general approach to understanding financial development—one that looks at the domestic and international sides of the process simultaneously. In this perspective, successful financial development is best characterized as the sustainable deepening and broadening of access to financial services, regardless of whether such services are provided at home or abroad, by securities markets or other markets. A greater attention to financial globalization does not imply, however, that the much wider scope for cross-border financial contracting resulting from globalization renders domestic markets useless. It is difficult to imagine that international financial markets would become a perfect substitute of local markets in every respect.<sup>39</sup> Thus, the point is not to deny the relevance of local financial markets but to stress that such relevance acquires meaning under globalization to the extent that domestic markets are a complement, rather than a substitute, to the international market integration.

One significant policy concern about the financial globalization process is that the increasing migration of firms to international financial centers may affect domestic stock markets adversely as too little activity remains at home.<sup>40</sup> This might help to explain our empirical results, as the evidence shows that the level of internationalization of Latin American stock markets far exceeds that of other regions (de la Torre and Schmukler, 2006). To the extent that this higher level of internationalization was not captured by the controls included in our regressions and that internationalization adversely affects domestic markets, this may explain the sign and significance of the Latin American dummy.

# **5. Conclusions**

In this paper, we analyzed the state of capital markets in Latin America. We found that despite the intense reform effort, capital markets in the region remain underdeveloped compared to markets in East Asia and developed countries. Furthermore, we found that stock markets in Latin America are below what can be expected, given the region’s economic and institutional fundamentals. In particular, our results indicate that there is a shortfall in domestic stock market activity (market capitalization, trading, and capital raising) in the region after controlling for many factors, including per capita income, macroeconomic policies, the size of the economy, and measures of the legal and institutional environment.

We described alternative ways of interpreting this evidence and discussed the lessons for the reform agenda. We argued that two stylized views dominate the current debate. The first contends that the gap between expectations and outcomes is due to the combination of impatience with imperfect and incomplete reform efforts. The second claims that the gap is due to faulty reform sequencing. Though differing in diagnoses and

> 39 Guiso, Sapienza, and Zingales (2004) find that local financial development is an important determinant of the economic success of firms (especially smaller ones) even in an environment where there are no frictions to capital movements.

> 40 A number of publications have expressed concerns that local markets are becoming illiquid due to internationalization (see, for example, Bovespa, 1996, Federation des Bourses de Valeurs, 2000, Financial Times, 1998, Latin Finance, 1999, and The Economist, 2000).

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