou (2004) and
  Portes and Rey (2005).

11
Determinants of capital flows

• Impact of recommendations on capital flows (Bond
  flows and Equity flows respectively)
• (i)
• (ii)
• where and percentage
  allocated by funds in country i with respect to
  the total amount invested in emerging economies.
• the average of the investment
  banks recommendations given to country i.
• Pull macroeconomic variables
  defined by capital markets (exchange rate, spread
  of sovereign bonds and rate of return of equity).
  

12
Determinants of capital flows

• Pull macroeconomic variables that are
  strongly influenced by real sector (economic
  activity, inflation rate and interest rate).
• country invariant variables which capture
  global factors (US nominal rates and US
  industrial production).
• Period of the analyses 1997-2005 for equity
  flows
• 2002-2006 for bond flows
• Frequency Monthly.
• Countries Argentina, Brazil, Chile, Colombia,
  Mexico, Peru and Venezuela.

13
Determinants of bond flows

14
Determinants of equity flows

15
Determinants of capital flows

• Three results
• The impact of investment banks recommendations
  on capital flows is positive and significant.
• The impact of the recommendations given to
  external public debt goes beyond sovereign bond
  flows. Indeed, although their influence is minor,
  these recommendations also affect private equity
  flows.
• 3. This new microeconomic variable improves the
  fit of capital flows regressions more than some
  traditional macroeconomic variables such as
  interest rates, economic growth and inflation
  rate.

16
Overview
Objective
1
Capital Flows and Brokers Publications
2
Determinants of Banks Recommendations
3
Conclusions and Policy Lessons
4
17
Recommendations and Research Literature

• Variety of results
• Analysts are confronted with a trade-off between
  sending true signals and optimistic signals.
  Jackson (2005).
• Larger number of buy recommendations than sell
  recommendations. Barber et al (2001).
• Market reaction to upgrades is less pronounced
  than the market reaction to downgrades by
  analysts. Asquith et al (2005).
• Impact of the measures introduced by the NYSE and
  NASDAQ, but also the sanctions established by the
  SEC in 2002. Madureira (2004), Boni and Womack
  (2002) and Unger (2001).

18
Recommendations and Research Literature

• Empirical studies of the relationship between the
  recommendations and underwriters are concentrated
  to OECD countries.
• Agrawal et al (2008), Lin et al (1998), Krigman
  et al (2001), Dechow et al (2000) and Michaely
  and Womack (1999).
• Research literature concentrated in emerging
  markets is scarce and exclusively concentrated in
  the equity market.
• Bacmann and Bollinger (2001), Seasholes (2000
  and 2004) and Chang et al (2000).

19
Investment banks business

• Banks are faced with a trade-off concerning
  recommendations
• While sell side business could have the incentive
  to build reputation by giving accurate
  information in the long term .
• . in the short term recommendations could be
  biased in order to obtain short term profits.
• Additionally, investment banking activities could
  be motivated to recommend optimistically the
  assets which they are participating as
  underwriters in an IPO.

20
Underwriters recommendations

• - 90 of the underwriters recommend at the issue
  date to buy or to maintain in their portfolio the
  bonds issued by the countries where they are
  acting as underwriters.

21
Size of the Market and Recommendations

• As the size of the market increases, the
  recommendation tends to become increasingly
  favourable too big to underweight.

22
The Argentinean Case

• 67 per cent of the recommendations were to
  maintain the positions in Argentinean External
  Debt (prior 2001). Two examples
• Morgan Stanley We are maintaining our Market
  Perform recommendation on Argentine
  bonds.Relaxation of fiscal targets and an
  innovative IMF-led financial package from
  creditors both improve Argentinas credit
  outlook. Argentina needs to raise an estimated
  2.6 billion to fulfil its first quarter
  financing requirements. New issues are expected
  to total 5.6 billion in 2001. Growth and fiscal
  performance are becoming the focus of investors
  attention. January 26, 2001.
• Salomon Smith Barney (Citigroup) The successful
  implementation of the IMF support package with
  the associated debt management transactions and
  the change in the global outlook probably
  increases the chances that economic activity will
  pick up in the second half of the year. We
  therefore recommend a neutral position in
  external bonds and local currency instruments.
  January 17, 2001 .

23
Underwriters Recommendations

• Structure of the Underwriting Market Few number
  of participants.

24
Underwriters Recommendations

• The probability that a government continues at
  state t1 with the same lead manager used in the
  previous period (t) is reduced.

25
Underwriters Recommendations

• Given the structure of the market, there is an
  incentive for non-underwriters to give an equal
  or better recommendation than underwriters.

26
Underwriters Recommendations

• A possible variable that represents the conflict
  of interest of banks could be the countries
  participation in the banks primary bond markets
  business (by using a long run analysis).
• Two years

27
Underwriters Recommendations

• 3 years

28
Underwriters Recommendations

• and 4 years.
• Moreover, some investment banks have specialized
  the origination business in small countries.

29
Political and Financial Crisis
Nominal exchange rate depreciation
Elections
Countrys Total
and government change
1989
17
1
Colombia
13
1,16
1990
14
2
Costa Rica
11
1991
3
3
Guatemala
11
1,14
1992
0
4
Ecuador
10
1,12
1993
10
5
Chile
10
1994
18
6
Peru
10
1,1
1995
6
7
Honduras
10
1,08
1996
8
8
Paraguay
9
1997
7
9
Brazil
9
1,06
1998
15
10
El Salvador
9
1,04
1999
12
11
Republica Dom.
9
2000
11
1,02
12
Uruguay
9
2001
4
13
Mexico
9
1
2002
13
14
Argentina
8
0,98
2003
8
15
Nicaragua
8
2004
6
16
Panama
8
0,96
2005
5
17
Venezuela
8
Source Frieden, Ghezzi y Stein, 2001
0,94
2006
11
18
Bolivia
7
-9
-8
-7
-6
-5
-4
-3
-2
-1
0
1
2
3
4
5
6
7
8
9
30
Political and Financial Crisis Some countries
achieved to decouple both cycles Mexico in 2000.
Timing of Presidential Elections and Exchange
Rate Depreciations in Mexico, 1975-2000
Election Year
Election Year
Election Year
Election Year
Election Year
Source Jorge Blázquez and Javier Santiso, 2004.
31
Political and Financial Crisis Others have
overcome the test of fire more recently Brazil
in 2006
Source Based on Juan Martínez and Javier
Santiso, 2003.
32
Political Events and Bond Recommendations

• Over the course of 2006, all the most important
  Latin American Countries (by excepting
  Argentina) elected their head of the state.

33
Political Events and Bond Recommendations

• In comparison to previous election periods, the
  elections of 2006 point to a markedly improved
  confidence.

34
Political Events and Bond Recommendations

• The Brazilian Case (2002 vs. 2006) Da Lula
  Preta (2002)

35
Political Events and Bond Recommendations

• The Brazilian Case (2002 vs. 2006).
• A Lula de Mel (2006). An Ex-Emerging Market?

36
Political Events and Bond Recommendations

• Chile Political event is not an issue. An
  Ex-Emerging Market? During the presidential
  elections of 2000 and

37
Political Events and Bond Recommendations

• Chile Political event is not any more an issue
• the Presidential elections of 2006.

38
Political Events and Recommendations

• Mexico A risk country before the election date.
  
• In 2000 due to the risk of transparency of the
  election process.

39
Political Events and Bond Recommendations

• Mexico A risk country before the election
  date.
• In 2006 due to the risk of AMLO (López Obrador).

40
Political Events and Bond Recommendations

• Are financial markets becoming less sensitive
  to Latin American Election Cycles? Probably YES,
  although Ecuador...

41
Determinants of the recommendations

• Impact of political events on investment banks
  recommendations
• where is the average of the investment
  banks recommendations given to country i.
• Pull macroeconomic variables
  defined by capital markets Exchange rate, spread
  of sovereign bonds, equity return, investment
  value and the weight of the
  country i in the EMBI Global index (proxy of
  conflict of interest) .

42
Determinants of the recommendations

• Pull macroeconomic variables that are
  strongly influenced by real sector (industrial
  production, inflation rate and interest rate).
• country invariant variables which capture
  global factors (US nominal rates, US industrial
  production and US High Yield spread).
• is a dummy variable that takes the
  value of 1 during presidential elections (3
  months before and after the month of the
  election).
• Period of the analyses 1997-2007
• Frequency Monthly.
• Countries Argentina, Brazil, Chile, Colombia,
  Ecuador, Mexico, Peru, Uruguay and Venezuela.

43
(No Transcript)
44
(No Transcript)
45
Determinants of the recommendations

• The investment value of sovereign bonds and the
  conflict of interest are significant explanatory
  variables behind banks recommendations.
• The Political Cycle is a determinant variable in
  explaining investment banks recommendations.
  More than some standard macro variables.
• The temporal horizon of investment banks
  recommendations is short term depending more on
  the continuity of macro policies than on
  structural reform.
• The credibility and stability of economic
  policies has improved in the eyes of Capital
  Markets analysts. Political risk however still
  remains an important consideration requiring
  further efforts on behalf of governments and
  political parties.

46
Overview
Objective
1
Capital Flows and Research Publications
2
Determinants of Banks Recommendations
3
Conclusions and Policy Lessons
4
47
Investment banks recommendations

• The impact of investment banks recommendations
  on capital flows is positive and significant.
• What are the determinants of investment banks
  recommendations? Investment banks business and
  political events could be important factors.

48
Policy Lessons

• There is a need for more detailed information
  disclosure by investment banks Push for
  financial markets transparency.
• Government agencies should do a strategic
  monitoring on what financial market are writing
  about their respective country vulnerabilities
  Monitor markets cognitive regimes.
• Given that banks recommendations and portfolio
  flows are related, an international co-operation
  scheme needs to be established to encourage
  Market Makers to cover more countries A Public
  Private Patnership in emerging markets finance?

49
Policy Lessons

• Emerging Markets Covered by Financial
  Institutions in 2006
• ( of total brokers)

50

• Thank you!
• Presentation based on
• Nieto Parra and Santiso (2007). The Usual
  Suspects A Primer on Investment Banks
  Recommendations and Emerging Markets. OECD
  Development Centre Working Paper, 258.Nieto
  Parra and Santiso (2008). Enter the Matrix Wall
  Street and Elections in Emerging Democracies.
  OECD Development Centre Working Paper,
  Forthcoming.
• http//www.oecd.org/dev