Back Matter

Back Matter

Author(s):
International Monetary Fund
Published Date:
September 1995
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    For earlier periods, see Dunaway and others (1995) and Collyns and others (1993 and 1992). For information on official financing flows to developing countries, see Boote and others (1995, forthcoming), and Kuhn and others (1995 and 1994).

    Full collateralization of principal would be a key issue in the ease of a bank package including par bonds, owing to the relatively high upfront cost of providing such collateral. The commercial banks also may be extremely reluctant to accept less than full collateral. Therefore, it may not be feasible to include a par bond in the menu of options in debt- and debt-service-reduction operations for low-income developing countries.

    As noted above, however, liquidity constraints in developing country securities markets may limit the ability of investors lo fully achieve an optimal allocation.

    Note also that there are some differences in behavior among institutional investors. Pension funds, in particular, are viewed as being somewhat longer-term investors and less prone to very rapid shifts in portfolio allocations among assets classes. In contrast, open-ended mutual funds may be more likely to shift allocations, reflecting the ability of the holders to readily redeem their share in these funds.

    Under the debt-for-development option, nongovernmental organizations (NGOs) exchanged their holding of the country’s claims for cash at 11 cents on the dollar. The proceeds were deposited in an escrow account, and the funds are to be invested in projects jointly agreed to by the NGOs and the Ministry of Planning, with financing for these projects from the escrow fund being equally matched by funds provided by the government.

    Debt tendered to this option was below the $5 million threshold established in the term sheet for the bond issue. This discount exchange proposed involved non-interest-bearing bonds with partial principal collateral. The discount rate and the level of collateral were to be determined in such a way that the cost of these bonds would be exactly 11 cents on the dollar.

    Because of the asymmetric treatment of creditors in the reallocation for par bonds, the implicit buyback price for creditors holding par bonds may be higher than 20 cents, whereas for those opting for the buyback, the price may he lower than 20 cents. The reason is that higher payments on par bonds leave lower amounts available for past-due interest payments, which are distributed pro rata among all creditors.

    The buyback price of 8 cents on the dollar is the lowest buyback price in an operation of this kind.

    The reprofiled debt includes obligations rescheduled under the March 1992 reprofiling agreement and under the September 1993 reprofiling agreement. The leasing debt corresponds to tranche B of the 1992 agreement.

    The deal had to be backdated to include principal amounts unpaid since March 1994. From that perspective, the maturity is 16 years with 6½ years of grace.

    The interest rate on the reprofiled, nonleasing debt included in the 1993 refinancing agreement is 1316 over Japan’s six-month prime rate.

    The joint and several clause makes each successor state of the former Socialist Federal Republic of Yugoslavia both jointly and individually responsible for all of the debt under ihe New Financing Agreement. The Agreement was concluded on September 20, 1988 and rescheduled about $7.3 billion in hank claims. This amount was subsequently reduced to about $4.2 billion as a result of debt conversions—of which about $0.5 billion could be allocated to Slovenia under the residency-of-beneficiaries criteria, and about $ 1.0 bit-lion could not be allocated to any of the successor stales. In September 1992, Slovenia reached an interim agreement with the banks, whereby interest payments were made into an account with respect to the country’s obligations based on an estimate of Slovenia’s share of the debt. However, the interim agreement did not cover amortization, and the grace period under the New Financing Agreement expired in December 1993. Thus, principal arrears accrued during 1994. Qualified creditors include all holders of the debt with the exception of “connected persons,” defined as entities in the Federal Republic of Yugoslavia (Serbia/Montenegro).

    While Slovenia was making interest payments on the basis of an estimated share of the debt, the payment took the form of deposits in a fiduciary account with a commercial bank. There are also interest arrears on the New Financing Agreement because other cosigners have not paid. In addition, there are principal arrears since January 1994.

    Excludes net capital flows to capital-exporting developing countries.

    In this discussion, average maturities refer only 10 the maturities on U.S. dollar-denominated issues that do not include enhancements.

    Throughout this paper, yield spreads refer to the difference between the yield on a bond at the time of issuance and the yield on U.S. Treasury securities of comparable maturity or other comparable government securities if the bond is not issued in U.S. dollars. U.S. Treasury securities and other comparable government securities are used as proxies for a risk-free return.

    For instance, yield spreads for Korean issuers were substantially lower than those generally available to borrowers from other developing countries. For private sector borrowers, the average spread declined from an average of 76 basis points in 1993 to 39 basis points in 1995.

    In part, this may reflect the requirement of an investment-grade rating for public placements of Samurai bonds. Many private entities in developing countries do not have such a high credit rating. A Samurai bond is a yen-denominated bond issued in Japan by a foreign entity.

    These estimates could vary somewhat depending on whether bondholders take advantage of early redemption options for some bonds. Maturing obligations also are valued at the exchange rates prevailing as of end-June 1995 and thus assume the full impact of the recent appreciation of the yen and deutsche mark against the U.S. dollar. Currency swap arrangements could reduce these estimates, although the initial borrowing cost would have been higher.

    An ADR is a U.S. dollar-denominated equity-based instrument backed by shares in a foreign company held in trust. The ADR is traded like the underlying shares on major U.S. stock exchanges or in the over-the-counter market, A GDR is similar to an ADR, but it is issued and traded on international markets.

    No comprehensive data on direct purchases by foreigners of securities on local financial markets are available. The data on the activities of emerging markets mutual funds provide an indicator of the potential magnitude of such purchases.

    Mutual funds covered in this report are those monitored by Lipper Analytical Services, Inc., and thus do not necessarily reflect all existing emerging market mutual funds. These funds include funds domiciled both in and outside the United States. A dedicated emerging markets mutual fund is defined as a fund that invests al least 60 percent of its assets in developing country securities.

    An approximation for net purchases of developing country equities by emerging markets mutual funds can be obtained by adjusting the changes in the funds’ net assets for share price changes reflected in the IFC (International Finance Corporation) Investable Indices. To the extent that emerging markets mutual funds hold part of their portfolios in cash, industrial country assets, or equities issued by developing countries in international capital markets, net purchases estimated in this way may misstate actual purchases of emerging markets securities in domestic markets. Moreover, changes in the IFC Investable Indices may not accurately reflect actual changes in the value of the portfolios or the emerging markets mutual funds.

    For a more complete explanation of such diversification strategies, see Harvey (1993).

    Changes in total returns on Eurobonds of a sample of developing countries consistently have low correlations among themselves and with returns on comparable U.S. bonds. This result may reflect the relatively thin trading of these securities.

    Membership includes the securities commissioners of Argentina, Bolivia, Brazil, Canada, Colombia, Costa Rica, El Salvador, Honduras, Jamaica, Mexico, Panama, Paraguay, Peru, the United States, and Uruguay.

    Members include the stock markets of Argentina, Chile, Colombia, Mexico, Peru, Spain, Uruguay, and Venezuela.

    The methodology used in this analysis follows that in Bekaert (1993).

    Assuming that transaction or informational costs are zero and that assets are infinitely divisible.

    This is the covariance of the asset’s expected return with the world portfolio’s expected return. The covariance is referred to as the asset’s beta (β). If a stock offers the same risk as the world portfolio, an investor would be willing to hold it in exchange for the same expected return on the world portfolio. If a stock’s return is expected to be negatively related to the return on the world portfolio, an investor will accept a lower rate of return because holding that asset will reduce the risk of his portfolio. Similarly, if the stock’s return is positively related to the world portfolio but it is more risky, an investor will demand a higher rate of return to hold it because it will increase the overall risk of his portfolio.

    All returns are calculated in excess of the holding yield on a U.S. Treasury bill with constant one-month maturity, intended to represent the riskless rate of return.

    By shifting from a portfolio composed entirely of the Financial Times-Actuaries (FT-A) World index to a portfolio divided equally between the IFC Emerging Markets Data Base (EMDB) Investable Composite index and the FT-A World index, investors would have increased the return on their portfolios from roughly 7 to 17 percent, while slightly decreasing portfolio variance from about 17 to 16 percent.

    The IFC-EMDB Global Composite portfolio is used as the proxy for a portfolio of developing country equities.

    This is the case even if expected returns are correlated with one another within the asset class—any two developing country assets that are correlated with one another should affect expected returns only through their impact on the world portfolio. When using actual returns as a proxy for expected returns, however, a nonzero coefficient on the developing country portfolio can reflect two possibilities: the traditional one-factor CAPM is insufficient to explain investor behavior, or unanticipated shocks to asset returns are shared across developing countries. If an unanticipated shock to one country spreads to others because investors, who treat developing country assets as a class, shift their sentiment regarding other markets, a nonzero coefficient would imply that the strict one-factor CAPM did not hold.

    The estimates use ex post realized returns as an estimate of exante expected returns on the assumption that ex post returns are equal to expected returns plus some small forecast error:

    where єt is assumed to be randomly distributed. An alternative approach is a conditional or expectational estimation, which attempts to model ex ante expected returns more closely by using an information set to calculate expected returns and then using these to estimate the parameters of equations (1) and (2). Conditional estimators based on the Generalized Method of Moments (GMM) method (not shown here) were weak, with large standard errors and few significant coefficients. The weak coefficients may indicate that the model specification is inappropriate for the data, or that the variables comprising the information set provide a poor estimate of expected returns.

    Using an F-test, the CAPM can be rejected with 95 percent confidence in seven markets (Brazil, Chile, Korea, Mexico, Malaysia, Taiwan Province of China, and Thailand) and with 90 percent confidence for India.

    The estimates of βem may be biased upward somewhat because the return on market j, rj, t, may have a significant weight in determining rem, t.

    Monthly data, which may be less affected by noise and may better demonstrate longer-term relationships, produce similar results. Two developing country equity markets are more sensitive to the world portfolio in monthly data (Korea, the Philippines) (see Table 12). With monthly data, the CAPM can be rejected in favor of the two-factor model in eight markets. The CAPM is no longer rejected for India; however, the CAPM is rejected for the Philippines with monthly, but not weekly, data.

    The βem term will reflect covariance with the emerging markets in Africa, Europe, and the Middle East in the IFC Composite Index.

    The estimates of βem and the regional betas may be biased upward somewhat because the return on market j, rj, t, may have a significant weight in determining rem, t or the regional return.

    By behaving in this way, institutional investors would take on the role of classic “noise traders.” For a discussion of noise traders and their influence on asset pricing, see Folkerts-Landau, Ito, and others (1995). See also Shleifer and Summers (1990) for applications of the noise-trader approach to explaining portfolio theory puzzles such as mean-reverting stock returns, the Mehra-Prescott equity premium puzzle, and closed-end mutual fund discounts.

    In this regard, widespread shifts in investor sentiment do not require that all investors shift their views of future fundamentals in the same way, or even that investors form views of fundamentals at all. If investors understand the noise-trading process and find it less costly to spot trends in investor sentiment than to learn about fundamentals, very small events could trigger widespread shifts.

    In some instances, this sort of “trend chasing” by uninformed noise traders might be a reasonable investment strategy, particularly if price movements caused by noise trading are difficult to discern from those caused by informed trading.

    Comprehensive and consistent estimates of institutional investor equity holdings in developing country stock markets are not available. However, partial indicators strongly suggest rapid increases in institutional investor holdings of developing country equities beginning in the early 1990s.

    Price deviations from a random walk do not necessarily imply market inefficiency. They can result from factors, such as shifting risk premiums, that are consistent with efficient markets. For this reason, the motivation for using the variance ratio is not to accept or reject the efficient market hypothesis, but to examine the change in the variance ratio between the two periods and draw inferences about the effects of institutional investor behavior.

    A variance ratio of less than unity reflects negative autocorrelation of excess returns. The variance ratio has several properties that make it particularly desirable for testing the presence of asset market inefficiencies. Since the variance ratio requires only a minimum of structural assumptions, it is robust to many specification errors common to alternative tests. It does not, for example, require that the variance of an asset’s rate of return be stable over time. By focusing on the behavior (rather than the level) of an asset’s return, the variance ratio avoids the specification errors occurring in tests that depend on correctly identifying and measuring an asset’s fundamentals. The variance ratio test is also robust to changes or asymmetries in the structure of autocorrelation. This property gives the test more power to detect erratic serial dependence than tests that require structurally stable autocorrelation. See Lo and Mackinlay (1988) for a complete discussion of the variance ratio test.

    Moderate changes in the timing of the two periods do not change the nature of the results presented in this section. The results are also robust for the length of the holding period (from 2-week to 32-week holding periods). Therefore, only the results for holding periods of 16 weeks are presented.

    As an indication of the size of the increase, a variance ratio greater than 2 implies that the rate of return increases (or decreases) in an accelerating manner—that is, an excess rate of return this period would lead, on average, to an even larger excess return next period. Moreover, the increase observed is several times greater than that which could reasonably be accounted for by an increase in the risk premium. For example, a 200 basis point increase in the risk premium for the portfolio of developing country stocks in the second period relative to the first would have increased the variance ratio calculated on a 16-week holding period by an estimated 0.6, compared with an actual increase of 2.7.

    Similar results were obtained by Lo and Mackinlay (1988) in their variance ratio test on U.S. stock market data. They found positive statistically significant autocorrelation on overall U.S. stock market index returns and negative (although insignificant) autocorrelation on the returns of individual securities.

    This assumes that the nominal debt remains constant. Even if movements in public debt are countercyclical as fiscal policy is used to smooth consumption, foreign currency debt could still serve as a hedge.

    For a discussion of the impact of capital inflows on domestic financial institutions, see Folkerts-Landau, Ito, and others (1995).

    A correct system of risk valuation would imply that loans to activities in the nontradables sector should be charged a premium that would be set aside by banks as a reserve against future losses in asset values arising from changes in the exchange rates. From the regulatory point of view, however, it would be difficult for government regulators to insist that banks accrue this kind of reserve, especially if the official policy is that no change in the exchange rate will occur. See Akerlof and Romer (1993).

    See Rodríguez (1993). The implied increase in private sector wealth also contributed to higher spending, which reinforced the upward pressure on the real exchange rate.

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