Trading Restrictions in Emerging Markets - dummies

Trading Restrictions in Emerging Markets

By Ann C. Logue

Stock exchanges in emerging markets often have strict regulations on whether investors outside the country can invest there. These restrictions are often designed to reduce the amount of perceived volatility in a market and increase the chances of investor success, although they may not achieve that aim.

If you’re investing in emerging markets, you need to be aware of certain trading restrictions:

  • Restrictions on foreign ownership: Nations have good reasons to try to restrict outside ownership of its businesses:

    • To protect an emerging economy from the volatility of quick trades. The term the traders use is hot money, and it applies to investors who invest big when the market looks good and sell at the very first sign of trouble. All the buying and selling can inflate bubbles and cause crashes, and no one wins when that happens.

    • To prevent outside investors from taking over a country’s business. Investors can buy share bit by bit and take over an entire company in no time.

    You often find restrictions on foreign ownership in international stock markets, and they’re also very common in real estate. In some cases, the restrictions may only apply to investments in industries considered to be sensitive, such as defense. In any event, they may limit your investment options.

  • Restrictions on short selling: Short selling is the practice of borrowing a security and selling it in hopes of buying it back at a lower price in order to repay the loan. Short sellers play a key role because they indicate when a stock price is too high. But, because short selling sometimes looks like a cynical bet on failure, regulators in many emerging markets restrict it at the first sign of trouble in the markets — if they allow it at all. This is a big problem for you if you use short selling as part of your investment strategy. In the long run, limiting short selling makes a market less efficient.

  • Restrictions on leverage: Leverage is the practice of trading with borrowed money. It lets you get a greater return than you may otherwise receive, but adds risk that you won’t have the cash to make good — the reason it’s restricted in most financial markets. Customers who want to trade on borrowed funds may have to prove that they’re creditworthy, or they may be limited as to how much they can borrow.

  • If a market prohibits leverage, prices are likely to be lower than they should be (and you know that people are going to find a way to trade on borrowed money anyway). If a market allows leverage with few restrictions, though, expect periodic blowups when a major borrower defaults.