With market behavior increasingly influencing the world economy, the IMF is seeking to enhance its understanding of the ways in which market decisions shape global financial flows and affect the policies and performance of national economies. Few have a stronger grasp of what the IMF should know about the markets than former IMF staff members who now head economic analysis units for leading investment banks and hedge funds.
The IMF Institute asked three such former staff members to examine how the IMF’s knowledge of the markets could be improved. The panel included Mohamed El-Erian, formerly Deputy Director of the IMF’s Middle East Department and currently European Head of Emerging Markets Economic Analysis for Salomon Smith Barney; David Folkerts-Landau, previously Chief of the IMF Research Department’s Capital Markets Division and at present Global Head of Emerging Markets Research for Deutsche Bank Securities; and Mahmood Pradhan, formerly Senior Economist in the IMF’s Asia and Pacific Department and currently Chief Emerging Markets Economist with Tudor Proprietary Trading hedge fund. In a wide-ranging and frank discussion on January 15, the three panelists recommended that the IMF gather more relevant market data that would give it a better feel for potential problems and likely market responses. They also agreed that more realistic projections for IMF-supported programs would strengthen the institution’s credibility with the market and offered market perspectives on the effective regulation of hedge funds and the viability of contingent financing mechanisms.
How the Markets Think
To ensure more timely and consistent reactions from the market, Mohamed El-Erian suggested, the IMF must learn more about how the market works. He sketched a framework of the types of information the market relies on; illustrated how elements other than fundamentals can guide market decisions, particularly in crises; and noted the implications of all this for the IMF’s efforts to prevent and deal with crises.
Framework. For the markets, data on country fundamentals are necessary, but far from sufficient, according to El-Erian. Other important factors are information on external market and credit conditions, the relative position of emerging markets, and last, but hardly least, market “technicals” (that is, information available from market trading and from market participants). In the best of times for markets and the IMF, all of these elements simultaneously flash green or red. More commonly, though, the signals are mixed, and then the markets and the IMF must sort through a welter of conflicting data.
In 1998, a weakening external environment led to very bad market technicals that in turn led to large capital flows and bad economic policies and outcomes. That is a difficult process to reverse, El-Erian said. The IMF must realize that, increasingly, the investor base in emerging markets is being shattered, and what might look like irrational contagion to the IMF is, in fact, a very rational portfolio reaction. Given significant casualties among emerging market investors—including hedge funds— and enormous volatility, he expected continued investor hesitance about reentering emerging markets. And the longer this state persisted, he added, the more bad technicals would result in bad economic policies.
An Illustration. El-Erian cited Russia as a clear instance where bad market technicals had ruled. By July, the country’s policy stance was weak, and external factors, principally low energy prices, further undermined Russia’s position. What happened when a policy package was injected into this mix? “Because market technicals were wrong,” he said, “that policy package had almost no impact on pricing and interest rates. Investors were ‘long and wrong’ on Russia and looking to get out.” The market was positioned to sell, so that the brief uptick the program provided was used solely to unwind positions. “Technicals totally took over the fundamentals,” El-Erian observed.
What This Means for the IMF. Given the disruptions to the investor base, investment in emerging markets is not likely to return soon, El-Erian cautioned. The IMF should factor in the damage done and expect a distinctly bumpy process of capital flows to developing countries. The market will, however, be attracted to economies that have no major exposure to systemic risk, with high reserves, low short-term debt, and good fiscal positions. Even for these economies, however, the news is not entirely good. Their problem will be managing success— that is, dealing appropriately with huge capital inflows.
For the IMF, El-Erian warned, there will be no easy answers. The conditionality and the phasing and backloading of financial support that typify IMF financing are not appropriate, he argued, for countries that have undergone a huge shock; backloading simply accentuates the problem. But the alternatives are not reassuring either, because they raise the specter of moral hazard. What can be done? El-Erian urged the IMF to pay greater attention to five areas:
Program design. Both the markets and the IMF should spend “a lot more time” on program design. The IMF could afford to be bolder on the funding side, but not in its policy mix.
Liability management. The IMF should play a more significant role in advising countries on their borrowing and on managing their debt. The private sector, with its vested interests, is not in a position to do so.
More analysis. There is a surfeit of information, but authoritative interpretation remains a scarce commodity.
The IMF should step in when there is a “market failure” in analysis. And it should look beyond fiscal and monetary numbers to key data contained in nondeliverable forward contracts and in market segmentation and swap-market information.
Involve the private sector early, and uniformly, in major policy initiatives. Otherwise, the market perception of risk and the resulting risk premium associated with major changes will overwhelm the benefits.
Don’t worry about being blamed. The IMF is going to be blamed; it is part of the market’s need for scapegoats. But ultimately, El-Erian counseled, “a lot of what the IMF says determines how the markets actually react.”
What the IMF Needs to Know
Key information, observed David Folkerts-Landau, is valuable, expensive, and usually not published. More— and more appropriate—data can enhance the IMF’s assessment of systemic risk events. There are roughly three types of market information: short-term trading, longer-term positional, and long-term structural. Short-term trading, or what he termed “noise trading,” has little value for capital market surveillance. Long-term structural information is the sort ofdata the IMF already does a good job ofgathering in the course ofits consultations with member countries.
Longer-term (that is, two or three quarters ahead) positional trading is crucial to capital market surveillance, however, and it is here that critical information failures have had serious consequences for the global financial system. Folkerts-Landau cited the extraordinary range of estimates, from $15 billion to $150 billion, for the dollar-yen carry trade (borrowing at low interest rates in yen in order to invest in U.S. dollar securities at higher rates) on the eve of the Russian crisis. The upper limit was closer to the truth, with significant implications for hedge fund behavior after the Russia crisis. This information is difficult to obtain, but investment banks and others are now working very hard to develop a more systematic feel for how positions are built up. From the IMF’s risk-management perspective, it is vital to develop a much better handle on very large positions as well as some sense of how major participants will react to disturbances.
Structural information is the key to understanding short-term dynamics, Folkerts-Landau explained. The markets’ risk management technology instantaneously adjusts positions across asset classes, countries, or instruments in the face of volatility. The markets’ need to offset volatility is the key to understanding contagion, and it is something the IMF must understand if it wants to understand how markets will react, how disturbances will spread, and who will be hit next, he said.
Folkerts-Landau advised the IMF to exercise care in using investment bank data. For tax and accounting reasons, profit and loss calculations are often shifted back and forth through in-house accounting systems.
Total return swaps and other derivatives may completely obscure balance of payments data. And, he added, countries do not always provide the true picture to the IMF. A lot of very short term—and for the banks, very profitable—flows and investments circumvent IMF programs. Even reserve numbers can be suspect, because in some cases, such as Russia, the reserves have been collateralized to borrow from U.S. hedge funds. Corrosion of key data in a crisis situation is rampant, he warned. “You have to understand what you are up against. People make a lot of money from this.” Folkerts-Landau also urged the IMF to refrain from commenting on market pricing—bond spreads and the like. Second-guessing the market was risky business and unhelpful, he noted, and tended only to undermine the IMF’s integrity with the markets.
To improve the quality and timeliness of the IMF’s market information, the organization should strengthen the links between its staff and private markets and must try to understand how market participants manage risk and how they react to it, Folkerts-Landau said. Half a dozen trained economists in the IMF’s capital markets team could gather key data. If the IMF could not match the banks’ resources in this regard, it could tap into them through regular, “nonbu-reaucratic” contacts.
What, asked Mahmood Pradhan, should the IMF know about hedge funds and how they make decisions? One essential element that the IMF has underestimated is that contagion is spread through “the way money is managed.” When a leveraged investor, such as a hedge fund, takes losses in one emerging market, it will readily liquidate positions elsewhere. And it will liquidate profitable positions first. Hungary, for example, might ask why its stock market suffered after Russia when Poland’s did not. Hungary did have somewhat weaker fundamentals and more connections with Russia, but more crucially, he explained, the country had the most liquid stock market—it was the easiest one in that region to get out of.
A hot topic at the moment, Pradhan said, is regulation of hedge funds. He argued that a regulator’s prime concern should be systemic risk and a level playing field. Hedge funds, he explained, have significantly less exposure in emerging markets than, say, investment or commercial banks. And, at present, banks that extend lines of credit have regular access to hedge funds’ net asset values and performance in terms of returns. Banks do not have access to net positions, however, and Pradhan argued that if hedge funds were forced to reveal net positions, it would effectively “end the industry.” He favored instead raising margin requirements—to reduce leverage and discourage excessive risk taking—through the banks that lend to hedge funds. This could improve the quality of bank regulation and ensure that information on aggregate and net positions on a currency can be relatively easily assembled from investment banks.
Folkerts-Landau argued that the regulators would do better to regulate commercial bank activities, which he believed were chiefly responsible for the large inflows and outflows during the crisis. Regulators would also be wise to separate proprietary (bank) trading from customer-driven trading. “There is something seriously wrong” with institutions that are guaranteed by taxpayers but take enormous amounts of international risk, he said.
Emerging markets—and the IMF— should be mindful that any country classified as an emerging market will face contagion. When losses occur, hedge funds have instructions to reduce exposure to the entire emerging market asset class, Pradhan said. Given what happened in emerging markets and to the hedge fund industry, he concurred with El-Erian’s prognosis: emerging market finance will be very difficult for at least a year or two.
Pradhan emphasized—and El-Erian and Folkerts-Landau underscored the point—that more realistic program projections were a critical issue for the IMF and its credibility with the markets. Last year, he noted, each letter of intent with Indonesia, Korea, and Thailand saw its growth projections revised downward and its fiscal targets pushed up. On Brazil, all of the panelists agreed the markets simply never believed the IMF’s projection of a minus 1 percent growth estimate for 1999. The IMF might look on the projections as targets, but the markets see a consistent and suspect optimism. Pradhan suggested a range of outcomes might be more advisable. Folkerts-Landau said he was “100 percent convinced that the IMF would do much better getting a realistic number out there in terms of market confidence.” Pradhan added that market confidence would also be bolstered if IMF programs addressed key market issues, such as corporate debt in Indonesia.
What information could the IMF usefully gather to inform its advice and program design? Know who holds country debt and what types of events might trigger a reversal, Pradhan counseled. Investment banks typically do know what type of investor is doing trades, so that a call to four or five investment banks should yield information on whether these investments are leveraged or not and whether the country would face liquidation trades. “There is no reason,” he said, “why this sort of information, in aggregate form, could not be supplied to regulators or to the IMF for surveillance purposes”
Ultimately, Pradhan argued, market positioning is a critical factor, and knowledge ofit must complement the IMF’s area of traditional expertise—its knowledge of economic fundamentals. El-Erian agreed, adding that if the IMF were aware ofthe big positions, understood how money is managed, and tracked key indicators, such as nondeliverable forward contracts, it would know a lot of what it really needed to know about the market.