The expansion of free-trade agreements has created a global market of goods and services that has led to better resource distribution. Capital markets seem to be following suit, but in emerging economies the lack of depth remains a challenge. The limited number of securities, the lack of liquidity and the slow emergence of derivatives markets create one-sided markets, where there are only potential buyers or sellers, but not both.
In these cases, the next logical phase of capital market development is deepening stock markets by allying them to other strategic markets and increasing their efficiency. This was the step taken by Colombia, Peru and Chile when in 2009 they agreed to merge their stock exchanges and form a common stock market. The initiative, which will become functional in 2011, already holds great promise for the participating countries, a complement to their economic growth and business development.
Each of the markets involved in the merger offers complementary features so integration is likely to be successful. This is already evident in the type of sectors included in the new stock exchange as well as by the number of companies listed. At the same time, the expansion of the markets as a result of consolidation is in itself beneficial. The exchange can now offer investors the advantages of economies of both scale and scope. Issuers and investors from the three countries will receive a higher aggregate value in financing terms without increasing transaction costs. Once the market integration is fully consolidated—a process that will take several years—future negotiations with other important financial centers of the region, such as Mexico and even Brazil, will become possible.
But to understand the benefits of the Colombia-Peru-Chile stock market merger, it’s important to look at Europe’s experience. As in Europe, this integration requires a significant effort to attain regulatory standardization through the consolidation of individual regulations and trading systems. Only a unified market will yield significant increases in stock market capitalization and trades at the transnational level.
International Experience
The 1999–2000 merger of the European stock exchanges stands out as one of the more exciting and bold global financial developments.
Before then, European capital markets were relatively underdeveloped compared to those of Japan, the United States and the United Kingdom. They also suffered from the kind of complex regulatory system now prevalent in Latin America. A lack of regional standardization led to regulatory arbitration, unnecessary securities movements and excessive costs.
In 1987, the European Commission began a process of standardization to establish a common set of regulations for its securities markets. But the rules issued over the next decade were not enough to unify the markets, thus impairing full integration. It was not until 1999, with the establishment of the Financial Services Action Plan, that Europe’s securities markets were finally standardized.
Soon after, the Paris, Brussels and Amsterdam stock exchanges merged in the second half of 2000, giving birth to the Euronext stock market. This merger sought to strengthen financial markets that individually could not compete in liquidity or capitalization with those of London or New York. Some of the world’s most important firms became part of Euronext, including blue chips such as Suez, L’Oreal and Philips.
The regulatory standardization and flexibility established by Euronext were critical to its success. In 2007, the New York Stock Exchange acquired Euronext creating one of the world’s most highly capitalized market groups, NYSE Euronext, operating on both sides of the Atlantic.
Euronext’s capitalization rose from 1.5 trillion euros ($1.35 trillion) in 2001 to almost 3 trillion euros ($4.1 trillion) in 2007, according to the International Federation of Stock Exchanges. And although it fell to 2 trillion euros ($2.8 trillion) in 2009—a result of the international financial crisis—recovery is expected along with that of the global economy. Even with the Eurozone’s low economic growth (close to 1 percent annually in recent years), the stock market’s regulatory reliability has yielded an acceptable performance.
The experience of Euronext shows that stock market integration should come in phases corresponding to increases in market liquidity and the number of securities available to the public. However, regulatory standardization is fundamental to ensure that integration achieves all the benefits that are expected.
These are important lessons—ones required for governments, businesses and investors in the three South American countries to take into consideration as they integrate their joint stock market.
The Benefits of Consolidation
Just a year after the Colombia, Lima and Santiago stock exchanges agreed to unify their markets, the newly-integrated market, the Mercado Integrado Latinoamericano (Mila, or in English, Integrated Latin American Market) will begin operations in 2011. The eventual, full consolidation of these three markets will lead to a market capitalization totaling $470 billion, with 51.2 percent coming from the existing Chilean market, 34 percent from Colombia and 15 percent from Peru.
The recapitalization of the merged market will be greater than that of Mexico ($350 billion), placing it second in Latin America behind Brazil’s exchange ($1.1 trillion).
Integration is essential for the Peruvian and Colombian markets due to their low levels of market capitalization and liquidity. Among other things, low levels of market liquidity limited the benefits for investors who could only concentrate on two or three companies’ shares. The result was that they were unable to diversify portfolios.
Integration should help enhance portfolio diversification and also promote the marketing of more diverse financial instruments across borders. For example, funds can be structured with instruments or securities from the different sectors prevalent in each of the three countries in order to make them more attractive to both investors and businesses.
The key to success for these integrated exchanges will be the new market’s liquidity.
Here, the best example in the region is Brazil, where the ratio of traded volume to GDP is 41.1 percent, according to the International Federation of Stock Exchanges and the International Monetary Fund. Brazil has the region’s highest liquidity levels due to the size of its economy, the development of internal markets for certain products and the regular inflow of foreign direct investment. By contrast, the liquidity level is only 24 percent for Chile, 8.4 percent for Colombia and 3.6 percent for Peru—a result of their smaller, more specialized internal markets.
In its consolidated state, the Mila would consist of 561 issuers, more than in the Brazilian (386) and Mexican (406) markets. Forty-one percent of listed firms would come from the Chilean market, 44 percent from Peru and 15 percent from Colombia. Of the total number of issuers, 46 average over $1 million in traded volume, offering their users trading and investment opportunities. Some of these companies include: Ecopetrol from Colombia; Copec, Endesa and LAN in Chile; and Volcán B in Peru.
Since the stock markets of these three countries are based in different economic sectors, integration would bring the added benefit of complementary activity for investors and issuers. For example, the Colombia Stock Exchange lists industrial and financial firms and has only recently seen significant participation from the mining or energy sector. Today, the state oil company (Ecopetrol), energy firms and banks such as Banco de Bogotá and Grupo Bancolombia are prominent.
Meanwhile, the Lima Stock Exchange is primarily made up of mining, construction and financial firms, with the materials sector making up 60.5 percent of listings as of October 2010. Shares in the Santiago Stock Exchange are mainly linked to services, banking and extractive industries as well as commercial, energy and even wine sectors. All this implies that investors interested in the new integrated market can access a much broader menu of investment options to maximize portfolio returns. This is the result of greater diversification.
Considering that Peru and Chile, unlike Colombia, are investment-grade rated by the three major credit rating agencies, investors in Peru and Chile will have more opportunities to invest in more speculative assets. On the other hand, Colombian investors, especially institutional investors, will have access to less risky assets.
In theory, this should lead to investments in safer assets, albeit with smaller returns, in Peru and Chile, and less safe, but more profitable ones, in the Colombian market. In other words, risk-taking Chilean and Peruvian investors can increase returns on their portfolios with Colombian assets that should outperform the Chilean and Peruvian yields, since Colombia has a lower international credit rating. At the same time, risk-averse Colombian investors will be able to acquire low-yield but secure assets from Chile and Peru.
In terms of coordinating stock transactions in the three markets, integration will call for unification and modernization of the mechanisms and methods of payments and delivery as well as adaptation of systems to facilitate efficient trading. Here, the question is: What advantages will the process bring for investment, and specifically, what are the benefits for the three national economies?
Regulatory standardization and flexibility will attract investors from other parts of the world to Latin America. This means that savings from other regions with surplus resources could finance essential projects in these three countries, all of them currently handicapped by a structural deficit in savings.
Moreover, the creation of Mila adds a second major market (alongside the Bovespa in Brazil) that is capable of competing for resources with the great financial centers including New York, London and Tokyo. This depth, resulting from a market with greater liquidity, could attract potential investors and prompt giant firms to list more shares in Latin America.
Beyond these benefits, integration will have three additional perks: greater market depth and liquidity that generates real market prices and stimulates trading in derivatives; improved corporate governance; and sustainable growth of a financing vehicle such as a securities market.
First, greater liquidity allows the market value of companies to be better reflected in their share prices and, in turn, makes for a better assessment of risk. Similarly, it serves as the basis from which to create hedging instruments (derivatives) that transfer risks to agents willing to take them on. The lessons learned from the 2007–2009 crisis suggest that accurate pricing of assets and the creation of transparent derivatives are fundamental to avoid another systemic crisis.
Second, the liquidity enjoyed by the integrated market and its volume of transactions will attract new firms. This will force many firms that do not presently qualify for listing on an exchange to institute transparent accounting practices and clean up business operations so that they can take advantage of the rewards of integration. In this scenario, the prospects for the real economies of these countries would indirectly persuade more businesses to enter the formal market, leading to overall societal gains.
Although the gains are difficult to quantify in theory, it is possible that businesses operating in the informal sector—because profits can be higher—would explore entering the formal market attracted by the greater liquidity offered by the new integrated stock exchange. Financing costs could also be reduced by joining this larger securities market.
Finally, the Mila, with its broad diversification of securities and liquidity, will become an important source of funding for listed firms. Businesses can turn to the integrated stock market by issuing stock sought by investors in all three countries who are looking for the higher returns that newly listed firms can generate.
This would help to reduce the financing costs for small companies: they would no longer have to exclusively depend on bank credit. Colombia, Peru and Chile would benefit, since firms in the traditional sectors—industry, trade and services—that spur economic growth would consolidate. It would also attract resources for large projects in infrastructure and social development. Such a smooth transition from savings to investing would provide the foundation for economic growth.
So Will it Happen?
Integration of the Colombian, Peruvian and Chilean stock exchanges into a single market structure presents great regulatory and technical challenges. If all obstacles are overcome, the process should yield returns in line with those of NYSE Euronext. With that success, it is highly likely that smaller exchanges (for example, Panama) or even more developed ones such as the Mexican Stock Exchange may join Mila in the next five years.
The Euronext experience suggests that exchange integration leads to increases in liquidity and the number of securities available. In terms of the real economy, gains should come in the form of greater opportunities for financing and attracting investors and, indirectly, in higher employment and tax revenues.
But integration is a long-term process. It took over 10 years for the European Union to achieve the regulatory standardization and flexibility that then allowed for the Euronext boom.
This is why it is critical to accelerate the necessary regulatory accords and standardization of transnational platforms. The central banks, financial regulators and ministries of economy of each country must play a clear and continuous role in this process. The tripartite coordination among so many institutions and laws, especially in the hothouse environment of a market that is sure to grow, will not be simple. But the rewards will be great, not just for financiers and established businesses, but also for small, start-up business and public revenue.
