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Bank for International Settlements (BIS) Investment Banks Recommendations and Emerging Markets: The Usual Suspects. Javier Santiso Chief Economist and Acting Director Sebastian Nieto Parra Research Associate OECD Development Centre. Basel - September 2007 . Overview. 1. Objective. 2. - PowerPoint PPT Presentation

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  • Bank for International Settlements (BIS) Investment Banks Recommendations and Emerging Markets: The Usual Suspects

    Basel - September 2007

    Javier Santiso Chief Economist and Acting Director

    Sebastian Nieto ParraResearch Associate

    OECD Development Centre

    *

    Objective1Capital Flows and Research Publications2Determinants of Banks Recommendations3OverviewConclusions and Policy Lessons4

    *

    Two core questionsDo 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.

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    Objective1Determinants of Banks Recommendations2Capital Flows and Brokers Publications3OverviewConclusions and Policy Lessons4

    *

    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).

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

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    Recommendations Database

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    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).

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    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.

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    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).

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    Determinants of capital flowsImpact 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).

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    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.

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    Determinants of capital flows

    We used Variance Inflation Factors (VIF) as a measure of the multi-colinearity in the regressions. The result of this analysis excluded two variables:

    - US Federal Funds Real rate (by substracting core CPI)

    - A Composite leading indicator (CLI) provided by the OECD.

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    Determinants of capital flows

    In order to determine if a Random Effects Model (REM) was an adequate econometric model for this analysis we realised the Hausman Test. The null hypothesis underlying the Hausman Test (FEM and REM estimators do not differ substantially) was rejected.

    In order to avoid problems of endogeneity between independent and dependent variables we have also taken into account the first lag of each of the explanatory variables in the regressions. In fact, by taking the lagged explanatory variable we could solve causality problems which are common to capital flows analysis.

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    Determinants of bond flows

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    Determinants of equity flows

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    Determinants of capital flowsThree 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.

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    Objective1Determinants of Banks Recommendations2Capital Flows and Brokers Publications3OverviewConclusions and Policy Lessons4

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    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).

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    Recommendations and Research LiteratureEmpirical 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).

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    Investment banks businessBanks 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.

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    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.

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    Size of the Market and Recommendations

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

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    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 .

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    Underwriters Recommendations

    Structure of the Underwriting Market: Few number of participants.

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    Underwriters Recommendations

    The probability that a government continues at state t+1 with the same lead manager used in the previous period (t) is reduced.

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

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    Underwriters RecommendationsA 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

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    Underwriters Recommendations

    3 years

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    Underwriters Recommendations

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

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    Political and Financial CrisisNominal exchange rate depreciationand government change0,940,960,9811,021,041,061,081,11,121,141,16-9-8-7-6-5-4-3-2-10123456789Source: Frieden, Ghezzi y Stein, 2001Country`s TotalElections 1Colombia131989172Costa Rica111990143Guatemala11199134Ecuador10199205Chile101993106Peru101994187Honduras10199568Paraguay9199689Brazil91997710El Salvador919981511Republica Dom.919991212Uruguay920001113Mexico92001414Argentina820021315Nicaragua82003816Panama82004617Venezuela82005518Bolivia7200611

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    Political and Financial Crisis

    Some countries achieved to decouple both cycles: Mexico in 2000.Source: Jorge Blzquez and Javier Santiso, 2004. Timing of Presidential Elections and Exchange Rate Depreciations in Mexico, 1975-2000 Election Year Election Year Election Year Election Year Election Year

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