Despite making considerable strides over the past two decades, Latin America’s equity markets are still underdeveloped compared to other regions. Of the eight Latin American countries covered in the World Economic Forum’s Financial Development Report 2012 – Argentina, Brazil, Chile, Colombia, Mexico, Panama, Peru and Venezuela – six rank in the bottom quartile with respect to equity market development.

Why is having a developed stock market important and what do I mean when I say that Latin America’s equity markets are “underdeveloped”?

To answer the first question, we have to delve into the theory of financial development. Many argue that the performance and long-term economic growth and welfare of a country are related to its degree of financial development. But what is financial development? According to the Financial Development Report, an annual publication of the World Economic Forum, financial development refers to “the factors policies and institutions that lead to effective financial intermediation and markets, as well as deep and broad access to capital and financial services”.

So where do stock markets fit into the equation? As one of four sub-groups of financial markets (the other three being bonds, foreign exchange and derivatives), stock markets play an integral part in promoting long-run growth. More specifically, they help minimize information costs and facilitate investment by reducing the cost of mobilizing savings. In addition, equity markets, among other factors, encourage innovation because they allow for risky and potentially productive companies to be financed more easily.

The benefits of stock markets are, as described above, quite evident. However, these gains can only be fully realized if a country’s equity markets are liquid and achieve scale. Aside from Chile and Brazil, which rank 29th and 32nd out of the 62 countries covered in the report, Latin America’s equity markets are comparatively underdeveloped. Lacking size and depth, Argentina, Colombia, Mexico, Panama, Peru, and Venezuela, all rank in the bottom 25%.

With regards to depth, Venezuela and Panama have stock market turnover ratios that rank 61st and 59th, while Argentina and Peru rank 57th and 52nd in terms of stock market value traded to GDP. Creating deep and liquid equity markets is beneficial because it helps minimize the risks associated with investing in long-duration projects. In addition, capital is allocated more efficiently as transaction costs are reduced and price discovery is more accurate.

The size of Latin America’s stock markets, as measured by stock market capitalization to GDP and the number of listed companies per 10,000 people, also suggests relative underdevelopment. For instance, Venezuela ranks 60th and Argentina ranks 56th in terms of stock market capitalization to GDP, while Mexico and Colombia rank 61st and 53rd in the number of listed companies per 10,000 people. Larger stock markets are advantageous because they contribute to greater capital mobilization and risk diversification.

One solution to the size and liquidity constraints of equity markets in Latin America is to create a regional stock market. Unfortunately, political considerations and the need for regulatory harmonization are considerable impediments. Therefore, for the time being, Latin American countries should continue to focus on the development of their own equity markets by prioritizing telecommunications infrastructure and creating more robust laws and institutions. This may take considerable time and public sector support, but the long-term benefits (not only for domestic equity markets) should make it a worthwhile commitment.

Author: Todd Glass is a Project Associate on the Financial Services Industries Team at the World Economic Forum and Co-Author of the Financial Development Report

Image: Investors observe Sao Paulo’s stock market at Sao Paulo’s stock exchange REUTERS/Paulo Whitaker