For many years firms in less developed economies have faced a number of constraints in relation to options available for financing. One of the most prominent reasons for this is government control. Governments in these economies have rules in place that limit the amount of instruments available and control the pricing of those that are available (Glen et al, 1994). Despite this fact, firms in these economies behave very much the same way as their counterparties in developed countries seeking to achieve optimal debt to equity ratios in order to minimize the cost of capital (Glen et al, 1994). As the world is becoming increasingly globalized, less developed economies are enjoying greater liberalization allowing them to access international capital markets, thus allowing them to enjoy more options of capital financing.
Traditional forms of Financing for LDE's
According to empirical evidence noted by Glen et al (1994) external financing as opposed to internal financing (from retained earnings) is used more over by firms in less developed economies as opposed to developed economies. This is further substantiated by Agarwala et al (2004) who cite a study done by Atkin and Glen (1992) that firms in G7 countries generally rely on internally generated funds, but firms in developing countries rely much more on externally generated funds such as bank loans.
One of the leading causes of this is due to underdeveloped markets and lack of sufficient financial institutions. For example, Agarwala et al (2004) note that some developing country banks are unable to adequately provide funding resources to firms especially where government demands overpower the private sector and another problem exists that if the macroeconomic environment is unstable it is deemed to risky to lend for the longer term.
Agarwala et al (2004) note India as an example where "40% of every rupee that is deposited in the bank must be held as reserves and directed credit accounts for 24% thus leaving only 36% of deposit to lend freely." Further to this in cases such as Poland, the biggest complaint is that banks won't lend to entrepreneurs who have no proven track record.
The level of debt to equity ratios in firms of developing economies are largely related to structure of their own financial markets and governmental regulation. In the early 1980's many less developed countries Governments such as Mexico, Brazil and Argentina had borrowed substantial amounts from banking institutions globally in the form of syndicated loans (Kohn, 2004, p.588). As interest rates increased, many of these countries were no longer able to service their debt obligation and defaulted, Mexico being the first. As a result of this crisis, the International Money Market was developed when the realization set in that the firms could borrow more cheaply using their own names instead of bank borrowing (Kohn, 2004, p.588).
Global integration then set the path for firms in Mexico to take advantage, however, while the government had moved towards liberalization, it still presented with a weak legal institution (Siegel, 2009). According to studies done by (La Porta, Lopez-de-Silanes, Shleifer, & Vishny, 1998; Wurgler, 2000) cited by Siegel (2009), weak laws hinder the progress of financial development and impedes economic development and limits the ability to obtain outside finance. Despite this fact, Mexican firms found a way around this by establishing cross border relationships with firms in the United States and conforming to their corporate governance practices. Another means was to cross list on the US stock exchange thereby having to conform to US accounting standards governed by the SEC (Siegel, 2009).
Global Mutual Funds and Venture Capital for LDC Firms
As time has progressed, less developed countries have been able to strengthen their domestic capital markets, and as a result their share in international market capitalization has grown from 3.7% in 1986 to 10.7% in 1995. As such this has this has become a more enticing asset class for private investors, which includes US mutual funds (Rea, n.d.).
According to the UNCTAD Secretariat (1997) the flow of non foreign direct investment has increased in emerging markets over the years. The main investors are financial institutions and institutional investors such as pension funds, insurance companies and investment trusts. This has thus increased the sources of external finance for LDC's in the form of equity securities.
Further to this the International Finance Corporation has encouraged the venture capital funding to developing countries in an attempt to improve equity financing access to small and medium firms as well as develop management skills. Over 85% of venture capital funding has occurred in Asia and the transitional European countries (UNCTAD, 1997).
Conclusion
While global liberalization has increased allowing less developed economies to enter the more developed markets, there are still many factors which impede the progress of many of these countries, such as weak legal and regulatory issues, less developed skills and higher costs of business transactions. One good question to ask is whether developing economies actually benefit from global integration by opening up their markets. Could such a move hinder their own domestic market and make them more susceptible to systemic risk? On the other hand, one can gather that LDC's that have opened up become more liberalized in their financial markets have benefited from the increased appetites of institutional investors seeking higher returns than are currently available in the more developed markets.
