Quality of Institutions and Import Substitution of Capital: Cross-country Research on the Corporate Bond Markets

Abstract

We have analyzed the institutional determinants of local currency (LCY) corporate bond markets development during the period of 2010–2016 on a cross–country sample. We have considered a wide range of indicators of the quality of the institutional environment including the Heritage Foundation's Index of Economic Freedom, the World Bank’s indicators of the development of political and legal institutions, the World Economic Forum’s indicators of corporate culture, the development and regulation of financial markets. Unlike most previous studies, we have tested not only static regression models (multifactor linear regressions) but also dynamic models based on the generalized method of moments (GMM), which allows to solve the problem of endogeneity of variables. The sample consists of 420 quarterly observations on 15 emerging markets, which were the leaders by the issuance volume of corporate bonds in the pre–crisis 2013. The results show that the low quality of institutional environment as well as macroeconomic and financial instability stimulate the growth of the share of LCY corporate bonds in the total issuance volume. In the periods of instability, local currency corporate bonds become less attractive for foreign investors, therefore, issuers are forced to raise capital in the domestic market, i.e. to realize the import substitution of capital. We rank factors by the significance of their influence on the explained variable. The most significant factors in both static and dynamic model specifications are the World Bank’s indicators of regulatory quality and rule of law. A decline in sovereign credit ratings also gives impetus to the development of LCY corporate bond markets. The results of our research show that more developed stock markets suppress the growth of LCY corporate bond markets: equity corporate bonds are competing financing sources for companies from developing countries. On the contrary, a developed banking sector contributes to the growth of the LCY corporate bond market: banks act as dealers and market makers. The devaluation of the national currency has the most significant positive influence on the explained variable among other macroeconomic factors, that is due to an increase in the cost of debt denominated in foreign currency.

Keywords

• corporate bonds
• quality of institutions
• developing countries
• local currency bond markets