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Banco de España Investment Banks’ Recommendations and Emerging Markets: The Usual Suspects Javier Santiso Banco de España Investment Banks’ Recommendations and Emerging Markets: The Usual Suspects Javier Santiso Chief Economist and Acting Director OECD Development Centre Madrid - January 2008

Overview 1 Objective 2 Capital Flows and Research Publications 3 Determinants of Banks’ Recommendations Overview 1 Objective 2 Capital Flows and Research Publications 3 Determinants of Banks’ Recommendations 4 Conclusions and Policy Lessons 2

Two core questions • Do recommendations given by investment banks have an impact on 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. 3

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

Recommendations Database • Construction of a unique database containing the recommendations given by the 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). 5

Recommendations Database • We have taken the recommendations given by 12 investment banks. All 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. 6

Recommendations Database 7 Recommendations Database 7

Recommendations Database Example: Average of the recommendations given to Brazil by the investment banks 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). 8

Recommendations Database We have taken 11 Latin American countries that represent nearly 95% of 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. 9

Capital Flows to Emerging Countries • A large body has studied the determinants of 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). 10

Determinants of capital flows • Impact of recommendations on capital flows (Bond flows and 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). 11

Determinants of capital flows : Pull macroeconomic variables that are strongly influenced by real 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. 12

Determinants of bond flows 13 Determinants of bond flows 13

Determinants of equity flows 14 Determinants of equity flows 14

Determinants of capital flows Three results: 1. The impact of investment banks’ recommendations on Determinants of capital flows Three results: 1. The impact of investment banks’ recommendations on capital flows is positive and significant. 2. 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. 15

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

Recommendations and Research Literature Variety of results: - Analysts are confronted with a trade-off 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). 17

Recommendations and Research Literature • Empirical studies of the relationship between the recommendations and 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). 18

Investment banks’ business • Banks are faced with a trade-off concerning recommendations: - While 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. 19

Underwriters’ recommendations nderwriterstheat heof -or to 90% issue to recommend buy date maintain in Underwriters’ recommendations nderwriterstheat heof -or to 90% issue to recommend buy date maintain in their portfolio the bonds issued by the countries where they are acting as underwriters. 20

Size of the Market and Recommendations As the size of the market increases, the Size of the Market and Recommendations As the size of the market increases, the recommendation tends to become increasingly favourable: “too big to underweight”. 21

The Argentinean Case 67 per cent of the recommendations were to maintain the positions 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 IMFled financial package from creditors both improve Argentina’s 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. 22

Underwriters’ Recommendations Structure of the Underwriting Market: Few number of participants. 23 Underwriters’ Recommendations Structure of the Underwriting Market: Few number of participants. 23

Underwriters’ Recommendations The probability that a government continues at state t+1 with the same 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. 24

Underwriters’ Recommendations Given the structure of the market, there is an incentive for nonunderwriters Underwriters’ Recommendations Given the structure of the market, there is an incentive for nonunderwriters to give an equal or better recommendation than underwriters. 25

Underwriters’ Recommendations A possible variable that represents the conflict of interest of banks could 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… 26

Underwriters’ Recommendations 3 years… 27 Underwriters’ Recommendations 3 years… 27

Underwriters’ Recommendations and 4 years. Moreover, some investment banks have specialized the origination business Underwriters’ Recommendations and 4 years. Moreover, some investment banks have specialized the origination business in small countries. 28

Political and Financial Crisis Nominal exchange rate depreciation and government change 1, 16 1, Political and Financial Crisis Nominal exchange rate depreciation and government change 1, 16 1, 14 1, 12 1, 1 1, 08 1, 06 1, 04 1, 02 1 0, 98 0, 96 Source: Frieden, Ghezzi y Stein, 2001 0, 94 -9 -8 -7 -6 -5 -4 -3 -2 -1 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 Country`s Total Colombia Costa Rica Guatemala Ecuador Chile Peru Honduras Paraguay Brazil El Salvador Republica Dom. Uruguay Mexico Argentina Nicaragua Panama Venezuela Bolivia 13 11 11 10 10 9 9 9 8 8 7 Elections 1989 17 1990 14 1991 3 1992 0 1993 10 1994 18 1995 6 1996 8 1997 7 1998 15 1999 12 2000 11 2001 4 2002 13 2003 8 2004 6 2005 5 2006 11 29

Political and Financial Crisis Some countries achieved to decouple both cycles: Mexico in 2000. 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 Source: Jorge Blázquez and Javier Santiso, 2004. 30

Political and Financial Crisis Others have overcome the test of fire more recently: Brazil 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. 31

Political Events and Bond Recommendations Over the course of 2006, all the most important 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. 32

Political Events and Bond Recommendations In comparison to previous election periods, the elections of Political Events and Bond Recommendations In comparison to previous election periods, the elections of 2006 point to a markedly improved confidence. 33

Political Events and Bond Recommendations The Brazilian Case (2002 vs. 2006): “Da Lula Preta Political Events and Bond Recommendations The Brazilian Case (2002 vs. 2006): “Da Lula Preta (2002)… 34

Political Events and Bond Recommendations The Brazilian Case (2002 vs. 2006). …A Lula de Political Events and Bond Recommendations The Brazilian Case (2002 vs. 2006). …A Lula de Mel” (2006). An Ex-Emerging Market? 35

Political Events and Bond Recommendations Chile: Political event is not an issue. An Ex-Emerging Political Events and Bond Recommendations Chile: Political event is not an issue. An Ex-Emerging Market? During the presidential elections of 2000 and… 36

Political Events and Bond Recommendations Chile: Political event is not any more an issue Political Events and Bond Recommendations Chile: Political event is not any more an issue … the Presidential elections of 2006. 37

Political Events and Recommendations Mexico: A risk country before the election date. In 2000 Political Events and Recommendations Mexico: A risk country before the election date. In 2000 due to the risk of transparency of the election process. 38

Political Events and Bond Recommendations Mexico: A risk country before the election date. In Political Events and Bond Recommendations Mexico: A risk country before the election date. In 2006 due to the risk of AMLO (López Obrador). 39

Political Events and Bond Recommendations Are financial markets becoming less sensitive to Latin American Political Events and Bond Recommendations Are financial markets becoming less sensitive to Latin American Election Cycles? Probably YES, although Ecuador. . . 40

Determinants of the recommendations • Impact of political events on investment banks’ recommendations : 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). 41

Determinants of the recommendations : Pull macroeconomic variables that are strongly influenced by real 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. 42

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Determinants of the recommendations 1. The investment value of sovereign bonds and the conflict Determinants of the recommendations 1. The investment value of sovereign bonds and the conflict of interest are significant explanatory variables behind banks’ recommendations. 2. The Political Cycle is a determinant variable in explaining investment banks’ recommendations. More than some standard macro variables. 3. The temporal horizon of investment banks’ recommendations is short term depending more on the continuity of macro policies than on structural reform. 4. 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. 45

Overview 1 Objective 2 Capital Flows and Research Publications 3 Determinants of Banks’ Recommendations Overview 1 Objective 2 Capital Flows and Research Publications 3 Determinants of Banks’ Recommendations 4 Conclusions and Policy Lessons 46

Investment banks’ recommendations 1. The impact of investment banks’ recommendations on capital flows is Investment banks’ recommendations 1. The impact of investment banks’ recommendations on capital flows is positive and significant. 2. What are the determinants of investment banks’ recommendations? Investment banks’ business and political events could be important factors. 47

Policy Lessons 1. There is a need for more detailed information disclosure by investment Policy Lessons 1. There is a need for more detailed information disclosure by investment banks : Push for financial markets transparency. 2. Government agencies should do a strategic monitoring on what financial market are writing about their respective country vulnerabilities: Monitor markets cognitive regimes. 3. 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? 48

Policy Lessons Emerging Markets Covered by Financial Institutions in 2006 (% of total brokers) Policy Lessons Emerging Markets Covered by Financial Institutions in 2006 (% of total brokers) • • Note: Countries most frequently analysed by Emerging Markets Analysts or covered by leading financial institutions. The percentage represents the average presence in their analysis. Only countries analysed by more than 25 per cent of the selected financial reports appear on the graph. Source: Nieto and Santiso (2007), calculation according to 10 selected investment banks 3 relevant emerging market indices 1 global association of financial Institutions. 49

Thank you! Presentation based on: Nieto Parra and Santiso (2007). “The Usual Suspects: A 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 50