Robust corporate earnings are the springboard for capital spending, but, to date, the Global Financial Stability Report noted, capital investment is the missing component in the current economic recovery, and corporate profitability has been disappointing in many sectors. The quality of corporate earnings is also of concern. Once the fallout from corporate excesses in the financial system is resolved, however, a fresh start can be made, where shareholder value is respected, but short-term share price increases are not held up as an ultimate goal at the expense of proper accounting practices.
Gearing all incentives toward short-term movements in share prices tempts potential misdoers, Häusler observed. Share prices operate not only as a yardstick for investors but also as a compensation mechanism for senior executives and an acquisition currency for the company, thereby enticing executives to broach ethical boundaries in the quest for the holy grail of improved share prices.
A healthy development has been that the markets have punished corporations whose reported earnings appeared unsustainable or were derived through questionable accounting. As the report points out, this in turn provides powerful incentives for corporations to make their financial accounts more transparent and puts pressure on countries to enact the regulatory changes needed to rebuild and safeguard the integrity of financial markets. Changes, supported by the IMF, are under way in the United States and Europe to strengthen corporate governance and oversight of capital markets.
Evolution of consensus 2002 GDP growth forecasts
Data: Consensus Economics
Weak corporate profitability has also had a negative impact on banks, with much strategic downsizing both in the cost base of some banks and in balance sheets, reducing the lending of some banks, not least to emerging markets. This trend will probably continue, Häusler added.
Japan and the rest of the world
What of Japan, whose financial and corporate sectors have been hit particularly hard in recent years by the lack of corporate profitability? Häusler indicated that the IMF would look more closely into the Japanese domestic financial system in the context of its upcoming country (Article IV) consultation and the ongoing Financial Sector Assessment Program. The Global Financial Stability Report focused its attention on the potential transmission of Japan’s financial difficulties to the international financial system, but it concluded that none of the three main transmission mechanisms is now of serious concern. The report finds little likelihood of any substantial repatriation of Japanese overseas assets back to Japan, given the very poor returns such assets can now earn in Japan; slim risk of a sharp fall in emerging market finance to Asian countries, because Asian countries are in much better shape and more resilient than a few years ago; and little concern about potential contagion through the interbank market, given that Japanese banks are less closely integrated into the international banking system than a few years ago.
A lack of profitability in insurance companies’ core business has induced them to get more involved in capital markets. What this means for insurance companies, and for the stability of the financial sector, is the subject of the report’s third chapter. In general, the report finds that international systemic risks associated with the financial market activities of insurance companies are relatively limited compared with those of the major internationally active banks and commercial banks. But uncertainties remain about the adequacy of their capital, the quality of their risk management, and the potential for financial risks to migrate from the banking to the insurance sector. Given the possibility that a collapse of insurance or reinsurance companies could threaten financial stability, the report recommends gathering better information on the financial activities of insurers and reinsurers. It points, in particular, to the need to know more about “the size, extent, and nature of reinsurance cover and the potential for a critical mass of major reinsurers to simultaneously experience financial difficulties.” It is encouraging, however, as Häusler noted, that insurers have liquid assets and illiquid liabilities—the reverse of banks.
Underperforming emerging market equities
Can local securities markets provide insurance against the vagaries of international markets? The report looks at this question and concludes that the underperformance of emerging market equities is not primarily due to overvaluation. The main factors contributing to the underperformance of emerging market equities are
• a string of financial crises, starting with Mexico in 1994, which drastically pruned U.S. dollar returns on emerging market equities;
• concerns about corporate transparency and governance; and
• the growing importance of American Depository Receipts and the trend away from local to international market listings, which have reduced the universe of liquid stocks in emerging markets and cut both the domestic and the global investor base.
Recent market performance
Since the report was finalized, Häusler pointed out, developments in mature equity markets have confirmed the report’s concerns about the pace of the recovery and the quality of earnings. That will probably continue until there are clearer signs of a turnaround in corporate profitability. The U.S. dollar has declined against the euro (about 3 percent) and the yen (about 2.5 percent) since May, but European equity prices did not benefit from that development, and there is also a lack of confidence in the profitability of European companies. The market is not convinced that if the U.S. equity market fell, Europe would necessarily benefit, which suggests that any exchange rate movement would not be violent.
Are U.S. equities still overvalued? The answer to that question, Häusler noted, depends on future earnings as well as on expectations. The March Global Financial Stability Report said that U.S. equities were richly valued, and they have fallen since then. If corporate earnings were to recover, Häusler said, there is no reason why U.S. equities should still be regarded as overvalued.
In the emerging bond markets, Häusler noted, there has for some time been a “rotation” away from Latin America and particularly from Brazil. This has led to significant investor risk aversion to emerging market debt, particularly with regard to South America, and other regions have not necessarily benefited as a result. Cash holdings of emerging market investors have risen, so the benefits for the rest of the world are limited. The investor base for such emerging market investments is critical and has to be monitored carefully.
With the decline of bank credit (especially from European and Japanese banks) as a source of capital flows to emerging markets and with the crossover investor less reliable than a dedicated investor as a source of funding, the role of foreign direct investment (FDI) has become increasingly crucial. Therefore, the investment climate under which FDI takes place, particularly in Latin America, has become extremely important. Any policies that hinder such investment or create contagion in that direction must be guarded against, Häusler cautioned.
What is the IMF’s forecast for capital flows for the emerging markets? Donald Mathieson, Chief of the IMF’s Emerging Market Surveillance Division, observed that while investment-grade borrowers continue to have reasonable access to both the bond and syndicated loan markets, bond markets are effectively closed for unsecured non-investment-grade borrowers. “They really cannot enter the market at any price they’re willing to pay, and we see that as a condition that’s likely to continue in the near term.” With regard to regional discrimination, Asian, Eastern European, and Russian borrowers have been able to access bond markets quite successfully, at both the corporate and sovereign levels, but corporate borrowers in Latin America have found access to markets much more difficult recently.
Mature equity market indices broadly flat
Data: IMF, Global Financial Stability Report, June 2002
Should the emerging markets be concerned about the ramifications of an abrupt fall in the U.S. dollar? Garry Schinasi, Chief of the IMF’s Financial Market Stability Division, based his response on historical experience with the U.S. dollar–yen rate. While there might be increases in volatility and some adjustments in other asset markets, he said it was hard to recall any real difficulty with adjustment in mature markets. But he added that the next Global Financial Stability Report would look into the implications of abrupt exchange rate movements for capital flows, particularly in emerging market economies.
Copies of the June 2002 issue of the Global Financial Stability Report are available for $42.00 ($35.00 for academics) each from IMF Publication Services. For ordering details, see page 204. The full transcript of the June 12 press briefing on the report is available on the IMF’s website (www.imf.org).