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We study how local stock market development and internationalization–listing, trading, and capital raising in international exchanges–are related to economic fundamentals. Using panel data, we find that higher-income economies with sounder macro policies, more efficient legal systems, greater openness, and higher growth opportunities have more developed local markets. Importantly, these fundamentals also relate to internationalization, and actually more so, since the better the fundamentals, the higher the ratio of internationalization to local market activity. Furthermore, we find that greater domestic stock market development is associated with subsequent higher internationalization. These findings are not consistent with firms internationalizing to escape poor domestic environments, but rather with better country fundamentals allowing firms to internationalize and with countries with more developed stock markets experiencing more internationalization. With liquidity agglomeration, better fundamentals might further accelerate internationalization, with potential negative effects on domestic markets, as others have already argued.

Financial markets, especially stock markets, have grown considerably in developed and developing countries over the last two decades. Several factors have aided in their growth, importantly, improved macroeconomic fundamentals, such as monetary stability and higher economic growth. General economic and capital market specific reforms, including privatization of state-owned enterprises, financial liberalization, the establishment of stock exchanges and bond markets, and an improved institutional framework for investors, have further encouraged capital market development. Financial globalization has also advanced in the last two decades with increased cross-border capital flows, tighter links among financial markets, and greater commercial presence of foreign financial firms in countries around the world. An important element of the globalization trend has been the increase in the stock exchange activities that take place abroad, most notably for emerging markets, but also for developed countries. Many firms now cross-list on international exchanges, with depositary receipts being a particularly popular instrument to access international markets.1 Going forward, many expect these globalization trends to continue as access to information improves, standards (concerning corporate governance, listing, accounting, and others) become more harmonized, technology advances, and inter-market linkages further increase. In this paper, we try to shed light on how economic fundamentals affect the processes of domestic stock market development and internationalization of stock exchange activities. We do this by analyzing a basic question: how do the macroeconomic and institutional factors that drive the development of local stock markets affect the internationalization process? Many papers have analyzed the factors influencing stock market development. More recently, a number of papers have also studied the factors driving internationalization. However, papers have studied these processes separately, working with different methodologies and samples, making comparisons difficult. In this paper, we use the same framework to analyze how economic fundamentals affect both domestic stock market development and the internationalization of stock market activities (listing, capital raising, and trading abroad) for a large panel of countries and years, thereby facilitating comparisons between the factors driving the two processes. How economic fundamentals affect domestic stock market development and the internationalization of stock market activities is not obvious. At least two possible views exist on the relation between economic fundamentals and domestic stock market development and internationalization. One view is that better institutional and macroeconomic environments spur more developed domestic stock markets, and therefore reduce the need and desire to use international markets. The first part of this view is uncontroversial, as much evidence exists on the positive link between fundamentals and financial market development.2 The second part is behind a number of recent papers on internationalization. According to this view, poor domestic environments prompt firms and investors to use international markets more intensively. An unfavorable domestic environment has long been considered one of the main reasons for capital flight and greater use by domestic residents of all types of financial services offered internationally (see, for example, Collier et al., 2000). This may also apply to the services offered by stock markets. Karolyi (2004), for example, argues that the growth of American Depositary Receipt (ADR) programs in emerging economies is the consequence of badly functioning stock markets, resulting from economic, political, legal, or other institutional forces that create incentives for firms to leave. Moreover, the literature on “bonding” argues that international markets are more attractive to firms from countries with weak institutional environments since they offer them the ability to “bond” themselves to a system that better protects investors' rights (see Benos and Weisbach, 2004, for a review of this literature).3 Thus, poor domestic environments are associated with worse domestic market development, but greater use of international markets. Conversely, improvements in fundamentals help develop domestic markets, but reduce the use of international markets. A second view considers that better domestic environments increase the attractiveness of assets to investors. Markets in general will offer larger amounts of external financing, higher liquidity, and a lower cost of capital when a firm's host country fundamentals improve. Under this view, macroeconomic and institutional factors determine the willingness of domestic and international markets to provide financing to firms. Investors in international markets, with the ability to invest globally, may reward more a better environment than investors in domestic markets.4 Provided that there is access to international markets, better domestic fundamentals will, under this view, lead to more (not less) use of international capital markets. The second view thus differs from the first one. Under the first view, any firm regardless of its domestic environment can choose to go abroad and in doing so can escape, at least in part, the poor domestic environment. Under the second view, however, only firms from good environments are able to go abroad, as the suppliers of capital grant them access to international markets at attractive enough terms. In sum, while there are arguments for both a positive and negative impact on internationalization of an improvement in those fundamentals that positively affect local market development, empirical tests can help us disentangle which view is best supported by the data. Doing so requires a formal analysis of the determinants of both stock market development and internationalization. We conduct this analysis for a large panel dataset, comprising 78 countries and using a relatively long time series, from 1984 to 2000. We start by documenting the patterns in domestic market capitalization, trading, and capital raising for high-, middle-, and low-income countries. Using individual firm data, we calculate similar measures of the level of internationalization and document these for each country grouping. We then formally analyze the factors driving domestic stock market development and internationalization, measured in each case by market capitalization, trading activity, and capital raising. Our results show that there are a (small) number of fundamental factors that affect both the development of local stock markets and the degree of international activity. We also find that generally these fundamentals affect local markets and international activity in the same way, i.e., as a country's macroeconomic and institutional environment improves, domestic stock exchange activity increases, but so does activity abroad. Moreover, we find that improvements in country fundamentals tend to have a greater impact on the internationalization process, i.e., internationalization accelerates as fundamentals improve. We also show that countries with more developed domestic stock markets see relatively more (subsequent) internationalization of stock market activities. Regarding the two views on the role of fundamentals, the findings that the processes of local stock market development and internationalization are driven by the same factors and that these processes are positively related are not consistent with the arguments that explain internationalization as the result of a poor domestic environment. The evidence rather supports the view that access to international markets depends to a greater extent on investors' assessment of the firms' home country environment, and less so on the decision of firms to escape countries with poor environments by going abroad. The paper is structured as follows. Section 2 provides a description of the data and illustrates some of the main trends in stock market development and internationalization over time and across our sample of countries. Section 3 describes the basic econometric tests and results. Section 4 presents some robustness tests and extensions. Section 5 concludes.

In this paper, we show that the underlying factors affecting the development of local stock markets also drive the internationalization of stock market activities. In particular, we find that, while better fundamentals are associated with an increase in both domestic activity and internationalization, improvements in country fundamentals tend to have a larger impact on capital raising, listing, and trading in foreign exchanges, resulting in a higher international activity relative to the domestic one. We also find that greater domestic market development is followed by a larger share of activity abroad. The findings that the processes of local stock market development and internationalization are driven by the same factors and that domestic market development is associated with subsequent internationalization are not consistent with the view that countries with bad fundamentals should see relatively more internationalization (and less local market development). They rather support the view that access to international markets depends in part on investors' assessment of the home country environment, and that better fundamentals make firms more attractive to investors in international markets. As such, they imply for one that other factors, aside from those mentioned in the bonding and related literature, are important in driving the process of internationalization. Moreover, our results suggest that, while countries may worry about internationalization, this process may be a natural part of their overall economic and institutional development, including opening to international markets. This raises questions with important policy implications. One key policy concern of the internationalization process is that it may affect domestic stock market development adversely as too little activity remains at home, exhibiting a potential vicious cycle. With liquidity agglomerating in one market, a process of improved fundamentals and increased internationalization may have negative spillover effects on domestic markets, providing international markets an even greater advantage.27 Large-scale internationalization may thus make it more difficult to sustain fully fledged local stock exchanges. This may not be a concern for the larger corporations that are likely to be driving the process of internationalization in any case. But many medium-sized firms may not be able to go directly overseas and may find it difficult to obtain equity financing when domestic markets shrink. This phenomenon would have major implications for such firms. To conclude, several extensions could complement the analysis conducted in this paper. Although we used as explanatory variables what we believe are the main drivers of stock market development and internationalization as identified in the literature, we did not explore all the variables mentioned in previous papers. Others, for example, have identified time zone differences and similarities in corporate governance and legal framework as affecting the internationalization process. Also, the quality of the home countries' banking system and other financial markets, as well as infrastructure factors (like the efficiency and reliability of clearing systems), may be important elements in determining domestic stock market development and (the degree of) internationalization. Furthermore, there may be specific aspects of the institutional environment that are particularly relevant for domestic market development or for internationalization, something our general indexes of the legal environment do not address. Finally, although we used individual firm level data to estimate our measures of internationalization, we only studied domestic stock market development and internationalization at the country level, and did not study the more micro, individual firm-specific behavior. Clearly, factors such as firm size are likely to affect the degree of internationalization. More research in these directions would be welcomed.