You are a top Treasury official for a developing country who has been asked for advice on how to best open the nation's stock market to foreign investment. Previously, the government did not permit foreigners to purchase domestic stock. Now, the government has a plan to create two markets: one for domestic residents and one for foreign investment. What are the potential drawbacks of this system, compared to allowing both domestic and foreign investors to trade in the same market? What are the larger implications for economic efficiency? How might the government be able to address these issues?

Question

What will be an ideal response?

Answer 1

The creation of two distinct markets will allow for a situation where the prices of the same stock may be different in the two markets. From an efficiency perspective, this is not a good thing. Ideally, those investors who value the stock most should have access to purchase the stock, regardless of which market they are located in. This separation of the two markets could lead to a misallocation of resources. One way to deal with this misallocation is to allow companies the option of issuing the number of shares that will allow them to equate the prices in both markets.