visible results.<sup>6</sup> The second view, encapsulated in the message “get the sequence right,” claims that the gap is due to faulty reform sequencing. This view draws attention to the problems that arise when some reforms are implemented ahead of others and argues that key preconditions should be met before fully liberalizing domestic financial markets and allowing free international capital mobility.<sup>7</sup> Though differing in diagnoses and policy prescriptions, these views are not necessarily incompatible and both capture important aspects of the problem at hand, yielding considerable insights. Our main argument, however, is that neither of the two views may adequately address a number of salient questions posed by the evidence. We therefore propose a third, complementary view that is much less prescriptive. This view can be encapsulated in the message “revisit basic issues and reshape expectations.”<sup>8</sup> It contends that, although more research is needed, it is difficult to pinpoint which factors may explain the relative underdevelopment of domestic capital markets in Latin America. Future research might find that the gap between predicted and observed outcomes is explained by some factor not included in the long list of controls used in this paper. Nevertheless, we claim that there might as well be important deficiencies with the expectations and design of past reforms. This view argues that policy initiatives need to take into account the intrinsic characteristics of developing countries (such as small size, lack of risk diversification opportunities, presence of weak currencies, and prevalence of systemic risk), and how these features limit the scope for developing deep domestic capital markets in a context of international financial integration. These limitations are difficult to overcome by the reform process. In other words, even if emerging economies carry out all the necessary reforms, they might not obtain a domestic capital market development comparable to that of industrialized countries.

The rest of the paper is structured as follows. Section 2 presents descriptive statistics on capital market development in Latin America and compares them to other regions. Section 3 describes the econometric estimations of whether stock market development in Latin America is close to the level predicted by fundamentals. Section 4 discusses the typological views on why the state of capital markets is different than expected. Section 5 concludes.

# **2. Capital Markets in Latin America**

This section analyzes the state of capital markets in Latin American countries and compares them to those in other countries. Figure 1 shows different indicators of financial development for selected Latin American, East Asian, and developed countries. In particular, this figure presents data on credit to the private sector by financial institutions, stock market capitalization, and the amount outstanding of private sector domestic bonds, all as a percentage of Gross Domestic Product (GDP), at year-end 2004.

> 6 Renditions of this view, in the more general context of assessing the impact of reforms on economic development, can be found, for instance, in Fernandez Arias and Montiel (2001), Krueger (2004), Singh et al. (2005), and World Bank (1997).

> 7 This view is articulated, for example, in Bhagwati (1998) and Stiglitz (2002).

> 8 This view is described in more detail in de la Torre and Schmukler (2006).

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