During 1999 and into the first half of 2000, global financial conditions generally improved in tandem with the strong rebound in the global economy. Following the most severe market turbulence—especially for emerging markets in the postwar period—entailing a succession of regional crises that enveloped the major financial markets, credit concerns have eased and global investors became more willing to engage in risk taking. This was especially evident in their rush to invest in technology-related companies that underpinned the “new economy.”
Throughout most of the 12-month period ending in June 2000, developments in international capital markets continued to be strongly influenced by the perception that the U.S. economy offered the highest risk-adjusted asset returns in the major currency areas. Favorable perceptions reflected the continued strong performance of the U.S. economy, uncertainty about growth prospects in Europe, and the halting economic and financial recovery in Japan. While this combination of factors might not explain all of the international reallocations of capital and risks, or all asset-price movements, it was an important part of the background against which these adjustments occurred. Beginning with the April–June 2000 period, this favorable sentiment about U.S. returns may have changed.
Emerging market asset prices saw strong increases in 1999 (see Table 3.1) as fundamentals in many countries improved and the domestic and external financing situation of most emerging markets continued to recover from the rolling crises that affected Asia, Russia, and Brazil between mid-1997 and early 1999. Further, despite the Nasdaq-induced weakness of March–May 2000, emerging market asset prices in mid-2000 were mostly higher than a year earlier, reflecting the ongoing unwinding of the (probably excessive) pessimism toward emerging market economies that had grown out of the recent crises. The outlook for the crisis-affected Asian countries continued to strengthen, although in most cases financial systems and corporate sectors remain weak and structural reform agendas, long. In Brazil, strengthened economic policies resulted in a much smaller than feared fallout from the January 1999 devaluation. Even in Russia the improvement in outlook has been noteworthy, and agreement was reached in February 2000 to exchange the defaulted London Club securities for Russian Federation eurobonds. Potential problems in some other emerging markets have so far been avoided, and those cases of significant weakness or slippages have generally involved country-specific problems that did not have systemic implications. For example, Ecuador’s default on its Brady bond debt in September 1999 had only modest effects on bond yields for other countries, the actual or prospective debt-servicing problems of Cote d’Ivoire and Nigeria in early 2000 were viewed as country-specific, and (as is discussed in Chapter V) Pakistan and Ukraine have been through debt renegotiations that have gone far more smoothly than was initially expected. Finally, the outlook for some of the stronger emerging market credits has continued to improve, most notably in Mexico, which was upgraded to investment grade by one major ratings agency, somewhat ahead of expectations. The net outcome of these developments was that the declines in net private flows to emerging markets in 1997 and 1998 were partly reversed in 1999 and data on gross flows for the first six months of 2000 provide reasons for continued cautious optimism.
The virulence of the 1998 turbulence in the mature financial markets took market participants and authorities by surprise, and some have acknowledged that they do not fully understand the rapidly changing structure and dynamics of global financial markets.1 As last year’s International Capital Markets report analyzed, a substantial buildup in derivatives credit exposures and leverage contributed importantly to the turbulence. This substantial leverage—LTCM accumulated $1.2 trillion in notional positions on equity of $5 billion—was possible primarily because of the existence of large, liquid OTC derivatives markets. The rapid growth, development, and widespread use of OTC derivatives markets has accompanied the modernization of commercial and investment banking and the globalization of finance, driven by recent advances in information and computer technologies, and has contributed significantly and positively to the effectiveness of global finance and, in particular, of international financial markets. Much has been written about derivatives as financial instruments and about the role of highly leveraged institutions. By contrast, less has been written about the markets for OTC derivatives per se, and the heavy reliance on them by the small group of internationally active financial institutions. This chapter attempts to fill part of this gap.
A prominent feature of the international financial landscape in recent years has been the occurrence of several financial crises—Mexico in 1994–95, Asia in 1997, Russia in 1998, and Brazil in 1998–99. In contrast to regular modulations in the volume of capital flows in response to changes in underlying economic fundamentals, a distinguishing characteristic of these crises was that markets became quickly and completely one-way. Private investors wanted, and attempted, to withdraw from these countries at the same time, with the dynamic very much resembling that of a run by depositors on a bank. Once sentiment soured, the dynamic became self-fulfilling in that once a critical mass of investors rushed to withdraw their claims, it became rational for everyone else to do the same.
For many emerging markets, one of the most striking structural changes in their financial systems during the 1990s has been the growing presence of foreign-owned financial institutions, especially in the banking system. In Central Europe, for example, the proportion of total bank assets controlled by foreign-owned banks rose from 8 percent in 1994 to 56 percent in 1999. In some major Latin American countries, almost one-half of total bank assets are controlled by foreign institutions. This greater foreign participation raises a number of important analytical and policy issues. These include the following:
As in previous years, the current International Capital Markets report considers a number of issues related to the functioning of key international financial markets and efforts to improve the management of systemic risks. In particular, this year’s report reviews and assesses recent developments and trends in the mature and emerging financial markets and addresses key aspects of the OTC derivatives markets, assesses and provides market views on proposals for private sector involvement in the prevention and resolution of crises, and examines the implications of the expansion of foreign-owned banks in many emerging markets.
This paper analyzes the price stabilizing properties of puttable and extendible bonds, their potential to help develop interest-rate derivative markets, and their use by governments. Their stabilizing properties imply that, when bond prices fall, prices for puttable and extendible bonds fall by less. Their embedded options work as a cushion and replicate the trading gains from hedging long-term bonds with interest rate derivatives. These bonds can help develop interest-rate derivative markets in developing countries and eventually increase demand for long-term government bonds. Informal evidence from OECD countries suggests that these bonds were useful in the 1980s, when interest rates were volatile.
Following a review and assesment of recent developments in capital market and banking systems, this year's International Capital Markets report review and assesses recent developments in mature and emerging financial markets and continues the analysis of key issues affecting global financial markets. It examines the systemic implications of the continued rapid development of the global over-the-counter derivatives markets and the expansion of foreign-owned banks into emerging markets. The report also analyzes market participants assessments of the proposals for private sector involvement in the prevention and resolution of crises.
In the context of the ongoing review of Fund facilities, this paper examines the analytical basis for Fund lending in emerging market countries and provides a broad-ranging perspective for reforming the General Resources Account (GRA) lending toolkit.
The Fund’s important lending role in crisis prevention and resolution is buttressed by its unique characteristics: (i) its ability as a nonatomistic lender to provide large-scale financing and reduce the likelihood of a run by private creditors; (ii) its ability as a cooperative institution with near-universal membership to agree conditionality with members, thus providing national authorities with a policy commitment tool to underpin confidence and catalyze private lending; and (iii) its de facto preferred creditor status, which allows it to provide crisis financing when private creditors may be reluctant to lend.