Emerging markets should reduce reliance on debt, says IMF working paper

By Reshmi Basu

New York, Jan. 4 - Emerging market countries should reduce their dependence on debt for external financing needs, according to "Institutions and the External Capital Structure of Countries," an International Monetary Fund working paper by Andre Faria and Paolo Mauro.

The authors argue that it would be more advantageous for emerging market countries to rely less on debt and increase the role of equity in their external capital structures because this would make them less vulnerable to economic crises.

Equity-like components such as foreign direct investment and portfolio equity are associated with factors of institutional quality, the authors noted. This explains the correlation between the institutional quality and frequency of crises. Weak institutions tend to increase countries' dependence on crisis-prone forms of financing, making them more vulnerable to the frequency and severity of shocks, they said.

The authors looked only at external liabilities - not the whole balance sheet, in order to grasp the factors underlying countries' existing capital structures. Substantial attention was devoted to the role of institutional quality such as the absence of corruption, red tape or political violence. The paper also focused on cross-country variations and looked at stocks of countries' external liabilities rather than total capital flows.

The authors find that key determinants of countries' capital structures include institutional quality and, to a less degree, educational attainment and the availability of natural resources.

Through rigorous empirical analysis, the authors found that institutional quality is positively associated with total equity, portfolio equity and foreign direct investment.

"Holding other factors constant, better institutions tilt countries' capital structures toward foreign direct investment and, to an even greater extent portfolio equity; and away from portfolio debt and, to an ever greater extent, other liabilities such as bank loans," said Faria and Mauro in the paper.

The authors found that foreign direct investment is vulnerable to institutional weaknesses such as red tape and bribes. Another finding is that institutional quality is positively associated with the ratio of portfolio equity to foreign direct investment.

"Thus, in countries where governance in general and corporate governance in particular is weak, the fear of expropriation may be even greater for portfolio equity than it is for FDI," wrote Faria and Mauro.

The authors concluded that external capital structures of countries play an important role in the implications of economic performance.

"Countries' reliance on equity-like instruments improves their ability to share risk with international investors."

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