Not only did capital flows to emerging markets increase dramatically, but their composition changed substantially as well. This could not have happened without these countries embarking on a financial liberalization process, relaxing restrictions on foreign ownership, and taking other measures to develop their capital markets, often in tandem with macroeconomic and trade reforms. 1 New capital markets emerged as a result, and the consequences were dramatic. For example, in 1985 Mexico's equity market capitalization was 0.71 percent of GDP and only accessible by foreigners through the Mexico Fund trading on the New York Stock Exchange. In 1995 this figure rose to 20.53 percent of GDP, and U.S. investors were holding about 19 percent of the market.
Market integration is central to both questions.
In finance, markets are said to be integrated when assets of identical risk command the same expected return. In theory, liberalization should bring about integration with the global capital market, and its effects on equity markets are then clear. Foreign investors will bid up the prices of local stocks with diversification potential while inefficient sectors will be shunned by all investors. Overall, the cost of equity capital should go down, which in turn may increase investment and ultimately increase economic welfare. 2 Foreign investment can also have adverse effects, as the recent crises in Mexico and Southeast Asia have illustrated.