- Ramana Ramaswamy, Jorge Roldos, Donald Mathieson, and Anna Ilyina
- Published Date:
- April 2004
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Eichengreen, Barry, and RicardoHausmann, and UgoPanizza,2002, “Original Sin: The Pain, the Mystery, and the Road to Redemption”paper presented at the IDB Conference, “Currency and Maturity Matchmaking: Redeeming Debt from Original Sin (November).
Emerging Markets Investor, 2001, “Thinking Global, Buying Local.”Vol. 8 (September), Issue 8.
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Jeanne, Olivier,2002, “Why Do Emerging Economies Borrow in Foreign Currency?”paper presented at an IMF Research Department Seminar (Washington, March6).
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Feldstein (1999) encouraged emerging markets to accumulate reserves as insurance against the disruptive financial effects of an abrupt reversal of capital flows. According to Greenspan (1999), the Deputy Finance Minister of Argentina, Pablo Guidotti, proposed that the level of usable reserves should exceed the one-year scheduled amount of foreign currency debt amortization (assuming no rollovers). Greenspan (1999) extended Guidotti’s proposal by arguing for a “liquidity-at-risk” standard that would require a country to hold liquid reserves sufficient to ensure that it could avoid new borrowing for one year with a certain ex ante probability, such as 95 percent.
Moreover, the ratio of emerging markets’ foreign exchange reserves to nominal GDP at the end of 2002 was at the highest level since 1990. Similar results hold for the ratios of reserves to imports and reserves to broad money (M2).
IMF (2003a) reported, for example, that during 1998–2000, the number of countries maintaining controls on both current and capital account transactions remained relatively unchanged (falling from 74 percent to 70 percent of all IMF members). Moreover, although the overall use of capital controls did not change, a growing number of countries began to regulate selected transactions. In particular, the number of countries maintaining controls on institutional investors rose sharply. While many of these controls were prudential in nature (such as limits on purchase of foreign assets), some specified the channels’ markets, and/or institutions for permitted cross-border transactions.
For example, Bubula and Ötker-Robe (2002) found that between 1995 and 2001 the proportion of emerging markets with de facto floating exchange rates rose from 9 percent to 50 percent. At the same time, the proportion of countries with a hard peg also rose from 9 percent to 16 percent. This evidence is consistent with what Fischer (2001) described as the “hollowing out” of exchange rate arrangements. However, Reinhart and Rogoff (2002) argue that the shift in exchange rate arrangements has been much more complex than indicated by official classifications. Their analysis suggests that many official pegs were de facto much more flexible and conversely that many floating exchange rates showed considerable rigidity.
Drawing on lessons from recent emerging markets crises, Greenspan (1999) noted that well-developed bond markets can act like a “spare tire” and substitute for bank lending as a source of corporate funding when bank lending dries up.
The economies include China, Hong Kong SAR, Malaysia, Singapore, Korea, Thailand, Argentina, Brazil, Chile, Mexico, the Czech Republic, Hungary, and Poland. The countries were selected on the basis of the availability of data on corporate bond issuance. The data on local bond issuance cover various types of instruments, including fixed interest rate bonds, floating interest rate bonds, and bonds indexed to such items as the price level or the exchange rate. In general, it is not feasible to segment the data by type of instrument.
The public sector is defined as the central government, government-owned financial institutions, and public sector enterprises.
Indeed, a strong banking system is likely to play a key role in facilitating the development of local securities and derivatives since banks in emerging markets often are key underwriters of securities, investors in bonds, providers of credit to securities houses, and suppliers of over-the-counter derivative products.
Even in the mature markets, the low credit risk and high liquidity features of government securities have made them natural providers of benchmark interest rates (see IMF, 2001).
The Mexican Congress has also approved the use of derivatives, but the pension funds still have to comply with some prudential rules and operating requirements (see Cervera and Quedry, 2003).
See La Porta and others (2000). Corporate governance and the development of local capital markets have been associated with macroeconomic outcomes such as output growth and the severity of exchange rate crises and output volatility (see Johnson and Shleifer, 2004, and references therein).
See, for instance, La Porta and others (2000) and references therein. The authors provide measures of investor protection for 49 countries and classify them by legal origin. Besides the provision of adequate (clear and regular) information about firm performance and external audits, investor protection is usually measured by the voting rights of minorities, their ability to exercise their vote by mail and call extraordinary shareholder meetings, to participate in executive boards and have mechanisms to sue or get relief from board decisions, as well as preemptive rights to new issues and tag-along rights in the case of changes in control—to protect them from dilution by controlling shareholders.
The system was devised with the aim of providing family-owned companies an incentive to list while retaining control—indeed, ownership of 17 percent of a company would ensure control. See Barham (2001).
Market participants, however, doubt that many corporates will take advantage of this provision as the large pension funds may have reduced incentives to invest in an opted-out company.
While most of the issues discussed in this section refer to equity markets, weak transparency and corporate governance are also a significant constraint for the development of corporate bond markets (see Sharma, 2000).
The nominalization of the short end of the curve has deprived the fixed-for-floating UF interest rates swap market of the reference rate for the floating leg of the transaction.
A credible monetary policy framework and a credible commitment not to bail out debtors are obvious policy implications of these analyses.
The argument applies equally to bank lending as to local bonds. Caballero and Krishnamurthy (2003) show that the limited development of local financial markets also reduces the incentives for foreign specialists—who would be willing to bring foreign capital to lend against domestic currency collateral—to enter the local market, reinforcing the underinsurance problem.
Eichengreen, Hausmann, and Panizza (2002) note that transaction costs in a world of heterogeneous countries and network externalities may give a small number of vehicle currencies a special attractiveness.
Similar issues arise in economies with dollarized deposits; see IMF (2003b) for a discussion of prudential and crisis management aspects of dollarized banking systems.
Experience shows that the CPI is less volatile than the exchange rate, especially during crises; price indexation is also a superior alternative to indexation through floating interest rates, as the latter are also quite volatile in emerging markets.
These concerns are particularly serious in the case of small stock markets. See IMF (2002a) for further details on domestic equity markets as a source of funding and an investment alternative for international investors. Structural issues in global and emerging equity markets are dealt with in IMF (2001).
Claessens, Klingebiel, and Schmukler (2002) show that countries that follow these types of policies tend to have larger and more liquid stock exchanges. However, they also show that as such fundamentals improve, the degree of migration to other exchanges also increases.
Pagano and others (2001) also show that the need for greater liquidity appears to be one of the most important factors in the decision to cross list shares and issue American Depository Receipts/Global Depository Receipts.
The focus here is on structural policies. The issue of official intervention in stock and bond markets in the context of speculative attacks is dealt with in Chapter V of IMF (1999).
Positive feedback traders are those that buy past winners and sell past losers; negative feedback traders (or contrarians) follow the opposite trading strategy.
By end-December 2002, U.S.-dollar-linked debt had fallen to $40 billion (from $77 billion the previous year), while the level of swaps outstanding had reached $26 billion.
The availability of derivative instruments and markets to trade them should not be confused with the availability of an abundant supply of “hedge”—the latter being related to the credibility of macroeconomic policies and the willingness to take one side of the market.
The authors caution, however, against attempts to follow this path—namely to reverse the opening of the capital account—for countries that have followed alternative sequencing strategies.
Chile is sometimes mentioned as an example; see Cifuentes, Desormeaux, and Gonzalez (2002).
Yuan (2000) shows that issuance of sovereign bonds in international markets creates informational externalities that improve the liquidity of corporate bonds.
These include work aimed at developing local bond markets by APEC, the ASEAN+3 group, and a recent proposal by the Asian Cooperation Dialogue (ACD). The latter would involve a set of Asian governments launching a regional bond fund, financed by Asian central banks, that would “catalyze” larger investments from institutional investors and would invest initially in U.S. dollar, euro, and other nonregional currency bonds, later diversifying into local currency bonds from government and corporate issuers.
See Greenspan (1999). However, while bond markets and banks have served as backup forms of financial intermediation in the United States, empirical evidence for a broader set of countries shows a positive correlation between bank lending and bond issuance—see Hong Kong Monetary Authority, HKMA (2001).
As in previous reports, only a select sample of emerging markets is covered in this chapter. These countries are those that have been visited by the stall in the past two years, and where information on recent developments is most up-to-date.
As yields in Singapore Government Securities (SGS) have generally been lower than those of G-7 securities, the costs of developing the market—including those of managing securities issuance and operating the SGS trading system—are likely to have been rather small.
As a result of this strategy, foreign currency debt as a percent of total government securities declined from 53 percent in 1997 to 42 percent in 2001 in Poland, and from 41 percent to less than 30 percent in Hungary in the same period.
As most Korean corporated bonds were guaranteed by banks, some analysts considered the bond market to be an extension of the banking system.
Some market participants disagree with the standardization of contracts, as they may constrain the issuers ability to accommodate company-specific financing needs.
Firm underwriting is an arrangement whereby investment banks make outright purchases from the issuer of the securities and they sell them at a profit or loss depending on market conditions; under alternative arrangements,
In the last quarter of 2002 volumes in local instruments surpassed those in external instruments for the first time since the survey was conducted.
Emerging Markets Trade Association (EMTA) data have the advantage of a common methodology across countries, but the fact that a large fraction of reporting firms are international banks means that sometimes individual country data differ from local sources. In particular, the latter show continued growth in trading volumes in Korea and Thailand, in contrast to Table 7.
Foreign ownership of government securities continued to increase in the second half of 2002 and early 2003—especially after the Irish referendum—reaching almost 40 percent in Hungary and 20 percent in Poland.
Further moves toward accession continue to underpin the attractiveness of convergence plays, while loose macroeconomic policies and uncertain exchange rate outlooks undermine them.
This may be, in part, due to the fact that foreign investors take positions in local bond markets through total return swaps, and the actual bond holding is registered with a local bank.
While the daily trading volume of indexed bonds was just 10 billion pesos (with an outstanding stock of 349 billion pesos), the corresponding figure for fixed-rate bonds was 140 billion pesos (for an outstanding stock of 107 billion pesos) in March 2002.
For many global investors, the benchmark used to measure emerging equity markets returns is the S&P/IFCI composite index. It is U.S. dollar based, excludes stocks that foreign investors are restricted from buying in emerging markets, and adjusts for float, liquidity, and market Capitalization. An alternative benchmark index for emerging market investors is the MSCI Emerging Market Free (EMF). The main difference between the two indices is that the MSCI EMF attempts to proxy the industry coverage of the local index, while the IFCI composite includes stocks solely on liquidity and accessibility considerations. Both indices are used extensively as benchmarks by emerging market funds and are highly correlated.
The Sharpe ratio equals the difference between the return on an instrument and a risk-free rate of return divided by the standard deviation of the return on the instrument.
Focusing on individual countries rather than the entire index for diversification purposes would not have helped matters. As noted earlier, dedicated emerging market funds have done no better than the index; there has been a high correlation of returns among emerging stock markets through much of the 1990s.
For instance, while the Thai baht depreciated by 38 percent over the 12 months to May 1998, the stock market declined by 66 percent in U.S. dollar terms; similarly, the Indonesian rupiah depreciated by 78 percent over that same period, while the dollar value of the stock market fell by 88 percent.
For instance, the Thai component of the IFCI has a price earnings ratio of 35 currently, while it is about 10 on the local stock market index; in Malaysia, the local stock market price-earnings ratio is 22, while the IFCI component of the country index has a price/earnings ratio of 52.
Indeed, the typical risk-return profile of ADRs is not very different from that of locally listed stocks because of arbitrage.
The trend toward internationalization of equity markets, which includes delistings, ADR issuance, dual listings and other phenomena, is discussed in IMF (2000); the shift of liquidity toward financial centers and consolidation of exchanges is described in IMF (2001).
See, for instance, Beck and Levine (2001). They argue that stock markets act as an offset to the monopoly power exercised by banks, and the competitive nature of the stock markets encourages innovative growth-enhancing activities as opposed to the more conservative intermediation approach of banks.
Based on the BIS quarterly reports.
This restriction is similar to the Korean “real demand principle.” It was aimed at limiting speculative activity, but was never strictly enforced until late 2001.
For example, the uncertainly about the enforceability of close-out netting provisions in an insolvency scenario is often mentioned as one of the factors that hampered the development of the OTC market in Brazil.
While in the OTC market, the derivative product is guaranteed by the issuer, the contracts listed on an exchange are guaranteed by the exchange. Thus, in the latter case, the counterparty risk is typically lower. Other advantages of using standardized derivative products offered by organized exchanges include faster execution, easier liquidation of contracts, and lower transaction costs.
The increase in the average daily trading volume of the KOSPI 200 options was even more stunning—from 1.6 million contracts in December 2000 to 9 million contracts in December 2002 (all contract volumes are based on file information provided by the FOW TRADE data).
Given that equity index derivative contracts traded on KSE are of a significantly smaller size than those traded on major exchanges, KSE is not considered in the BIS global ranking of exchanges. However, according to the BIS quarterly survey, KSE is the largest derivatives exchange in the world based on the number of contracts traded.
These instruments typically provide for a minimum principal amount to be repaid to investors and a variable return amount based on the performance of an index or a portfolio of securities.
Both estimates exclude emerging Asia. Deutsche Bank is believed to be the largest broker-dealer in the emerging market credit derivatives.
A credit default swap is a financial contract under which the protection buyer pays a periodic fee (expressed in basis points per notional) in return for a payment by the protection seller contingent on the occurrence of a credit event. A credit-linked note is a security with principal and/or coupon payments linked to the occurrence of a credit event with respect to reference entity (i.e., it is a structured note with an embedded default swap). In a synthetic collateralized debt obligation (CDO), the issuer of notes (protection buyer) is typically either a special purpose vehicle or a bank and the payments are usually linked to a portfolio (which may be actively managed) of default swaps referencing a variety of credit risks. The proceeds from issuance of CDOs are reinvested in a collateral consisting of highly rated government securities, which is used to pay interest and principal on the notes.
This is based on the emerging markets credit derivatives survey conducted by the Emerging Markets Trading Association (EMTA) and released in May 2003. The questionnaire requested notional values of all credit derivatives traded during the period from January 1 to March 31, 2003. A total of 22 internationally active banks participated in the survey (excluding Deutsche Bank).
For example, J.P. Morgan has recently launched the Emerging Markets Derivative Index (EMDI), which is a basket of 19 sovereign CDSs. Separately, Merrill Lynch has launched the Asia-Liquid Indexed Credits (Asia-LINC), with 25 reference entities in the basket representing corporate credits from China, Hong Kong SAR, India, Korea. Malaysia, Philippines, Singapore, Taiwan Province of China, and Thailand.
An obvious disadvantage is that as with any insurance contract, no payout occurs if protection expires before the credit event.
The existence of a liquid corporate bond market is critical because the CDS counterparties use the underlying bond market to hedge their swap positions. In addition, the type of reference obligations most commonly included in a CDS contract is “bonds,” and less often “bonds and loans” or “specified obligations.”
This move was intended to result in a more efficient pricing of both instruments and a reduction of the transaction costs for end users of these instruments, with mutual funds being the main users of the real-denominated bonds, and with local corporates being the main users of currency hedges. Before March 2002, Brazilian corporates had to pay a premium to the financial intermediaries for transferring the U.S. dollar hedge component of the U.S. dollar-linked bond to them through currency swap arrangements. Of course, the fact that the BCB became the main supplier of currency hedge to corporates did not remove the currency risk, but rather shifted the risk to the BCB. The question of how the BCB should manage this risk without adverse implications for exchange rate or macroeconomic stability is beyond the scope of this chapter.
The term “convergence trade” refers to a bet that the local inflation rate (and thus long-term interest rates) in an emerging market will converge to a particular developed market rate (in the United States or in the EU) within a certain period of time or as economic integration progresses.
This exercise uses monthly time series of foreign purchases of local shares (from Bloomberg) and trading volumes in local equity and foreign exchange derivatives markets (from the FOW TRADE data).
See the notes on the index methodology on http://www.tremont.com.
“Basis” is the difference between bond spread (over LIBOR) and the CDS premium for the same credit/same maturity.
An important feature of CLNs is that they can be issued in Euroclearable form and listed on international exchanges. In contrast to CDSs, which do not pay the protection buyer until a credit event occurs, the credit-linked notes allow the protection buyer to receive cash payment at the time of the issuance of the notes, and thus eliminate the counterparty credit risk inherent in the CDSs. For more detailed discussion of various credit derivative products offered by major investment banks, see Deutsche Bank (2003) and Ranciere (2002).
Equity swaps are a subset of the total return swaps discussed are discussed below.
At the end of 1994, foreign exchange reserves of the Banco de Mexico were at 86.1 billion.
Other structured instruments were also used in the run-up to the Asian crisis. For example, one of the well-known instruments was called a PERL—principal exchange rate linked note, described in detail in Dodd (2001). A PERL was a dollar-denominated instrument that generated cash flows linked to a long position in an emerging market currency. If the exchange rate remained stable, the return on the PERL was significantly higher than the return on the similarly rated dollar paper, but in the event of major depreciation, the return could become negative.
The most recent (1999) ISDA guidelines include the following types of credit events: “failure to pay,” “obligation acceleration,” “obligation default,” “repudiation/moratorium,” and “restructuring.”
By comparison, as of November 2001, the value of the EMB Global Argentina subindex was around $51 billion.