Does privatization in emerging economies have a significant indirect effect on local stock market development through the resolution of political risk? It is suggested that a sustained privatization program represents a major political test that gradually resolves uncertainty over political commitment to a market oriented policy as well as to regulatory and private property rights. Evidence has been suggested that progress in privatization is correlated with improvements in perceived political risk and that these improvements are significantly larger in privatizing countries than in non-privatizing countries, indicating that the resolution of such risk is endogenous to the privatization process. Further research shows that changes in political risk in general tend to have a strong effect on local stock market development and excess return in emerging economies, also suggesting that political risk has a price factor. The resolution of political risk resulting from successful privatization has been an important source for the rapid growth of stock markets in emerging economies. The rapid evolution of capital markets in developing countries has emerged as a major event in recent financial history. Portfolio flows to emerging countries rose from 1989 to 1995 and kept rising until the recent crises.

Local stock markets also grew considerably in size. These remarkable developments followed a crisis period when foreign debt and large government deficits had undermined confidence in these economies. A critical policy change in many of these countries has been the establishment of large privatization programs. The known benefits of privatization are a reduction in public debt, improved incentives and efficiency, and better access to capital. Sales to the private sector led to an inflow of foreign capital and technological transfers and have increased integration of local firms in international trade patterns. Although the privatization process in developing countries has been studied extensively, little attention has been given to its impact on the development of the local equity markets.

The coincidence of the emergence of local stock markets and the progress of privatization asks the questions as to what extent these developments are related. As many countries carried out privatization sales through offerings on the local stock exchange, sales certainly led to increases in market capitalization. Although privatization appears to be associated with stock market development, there must have been both a reduction in discount rates and / or new private issues. Listings of large privatized companies provide substantial impact on trading liquidity while at the same time increasing investment opportunities for local investors to increase their portfolio diversification; these effects have a positive impact on the risk-sharing function of the market and lead to market deepening. Some argue that firms seeking listings create an externality for other firms because their shares increase the potential for diversification for all investors. As the original owners incur some flotation costs but do not receive all the benefits of diversification, there will be an under supply of new listings.

Privatization may resolve this "low listing trap" by adding diversification possibilities, encouraging both investment and listings by private firms. In addition, an increase in overall liquidity due to new privatization-related listings can have a self-reinforcing effect on the willingness to hold shares, removing the local market from a "low-liquidity trap." These gains in market deepening and broadening could of course be the result of new private listings as well; there is no specific role here of privatization. For this argument we argue that the process of privatization itself, whenever implementing rigorously and consistently, leads to a progressive resolution of regulator and legal uncertainty, and thus to a resolution of uncertainty over future policy. In particular, successful privatization results in a strengthening of property rights and institutional reliability, which broadens the appeal and confidence in equity investment. As such, its impact is particularly relevant for emerging stock markets, whose legal systems are less developed. The argument that prior to a sale, a government is uniquely motivated to establish a solid regulatory framework and to sell state-owned enterprises, the government also has incentives to facilitate stock market transactions.

This may reverse a policy of discouraging private capital issues in order to fund the state's own funding needs. However, this process is neither instantaneous nor irreversible: after the sale there is some potential risk of a policy reversal, particularly as many countries privatize at a time of difficult economic conditions and privatization hits entrenched political constituencies. Only as the commitment to the announced policy is sustained over time, a progressive resolution of policy uncertainty is specific to privatization sales, even when privatization does not take place predominately through public share offerings. This argument has two testable implications. First, the recent wave of privatization sales in developing countries should have altered the perceived political risk would have affected the attractiveness of equity investments and lead to stock market development. Now we will investigate these two implications in order to assess to what extent privatization contributes to the strengthening of local stock markets through the resolution of political risks.

Focus has peen placed on countries that have privatized extensively over a number of years and use several quantitative indicators that proxy for our notion of political risk. Then, we assess the importance of political risk for stock market development in emerging economies by relating changes in stock market development proxies such as market capitalization, traded value and excess returns to changes in political risk. The second part of the analysis reveals that such changes in political risk are strongly associated with growth in stock market capitalization, traded value and excess returns. The economic impact of changes in political risk on stock market development appears large. These results suggest that the resolution of political risk through privatization has been an important factor in the recent emergence of the stock markets of developing countries. The analysis on the influence of political risk on stock market development is also related to recent research on the link between the legal institutional framework and corporate finance.

It has been found that countries with lower quality of legal rules and law enforcement have smaller and narrower capital markets and that the listed firms on their stock markets are characterized by more concentrated ownership. Research also shows that firms in countries with high ratings for the effectiveness of their legal systems are able to grow faster by relying more on external finance. This analysis contributes by looking at the relation between stock market development and political risk, a measure of the quality of the institutional framework that supports the viability of external finance. The results are related to the research on growth in emerging economies, which suggests that development of local financial markets support economics growth. It has been found that stock market variables such as market capitalization and various measures of asset mismatched pricing help predict subsequent economic growth. This suggests that countries have much to gain from privatization.

In conclusion, the results have implications for the analysis of market segmentation, of which political risk is viewed as one of the main causes. Emerging capital markets are believed to have grown largely as a result of decreasing segmentation. This raises the question of why these markets have become progressively more integrated in the first place. Provided evidence shows that higher levels of political risk is a priced are related to higher degrees of market segmentation. It has also been shown that expected returns are related to the magnitude of political risk. They find that in both developing and developed countries, the lower the level of political risk, the lower is required stock returns.

Taken together with other results, it seems that political risk is a priced factor for which investors are rewarded and that it strongly affects the local cost of equity, which may have implications for growth.