Annex II Recent Developments in Developing Country Capital Markets
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International Monetary Fund
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English
Print Publication Date:
17 Sep 1996
Keywords:
WEFS; market; market participant; market infrastructure; settlement risk; market development; deutsche mark; secondary market; liquidity crisis; Thai baht; institutional investor; Foreign direct investment; Bonds; Loans; Commercial banks; Capital flows; Asia and Pacific; Global; Middle East
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Abstract

Despite the serious disruptions in early 1995 as a result of the Mexican crisis, total net capital flows to developing countries and countries in transition reached a record $228 billion in 1995. Notwithstanding early fears of widespread spillovers of Liquidity problems in Mexico, markets appeared relatively quickly to distinguish between those countries with sound fundamentals and those that seemed to share some features of the Mexican economy, which then saw at least temporary declines in market access and capital inflows. This regional differentiation is revealed by data on capital flows and securities issues. But even those countries that experienced the most serious contagion effects had almost fully regained access to international financial markets at precrisis spreads by the end of the year. Moreover, some countries that at first glance seem to have been relatively untouched by the crisis, particularly those with pegged or fixed exchange rates, were tested by international investors. In addition to the change in the regional nature of capital flows, there was a change in the composition of capital flows, with a decrease in portfolio investment and an increase in bank lending to developing countries and countries in transition.

Despite the serious disruptions in early 1995 as a result of the Mexican crisis, total net capital flows to developing countries and countries in transition reached a record $228 billion in 1995. Notwithstanding early fears of widespread spillovers of Liquidity problems in Mexico, markets appeared relatively quickly to distinguish between those countries with sound fundamentals and those that seemed to share some features of the Mexican economy, which then saw at least temporary declines in market access and capital inflows. This regional differentiation is revealed by data on capital flows and securities issues. But even those countries that experienced the most serious contagion effects had almost fully regained access to international financial markets at precrisis spreads by the end of the year. Moreover, some countries that at first glance seem to have been relatively untouched by the crisis, particularly those with pegged or fixed exchange rates, were tested by international investors. In addition to the change in the regional nature of capital flows, there was a change in the composition of capital flows, with a decrease in portfolio investment and an increase in bank lending to developing countries and countries in transition.

This annex discusses developments in 1995-96 in the capital markets of developing countries and contries in transition and examines both the available balance of payments capital flow data and data on transactions in the primary and secondary markets for debt and equity instruments. It then describes recent developments in investment flows from the United States and Japan. Finally, the annex highlights recent developments in the banking systems of selected countries, an element of the “fundamentals” that has increased in prominence since the Mexican crisis.

Capital Flows in the Balance of International Payments

Total private capital flows to developing countries and countries in transition increased by 29 percent in 1995 to $211 billion, higher than in any previous year (Table 23).1 Capital flows to Asian developing countries and to the countries in transition accounted for almost all of the increase in flows. The share of total flows to Asian developing countries remained unchanged, at 50 percent, but the share of flows directed to the countries in transition doubled, to 14 percent. Flows to Latin American countries remained essentially unchanged over 1994 levels at $49 billion, resulting in a decline in that region’s share of total flows to 23 percent, from 30 percent in 1994, while flows to Africa actually declined. These changes in the regional distribution of total capital flows generally reflect the differences in severity of spillovers from the Mexican liquidity crisis across countries. The “Tequila effect” was strongest in Latin American countries, such as Argentina and Brazil—also important participants in the international capital markets—and less so in Asian developing countries, which saw only short-lived contagion effects.2 Similarly, developments in Mexico did not affect the countries in transition to a great extent.

In addition to the geographic reallocation of capital flows to the countries in transition, there was an important change in the composition of capital flows—a doubling of "other" capital flow’s, which is manily bank lending.3 These capital flows increased from $43 billion in 1994 to $85 billion in 1995, increasing their share in total flows from 26 percent in 1994 to 40 percent in 1995. Other capital flows rose in all regions except Africa. The share of capital flows accounted for by foreign direct investment declined slightly to 39 percent, although direct investment flows in 1994 had been at an unusually high level. Portfolio capital flows fell sharply, however, both in levels—from $53 billion in 1994 to $43 billion in 1995—and in proportion to total flows, declining from 33 percent of the total in 1994 to 20 percent in 1995.

Table 23.

Private Capital Flows to Developing Countries and Countries in Transition

(in billions of U.S. dollars)

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Source: International Monetary Fund. World Economic Outlook database,

Short- and long-term trade credits, loans (not including use of IMF credit), currency and deposits, and other accounts receivable and payable.

A positive sign indicates a net increase.

There also were noteworthy changes in the composition of flows within regions.4 In Asian developing countries, although there was a slight increase in importance of other flows at the expense of portfolio flows and foreign direct investment, the change in proportions was not large. Indeed, the important changes in composition of flows to Asian developing countries occurred in 1992 and 1994. In 1990-92, Asian countries relied heavily on bank borrowing, with the “other” category accounting for more than 64 percent of total capital inflows and foreign direct investment accounting for 30 percent or more. Portfolio capital flows were negligible. In 1992, other capital flows declined sharply, as portfolio investment increased to 32 percent of total flows and foreign direct investment rose to 47 percent. While the share of foreign direct investment has stabilized at about 50 percent of total capital flows since 1992, portfolio investment dropped sharply in 1994 to just below 20 percent, and remained at that level in 1995.

Among the Latin American countries, other capital flows nearly doubled in 1995 to $23 billion, representing 45 percent of capital flows to the region. This performance matched the level of such flows in 1992 both in dollars and percentage terms. Portfolio capital flows, conversely, declined sharply in 1995 to $10 billion, the lowest amount in six years. Countries in this region have tended to rely more heavily on portfolio investment than countries in other regions except the Middle East, where foreign direct investment has been insignificant. Hence, the withdrawal of foreign portfolio investors from the international markets in 1995 seriously affected capital flows to Latin American countries.

Foreign direct investment flows have recently been relatively more important for the Asian developing countries than for Latin American countries, where such flows accounted for only 35 percent of net inflows in 1995. A better comparison, however, is the ratio of net foreign direct investment to GDP, which was 1.9 percent for the Asian developing countries in 1995 and 1.1 percent for the Latin American countries. The relatively higher ratio in the Asian developing countries, however, goes back only to 1993. During 1990-92, Latin American countries attracted more foreign direct investment in proportion to GDP than did the Asian developing countries.

The different patterns of capital flows to Asian and Latin American developing countries have been attributed to a number of factors, and in particular to the relatively faster growth rates among the Asian countries.5 Private capital inflows to Asian developing countries in 1995 were 3.8 percent of GDP, compared with 3.0 percent for the Latin American countries; in 1994, the proportions were 3.4 percent and 3.1 percent, respectively. However, despite having had a higher average real growth rate than the Latin American countries since 1990, the developing countries in the Middle East and Europe received capital inflows of only 1.5 percent of GDP in 1995 (1.1 percent in 1994). Among these regions, the ratio of direct investment to portfolio investment also does not appear to be strongly correlated with growth. The countries in transition have had a slightly higher ratio than the Asian developing countries during 1990-95 despite a negative real growth rate.

The success in attracting foreign direct investment to the countries in transition suggests strongly that it is not just growth that matters, but also the structural characteristics of the economy. In particular, the Asian developing countries and the countries in transition are seen by some investors as providing more attractive investment climates because their goods and labor markets are perceived as being more liberal than those in Latin America, for example. Also, much foreign direct investment appears to be motivated by the desire on the part of multinational corporations to locale production facilities in low-labor-cost countries, an explanation that applies in particular to Japanese direct investment in the Asian region. Another factor that might explain the relatively higher proportion of portfolio capital flows to Latin America compared with Asian developing countries is that Latin American securities markets are more fully developed than those in the Asian developing countries. With more mature and liquid domestic securities markets, these countries provide a greater range of instruments through which foreign funds can be invested, which may explain why they attract relatively more portfolio capital.

Capital flows to the countries in transition increased sharply in 1995 to $30 billion, up from $11 billion in 1994. These countries accounted for 14 percent of total capital flows in 1995, compared with only 7 percent in 1994, As in the other regions, the main source of growth in capital flows was from bank lending. Thus, despite a doubling of foreign direct and portfolio investment, the share of other capital flows in total capital flows to these countries rose to 42 percent, from 24 percent in 1994. The sources of external financing for these countries has diversified considerably since 1993, when foreign direct investment accounted for 83 percent of inflows. Indeed, during 1991-93, other capital flows were negative.

Large capital inflows can have important macro-economic consequences in the recipient countries, including an appreciation of the currency or an expansion in the money supply.6 In 1995, central bank reserve assets in developing countries and countries in transition increased by $107 billion, just over half of the magnitude of capital inflows (Chart 26). Among the Latin American countries, Argentine and Brazilian reserves declined significantly in the first quarter of 1995, The stabilization of financial markets in the second half of the year enabled reserves to rise rapidly. Brazilian and Mexican non-gold reserves returned to precrisis levels in July 1995, while Argentine reserves recovered most of their losses in December 1995 and edged above the precrisis level in March 1996. Mexican reserves increased by $1! billion in 1995, while Brazilian reserves increased by $13 billion. Capital inflows to Brazil have continued strongly in the first quarter of 1996 as reflected in non-gold reserves, which increased by $4 billion. In the Asian developing countries, the increase in reserves accounted for about 50 percent of the capital inflows in 1995, compared with more than 75 percent in 1994, Only Malaysia and India among the main recipient countries experienced a decline in reserves in 1995—in Malaysia’s case despite an appreciation of the currency.

Chart 26.
Chart 26.
Chart 26.

Total Reserves Minus Gold of Selected Developing Countries and Countries in Transition

(In billions of U.S. dollars)

Source: International Monetary Fund, International Financial Statistics.

Foreign exchange markets experienced considerable turbulence in the aftermath of the Mexican devaluation on December 22, 1994 (Chart 27). After declining 53 percent from its pre-devaluation level of MexN$3.47 to MexN$7.45 on March 9, 1995, the Mexican peso stabilized at around MexN$6 to the dollar in the second and third quarters of 1995. In October and November 1995, the peso came under heavy selling pressure, and it depreciated more than 23 percent, reaching MexNS7.9 per dollar on November 15. Since late 1995, the peso has traded in a narrow range around MexNS7.5 per dollar, reflecting several factors including, a favorable response to the 1996 budget, stepped-up efforts to support troubled commercial banks, and several successful international bond placements.

The Chilean and Argentine currencies were not significantly affected by the Mexican devaluation, in part because of the sound economic fundamentals in Chile and the adherence to the currency board system in Argentina. The trading band for the Brazilian real has been gradually lowered since the end of 1994, and the real experienced only temporary fluctuations in response to the Mexican crisis.

In Asia, the spillover effects of the Mexican crisis proved to be short lived in early 1995 for all but a few countries. The Thai baht, for example, appreciated slightly immediately following the Mexican crisis, but came under heavy selling pressure in January 1995. Intervention by the Bank of Thailand tightened liquidity and drove short-term interest rates to 100 percent, which succeeded in strengthening the currency. Similarly, the Hong Kong and Indonesian currencies came under pressure in mid-January 1995. In the Philippines, the peso depreciated by 5—10 percent following the Mexican devaluation, and again came under pres-sure later in the year. Increases in interest rates have countered much of the more recent pressure on the Philippine peso, which has been fairly stable since the fall of 1995. While a policy of passive intervention to maintain exchange rate stability effectively insulated the Indian rupee from any spillovers in the first half of 1995, a decline in capital inflows and an increase in imports gradually put pressure on the currency later in the year. Speculative pressures added to the fundamental weakness, resulting in a 19 percent depreciation between September 1, 1995 and February 5, 1996. The authorities responded to this pressure by intervening in the foreign exchange market, increasing money market interest rates, and introducing measures to encourage net capital inflows. These measures, and a surge of capital inflows in February 1996 from foreign investors, brought the exchange rate of the rupee vis-à-vis the U.S. dollar back down from its peak of Rs 37.9 to Rs 34-35, where it has since remained.

Chart 27.
Chart 27.
Chart 27.

Exchange Rates of Selected Developing Countries and Countries in Transition

(Local currency-U.S. dollar)

Source: Bloomberg Financial Markets.

The large depreciation of the U.S. dollar against the yen in March 1995 resulted in significant appreciations of the currencies of some Asian developing countries. In particular, the Korean. Malaysian, and Thai currencies appreciated strongly against the dollar during this period. This sudden appreciation resulted in a speculative attack on the Thai baht in March 1995. The appreciation of the baht led to speculation that the Bank of Thailand might change the composition of the basket (consisting of the U.S. dollar, the yen, and the deutsche mark), and there was heavy selling of Thai baht in March 1995. On March 8, the Bank Thailand lightened liquidity conditions in the money market causing the overnight interbank rate to rise 300 basis points, which succeeded in ending the attack.

Transactions in International Capital Markets

Bonds

Bond issuance in the international markets by entities in the developing countries and countries in transition increased slightly in 1995 to nearly $58 billion, but remained well below the $63 billion issued in 1993 (Table 24).7 Asian developing countries issued a lower dollar amount of bonds in 1995 than in 1994. but the volume of issues by Latin American countries increased by 28 percent. Issues from the European developing countries and countries in transition increased by 85 percent, owing to sharp increases in issues by Turkey and Hungary. The market was essentially closed in the first quarter of the year as investors sorted out which countries represented reasonable repayment risks and issuers waited until the volatility in secondary market spreads settled down. Total issues in the first quarter of the year reached only $5 billion in 1995, less than half of the average quarterly rate of issue in 1994. Korea alone accounted for 56 percent of the volume of issues in the quarter. By the end of the second quarter, however, the pace of activity had returned to precrisis levels.

While the decline in industrial countries’ interest rates might have given those countries that were relatively unaffected by the Mexican crisis an incentive to hasten their pace of bond issues in 1995, the Latin American countries placed great importance on returning to the markets quickly. In particular, the Argentine. Brazilian, and Mexican issues in the second and third quarters were highly successful in attracting broad-based support outside the United States and therefore in establishing a benchmark price in the postcrisis environment. The Republic of Argentina issued a $1 billion global bond on April 1, 1995; the Republic of Brazil entered the market in May with a Euroyen bond worth S922 million at a 454 basis-point spread over Japanese government bonds; and the United Mexican States issued a $1 billion bond in July 1995 at a 555 basis-point spread. The bond issue was particularly important for Mexico, which had not issued a sovereign bond in the international markets since 1993. The fact that these three countries were able to return to the markets, even at wide spreads, marked the reopening of the bond market to emerging market countries. Issues in the third quarter of the year rose to a record $21 billion, with essentially all historically important bond issuers from developing countries and countries in transition being represented. The pace of new issues declined slightly in the final quarter, but the total volume remained high at over $17 billion.

The pace of issuance in the international bond markets has accelerated in 1996, with first quarter issues totaling $20 billion.8 Western Hemisphere developing countries have increased their share of total issuance, accounting for 54 percent of total volume, compared with 40 percent in 1995. The Mexican government, for example, raised $4.2 billion in the first five months of the year, including the bond issued to replace Brady bonds described above. One of the most important of these Mexican bonds was a $1 billion issue at the end of January 1996. The offering was initially launched at a spread over U.S. Treasury bonds of 445 basis points, but strong trading soon pushed it to 435 basis points. The success re-established the key U.S. institutional investor base for Latin America, ending the reliance on European and Japanese investors for Latin American bond financing. This bond was quickly followed by Argentina in February with a $1 billion five-year global issue at terms that were more favorable than the Mexican issue.

The turbulence in the secondary markets for developing country debt during the Mexican crisis is indicated in the prices of Brady bonds (Chart 28). The Mexican liquidity crisis led to a steep rise in the stripped yield spreads of Mexican Brady bonds in the secondary markets from a precrisis level of 417 basis points over U.S. Treasury bonds to a peak of 1,779 basis points on March 8. 1995. Over the same period. Brazilian Brady bond spreads increased by 788 basis points and spreads on Argentine Brady bonds rose by 1.604 basis points. After the peak of the crisis in March 1995. spreads generally recovered quickly. Rising concerns in October 1995 about the recovery in Mexico led to a temporary increase in spreads for these countries’ Brady bonds. While Argentine and Brazilian Brady bond spreads have since returned to precrisis levels. Mexican bonds still have not recovered their losses.

The differentiation by international investors between bonds issued by Latin American and other countries is highlighted in Chart 28. The increase in spreads in the first quarter of 1995 was much greater for Latin American Brady bonds than for the non-Latin American bonds.9 Spreads on Philippine Brady bonds, for example, only rose by 545 basis points to March 8, 1995.

The wider spreads in secondary markets were reflected also in wider spreads at issue for international bonds. In particular, average spreads for Mexican U.S. dollar-denominated bonds rose from 204 basis points for 1994 to 549 basis points in 1995. The increase in spreads was less dramatic for Argentina and Brazil, where spreads on their dollar-denominated bonds increased by 162 basis points and 35 basis points, respectively, although in the case of Argentina there was only one issue. Spreads have since come down sharply: average yield spreads declined more than 100 basis points for Argentina and Mexico and 65 basis points for Brazil. Just as the secondary market spreads did not widen as sharply for Asian developing countries, so too did yield spreads at issue not widen significantly. Indeed, spreads for India. Indonesia, and Thailand were lower in 1995 than in 1994. However, owing in large part to political developments in the region in the first quarter of 1996, spreads widened by an average 21 basis points for Asian developing countries.

Table 24.

International Bond Issues by Selected Countries and Regions1

(In millions of U.S. dollars)

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Source: IMF staff estimates based on Euromoney Bondware

Including note issues under European medium-term notes (EMTN) programs.

Chart 28.
Chart 28.

Secondary Market Yield Spreads on Selected Brady Bonds 1

(In basis points)

Source: Salomon Brothers.1 Stripped yield spread on Par Brady bond for all countries, except for Bulgaria (Discount Brady bond).

With interest rate spreads widening, borrowers adopted a number of measures to reduce their costs. First, the currency of issuance changed to exploit opportunities to target markets where the base interest rate was relatively low (Table 25). These changes in issuance patterns were at least partly driven by circum-stances. The withdrawal of significant investor support from the United States forced borrowers to look elsewhere. Consequently, the dollar’s share of total bond issues by developing countries and countries in transition declined sharply, from 76 percent in 1994 to 57 percent in 1995. This decline in importance of the dollar sector was not shared by the industrial countries—the dollar’s share of international bond issuance by industrial countries increased from 36 percent to 38 percent in 1995. The share of yen bonds in total issuance by developing countries and countries in transition doubled to 26 percent, while the deutsche mark sector recovered by accounting for 10 percent of total issues after a poor year in 1994. The deutsche mark sector has continued to expand in importance, accounting for 17 percent of issues in the first quarter of 1996, while the yen’s share has declined to 16 percent, slightly higher than in 1994. The expansion of the yen and deutsche mark sectors for developing countries and countries in transition mirrors the developments in industrial country bond issuance, as noted in Annex I.

Table 25.

International Bond Issues by Currency of Denomination

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Source: IMF staff estimates based on Euromoney Bondware.

The change in currency of denomination also allowed borrowers to mitigate the general decline in bond maturities in 1995. The average maturity of un-enhanced U.S. dollar-denominated bonds declined from 6.5 years in 1994 to 4.3 years in 1995. In the yen sector, however, the decline was from 6.4 years to 5.5 years, while in the deutsche mark sector, average maturity declined only slightly, from 5.1 years to 4.8 years.

Bond maturities have also risen in 1996, and more issuers have been able to issue fixed-rate bonds. In January, the Malaysian electric utility Tenaga issued a $150 million 100-year bond, which was followed by China’s $100 million, 100-year Yankee bond yielding 299 basis points over 30-year U.S. Treasury bonds at launch. In May 1996, Mexico launched a $1.75 billion 30-year global bond following an exchange offer for Brady bonds. The issue marked the longest-maturity bond issued by a Latin American country since the 1982 debt crisis, and established a new benchmark for Mexican bonds. At the same time, Argentina broke another record by issuing a 15-year, DM 500 million bond, the longest deutsche mark issue by a Latin American country. Overall, maturities for bonds issued by developing countries and countries in transition have been increasing since the last quarter of 1995, averaging 6.5 years for unenhanced U.S. dollar bonds in the first quarter of 1996—the same average maturity as in 1994. Average maturities in the yen and deutsche mark sectors, at over 7 years, are longer than the 1994 averages. However, overall spreads have widened in the dollar and deutsche mark sectors.

A second change in the pattern of bond issuance in 1995 was an increase in the importance of sovereign issues in the total. This was particularly true for the Western Hemisphere developing countries, where sovereign issues rose from 17 percent of total issues in 1994 to 50 percent in 1995 as the governments of Argentina, Brazil, and Mexico issued large amounts of debt to refinance maturing obligations and to try to reestablish benchmarks in the international markets. At the same time, the increase in importance of government issues was accompanied by an increase in importance of issues by commercial banks, which issued $2! billion in bonds in the international markets. This accounted for 36 percent of total issuance, up from 32 percent in 1994. The importance of commercial banks in total issues declined in the fourth quarter of 1995. In the first quarter of 1996, the commercial banks’ share reached only 27 percent, while the share of sovereign issues in the total increased to 37 percent.

The desire on the part of some governments to create a more liquid benchmark in international markets was clearly expressed in the innovative SI,75 billion global bond issued by the Mexican government in May 1996 (Box 5). In this transaction, $2,337 million in Brady bonds were swapped for the new global bond, which, because of its broader distribution and commitments on the part of the underwriters, was expected to provide a more liquid benchmark in the secondary market. Moreover, the Mexican authorities believed that the prevailing stripped spreads in excess of 700 basis points did not represent a reasonable valuation of Mexican risk, and anticipated that the new bonds would be issued at a much lower spread. The bond was issued at a spread of 552 basis points over 30-year U.S. Treasuries. By freeing up the collateral behind the swapped Brady bonds, the Mexican government was also able to pay down some of its short-term debt.

Many companies in developing countries raised funds by securitizing foreign currency receivables. Securitization often allows issuers to obtain ratings for their issues that are higher than the sovereign rating ceiling that generally applies to straight bond issues. Hence, they are able to issue bonds at narrower spreads than even their governments could. In 1995, 35 international bonds were secured, compared with only 22 in 1994. Firms in Western Hemisphere countries issued proportionately more securitized bonds than those in Asia. For example, Telefonos de Mexico securitized $280 million in long-distance service receipts from the United States through Bankers Trust.

Mexican Brady Bond Exchange

On April 17, 1996, the Mexican government announced an offer to holders of its U.S. dollar-denominated Brady bonds to exchange their bonds for a new issue of uncollateralized $1-2.5 billion dollar-denominated 30-year global bonds. At the time, there were $15.5 billion in par bonds and $7.5 billion in discount bonds outstanding measured at market prices. The face value of these bonds was $28 billion. The principal of these bonds was collateralized by zero-coupon U.S. Treasury bonds, while the interest payments were backed by Value Recovery Rights (VRRs), which represented claims on oil revenues. The VRRs were slightly in the-money at the time the exchange was announced, with the first payments due in September 1996. The Brady bonds were to be exchanged for a clearing spread—to be determined by a Dutch auction closing April 30, 1996, but subject to a minimum 125 basis points—over a fixed margin (300 basis points) over the market spread over U.S. Treasuries at close of business on April 26, 1996.

The results were announced on May 1, 1996. Of the approximately $3 billion in Brady bonds that had been offered for exchange, the authorities accepted $1,894 million in par bonds and $443 million in discount bonds measured in face value. The yield to maturity on the global bonds was set at 12.40 percent (an 11.5 percent coupon)—the sum of the 6.88 percent yield on the U.S. Treasury bond at close of business on April 26, plus the fixed 300 basis point spread plus the 2.52 percent clearing spread determined by the auction, for a yield spread at issue of 552 basis points over 30-year U.S. Treasuries. On the day before the swap offer was announced, Mexican par bonds had closed at a stripped yield spread of 745 basis points, and discount bonds had closed at a 780 basis point spread.

As a result of this swap, the Mexican government freed up approximately $650 million in collateral that it had been holding on the Brady bonds, allowing it to pay down some of its short-term debt. The average maturity of Mexican debt was also lengthened because the new bond has a 30-year maturity, while the bonds that were exchanged had a remaining maturity of 23 years. The operation also lowered Mexican interest payments by a present value of $170 million.

Despite a number of well-publicized securitized deals from Latin America in particular, credit enhancements in general continued to decline in importance in 1995 as they had in 1994. Only 25 percent by value of the international bonds issued by developing countries and countries in transition were enhanced, compared with 39 percent in 1993. The main source of the decline was in the Asian region, where the international convertible bond market shrank markedly. Only 58 of 240 Asian international bonds were convertible in 1995, compared with 94 out of 260 in 1994. By value, only 35 percent of Asian bonds carried credit enhancements in 1995, versus 53 percent in 1994. This trend remained the same through the first quarter of 1996. However, in 1996 credit enhancements by Western Hemisphere developing countries have declined sharply, to only 9 percent of total issues by value, compared with 20 percent in 1995. In the first five months of 1996, credit enhancements have declined even further, applying to only 19 percent of total issuance.

The International Yen Hand Markets

A key development in 1995 was the change in currency composition of bonds issued by developing countries and countries in transition. Yen-denominated issues increased sharply from the equivalent of $7.4 billion in 1994 to $15.3 billion in 1995. increasing the yen’s share in total issues from 13 percent to 26 percent. Bonds denominated in deutsche mark rose from the equivalent of $1.6 billion (3 percent of market share) in 1994 to $5.7 billion (10 percent) in 1995.

An important reason for the increase in yen-denominated bonds was the low interest rate prevailing in Japan in 1995. The official discount rate was lowered to 1.0 percent in April 1995 and to 0.5 percent in September 1995. Also. Japanese investors were prepared to purchase bonds issued by developing countries and countries in transition at much lower spreads than were investors in the U.S. market. Hence, interest rates on yen bond issues were substantially lower in these markets than in other segments of the bond market, particularly the U.S. market. The expansion of the yen market was further aided by the deregulation of the international yen-denominated bond market, particularly the elimination on January 1, 1994 of the 90-day lockup period before which sovereign yen-denominated Eurobonds could be sold to Japanese investors after initial placement, facilitating access by sovereign issuers to the domestic investor base. Access has been made even simpler with the elimination, after January 1, 1996, of the minimum credit rating requirement for Samurai bonds and, after August 2, 1995, of the 90-day lockup period on all other nonresident yen-denominated Eurobonds.

While yield spreads at issue rose in the yen sector as they did in the U.S. dollar sector, the increase was much smaller.10 Average sovereign yield spreads increased by only 120 basis points, compared with an increase in average spreads of 181 basis points in the U.S. dollar market.11 The average yield spread in the yen market, for example, was only 280 basis points above Japanese government bonds—resulting in nominal interest rates below the U.S. Treasury bond rates. For example, Mexico issued a $1 billion U.S. dollar-denominated bond in July 1995 at a spread of 556 basis points over the Treasury bond yield, and two weeks later issued a ¥100 billion three-year bond at a swapped yield spread of 336 basis points over U.S. Treasuries.

The possibility of low-cost financing in the Japanese markets was attractive to a large number of developing countries and countries in transition. One of the most active issuers in the yen market has been the National Bank of Hungary. Between 1987 and 1995, the National Bank of Hungary tapped these markets 27 times, with net outstanding volume at the end of 1995 of the equivalent of $7.4 billion—nearly half its outstanding net foreign debt of $17 billion.12 The latest issue in December 1995 had a maturity of 15 years and a 200 basis-point spread over Japanese government bonds—implying a coupon rate of only 5.2 percent.

Most international yen bonds are either Euroyen issues or Samurai bond issues. Samurai bonds are yen-denominated bonds issued by non-Japanese residents and sold to investors in Japan under Japanese regulations. This differentiates Samurai bonds from Euroyen bonds, which are issued in the international offshore market (usually in London). There are also yen-denominated bonds issued by nonresidents through private placements in Japan—Shibosai bonds—but the volumes are not large. Table 26 shows the total issues of Samurai and Shibosai bonds since 1985. Issuance activity increased sharply in 1992. The share of issuers from developing countries and countries in transition also has increased in the past few years, from 29 percent in 1990 to 80 percent in 1994.

From the issuers’ point of view, whether to issue in the Euroyen market or in the Samurai market depends on a number of considerations. First, the investor bases are different: the former is exclusively an institutional investor base, while the Samurai market has a large retail investor base. Second, the underwriting fees and other issuance costs are nearly three times higher in the Samurai market compared with the

Euroyen market.13 Third, until 1996. only investment-grade issuers could sell Samurai bonds, a restriction that did not exist for the Euroyen market. Fourth, prior to 1996, Euroyen issues by nonresidents were subject to a holding period restriction before they could be sold in Japan. Offsetting these apparent advantages of issuing yen-denominated bonds is the currency risk that the issuers undertake if they do not hedge their yen exposure. Many developing countries that have issued yen-denominated bonds are believed not to have swapped out of yen. possibly exposing themselves to exchange rate risk, particularly since markets forecast a significant appreciation of the yen over the next two years.

Table 26.

Samurai Bonds Issuance, 1985-95

(Amount in billions of Japanese yen and share in percent)

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Sources: Japanese Ministry of Finance.

The difference between the total amount and the sum of the amounts for developing and industrial countries is issuance by international financial institutions.

The narrow interest rate spreads over Japanese government bonds and the high volume of yen-denominated issues by developing countries have raised concerns that the investors have underpriced credit risk and that issuers have underestimated the potential exchange rate risk under the attraction of the very low nominal interest rates. The former concern centers on the importance of retail investors in the Japanese bond markets, particularly since the market has now been opened up to subinvestment grade issuers. The share of Samurai bonds held by individual investors in Japan increased between 1991 and 1994 from 16 percent to 32 percent. However, retail investors increased their holdings of Samurai bonds significantly in 1995 to 48 percent. The same concern about the relative lack of sophistication of the investor base has been raised with regard to other bond markets, including the German market, in which retail investors are important purchasers of bonds issued by developing countries.

Retail investors in Japan may not have fully appreciated the credit risk of the issues in which they have invested in part because of the ratings assigned to these issues by Japanese rating agencies (Table 27). Sovereign or public sector issuers in many developing countries and countries in transition consistently have received higher ratings from the Japanese agencies than they have from the U.S. agencies, even in cases such as Uruguay where it would be difficult to argue that the Japanese investors or rating agencies would have a better understanding of the issuer. Of particular interest is the case of the National Bank of Hungary, a long-time issuer in the Samurai and Euroyen markets despite having a subinvestment grade rating from both Moody’s and S&P. To illustrate how the more favorable ratings given by Japanese agencies have affected average credit quality in the yen bond markets—as perceived by investors that accept the U.S. agencies’ ratings—Table 28 presents issues in each year since 1993 categorized according to Moody’s ratings of the issues. In 1993, 38 percent of international yen-denominated bond issues had a subinvestment grade rating from Moody’s. This proportion increased to 64 percent in 1995. Countries with relatively low ratings, or with little or no history in international markets, have accessed the yen market at narrow spreads. The June 14, 1996 default by a private Bulgarian bank on a ¥5 billion private placement bond it sold to Japanese banks in 1989 has renewed concerns about the credit risk facing Japanese investors.

Secondary Market Trading

The growing volume of bond issues by developing country issuers is supported by a maturing secondary market for developing country debt instruments and derivatives, which provides information on equilibrium yield spreads and on investor sentiment in general. Despite the near collapse of the primary market in the first quarter of 1995 and its slow recovery in the second quarter, transactions in the secondary markets for developing country debt and related derivatives declined only slightly in 1995 to $2,739 billion (Table 29). As in past years, trading in Latin American debt dominated the market in 1995, accounting for 83 percent of total trading.14 Brazilian debt instruments were the most heavily traded securities (38 percent of the total), followed by Argentine and Mexican debt instruments. With only one sizable Brady bond issue in 1995 (by Ecuador), and a number of countries, including Mexico, buying back Brady bonds, turnover in this instrument declined to 58 percent of total trading, compared with 61 percent in 1994.15 Similarly, a continuing decline in the average stock of loans traded in the market contributed to a 28 percent fall in turnover in that segment of the market. These declines were offset by a 41 percent increase in trading in non-Brady sovereign and corporate bonds, indicating the continuing high level of issuance activity in the primary markets in 1995. Trading in local market instruments continued to increase in 1995, accounting for 21 percent of total turnover. The most commonly traded local instruments were those of Argentina, Brazil, Mexico, Poland, and South Africa. The high price volatility in the first part of the year contributed to a 25 percent increase in trading in derivative instruments, although this segment of the market remains relatively small.

Table 27.

Bond Rating Comparisons of Selected Japanese Yen Issues, 1994-951

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Sources: Adapted and updated from Andrews and Ishu (1995); Euromoney Bondware: Japan Bond Research Institute (JBRI); Japan Credit Rating Institute (JCR); Moody’s; and Nippon Investor Services (NIS)

Each rating is at time of issuance. In the case of multiple issuance, the most recent rating is shown.

Table 28.

Average Credit Quality of Japanese Yen-Denominated Bonds

(Amount in millions of U.S. dollars and share in percent)

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Source: IMF staff estimates based on huromoney Bond ware.
Table 29.

Secondary Market Transactions in Debt Instruments of Developing Countries and Countries in Transition

(In billions of U.S. dollars)

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Sources: Emerging Markets Traders Association and IMF staff estimates,

Data for 1993 do not include trading in short-term local market instruments.

International Equity Markets

International placements of equity by developing countries and countries in transition declined by 38 percent in 1995 to $11.2 billion, slightly lower than the volume placed in 1993 (Table 30). Total issues by Latin American countries fell by 80 percent to only $962 million, and both Argentina and Mexico had no issues at all during the year. Issues by Asian developing countries declined by 27 percent. In Europe, a 53 percent increase in equity issues by the countries in transition was more than offset by an 86 percent de-cline in Turkish issues. As with the bond market, first quarter activity in 1995 was almost nonexistent—only six countries sold any equity—with only $622 million sold, a fraction of the average quarterly volume of $4,5 billion in 1994. The volume of placements recovered in the second quarter and quickened through the end of 1995, but remained below 1994 levels.

Table 30.

International Equity Issues by Selected Countries and Regions

(In millions of U.S. dollars unless otherwise indicated)

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Source: IMF staff estimates based on Euromoney Bondware.
Table 31.

International Emerging Market Equity Funds

(As of December 31)

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Source: Micropal Inc.

Table 31 presents indirect evidence on equity investment flows to developing countries by mutual funds. Equity funds surveyed in the table include global equity funds, regional funds, and funds designated to specific countries. The total net asset value of these funds in 1995 was $108.8 billion, slightly below the 1994 figure, although the total number of funds increased from 954 to 1.254.16 The decline in the total net asset value mainly resulted from the decline of funds dedicated to the Western Hemisphere. In particular, the net asset value of Latin American regional funds fell from $10.9 billion in 1994 to $8,5 billion in 1995. and almost all Latin American country funds experienced declines. The largest declines occurred in funds for Mexico (down by $723 million) and Brazil (down by $504 million).17 In contrast, the net asset value of Asian regional funds increased by $2.1 billion to $34.8 billion. The main beneficiaries of this growth were funds investing in China and “China-concept” funds, Korea funds, Thailand funds, and Vietnam funds. Among the funds that lost capital were those for India. Indonesia. Malaysia, Pakistan, the Philippines, and Taiwan Province of China. The total net asset value of East European regional and country funds jumped from $1.48 billion in 1994 to $2 billion in 1995, and the number of related funds increased from 38 to 62 over the same period.

These developments in the international markets reflect the difficulties in domestic equity markets in these countries (see Chart 2). In local currency terms, the Mexican market lost 35 percent of its value between December 19. 1994 and February 27, 1995. The equity markets in almost all developing countries and countries in transition suffered losses in the beginning of 1995, but the Latin American markets suffered the greatest declines. In all of the countries represented in Chan 2 except India, however, these initial losses were soon reversed. Even the Mexican stock price index returned to precrisis levels on July 6, 1995.

Activity during 1995 for global and international equity mutual funds is presented also inChart 29. which shows net sales of fund units during 1995 and into 1996. The chart also shows the monthly return on a composite index compiled by the International Finance Corporation. With equity returns turning negative in January 1995, and remaining very low for the rest of the quarter, net inflows into these mutual funds were very low. Clearly, however, as returns in the local equity markets recovered in the second quarter of 1995, inflows into mutual funds picked up. Indeed, the How of new money into these funds follows reasonably closely the returns on equity. In October 1995, for example, the decline in the stock index was matched by a drop in inflows into mutual funds, while the January 1996 increase in stock prices was matched by a surge of inflows.

The sharp price adjustments scared off many domestic investors, resulting in declines in liquidity in some countries. Average monthly turnover in Mexico, for example, fell by 14 percent from 1994 to 1995, while that in Argentina and Brazil dropped by 48 percent and 26 percent, respectively (Table 32). The steepest declines in liquidity, however, were observed in countries or regions that were relatively unaffected by the Mexican crisis. Turnover in the Chinese, Indian, Korean, Malaysian, Taiwanese, and Thai stock markets declined by between 35 percent and 51 percent in 1995. The Turkish stock market was strongly bullish in 1995, with turnover increasing 74 percent, and the stock price index rising 60 percent in 1995.

The weakness in prices and decline in turnover in many countries and the increased uncertainty during the serious economic downturn in some of the Latin American countries provided strong disincentives for new issues on the domestic and international markets. New equity issues in Argentina declined by 88 percent, in Mexico by 53 percent, and in Brazil by 30 percent (Table 33). Total issues by Asian emerging markets were essentially unchanged compared with 1994, as decreased issuance in India and Indonesia offset increases elsewhere in the region.

Countries with open but small financial markets may be subject to greater volatility related to foreign investors’ purchases and sales of local stocks as they become increasingly influenced by developments abroad. Since a small fraction of the assets of large institutional investors in industrial countries can often represent a large supply of capital in an emerging market, a small shift in these investors’ portfolio allocations—possibly in response to developments elsewhere in the world—could potentially result in a significant price movement in the local market. The influence of foreign investors can be exacerbated if a large number of domestic residents take their cue from the actions of the foreign investor, thereby reinforcing any volatility that is transferred to the market from abroad. It is usually difficult to examine the influence of foreign investors in the local stock market, because buying and selling by foreign investors is usually not reported separately. In Thailand, however, such statistics are available (Table 34). In 1993, net foreign invesment in Thai shares was the equivalent ol $2.7 billion; in 1994, foreign investors sold $396 million; and in 1995. they again were net purchasers, acquiring $1.96 billion.18 During those years, the Stock Exchange of Thailand (SET) index increased sharply in 1993, declined in 1994. and then recorded a moderate gain in 1995. Chart 30 shows the time series of foreign investors’ net purchases of Thai stocks and monthly returns of the SET index. The graph suggests a positive correlation between foreign investment in the market and the local currency returns. This correlation is confirmed empirically: in a regression of foreign net investment on the SET index return, a B 1 billion net inflow from foreign investors increases the return on theSET indexby 0.4 percent in the month.

Chart 29.
Chart 29.

Net Sales of Global and International Mutual Funds and Change in IFC Emerging Market Investable Composite Index

(Net sales in millions of U.S. dollars and change in IFC index in percent)

Sources: International Finance Corporation and Investment Company Institute.
Table 32.

Stock Market Turnover Ratio in Selected Countries and Regions

(In percent, monthly averages)

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Source: International Finance Corporation, Emerging Markets database.
Table 33.

Value of New Equity Issues in Selected Countries and Regions1

(In millions of U.S. dollars)

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Source: International Finance Corporation, Emerging Markets database

Includes only new issues in exchange for cash.

Table 34.

Net Flows of Portfolio Investment to Thailand

(In millions of U.S. dollars)

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Source: Bank of Thailand

Mostly investment flows from The Bahamas, Japan, Luxembourg, Switzerland, and the Virgin Islands.

Mostly Australia, Japan, Luxembourg, and Switzerland.

Chart 30.
Chart 30.

Foreign Investment and Returns on the Thai Stock Market

(In percent)

Source: Bank of Thailand.

International Syndicated Loans

Faced with the high costs of funding in the equity and bond markets in the wake of the Mexican crisis, developing countries turned to the syndicated loan market to raise funds. The international syndicated loan market was highly liquid in 1995, with unusually low margins and high volumes of transactions. 19 Medium- and long-term syndicated loan commitments to all developing countries and countries in transition increased by 36 percent in 1995 to $75 billion, after having increased by 29 percent in 1994 over 1993 levels (Table 35). The increase in lending benefited all regions, but most of all the Latin American region. Asian countries continued to attract the largest share of bank lending—55 percent in 1995, down from 64 percent in 1994—but loans to Latin American countries more than doubled, bringing that region’s share up to 13 percent of the total.

While developing countries and countries in transition withdrew from the primary markets in international bonds and equity in the first quarter of 1995, new syndicated lending was only 10 percent below the average quarterly rate for 1994. The decline was greater, however, for the Latin American region, but lending to that region surpassed 1994 levels early in the third quarter. Moreover, average spreads on new loans did not increase much in 1995. rising from 99 basis points in 1994 to 105 basis points. After rising to 102 basis points in the first quarter, spreads narrowed sharply during the rest of the year, and have declined in 1996 to an average of 77 basis points in the first quarter. The main market response was to widen spreads for private issuers—to 136 basis points for the year, compared with 88 basis points for public issuers. Despite the widening of the private-public spread differential, private borrowing actually rose taster than public borrowing. Loans to the private sector increased by 56 percent in 1995, with most of this borrowing occurring in the second half of the year, while loans to the public sector increased by only 22 percent. In the first quarter of 1996. the differential has narrowed, as public sector borrowers raised funds at an average margin of 65 basis points, compared with a margin of 90 basis points for private borrowers.

As is the case with international bond issues, inter bank loans account for an important share of bank lending to developing countries and countries in transition.Table 36 documents the recent evolution of interbank credit from BlS-reporting banks to banks in developing countries and regions and countries in transition While interbank loans to Hong Kong and Singapore are historically high, owing to their role as regional financial centers, net lending to Korea and Thailand, for example, increased by $16 billion and $30 billion, respectively. At the end of 1995, Thailand was the most important developing country borrower from BlS-reporting banks after Hong Kong and Singapore, with net credit outstanding of $68 billion. The situation is very different among the Latin American countries. Argentine banks have not been significant borrowers from BlS-reporting banks, with only $2 billion in loans outstanding at the end of 1995. Brazilian banks, formerly heavy borrowers from international banks, have reduced their outstanding loans by $38 billion in the past two years. Net borrowing by Mexican banks in 1994 of $9.4 billion was reversed in 1995. with repayments of $10 billion, leaving a balance outstanding of $6 billion. Banks in the countries in transition and Turkey have reduced their net credits from foreign banks in the last three years. Since 1994, Polish banks have been net lenders to BlS-reporting banks.

Key Segments of the Investor Base: Japan and the United States

While data on capital flows on an aggregate basis—total inflows and outflows on different types of financial transactions—are increasingly easily available, evidence on bilateral flows remains difficult to obtain. Some estimates are available, however, and they provide useful insight into the recent trends in the investor base for developing countries, particularly in Asia and Latin America.

Table 35.

New Medium- and Long-Term Commitments to Selected Countries and Regions

(In millions of U.S. dollars)

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Source: IMF staff estimates based on Euromoney Loanware.
Table 36.

Changes in Net Assets of BIS-Reporting Banks vis-à-vis Banks in Selected Countries and Regions

(In millions of U.S. dollars)

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Source: Bank for International Settlements (BIS). See Table 4 for a list of the BIS-reporting banks.
Chart 31.
Chart 31.

Net Purchases of Foreign Stocks and Investment Trusts by Japanese Investors Through Securities Companies

(In millions of U.S. dollars)

Source: The Securities Firms Association of Japan.
Table 37.

Equity Flows to Latin America

(In billions of U.S. dollars)

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Source: Baring Securities

Preliminary estimates.

Chart 32.
Chart 32.

United States: Net Portfolio Flows to Defined Regions, 1994

(In millions of U.S. dollars)

Source: United States, Department of the Treasury.Note: See the text for the definition of regional groupings.
Chart 33.
Chart 33.

United States: Net Portfolio Flows to Defined Regions, 1995

(In millions of U.S. dollars)

Source: United States, Department of the Treasury.Note: See the text for the definition of regional groupings.

Tables 37 and 38 present a breakdown of equity investment flows, both portfolio and direct investment, for Latin America and Asian developing countries.20 The Latin American data show the importance of the United States as a source of investment in the region. Between 1989 and 1995. 57 percent of net equity flows to Latin American countries came from the United States, and more than 70 percent of these flows were in the form of direct investment. For the Asian countries, by contrast, while equity flows within Asia (including Japan) have also represented the largest part of investment flows. Japan has played a much less important role than the United States has in Latin America, Japanese investment in Asian developing countries has accounted for only 16 percent of total inflows over the past seven years. The relative decline in importance of Japan as a source of capital is due not to a decline in Japanese investment, but to an increase in equity capital flows within the region and from the rest of the world. Moreover, almost half of the equity flows from Japan to developing countries in the region have been in the form of portfolio investment.

Japanese equity investment abroad declined sharply in 1995, mainly because of domestic factors, including the Kobe earthquake, large swings in the dollar-yen exchange rate, and a weak domestic economy. In addition, the continuing deterioration of corporate and bank balance sheets contributed to the reduction in overseas equity investments. In 1995, Japanese investors’ net equity investment flows to other Asian countries dropped from about $1.5 billion to under $8 million: flows to non-Asian countries declined by 94 percent to only $246 million (Chart 31).

The United States is an important source of investment in Asian developing countries from outside of the region. Charts 32 and 33 show net U.S. portfolio investment flows to different regions in 1994 and 1995.21 The charts demonstrate that U.S. equity investment in Asian developing countries has been significantly greater than investment in Latin America. However,

Table 38.

Equity Flows to Asian Developing Countries

(In billions of U.S. dollars)

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Source: Baring Securities

Preliminary estimates

U.S. investors have been net sellers of bonds issued by the Asian newly industrialized economies (NIEs), and in 1994 these sales offset purchases of bonds issued by other Asian developing countries.

A comparison of the two charts reveals the impact of the Mexican crisis on capital flows to Latin American countries that is indicated in the balance of payments statistics described above. After net purchases of Latin American bonds and equity of $5.6 billion in 1994, U.S. investors’ purchases declined to $441 million in 1995. This sharp reduction in portfolio investment to Latin America was not repeated in other regions, except that the mix between fixed-income and equity investment in Asian developing countries changed. In the Asian countries, other than the NIEs, U.S. investment in 1995 was predominantly in bonds, whereas in 1994 it had been mostly in equity. Meanwhile, equity investment in the NIEs was $4.9 billion in 1995, suggesting that U.S. investors sought the relative security of the more liquid stock markets in Asia, and invested elsewhere in the region in fixed-income assets that earned considerably higher yields than were available in the United States.

Overall, moreover, U.S. investors’ net purchases of foreign fixed-income securities more than quadrupled in 1995 (Chart 34), while equity portfolio investment increased hardly at all. This increase in investments in foreign bonds was motivated at least in part by the decline in domestic U.S. rates, just as Japanese investors’ purchases of foreign bonds reflected the historically low rates available in Japan. In the past four years, this relationship between U.S. investors’ net purchases of foreign bonds and the U.S. long-term interest rate has been fairly constant. The decline in interest rates in 1993 led to a 415 percent increase in purchases of foreign bonds in that year, while the increase in rates in 1994 led to an88 percent decline. During 1995, as long-term interest rates in the United States declined, investment in foreign bonds increased steadily.

Developments in Selected Emerging Market Banking Systems

The strength of domestic banking systems emerged as a key factor in the ability of countries to withstand liquidity crises in 1995, as with the case of Mexico.22

The shock inflicted on the Mexican banking system by the peso devaluation and the sharp increase in interest rates in early 1995 rendered a large part of the system insolvent or undercapitalized, ultimately requiring the authorities to assist in the restructuring of all privatized banks during 1995. Moreover, the weakness in the banking system had been a drag on the recovery from the output contraction in the first part of 1995. Across a wide range of countries, the strength of the banking system was a key factor determining the degree to which other developing countries sustained real economic spillovers from the Mexican crisis. The experiences of Argentina and Chile provide contrasting case studies (Boxes 6 and 7),

Chart 34.
Chart 34.

United States: Yield on 30-Year Treasury Bonds and Net Portfolio Outflows

(Period average yield in percent and outflows in millions of U.S. dollars)

Source: United States, Department of the Treasury.

Impact of the Mexican Crisis on Chile’s Financial Markets

The impact of the Mexican crisis of December 1994 on the Chilean financial markets was contained and shortlived, suggesting that investors discriminated among Latin American countries. Virtually all financial variables, except for the domestic stock market, had returned to their precrisis levels by the beginning of the third quarter of 1995. Most notably, the banking system remained immune to the shock waves of the crisis throughout the year.

The impact of the crisis on exchange rates and interest rates was limited. The exchange rate was allowed to depreciate by about 5 percent within the band in January and Fehruary 1995. By March, exchange rate pressures had subsided, and the peso began to appreciate. Long-term interest rates on indexed instruments rose by about 40 basis points to 6.3 percent in the first quarter of 1995, while short-term interest rates on indexed instruments remained stable during this period.

Chilean equity markets stumbled after the Mexican de-valuation, with the general stock index (IGPA) falling by about 3 percent in the first three days following the crisis. Tensions in the stock market persisted during the first part of January, as investors’ confidence in a fast resolution of the Mexican crisis dissipated, and fears of indiscriminate capital flight out of Latin America mounted. During the first ten days of January, the IGPA, as well as most Chilean American Depository Receipts (ADRs), dropped sharply, but recovered most of their losses in the second half of the month. The stock market underwent an even steeper decline in the first nine days of March, when share prices took a 14 percent dive. This decline appears to have been prompted by heavy selling of Chilean ADRs by foreign funds concerned about the exposure of Chilean companies to the deteriorating financial condition of the Argentine economy, and more generally, as part of an overall strategy to reduce their exposure to

Latin America. By the end of March, however, the stock market had rebounded, and as conditions began to stabilize in Mexico and Argentina in the second quarter of 1995, Chilean stock prices rallied.

Aside from the regional turmoil, the performance of the Chilean stock market in the second half of 1995 was influenced by a number of domestic factors, including the central bank’s tightening of monetary policy and the poor performance of stocks from the electrical and telecommunication sectors (which account for two thirds of market capitalization). In particular, the share prices of electrical companies registered a sharp drop in the third quarter of 1995, owing to the announcement of the construction of two pipelines to import natural gas from Argentina, which raised fears about a possible glut in the market and a squeeze on profit margins. The price of telephone companies’ shares also declined in the second half of 1995, mainly as a result of a price war among telecommunication companies to increase their market share in the newly deregulated long-distance market. In addition, beginning in the third quarter of 1995, the stock market experienced a downward adjustment, which reflected an initial overvaluation of share prices originating from significant capital gains accumulated in previous years. Despite these factors, by the end of 1995, the IGPA was 3.8 percent above its precrisis level, and most Chilean ADRs had regained their precrisis price levels.

Despite the general unease about Latin American issuers in international capital markets in 1995, Chile’s economic fundamentals and healthy external financial position enabled it to become the first country in Latin America to obtain an investment grade rating by Standard and Poor’s in July 1995. The A- rating further enhanced domestic companies’ ability to tap international capital markets. Indeed, three out of a total of seven ADRs issues from Latin America in 1995 were Chilean entities (Santa Isabel, Sociedad Quimica y Minera de Chile SA, and Banco de A. Edwards).

In contrast to other banking systems in the region that were severely affected by the Mexican crisis, the Chilean banking sector expanded and prospered in 1995. Bank deposits and credit activity were unaffected by the regional turmoil in the first quarter of 1995, growing at rates of 8 percent and 5 percent, respectively. Over the entire year, total deposits in the banking system increased in real terms by almost 12 percent, while total loans increased in real terms by about 18 percent. Loan demand was particularly buoyant in the middle-market, consumer, and real estate sectors. Notwithstanding the fast growth in lending activity, the Chilean banking system registered an improvement in its already high-quality asset portfolio; the ratio of past due loans to total loans declined slightly to below I percent during 1995, and the ratio of past due loans to equity fell from 9.1 percent to 8.8 percent. Overall, early concerns about potential asset quality deterioration due to the large investments of Chilean companies in neighboring countries (for example. Argentina and Peru) did not materialize. Banks’ profitability remained high, with average return on equity (after subordinated debt payments) increasing from 12.2 percent in 1994 to 12.9 percent in 1995, and some strong banks boasting returns of 15-16 percent.

Chile’s prudent macroeconomic management, its low reliance on short-term portfolio inflows, and the quality of its banking system are the main factors that explain the minimal impact of the Mexican crisis on its financial markets. The country’s large domestic saving base, developed partly through a private pension fund system that now holds more than $25 billion in assets, has allowed Chile to finance most of its investment needs internally, thereby reducing the vulnerability of the domestic financial system to sudden outflows of capital. The Central Bank reserve requirement on short-term capital inflows also contributed to reducing the dependence of Chilean financial markets on foreign funds. In fact, in recent years, most capital flows have been in the form of direct investment and long-term portfolio investment, and in December 1995, less than 5 percent of the Chilean stock market was held by foreigners (excluding foreign holdings of Chilean ADRs). After weathering a major banking crisis in the 1980s, the Chilean banking system has evolved into a sound industry in recent years, owing to the conservative lending practices of banks and the strict monitoring of their activities by supervisory authorities. The supervisory oversight has also been complemented by the development of a stringent risk classification system, proper auditing procedures, and reliable reporting requirements.

Having withstood the shock of the major regional crisis and demonstrated the depth of the macroeconomic reform process, Chilean authorities currently face the challenge of opening their financial system to international markets, while adapting their supervisory and regulatory system to a global and competitive environment. The new banking law, currently under consideration, represents an important step in that direction. Under the new law, Chilean banks that fulfill certain minimum capital adequacy requirements will be allowed to expand their operations internationally, and service the regional activities of their corporate clients. The law will also allow banks to move into presently prohibited areas such as factoring and securitization. Although such expansion would improve the diversification of banks’ portfolios, it may represent a serious challenge to the prudential authorities’ ability to supervise the banks’ foreign activities. This will become even more problematic once banks start to move into off-balance-sheet and derivative operations, which at present are limited domestically. The international expansion of Chilean banks would therefore need to be accompanied by an increase in the capability and expertise of Chilean bank supervisors and a greater control of the risk exposure of banks on a consolidated basis.

Western Hemisphere

The Mexican banking system suffered serious dislocations as a result of the liquidity crisis early in 1995. which required extensive government support to prevent the collapse of some of the larger institutions as well. Six of the 18 privatized banks have either been “intervened” or taken over by the government; the remaining banks have received assistance through one or more of the support programs. By the end of the year, due in large measure to this government support, the risk of systemic crisis had eased to a large extent. However, as indicated in their intrinsic-strength ratings, Mexican banks remain weak (Table 39). Although six institutions were subject to intervention during the year, the results for the rest of the banking system showed only a slight decrease in aggregate net income, from MexN$3,426 million in 1994 to MexN$3.125 million in 1995.23 Supported by sharply higher interest rates, net interest margins widened from an average of 5.9 percent in 1994 to 8.8 percent in the first half of 1995, before declining to an annual average of 6.0 percent for the full year. The decline in margins was due to a combination of falling interest rates after their peak in April, and an increase in nonperforming loans, but government support programs limited the decline in income. The ratio of nonperforming loans to total loans rose from 9,0 percent at the end of 1994 to 15.2 percent at the end of September 1995 before declining slightly to 12.3 percent at the end of 1995. If the “intervened” banks are excluded, the ratio at the end of 1995 was 7.0 percent.24 At the end of the year, the aggregate capital ratio for “nonintervened” banks had risen to 12.1 percent, from 9.8 percent at the end of 1994.

Spillovers of the Mexican Crisis on Argentina’s Financial Markets

Argentina was one of the countries most severely affected by the Mexican financial crisis of December 1994, The devaluation of the Mexican peso triggered an abrupt fall in the demand for Argentine financial assets which, in a matter of weeks, escalated into a major banking crisis. Between mid-December 1994 and March 1995, the prices of Argentine stocks and bonds traded in domestic and international markets plummeted; the Argentine banking system lost about $7.5 billion (16 percent) of its total deposits; the central bank lost more than a third of its stock of liquid international reserves ($5.5 billion); and prime interest rates on peso and dollar loans rose from a level of around 10 percent to more than 40 percent and 30 percent per annum, respectively. At the same time, new issues of private and sovereign Argentine bonds in the international bond markets fell from an average of $1.5 billion a quarter in 1994 ($2.1 billion in the fourth quarter) to zero in the first quarter of 1995. However, foreign lines of credit to Argentine banks increased by $2 billion during December 1994 to May 1995.

The severity of the crisis is difficult to explain solely in terms of the shift in foreign investors’ sentiment away from emerging markets following the events in Mexico. Indeed, a number of factors might have contributed to magnifying and propagating the initial shock, including memories of previous financial crises that entailed confiscation of deposits, the long-standing segmentation of the banking system, the slowdown in the pace of remonelization and declines in the rates of return of Argentine assets daring 1994, investor doubts about the sustainability of full convertibility of current and capital account transactions, a constrained lender-of-last-resort function of the central bank under the quasi-currency board in place since 1991. and the fact that bank deposits were not insured.

These potential factors together with the uncertainty surrounding the finalization of the international financial assistance to Mexico had an effect on financial developments in Argentina. By mid-February, the bulk of the drop in stock and bond prices had already taken place; the run on deposits had been concentrated in the peso segment of those institutions that participated actively in international capital markets; and the interbank lending rate had remained below 15 percent. Wary of the course of events, and perceiving an increased country risk, international banks with branches in Argentina cut off credit lines temporarily to their branch operations in late February. These actions had a negative effect on confidence and led to another bout of instability. In early March, almost three months after the initial shock, interbank lending rates skyrocketed beyond 70 percent per annum and in the ensuing weeks the run on deposits spread to dollar- as well as peso-denominated liabilities and affected all financial institutions in the system, regardless of their size or ownership structure.

The authorities responded to the crisis quickly. Fully committed to preserving the Convertibility Plan, the central bank contained the adverse effects of the withdrawal of deposits on the solvency of the banking system. To this end, and stretching to the limits its constrained lender-of-last-resort functions, the central bank took a series of measures aimed at mitigating the liquidity crunch and speeding up the restructuring of distressed institutions. The first line of defense consisted of a progressive lowering of the high average reserve requirements, the suspension of a number of troubled wholesale banks, the direct injection of central bank credit via rediscounts and swaps, and the creation of two safety nets to redistribute liquidity within the system (the first funded with voluntary contributions of five private banks and the second with the transfer of 2 percent of bank reserves—over $800 million—to a special account at the stale-owned Banco de la Nacidn). From late February to mid-March 1995, as the crisis worsened, the authorities stepped-up their response with the announcement of a Fund-supported program containing strict fiscal austerity measures (including tax hikes and nominal wage cuts), the passing of a law enabling the central bank to increase the size and maturity of its rediscount operations and broadening its faculties to intervene and restructure troubled institutions, a further reduction of reserve requirements, and the creation of two fiduciary trust funds to foster the privatization of provincial banks ($1.3 billion) and the restructuring and consolidation of private banks ($2.5 billion)—although the second trust fund was not fully used. The trust funds were financed with loans from multilateral agencies and with a government pledge to raise $2 billion through bond placements in domestic and international markets. By the end of April, the monetary authorities had been able to release the equivalent of $5.4 billion of liquidity into the system, more than one third of it in the form of central bank loans. The extra liquidity, added to the rollover of some foreign credit lines early in the year and the high and well-enforced capital adequacy ratios, allowed the financial system to withstand the run on deposits without any major casualty among banks or a massive compression of credit to the private sector—which, in the event, fell by $1.8 billion through the end of March. Argentina’s capital requirements are 11.5 percent of risk-adjusted assets, in addition to requirements based on the interest rate level charged on loans. Banks maintained a capital-assets ratio that largely exceeded this minimum requirement. As a result, the Argentine banking system had a capital-assets ratio of close to 20 percent of risk-adjusted assets at the end of December 1995.

Financial markets stabilized in the second quarter. By the end of May 1995, stock and bond prices had risen 50 percent above their March lows, trading volumes had doubled, interest rates on peso and dollar loans had dropped by about one half (to 19 and 16 percent per annum, respectively), and the government had secured its $2 billion contribution to the fiduciary trust funds with two issues of three-year U.S. dollar bonds at a spread equivalent to some 340 basis points—one of which was entirely subscribed by domestic residents. The first placement marked the reentry of Argentina to international capital markets, and was promptly followed by four issues of nonsovereign bonds for a total of about $600 million (including a seven-year issue by YPF that secured a spread below sovereign risk). In the banking system, the run on deposits abated in April 1995. when a mandatory and fully funded private deposit insurance scheme with fixed insurance limits was created, and was completely arrested after the Presidential elections in mid-May: indeed, from May 15 to June 30. 1995 the re-flow of bank deposits exceeded $2.2 billion and the central bank regained $1.4 billion of liquid international reserves. The process of bank restructuring also continued in this period: three small banks were closed, more than 30 private financial entities (mostly cooperatives and wholesale banks) were merged or absorbed by larger banks, and a number of local governments took concrete measures toward the privatization of provincial banks.

Nonetheless, the events of early 1995 worsened most performance indicators of the Argentine financial system. The liquidity squeeze that followed the run on deposits led to a marked slowdown of economic activity and a deterioration in the asset position of the majority of banks. As a result, the ratio of nonperforming loans (net of provisions) to total credit for the system as a whole increased from 3.7 percent to 8.5 percent between December 1994 and June 1995; the rise in nonperforming loans was much sharper in the weaker segments of the system, such as wholesale banks, cooperative banks, and. especially, provincial banks (where the ratio increased from 5.0 to 13.7 percent). Bank profitability also suffered, owing to higher loan loss provisioning and record-high funding costs, and the overall financial system recorded its worst half-year outcome since 1992, with losses of more than $330 million. Again, provincial banks fared much worse than the rest, but private banks as a group also recorded losses in excess of $100 million (mainly due to the dismal results of wholesale and cooperative banks). Moreover, despite the progress in bank consolidation, the differences among the various segments of the Argentine banking system widened in the first semester: by the end of June 1995. the 20 largest banks had increased their share of the system’s assets and liabilities by some 5 percentage points and had captured the lion’s share of the deposit reflow initiated in mid-May.

Progress toward lull restoration of confidence in financial markets proceeded at a slow but steady pace in the second half of the year. Prices of Argentine stocks and bonds and the stock of central bank’s liquid international reserves reached their precrisis levels by the end of December, whereas interest rates and total bank deposits did so a little later, during the first two months of 1996. Thus, for most financial variables, the recovery phase of the cycle lasted roughly twice as long as the downslide of early 1995. Two important exceptions to this general pattern were access to international capital markets and bank lending to the private sector. Argentina’s ability to tap international capital markets was almost fully restored by the end of the second quarter. In fact, in the second half of 1995 Argentina raised some $4.8 billion (90 percent of the total raised in 1994) with 23 bond issues, half of them from nonsovereign borrowers; the trend continued in the first quarter of 1996. with the placement of 15 bond issues (8 of them nonsovereign) for a total in excess of $3.8 billion. Argentina’s reentry was facilitated by an unusually strong demand for high-yield debt instruments from non-U.S. foreign investors—especially from Germany and Japan—which allowed the government to satisfy its borrowing requirements and at the same time establish baseline terms for issues of private sector instruments. By the end of March 1996. spreads on new issues of Argentine paper remained above the levels secured in mid-1994. but the maturities of new placements had increased steadily—lo an average of more than six years. In contrast, bank lending to the private sector remained essentially unchanged from April to November at about $45.5 billion, and only started to grow, albeit rapidly, in early January 1996. The sluggishness of private sector credit was partly a consequence of the downturn in economic activity, but reflected as well a number of supply factors. These included the still high levels of real interest rates—particularly for nonpreferential borrowers, the ongoing restructuring of the banking system, and attempts by the larger banks to rebuild their liquidity margins and reduce their outstanding obligations with foreign creditors and the central bank.

The process of bank consolidation continued throughout this period, alongside a rising concentration of assets and deposits. In March 1996 the Argentine financial system consisted of 153 institutions, down from a total of 205 in December 1994 (a decline of 25 percent). About two thirds of the fall in the number of entities was accounted for by mergers and acquisitions of small private cooperative banks, but the number of wholesale banks and nonbank financial institutions also declined. In addition, out of 33 banks owned by the public sector at the end of 1994, 2 provincial banks had been liquidated. 9 had been privatized, and another 9 were in the final stages of privatization. In spite of this cleansing process, the banking system remained highly segmented and concentrated. The share of private banks in total assets and deposits remained at around 60 percent. Also, the share in total assets of the largest 20 banks (which include five public sector banks) increased from 64 percent to 75 percent over the course of the year. With regard to banks’ overall performance, a number of indicators showed signs of modest improvement by the end of December 1995. The ratio of impaired loans net of provisioning to total credit for the system as a whole stabilized at its October 1995 level of about 10 percent, despite a steady worsening of the ratio in provincial and private regional banks in the fourth quarter; lower operational and funding costs and the shift in August to a system of uniform and remunerated liquidity requirements allowed some gains in efficiency; and the overall financial system recorded profits of more than $82 million ($136 million for private banks) in the second half of the year.

Table 39

Moody’s Bank Financial Strength Ratings for Selected Countries and Regions, May 19961

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Source: Moody’s Investors Service

For an explanation of these ratings, see Box 3 in Annex 1.

The effect of the liquidity crisis on asset quality and the establishment of various government-financed programs aimed at easing the burdens of both banks and their borrowers overshadowed the entire industry in 1995. Interest rates rose sharply in early 1995, resulting in a rapid buildup in nonperforming loans.25 Aggregate nonperforming loans increased steadily from MexN$56.6 billion at the end of 1994 to MexN$103.6 billion at the end of September 1995. In response, the authorities instituted a series of programs in 1995thatfacilitated loan restructuring and loan sales by banks (Box 8). Consequently, nonperforming loans on banks’ balance sheets declined in the fourth quarter of 1995 before increasing again in 1996. At the end of March 1996, nonperforming loans were MexNS106.59 billion—12.9 percent of total loans.26 Reserves amounted to MexN$75.86 billion at the end of March 1996. up from MexN$39.9 billion a year earlier.

To restore confidence in the banking system, the Mexican authorities introduced a number of bank regulatory requirements aimed at improving loan loss provisions and disclosure, in addition to the loan restructuring and recapitalization programs. Effective the end of March 1995, banks were required to have loan loss reserves equal to the greater of 60 percent of nonperforming loans or 4 percent of total loans. More recently, from July 1996, banks will be required to prepare their financial statements according to both Mexican and international accounting principles, and from June 1997 only according to the latter. A key implication of this requirement is that reported nonperforming loans will increase, since Mexican accounting rules include only the unpaid interest and principal in the definition of non-performing loans. The Ministry of Finance recently re-ported that the end of 1995 nonperforming loans for the recapitalized banks were 14 percent of total loans under international accounting principles.

The support given to the banking system has come at a significant cost to the authorities. Under the programs described in Box 8, the direct and indirect costs are as follows: (1} from the Unidades de Inversion (UDI) program, the cost to the government is the difference between the implicit real CPP (Costo Porcentual Promedio) based interest rate it pays and the UDI real rate plus possibly a further loss if the principal is irrecoverable at maturity; (2) under the small debtors assistance program, Programa de Apoyo Inmedialo a Deudores de la Banca (ADE), the government pays the difference between the fixed rates under the program and an agreed-upon margin above the Tasa de Inierés lnterbancaria de Equilibrio (TIIE);27 (3) under the loan-purchase agreements, the cost to the government comes from the difference between what the acquired loans earn, and what the government pays on the bonds it issued to finance their acquisition; (4) as a result of direct intervention there are costs to keeping the intervened banks open and perhaps losses arising from sales of assets.

In February 1996, the Mexican authorities estimated the present value of the cost of these bank support programs at MexN$90.8 billion, or 5.5 percent of 1995 GDP to be spread over 30 years. Since then, however, the participation in loan sales of three more banks added approximately MexN$11 billion to the total. Also, the total gross financing from FOBAPROA has increased to MexN$40.2 billion since January 1995.28 In addition, in

Government Assistance to the Mexican Banking System

Liquidity assistance in foreign currency. In early 1995, Fobapro Aprovided short-term assistance to banks experiencing difficulties servicing their foreign currency liabilities. Such assistance peaked in early April 1995 at $3.9 billion and was fully repaid by the end of September 1995.

Temporary capitalization (Procapte). Fobaproa purchased callable mandatory convertible subordinated bonds from the banks. The bonds were convertible into common shares sufficient to raise the banks’ capital ratio to 9 percent. The conversion date (to shares), originally set at five years, may be accelerated if the participating bank’s capital ratio falls below 2 percent or below 25 percent of the average of the banks participating in the pro-gram. The proceeds of the bonds were placed in the central bank. Five banks took advantage of PROCAPTI, receiving a total of MexN$7.0 billion in capital. At the end of April 1996, three banks remained in the program with an outstanding debt of MexN$3.2 billion. The Procapte program has no monetary impact because proceeds of the bonds purchased by Fobaproa are deposited at the Bank of Mexico.

Unidades de Inversión (UDls), MexN$l85 billion in loans (27 percent of the September 1995 total) were allocated for restructuring into UDls. The principal of the loan was converted into UDls and indexed to the rate of inflation, and maturities were lengthened by up to 30 years, depending upon the type of loan. Restructured loans were placed in a trust (consolidated into the bank in December 1995) that was funded by loan loss reserves from the banks in the amount of 15 percent of the loans, and from government funds denominated in UDls. The banks were required to hold nonnegotiablc zero-coupon government bonds, equal to the amount of the government’s funding, that accrued interest at the CPP rate. As the restructured loans are repaid, the government bonds are retired and the nonnegotiablc bonds are redeemed. By April 1996. MexN$ll9.8 billion in loans had been restructured into UDls.

Programa de Apoyo Inmediato a Deudores de la Banco (ADE). MexNSl 10 billion in loans (25 percent of total loans) to small debtors were eligible for temporary interest rate relief for 13 months (18 months in the case of the agricultural sector). The government offered debtors below-market fixed rates on their loans for 13 months, provided they signed a letter of intent to restructure by January 31. 1996 and remain current. The difference between the fixed rates under the program and an agreed-upon margin above THE, or in the case of mortgages, the UDI, was paid by the government. The program gave the government the option to make these payments in cash or through five-year government notes, capitalizing interest for two years and bearing the 28-day Cetes rate. In November 1996 the government began paying the difference in cash. By early April 1996, 1.8 million loans (86 percent of the eligible total) had been restructured.

Loan purchases. Fouaproa agreed with some banks to purchase MexN$2 in loans for each MexN$l in new private capital. The loans were purchased with ten-year zero-coupon nonnegotiable bonds guaranteed by the government. Banks continue to service the loans, and collections are forwarded to Fobaproa, which applies the payment to bond redemptions. Banks generally share 20-25 percent of the downside risk should the transferred provisions be insufficient to cover loan losses. By the end of December 1995, MexN$69 billion in loans had been purchased from 12 banks, more than 10 percent of the gross loans of the banking system. By the end of March 1996, MexN$80.9 billion of loans had been purchased. All 12 privatized, nonintervened banks have participated. In March 1996. the Mexican authorities announced their intention to establish an institution similar to the U.S. Resolution Trust Corporation to allow for the orderly disposition of the assets acquired by Fobaproa.

Toll road restructuring. In 1995. the government restructured all of the banks’ loans to the toll road concessions into UDls for 24 months, reimbursing the banks for the difference between interest due and the cash flow generated by the project. After two years, the government will assume the debt that each project cannot service.

Direct intervention. Fobaproa has intervened in or taken over ten banks as of July 1996 (two in 1994, six in 1995, and two in 1996). During 1995, Fobapro Aprovided liquidity assistance of MexN$34.76 billion to intervened and weak banks (MexN$40.138 billion by the end of March 1996).

Table 40

Cast of Mexican Bank Support Programs1

(In billions of Mexican new pesos)

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Source: National Banking and Securities Commission, Mexico.

Present value in billions of Mexican new pesos and percent of GDP.

May 1996, the authorities announced yet another loan-relief plan, this time aimed at mortgage loans that have already been restructured into UDls. or that will be restructured by the end of September 1996. By lengthening maturities, this program will cut monthly payments by up to 30 percent in 1996, with the cuts gradually tapering off to 5 percent by 2005. Only the first 500.000 UDls in principal are eligible for restructuring; some 900.000 mortgages are eligible. The program is expected to cost MexN$27 billion, or 1.2 percent of 1995 GDP, raising the total cost of bank support to MexN$148 billion, or about 6.6 percent of 1996 GDP (Table 40).

Most of the loan restructuring programs were not applied to the debts of large corporations, some of which have encountered difficulties in repaying their domestic and foreign debts.29 To contribute to the restructuring of these liabilities, a new unit (UCABE) was created.30 Supported by the commercial banks and the government—but independent of the government—UCABE considers individual credits and acts as an intermediary in the negotiations between banks and firms that Request its intervention. By late April 1996, the office was reviewing approximately 40 cases, involving S6.5 billion in debts.

Asia

Indian banks returned to profitability in 1994-95 after two years of losses, buoyed both by a very large increase in net interest revenue and lower loan loss provisions.31 A 17 percent increase in interest income from investments led to a 61 percent rise in net interest income. At the same time, after two years of high loan loss provisions in 1993-94. owing to worsening asset quality and tighter provisioning requirements, provisions fell by 38 percent in 1995 to 34 percent of net interest revenue, from 88 percent in 1994. The result was an aggregate net profit of Rs 13.4 billion after combined losses of Rs 66 billion over the previous two years.

Banking sector reform has been a priority since the 1991 Narasimham Committee report, which identified weaknesses in the banking system and proposed a number of reforms. Most of the Committee’s recommendations have been implemented. These included improved asset classification and provisioning requirements, capital adequacy requirements, more rigorous on-site examinations, the reduction of reserve requirements, interest rate deregulation, and increased competition in the banking sector.

Despite the decline in provisions in 1994-95, asset quality remains a key source of concern with the Indian banking system. Largely because of the high proportion of mandated lending to priority sectors—40 percent of loans for domestic banks and 32 percent for foreign banks—and past lax credit standards, nonperforming loans comprised approximately 23 percent of state bank loans in March 1994.32 Subsequently, this proportion is thought to have declined slightly. On average, loan loss reserves provide coverage for approximately one third of this total.33 A tightening of loan classification and provisioning requirements in April 1992 forced banks to greatly increase their levels of provisioning, which resulted in the net losses in the 1993 and 1994 fiscal years.34

While most banks’ nonperforming loans problems are believed to be manageable, four state banks are in need of assistance.35 This comes after the government injected Rs 57 billion into the state banks in 199394 and budgeted another Rs 56 billion in 199495 to allow them to reach the mandated 8 percent capital ratio.36 In return for capital injections, the banks were required to sign memoranda of understanding with the Reserve Bank that committed them to set performance targets for deposits and loans and asset quality improvement as well as to modernize their operations. In the event that banks do not meet these targets, the Reserve (Bunk can impose sanctions, including raising reserve requirements, denying them refinancing facilities, restricting their access to the money market, and imposing fines. It is thought that through the enforcement of the new asset classification and provisioning regulations, the banking system will be able to resolve the bad loan problem out of current earnings—with little further financial assistance—in two to three years.

In addition to the financial impact of the stock of nonperforming loans, the financial situation of banks is further compromised by the statutory liquidity ratio and the cash reserve ratio, which together force banks to hold 39 percent of net demand and time liabilities in low-interest government securities.37 Since these requirements are met by holding essentially illiquid government securities, most of which yield interest at below-market rates,38 they impose a significant cost on the banks—particularly given the underdeveloped capital markets and interbank deposit market where banks might raise alternative funds—as well as reducing liquidity and forcing banks to charge wider inter-mediation spreads on that small proportion of their assets for which they are free to set interest rates.39 Moreover, the capital injections that the banks received in 1993—95 had to be invested in 12-year Transferable Recapitalization Bonds, which carry a very low interest rate and for which there is effectively no secondary market. Government securities accounted for 23 percent of banks’ assets at the end of March I995. The requirement that 4(1 percent or more of these must be marked to market imposed further costs when interest rates rose in 1995. This marking-to-market requirement was increased to50 percent in April 1996. and as a result two more banks were unable to meet the capital adequacy requirement, bringing the total number of such banks to six or seven.

The banking system in Thailand has grown rapidly in recent years, with aggregate claims on the nonfinancial private sector increasing by 24 percent in 1995, after increases of 30 percent in 1994 and 24 percent in 1993, This loan growth has fueled rapid real growth in the economy despite relatively restrictive monetary policy implemented to control the rate of inflation. The high interest rates, however, have allowed Thai banks to earn relatively wide net interest rate spreads, and hence they have been consistently profitable. In 1995, for example, during which interest rates rose to four-year highs, banks’ interest margins widened significantly. The largest commercial bank, for example, reported a 100-basis-point increase in its margin to 4.75 percent. These wide spreads, combined with high volume growth, resulted in large increases in net income over 1994 results. Five of the ten largest banks have reported summary results for 1995, and these show increases in net income ranging between 11 percent and 25 percent.

There are some negative indicators in the recent performance of the that banking industry. Chief among these are the decline in liquidity and the expansion in net foreign liabilities. The decline in liquidity is reflected in higher interbank interest rates and in the loan-to-deposit ratio, which has increased steadily to 131 percent at the end of 1995 compared to 110 percent at the end of 1993, Moreover, an increasing proportion of this lending is funded by foreign borrowing. Commercial banks’ net foreign liabilities increased by 51 percent in 1995. after jumping by 214 percent in 1994.40 Borrowing from foreign banks—including Bangkok International Banking Facility (B1BF) units—accounted for 20.9 percent of total liabilities at the end of 1995, up from 9.8 percent at the end of 1993. Significantly, much of these foreign liabilities are thought to be unhedged, exposing the banks to foreign exchange risk. The central bank has introduced a number of measures to try to reduce the average ratios of loans to deposits and net foreign liabilities to capital. These included raising the bank rate, requiring reductions in these ratios by banks whose ratios exceed the average, raising reserve requirements on nonresident baht deposits, raising the minimum size of BIBF loans to resident companies, and increasing capital requirements.

Information on asset quality is not readily available for Thai banks, since they are not required to disclose nonperforming assets or reserves. Accrued interest receivable declined slightly to 1.4 percent of loans at the end of 1995, but allowances for possible loan losses increased to 2 percent of loans, from 1.8 percent at the end of 1994. Loan loss provisions fell as a proportion of net interest revenue in 1994, although at least one bank has seen a significant increase in nonperforming loans.41 The Bangkok Bank of Commerce was instructed to raise additional capital in 1994 to bring loan loss reserves up to minimum standards. In July 1995, B 3 billion was raised, a quarter of which was acquired by the Fund for the Reconstruction and Development of Financial Institutions. At the time, the bank was believed to hold B 12 billion in doubtful assets. By the end of 1995, the bank was apparently technically insolvent, with a negative net worth of B 6.43 billion. Some 47 percent of its assets were reported to be deemed “low quality” or “high risk,” only 4 percent of which was believed to have been covered by reserves. The Minister of Finance has appointed a panel to administer the bank and is attempting to attract additional private capital into the bank.

The situation for Thai banks is likely to become more difficult in the future. Banks are facing increasing competition from nonbank financial institutions as the barriers between market sectors weaken. Moreover, the central bank is expected to grant up to 12 new banking licenses in 1996. This is likely to have the greatest impact on the smaller bank. which have seen the fastest loan expansion and a narrowing of interest margins in recent years.

Countries in Transition

Banks in the transition economies face many challenges as they struggle to place their operations on a sound market-oriented footing despite critical shortages of skilled managers and other personnel. The most crucial task is still to improve credit risk management—to evaluate loan applications on the financial condition of the borrower and the use to which the funds will be put, rather than on noneconomic criteria or simply on the value of collateral. In the Czech Republic and Hungary, the supervisory framework is now well established. Both countries have introduced prudential regulations in line with European Union standards in anticipation of membership in the Union, although transitional arrangements are in place for some of the former state-owned banks, particularly with respect to capital adequacy.42 In Hungary, moreover, the Ministry of Finance is proposing to unify the supervision and regulation of the banking, securities, and insurance sectors under one agency—ultimately combining the existing State Banking Supervision, State Insurance Supervision, and the Securities and Stock Exchange Commission. The first step will be to create a committee structure involving these three agencies and the Ministry of Finance to provide greater coordination between these regulators. Later legislation will then implement functional regulation—based on the activities rather than on the institutions.

While the supervisory and regulatory framework is rapidly being put in place, deteriorating asset quality remains a key challenge for banks in these countries. Although most of the state banks had their balance sheets cleansed of inherited nonperforming loans in the early 1990s, asset quality problems have re-emerged due to the slow economic growth during the transition, and continuing poor lending practices. In the Czech Republic between 1991 and mid-1994, some Kc 226 billion in loans were removed from bank balance sheets or swapped for government securities (including bonds of the National Property Fund), and Kc 55.8 billion in capital was injected.43 The total represents about 30 percent of 1993 GDP. In Hungary, approximately Ft 310 billion (9 percent of 1993 GDP) was spent in “loan concentrations” and recapitalization between 1992 and 1994. In both countries, the recapitalization of the banks was a drawn-out process, with repeated rounds of loan purchases and recapitalization, with inevitable detriment to bank managers’ incentives to quickly restructure their businesses.

At the end of 1995, there were 55 banks and bank branches in the Czech Republic, with total assets equal to approximately 156 percent of 1995 GDP. The 34 foreign or joint-venture banking establishments held 15.6 percent of industry assets. The four largest banks have significant—in some cases majority—government ownership stakes, and command a total of 61.5 percent of industry assets.44 Despite the rapid increase in the number of banks since 1991, it remains a relatively oligopolistic industry. In 1995, aggregate profits in the banking system declined by 41 percent as noninterest costs rose sharply and securities trading losses and revaluation losses offset a 19 percent decline in provisions.45 The declining profitability of the banking sector is a reflection of their poor asset quality. Nonperforming loans among Czech banks remain stable at 35 percent of total loans, and although most of the banks, particularly the largest, are believed to be have adequate reserves against losses, loan growth has been slow,46 These wide interest rate spreads and the very short maturity of most bank loans have fueled much of the foreign borrowing by Czech enterprises. While loans have remained constant in real terms, the banks’ investments in securities rose from Kc 102 billion at the end of 1993 to Kc 306 billion the end of 1995.

Asset quality problems are most severe among the smaller private banks. Until 1993. the minimum capital requirement for a new bank was low—Kc 50 million—and as a result a large number of private banks entered the market. Some of these have since encountered serious problems. Since 1994, seven banks have been put under administration or had their licenses revoked.47 As a result of the deteriorating quality of the new banks, the minimum capital requirement was raised in 1993 to Kc 500 million, but no new licenses have been granted since then. The authorities prefer to see consolidation within the industry, including acquisitions by foreign banks, rather than new entries. A key difficulty that banks faced in clearing up delinquent loans was eased in July 1995 with revisions to the banking act, allowing banks greater scope to make pretax provisions and write-offs. Moreover, the authorities appear to have adopted a stricter stance toward weak banks. Creditors have lost money in some recent bank closures, and a deposit insurance system established in 1995, replacing the former state guarantee on deposits at state-owned banks, may give the central bank greater freedom to allow banks to fail.48

At the end of 1994, there were 44 commercial banks in Hungary with total assets equal to approximately 70 percent of 1994 GDP. The government directly or indirectly owned 60 percent of banking system assets at that time. The industry continues to be dominated by the six largest, majority state-owned banks, which command 70 percent of the system’s assets. However, the government is committed to continuing the privatization of banks, reducing its share of total bank capital to below 25 percent by the end of 1996. Foreign participation in the banking sector is considerable, with 25 percent of capital and some of the more dynamic banks being foreign owned. Asset quality remains an important, but declining, problem for Hungarian banks. At the end of September 1995, 18.2 percent of loans were impaired to some degree, down from 22 percent at the end of 1994 and 29 percent at the end of 1993.49

Despite the loan consolidation exercises of 1992-94, the need for high loan loss provisions has impaired the banks’ earnings. Combined net income of the seven largest commercial banks reached Ft 13 billion in 1994, after losses of Ft 87 billion and Ft 30 billion in 1993 and 1992, respectively.50 The main influence on earnings has been loan loss provisions, which consumed 170 percent of net interest earnings in 1992, 135 percent in 1994, but only 27 percent in 1995.51 The banks have had consistently high net interest margins, averaging 6.87 percent in 1995, up from 5 percent in 1994.52 These wide spreads are necessitated by the banks’ need to ensure an adequate risk-adjusted return and to build up loan loss reserves. However, the relatively high funding costs available to banks, due in part to the crowding out of funds by the government’s need to finance its deficit, resulted in lending rates that averaged over 12 percentage points, fueling much of the foreign borrowing by Hungarian firms and contributing to a growth in bank lending that has lagged behind the inflation rate.

1

In addition to these private capital flows, net lending by the IMF of $17 billion brings the total to $228 billion as discussed in Section II.

2

The data on reserves, discussed below, show that capital flows to Argentina, Brazil, and Mexico recovered relatively quickly.

3

“Other” capital flows are defined as short- and long-term trade credits, loans (excluding, in Table 23, use of Fund credit), transactions in currency and deposits, and other unspecified transactions. This item might include direct lending by the corporate sector that is not bank intermediated. The assertion that most of the increase in this category of flows is due to an increase in bank credit is supported by the data on syndicated lending and cross-border interbank borrowing presented below.

4

Some caution is prudent in interpreting data for different types of capital flows, as in some cases it can be difficult to distinguish between, for example, direct investment and equity portfolio investment, and these difficulties may not be resolved in the same way in different countries.

5

The average annual real growth rate since 1990 for the Asian developing countries has been 8.4 percent, compared with 3.0 percent for the Latin American countries (3.5 percent during 1990-94).

6

For more discussion on the economic consequences of capital inflows, and of the range of policy responses adopted by recipient countries, see International Monetary Fund (1995b).

7

Because of differences in data sources and treatment, the data on bond issues, equity placements, and loan commitments in this annex are not directly comparable to those in Annex I.

8

Total issues to end-May 1996 were $38.2 billion, 66 percent of total issuance in 1995.

9

The Salomon Brothers index of Latin American Brady bond prices registered an 18 percent decline in the first quarter of 1995, compared with a 7 percent decline for non-Latin American Brady bonds over the same period.

10

Also, as was noted above, average maturities in the yen markets did not shrink to nearly the same degree as did maturities in the dollar market.

11

Average spreads increased by 135 basis points in the deutsche mark sector.

12

This calculation does not take into account currency and interest rate fluctuations since issuance.

13

The costs are estimated to be 79 basis points for Samurai bonds and 28 basis points for nonresident Euroyen issues.

14

The Emerging Markets Traders Association (EMTA) believes that trading in Asian securities may be underreported in their data. The EMTA was founded in 1990 to promote the development of secondary markets for emerging market instruments. In January 1996, the Loan Syndications and Trading Association was formed to promote the development of secondary markets specifically for commercial bank loans.

15

Peru concluded a Brady agreement in October 1995 covering $4.4 billion in principal and associated interest on commercial bank debt, but the bonds have not been issued yet. Panama concluded an agreement in April 1996 covering $3.5 billion in debt.

16

Changes in net asset values can be due to changes in equity prices, exchange rates, and purchases and sales of fund units, and so do not necessarily imply changes in investment flows.

17

Some of the declines may be due to currency depreciation. For example, in dollar terms, the Mexican stock market fell in 1995, but in local currency terms it rose above the precrisis level. The precise separation of the currency devaluation effect and the capital loss of the assets themselves requires knowledge of the currency allocation of the assets in the funds.

18

In 1994, the turnover by foreign investors represented 16 percent of total trading on the SET.

19

See also the discussion of international syndicated lending in Annex I.

20

Data problems complicate the interpretation of bilateral investment flows because investors may make use of intermediaries in third countries and these flows might not be properly attributed in the data.

21

The regional groupings in Charts 32 and 33 are those used by the U.S. Department of the Treasury. “Asian NIEs” include Hong Kong, Korea, Singapore, and Taiwan Province of China; “Emerging Asia” includes China, India, Indonesia, Malaysia, the Philippines, and Thailand; “Western Hemisphere” includes Argentina, Brazil, Chile, Colombia, Mexico, Uruguay, and Venezuela. “Countries in transition” include Bulgaria, Czechoslovakia (as defined in the U.S. Treasury Bulletin), Hungary, Poland, and Russia.

22

See International Monetary Fund (1995b) for a discussion of the condition of the Mexican banking system prior to the devaluation and the effects of the crisis on the banking system in the first quarter of 1995.

23

These data aggregate the results of 27 domestic and 15 foreign banks, as published by the Comisiôn Nacional Bancaria y de Valores (CNBV) in the Boletin Estadistico de Banca Multiple, December 1995. The 8 domestic banks that have been subject to “intervention” are excluded.

24

If the purchased loans are included in the calculation, the ratio of nonperforming loans to total loans for the banking system as a whole was 16.9 percent at the end of 1995.

25

The benchmark Tasa de Interes Interbancaria Promedia (TIIP) rate rose from 20.2 percent immediately before the devaluation to a peak of 109.7 percent in mid-March 1995.

26

These totals include the loan portfolios of the intervened banks, but not restructured loans. Restructured loans at end-December 1995 totaled MexN$145.9 billion. This total comprises MexN$92.8 billion in UDIs and another MexN$53 billion in new pesos.

27

As for the banks, their costs are derived from the forgone margin on the loans above the agreed rate, one half of the subsidy for differentials greater than 16 percent, plus the opportunity cost of carrying a low-yielding asset. The government estimated the present value cost of ADE at MexN$24.2 billion, of which MexN$13.4 billion would be borne by the government and MexN$10.8 billion by the banks. By the end of the year, MexN$15 billion had been transferred to the Fondo Bancario de Protection at Ahorro (FOBAPROA) to cover the expected losses.

28

FOBAPROA, the deposit guarantee fund, is financed by contributions from banks equal to 0.3 percent (1 percent for new, including foreign, banks) of the captation directa (principally deposits, bonds, subordinated debentures, bankers’ acceptances, and money desk repos). In times of stress, this can be increased to 0.7 percent (1.5 percent for new and foreign banks). In addition, FOBAPROA can borrow from the central bank.

29

For example, Sidek stopped paying interest on its Eurobond in March 1996 and has initiated negotiations to restructure its debts, including through the use of asset sales and debt for equity swaps.

30

Unidad Coordinadora para la Restructuracion del Adeudo Bancario Empresarial.

31

Data discussed pertain to the aggregated financial statements of the 20 largest commercial banks in India at the end of March 1995.

32

Indian banks do not disclose data on asset quality; this figure is reported by Standard and Poor’s. In addition to priority sector loans—mostly to agriculture and small enterprises—banks must lend to the India Food Corporation, which in some cases absorbs another 5-6 percent of loans.

33

A loan is considered nonperforming if it is 180 days past due. Loan loss reserves equal to 10 percent of substandard loans (nonperforming for less than two years) or 100 percent of loss loans or the unsecured portion of doubtful loans (nonperforming for two-three years) were mandated in April 1992 and had to be in place by March 1995.

34

Provisions increased from 50 percent of net interest revenue in 199192 to 82 percent and 88 percent, respectively, in the next two fiscal years, before declining to 34 percent in 199495.

35

A fifth problem bank, the New Bank of India, was merged with the Punjab National Bank in September 1993. Public sector banks account for about 90 percent of banking system assets.

36

The 1995 96 budget reportedly included another Rs 8.5 billion for capital injections into the state banks. In addition, the government has allowed state banks to tap capital markets—provided the state ownership share is not diluted below 51 percent—although only the State Bank of India and one nationalized bank have taken advantage of this opportunity. The April 1992 reforms introduced a modified Basle-type risk-weighted capital adequacy requirement that all Indian banks had to meet by the end of March 1996.

37

At the time of the Narasimham report, the reserve requirements totaled 63.5 percent of net demand and time liabilities.

38

Since 1992, government securities have been sold at auction, so bonds purchased since then yield market interest rates.

39

After meeting the 39 percent reserve requirement, banks must allocate 40 percent of lending to priority sectors, often at concessional interest rates.

40

Net foreign liabilities at the end of 1995 exceeded twice the banking system’s capital. It is thought that much of what is reported as domestic lending is actually denominated in foreign currency, so that the true net foreign currency exposure is lower. Banks are required to meet a net exposure of 15 percent of capital.

41

Loans become nonperforming after they are 12 months past due, and banks are not required to hold loan loss reserves against the portion of past-due loans that is secured by collateral, which is often real estate.

42

In Hungary, the introduction of European Union standards for banking regulation is contained in proposed amendments to the Banking Act. The new act will apply to both credit institutions and nonbank financial services. The act will upgrade prudential regulations and strengthen the supervisory powers of the State Banking Supervision. It will also eliminate the need for foreign banks to set up subsidiaries as opposed to branches in Hungary.

43

International Monetary Fund (1995a).

44

At the end of 1995, the government owned 27 percent of banking system assets.

45

These data pertain to developments in the Czech banking system excluding the four institutions that were liquidated in 1994 and 1995.

46

Nonperforming loans are defined as loans that are 30 days or more past due. However, approximately 80 percent of the bad loans are actually more than 90 days overdue. On a risk-weighted basis, nonperforming loans were 23 percent of total loans at the end of 1995.

47

Banka Bohemia in 1994; Kreditni a Prumyslova Banka, AB Banka, Ceska Banka in 1995; and Ekoagrobanka, Pruni Slezska Banka, and Podnikatelska Banka in 1996.

48

Deposit insurance covers 80 percent of an individual’s deposits at a bank, up to Kc 100,000.

49

Almost half of these loans (8.7 percent of total loans) are in the "watched" category.

50

This discussion of recent developments in the Hungarian banking system is based in part on the financial statements of the seven largest commercial banks, as reported by IBCA Ltd.

51

A tougher Bankruptcy Law, introduced in 1991, necessitated sharply higher provisioning. Under that law, firms had to file for liquidation or reorganization if they fell behind on their loan payments by 90 days or more (see Gray, Schlorke, and Szanyi (1995)). This triggered a massive wave of filings—more than 22,000 in 1992-93—that forced banks to sharply increase their provisions. The four large banks that have been in existence since 1991 saw their aggregate loan loss provisions rise from 53 percent of net interest income in 1991 to 249 percent in 1992 and 292 percent in 1993, before falling to 42 percent in 1994.

52

Alternatively, the average differential between interest rates on new loans and interest rates on deposits in 1995 was 7.8 percentage points in 1995, 8.1 percentage points in 1994, and 10.6 percentage points in 1993.

  • Collapse
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Cover International Capital Markets
International Capital Markets
Developments, Prospects, and Key Policy Issues, 1996
ISBN:
9781557756091
ISSN:
0258-7440
Publication Date:
17 Sep 1996
Publisher:
International Monetary Fund
DOI:
https://doi.org/10.5089/9781557756091.083
Pages:
171
  • Chart 26. Chart 26.
    View in gallery
    Chart 26.

    Total Reserves Minus Gold of Selected Developing Countries and Countries in Transition

    (In billions of U.S. dollars)

  • Chart 27. Chart 27.
    View in gallery
    Chart 27.

    Exchange Rates of Selected Developing Countries and Countries in Transition

    (Local currency-U.S. dollar)

  • Chart 28.
    View in gallery
    Chart 28.

    Secondary Market Yield Spreads on Selected Brady Bonds 1

    (In basis points)

  • Chart 29.
    View in gallery
    Chart 29.

    Net Sales of Global and International Mutual Funds and Change in IFC Emerging Market Investable Composite Index

    (Net sales in millions of U.S. dollars and change in IFC index in percent)

  • Chart 30.
    View in gallery
    Chart 30.

    Foreign Investment and Returns on the Thai Stock Market

    (In percent)

  • Chart 31.
    View in gallery
    Chart 31.

    Net Purchases of Foreign Stocks and Investment Trusts by Japanese Investors Through Securities Companies

    (In millions of U.S. dollars)

  • Chart 32.
    View in gallery
    Chart 32.

    United States: Net Portfolio Flows to Defined Regions, 1994

    (In millions of U.S. dollars)

  • Chart 33.
    View in gallery
    Chart 33.

    United States: Net Portfolio Flows to Defined Regions, 1995

    (In millions of U.S. dollars)

  • Chart 34.
    View in gallery
    Chart 34.

    United States: Yield on 30-Year Treasury Bonds and Net Portfolio Outflows

    (Period average yield in percent and outflows in millions of U.S. dollars)

Chart 26.

Total Reserves Minus Gold of Selected Developing Countries and Countries in Transition

(In billions of U.S. dollars)
Chart 26.

Total Reserves Minus Gold of Selected Developing Countries and Countries in Transition

(In billions of U.S. dollars)
Chart 27.

Exchange Rates of Selected Developing Countries and Countries in Transition

(Local currency-U.S. dollar)
Chart 27.

Exchange Rates of Selected Developing Countries and Countries in Transition

(Local currency-U.S. dollar)
Chart 28.

Secondary Market Yield Spreads on Selected Brady Bonds 1

(In basis points)
Chart 29.

Net Sales of Global and International Mutual Funds and Change in IFC Emerging Market Investable Composite Index

(Net sales in millions of U.S. dollars and change in IFC index in percent)
Chart 30.

Foreign Investment and Returns on the Thai Stock Market

(In percent)
Chart 31.

Net Purchases of Foreign Stocks and Investment Trusts by Japanese Investors Through Securities Companies

(In millions of U.S. dollars)
Chart 32.

United States: Net Portfolio Flows to Defined Regions, 1994

(In millions of U.S. dollars)
Chart 33.

United States: Net Portfolio Flows to Defined Regions, 1995

(In millions of U.S. dollars)
Chart 34.

United States: Yield on 30-Year Treasury Bonds and Net Portfolio Outflows

(Period average yield in percent and outflows in millions of U.S. dollars)

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