I Overview of Developments and Key Issues
- International Monetary Fund
- Published Date:
- January 1987
This study provides an assessment of trends in the international capital markets, including most notably recent market shocks to the financial system and developments in the debt situation. It also reviews the scope of progress achieved over the last few years in strengthening the financial system. The study focuses on trends in industrial country markets, including liberalization measures, innovations and structural changes, and relevant changes in supervision.1 It reviews key factors influencing the debt situation, including provisioning by commercial banks and innovative financial modalities.2
Activity in international capital markets continued to surge during 1986–87, although significant strains emerged during this period. Net lending between industrial countries through international bank credit and bond markets more than doubled during the first half of 1987 compared with the same period in 1986 (Charts 1 and 2). This very rapid increase followed a similar doubling of flows between 1985 and 1986. Net lending to industrial countries during 1986–87 increasingly reflected expansion in the interbank market since the volume of bond issuance declined during 1987. Activity in the Eurobond market in 1987 was adversely affected by interest rate developments and by two incidents: first, the collapse in December 1986 of the perpetual note market, which spilled over into the entire floating rate note market, and second in October 1987, the sharp fall in prices in global equity markets, which had an adverse impact on equity-related bonds.
Chart 1.Growth of International Bank Claims, 1976–87
Sources: Bank for International Settlements, International Banking and Annual Report; International Monetary Fund, International Financial Statistics; and Fund staff estimates.
1 These data do not net out interbank redepositing.
2 Twelve months to June 1987.
Chart 2.Gross International Bond Issues, 1976–87
Sources: Organization for Economic Cooperation and Development, Financial Statistics Monthly.
1 Including offshore centers.
2 First three quarters annualized.
Widening imbalances among industrial countries during 1986–87, together with increasingly sophisticated use of international markets, raised activity to historically high levels. Competitive pressures in financial markets remained intense. In part, this reflected increased competition for a share of the market by institutions entering new activities, as liberalization in several major countries opened up markets to greater foreign and domestic competition. Some observers believed the rapid expansion and structural changes in the financial markets left these markets vulnerable to major financial disturbances. More fundamentally, however, the disturbances that took place in 1987 were traced to investors’ uncertainties about official policies and the underlying imbalances in the global economy.
Given the extensive changes that have taken place in domestic and international financial markets, the authorities in all industrial countries have begun to adapt their supervisory and regulatory framework to reflect better the new financial environment. These efforts acquired added importance with the recent financial market shocks. This adaptation has involved further strengthening of bank capital—in particular including off-balance sheet items in the appraisal of capital adequacy and harmonizing of regulatory conditions across different markets. There is now an urgent need to press forward with coordination of the supervision of bank and nonbank financial intermediaries, both within national markets and between markets. The interest rate exposure of banks and developments in the interbank market remain areas where official surveillance will be most important.
The huge flows among industrial countries raise four main concerns. First, the magnitude of present current account imbalances, and the associated net capital flows, would not appear sustainable over the longer term. Second, while the large gross movements—especially in the interbank market—may reflect mainly arbitraging of market and regulatory conditions, these gross flows are not transparent. Third, failure in one part of the market could be contagious to other sectors—conceivably resulting in an abrupt contraction. Fourth, the contrast between trade restrictions and financial liberalization has been pointed to as a potential source of instability in financial markets. In the view of most officials and bankers, the key to maintaining sound financial markets lies not in controlling capital flows but in liberalizing trade, in pursuing coordinated economic policies in key currency countries, and in sustaining growth-oriented adjustment in the major developing country borrowers.
In contrast to the rapid growth in net lending to industrial country borrowers, lending to developing countries through bank credit and international bond markets slowed to a very low level during 1986–87. Thus, the split in international capital market activities that began in 1982 became even more accentuated during this period. Within the group of developing countries, there also was a split in lending activity. Countries without recent debt-servicing problems borrowed some $15 billion during 1986 and the first half of 1987, in contrast to net repayments of about $9 billion by countries with recent debt-servicing problems.
During late 1986 and early 1987, the debt situation entered a problematic period as the collaborative approach came under serious pressure reflecting problems in completing the Mexican package, difficult discussions in advisory committees regarding the restructurings for Chile and the Philippines, and the suspension of payments by Brazil, Côte d’Ivoire, and Ecuador. Subsequently, the collaborative approach has recovered to some degree. The banking community responded with greater technical imagination, and a sense of urgency, to Argentina’s request for new money, including elements of securitization.
Banks noted significant progress in completing the 1986–87 round of financial packages and the initiation of a broader range—the “menu” approach—of financing options. In the 12-month period to September 1987 some $10 billion of new commercial bank commitments for three countries—Mexico, Argentina, and Nigeria—were assembled along the lines envisaged in the Baker initiative. Debt restructurings were finalized or agreed in principle with, among others, Chile, the Philippines, Morocco, and Uruguay, while banks agreed to allow a debt buy-back by Bolivia. A lead management group of banks agreed to the term sheet for a loan of $1.1 billion to Colombia—which had earlier made use of concerted financing while not rescheduling its debt. Subsequently, the bank advisory committee for Brazil and the Brazilian authorities issued a joint press release, in November 1987, announcing that preliminary understanding had been reached on the “normalization of relations between Brazil and the international financial community.”
For the immediate future, banks indicated four principal issues during discussions with Fund staff. First, the menu of financing options should be widened further, and in the view of some banks include enhanced exit bonds and voluntary interest capitalization. Second, banks intend to press forcefully for actions by debtor and creditor governments that would minimize their own exposure increase. Third, the situation of debtor countries remains vulnerable to external developments, and banks are pressing for official involvement to cushion possible shocks. Fourth, leading banks are keenly aware of the discounts at which loan claims are transacted, and—for various reasons—are building up their loan-loss reserves. However, with the exception of the proposed Bolivia buy-back, exit bonds, and debt conversion schemes, they rule out at present reduction of claims on debtor countries.
The outlook for lending to developing countries that have experienced payments difficulties has deteriorated during the past year. For most of these countries, the prospect for a resumption of spontaneous general purpose bank lending appears very limited. Notwithstanding progress in the present round of restructurings, there is serious concern about the difficulty of mustering concerted loans from banks for “nonsystemic” countries.
Three main factors account for these problematic aspects of the present outlook: the uncertain prospects for interest rates and export markets in industrial countries; adverse economic trends in a number of developing countries; and a desire by banks to strengthen their competitive positions by minimizing their exposure to debtor countries. Notwithstanding these concerns, many institutions indicated willingness to engage in a limited volume of new short-term trade and project finance to support the business of major industrial country clients with developing countries.
Market Stresses and Official Responses
Financial markets were buffeted by several financial shocks during 1986–87, including abrupt setbacks related to market risk, such as the fall in equity prices and in the U.S. dollar, to liquidity risk, including the collapse of the perpetual floating rate note market, and to credit risk, most notably the suspension of payments on bank debt by Brazil, Côte d’Ivoire, and Ecuador. Developments in the debt situation are discussed in detail in the next section; the remainder of this section will focus on the more general implications of these various risks for major financial markets.
The financial disturbances of the past year have revealed various factors that have affected the transmission of disturbances from one financial market to another. In addition, the behavior of markets under strain was shown to differ considerably, although financial markets generally remained robust. Concern about the financial system related in part to structural changes in capital markets but could be traced primarily to two fundamental sources: the continuing problems resulting from the correction of past macroeconomic imbalances and uncertainty concerning the future course of official policies to address present imbalances.
Vulnerability to Credit Problems
Banks’ credit exposure to countries in payments difficulties has been significantly diluted since 1982, and the trend toward weaker capital ratios among banks, which emerged in the 1970s, has been reversed. Nonetheless, in certain countries some leading institutions remain heavily exposed to sovereign risk, while the quality of domestic loan portfolios has not improved uniformly during four years of economic expansion.
Between 1982 and June 1987, U.S. banks’ capital relative to their exposure to developing countries more than doubled, to 106 percent (Chart 3). Although other countries do not publish comparable statistics, their banks’ exposure has on average decreased substantially as a consequence of capital increases, provisions, lower or negative net lending and recently the decline of the U.S. dollar.
Chart 3.Selected Balance Sheet Data for U.S. Banks, 1977–First Half 1987
Sources: Federal Financial Institutions Examination Council, Country Exposure Lending Survey.
1 Twelve months to June 1987.
2 Excluding offshore centers.
New provisions by nine U.S. money center banks, which totaled $11 billion, were in general well received by financial markets, especially equity markets. Nevertheless, these banks’ income positions clearly remain vulnerable to an interruption in interest servicing by debtor countries. For example, it has been estimated that nonpayment of interest equivalent to a 3 percentage point cut in the interest rate would lower average annual after-tax earnings of the nine U.S. money center banks by some 25 percent for the period 1987–89, compared with earnings in 1985. It is notable, nonetheless, that the markets reacted calmly to the announcement by the Brazilian authorities that they could no longer make interest payments on their medium-term external bank debt.
In gauging the vulnerability of the financial system, it should be borne in mind that adverse economic circumstances affecting sovereign loans could have a simultaneous, negative impact on domestic credit quality. In some countries, bank exposures to energy, agriculture, real estate, shipping, and elements of heavy industry remain problematic. In addition, firms in some major industrial countries have increased their leverage significantly. Ratios of corporate debt to gross national product (GNP) rose significantly in the Federal Republic of Germany and Japan during 1980–85. In 1985, corporate loan default rates were also at a ten-year high in the United States and the Federal Republic of Germany, and personal loan default rates peaked in the United Kingdom and the Federal Republic of Germany. In domestic, as in international, business, the prevalence of floating rate lending—which effectively transforms interest rate risk into credit risk—implies that the quality of banks’ loan portfolios remains vulnerable to higher interest rates.
Bank supervisors have achieved substantial progress in securing agreement internationally on an effective approach to supervising credit risk within the banking system. The issuance in March 1987 of the U.S.–U.K. convergence proposals for monitoring capital adequacy, building on work of the Basle Supervisors Committee, foreshadowed the adoption of a common supervisory framework for credit risk by most industrial countries. This framework—the risk-asset ratio—applies different capital weights to various credit risks incurred by banks through both on- and-off balance sheet activity. In the case of note-issuance facilities and swaps, many market participants thought that the actual or anticipated effect of supervisory ratios had a salutary effect on pricing.
The risk-asset ratio is a yardstick to measure the adequacy of capital held by banks of different countries, thus meeting both prudential and competitive concerns. The Fourth International Conference of Bank Supervisors, hosted by de Nederlandsche Bank in 1986, provided an important opportunity for developing countries to voice reactions concerning the previously mooted higher risk weights for sovereign loans to all developing countries—a feature not incorporated in the U.S.–U.K. proposals.
As the financial services industry in industrial countries become more integrated, the issue of credit risk management by securities houses becomes more important. At the same time that banks are exploring the risks and opportunities in securities activities, securities houses are acquiring credit risks for periods of time through expanding underwriting and dealing activities and through bridge loans. In response, some leading securities houses have set up credit committees, although some credit appraisal and monitoring procedures are still at an early stage of development.
To some degree, rapid disintermediation has diminished transparency of credit exposures through various instruments and intermediaries. This disintermediation may in part be a side effect of supervisory actions that have increased the capital costs of banks. Efforts have been undertaken under the aegis of the Bank for International Settlements (BIS) to improve prudential reporting—especially of off-balance sheet items—and to capture securities data more fully. Monetary authorities, including the Fund, face considerable challenges in keeping pace, in statistical work, with rapidly changing markets. Moreover, even when reporting is comprehensive, as in the interbank market, it is difficult to disentangle flows related to real economic activity from arbitrage and attempts to bypass regulatory controls.
Overall, the vulnerability of the system to a general deterioration in credit quality is difficult to evaluate precisely, but it appears considerable, especially when assessed in light of the relative maturity of the present economic expansion in the industrial economies. For the Fund, the implications of this situation reside, first, in a need to encourage economic policies that will avoid a global downturn or a renewed surge in inflation and interest rates. Second, continuing collaborative approaches among the parties to the debt strategy will remain vital to maintain a process that is orderly and allows confidence to be further rebuilt.
Liberalization and innovation have tended to increase the efficiency of capital markets in several ways. Intermediation costs have been reduced by shifting intermediation to securities markets and by increased competition within the financial services industry. New instruments, such as swaps, have facilitated the arbitrage of financial conditions in different markets and over a wider spectrum of assets and maturities. Finally, hedging opportunities against fluctuations in exchange rates and interest rates have been enhanced through a variety of techniques, over a longer maturity period, and with risks potentially shared more widely among market participants.
The widespread application of new communications and computer technology to financial markets has made some of these innovations feasible and has permitted major institutions to manage their trading operations on a total basis. Market responses to developments can be quickly transmitted across markets and time zones and entail a significantly larger volume of transactions. In recent years, financial markets have thus changed considerably, and price volatility—in currency, bond, or equity markets—has at times increased.
Market participants have observed that new markets have been created and old markets restructured; new instruments developed; and unfamiliar lines of business developed by existing financial institutions. These changes could result, and indeed on occasion have resulted, in dislocations in financial markets. Such events were seen by some as part of a learning process in the markets. Most market participants were of the view that the risks associated with this process of improving the efficiency of intermediation and distribution of risks were small relative to the gains. Others worried, as did many supervisors and monetary officials, that supervision was hard pressed to keep pace with developments in the market.
The capital markets—both international and domestic—did indeed experience and withstand a number of financial shocks in 1986 and 1987. Some of these shocks were related to abrupt changes in market conditions, such as movements in exchange rates, interest rates, and equity prices, or were related to instruments. It is instructive to review the impact of these shocks, which are discussed below.
During 1986–87, the U.S. dollar depreciated sharply against other major currencies; this movement was absorbed without serious foreign losses to the banking system or failures in swap instruments. To some extent, internal and regulatory limits placed on banks’ uncovered exposure in foreign exchange, after the disturbances of the mid-1970s, may have contributed to reducing potential losses during this period. Substantial losses related to holding of unhedged U.S. dollar-denominated assets were experienced by nonbank financial institutions in some industrial countries, especially in Japan. These losses occurred mainly in institutions that were highly capitalized and profitable.
Similarly, U.S. dollar interest rates rebounded sharply during early 1987; this development was sobering for the market but did not produce significant disclosed losses. It did reveal, however, that market participants (e.g., in collateralized mortgage obligations) may find themselves less well hedged than expected or that their risk management system was less than wholly effective.
The collapse of the perpetual floating rate note market in December 1986 was a major shock to that market; market making in perpetual floating rate notes virtually ceased as prices fell sharply and liquidity vanished. According to market participants, this development reflected initial underpricing of the instrument as illusions about their liquidity built up and then evaporated at which point it became apparent that nonbank investor demand had been negligible. A contributory factor may have been rumors that bank supervisors in additional countries were considering applying capital costs to these notes to avoid “double leveraging” of the international banking system (i.e., banks holding each other’s capital). Spillover occurred into the larger floating rate note market, which during 1985–86 accounted for over one fourth of all international bond issues; issues of all floating rate notes fell during the first three quarters of 1987, amounting to only about 15 percent of the volume during the comparable period of 1986. There was, however, little adverse spillover into the fixed rate sector of the international bond market.
In October 1987 equity prices plunged in a number of stock exchanges in industrial countries, with the largest decline in the United States. Some factors have acted to limit the spillover to other financial markets (e.g., higher margin requirements, high capitalization, government actions), while others may have heightened the spillover to other financial markets (e.g., global portfolio management, program trading, telecommunications). The impact of the recent decline in equity prices may have been reduced in particular by the fact that margin requirements on stock purchases are high, except for options and futures contracts. Credit lines extended by banks to mutual funds and other institutional investors have helped them meet redemptions or margin calls without forcing further equity sales.
While information on the distribution of losses resulting from the recent fall in equity prices is incomplete, many of the major securities houses appear to have experienced losses that are small relative to their capital bases, although some smaller securities houses and broker-dealers have closed and others were expected to be merged. In some countries, losses experienced by commercial banks were limited by regulatory restrictions on their holdings of equity. In some other countries, where universal banking prevails, commercial banks frequently had substantial amounts of “hidden” capital reserves, through the valuation of securities on a very conservative basis.
During the periods surrounding these recent market disturbances, significant risk existed that affected institutions would be unable to obtain funding for their portfolios. Indeed, some securities houses, especially smaller firms whose solvency had been called into question, faced liquidity shortages. Investor protection measures relating to the operations of securities houses or broker-dealers have helped prevent a general withdrawal of funds from those institutions. In addition, the clear and coordinated commitment by major central banks to provide adequate liquidity to the financial markets has been a factor of central importance preventing the emergence of widespread funding difficulties.
The robustness of the markets in the face of these shocks is a most encouraging development; however, to the extent that these shocks produced losses, those losses occurred primarily in institutions that were highly capitalized and profitable. Thus, the risk of institutional failure spreading to other financial markets was limited. Moreover, they occurred under conditions of high liquidity in the financial system. Other substitute instruments and markets were also available for intermediating flows, which helped to lessen the spread of disruptive events. In particular in the Euromarkets, ready substitute instruments were available, commitments of syndicated loans increased in 1987 for the first time since 1982, and issuance of short-term paper expanded. Substitutes for equity issues may not be as readily available.
Given these developments, and substantial progress in harmonizing approaches to credit risk, the supervisory community is turning its attention to the supervision of market risks. Progress in this area is seen as urgent by officials, in light of the growth of the securities markets and their close links to wholesale money markets, to which problems could spread.
The essence of regulation for securities houses—where these entities are separated from banks de jure or de facto—is to ensure that the institutions can absorb sharp market fluctuations. This approach marks asset values in the balance sheet to their market price and tests their liquidity, frequently. Just as, for banks, the “risk-asset ratio” approach has become a widely accepted technique for supervising credit risks, so assigning capital cover to market assets based on price volatility factors (setting “haircuts” of asset values) has become the widely recognized approach to regulating securities houses.
The coverage of regulation of securities houses often, however, does not extend to monitoring the solvency of foreign—or even domestic—affiliates. Regulation has traditionally been concerned primarily with investor protection. Lender-of-last-resort facilities normally are not available directly to such institutions. Recent events have shown that some central banks may be willing to extend those facilities to nonbank institutions and even to institutions located in countries outside their jurisdiction.
Clearly, securities houses activities are closely integrated with wholesale money markets and banking activities, and the overlap in business interests between banks and securities houses continues to increase. Initial contacts have begun between securities regulators in leading financial market countries on both a bilateral basis between major centers and in various multilateral forums. Specifically, the International Organization of Stock Exchange Commissions and the Wilton Park Group of Securities Regulators have had meetings to discuss various issues, but they have not yet focused on prudential concerns.
Bank supervision is principally oriented to the capacity of institutions to evaluate and absorb credit risk. Bank supervisory procedures have in the past tended to capture market risk in an ad hoc way—except for foreign exchange positions, which have been comprehensively monitored by special reports since the failure of Bankhaus I.D. Herstatt. Securitization of banks’ assets is as yet only at an early stage; it is estimated that at most 2–3 percent of bank claims have been newly securitized during the recent wave of changes. Considerable progress, however, has been made in the United Kingdom in incorporating the haircuts of assets values described above into the framework of banking supervision.
Banks’ control over their liquidity positions has strengthened substantially since 1982. Most banks have reduced their reliance on “purchased” funds from the wholesale markets and on interbank placements. The desirability of “core” funding from identified sources has become re-established, while banks have also sought to hold additional primary liquidity—liquid liabilities of the central government—in their principal funding markets. Nevertheless, the record growth of the interbank market—$850 billion over two years—raises some macroprudential concerns: banks may be funding at short term substantial increases in their securities portfolios; competition for balance sheet size between a few major banks has been intense; and affiliates in foreign centers are being used to circumvent regulatory “rigidities” in certain countries, diminishing the transparency of the system.
Monitoring of banks’ liquidity by supervisors is undertaken essentially on a local market basis. Techniques are now being developed to monitor overall exposure to liquidity risk (“survival period”) in foreign as well as domestic currencies. But the liquidity links within banking groups—especially those between subsidiaries with independent treasury managements—remain somewhat unexplored, and lender-of-last-resort responsibilities in this area are complex.
The events in the equity markets illustrate that the liquidity of various markets under conditions of strain has been considerably different. For example, during the recent episode, equity markets in the United States experienced both record price declines and record volumes, while many other markets—including the secondary Eurobond markets—saw a sharp reduction in the volume of transactions. The disappearance of market makers during a crisis period has been a factor in this loss of liquidity. Indeed in the United States, a self-regulatory organization (the National Association of Securities Dealers (NASD)) has announced proposals to improve market making in the over-the-counter market.
The mushrooming volume of financial transactions has led to greatly increased pressure on international settlement systems. The most serious problems are occurring in instruments far removed from key money market settlements—in particular certain European equities. In the wake of recent financial shocks, some settlement systems (e.g., equities and Euro-floating rate notes) experienced difficulties. In contrast, settlement systems for government bonds and interbank transactions functioned well, in part reflecting official policies designed to limit, to the extent possible, the credit risks involved with these systems. The continuing increase in vigilance by the authorities over settlement risks—including recent moves to limit risks in government bond and interbank settlements—appears wholly appropriate.
To the extent that intermediation activity shifts within or between countries in response to regulatory regimes, the case appears strong for harmonizing more fully the regulatory—and tax—treatment of similar business in different institutions, and for reducing the existing institutional barriers between bank lending and activity in negotiable instruments. The need for coordination among different regulatory bodies, domestically as well as internationally, poses a challenge potentially greater than the challenge faced by banking supervisors in the early 1970s. In late 1987, the Chairman of the U.S. Federal Reserve Board supported the creation of a U.S. agency to coordinate regulatory policies among the various components of the U.S. financial system.
Although the Fund is not directly involved in this intergovernmental supervisory cooperation, it has an abiding interest in its satisfactory progress. The current prominence of capital flows in the trade and payments system, while these flows appear principally responsive to macroeconomic factors, could become a potential source or transmission channel for instability in the system. It remains important to note that the long-run effectiveness of both supervisory and lender-of-last-resort arrangements depends crucially on maintaining market discipline and on policies to secure a stable financial environment.
The interactions between macroeconomic policies and financial market changes are complex. In discussions with officials, staff inquiries concentrated on the key aspects of recent experience and of policy concerns. One area of discussion related to the effect of structural changes in financial markets on the authorities’ capacity to design and implement monetary policy.
The task of short-term monetary management can undoubtedly be complicated by the removal of domestic price and quantity regulations in financial markets. This is partly a transitional problem, associated with the shift from credit restraints to price allocation; with the availability of new instruments that blur the edge between money and capital market transactions; and with changes in the private sector’s demand for money. The seriousness of these complications is probably least when financial conditions and policies have been steady. In “low-inflation” countries where the structure of bank liabilities did not change sharply, the reliability of monetary aggregates as guides to policy formulation has posed lesser problems for the authorities.
A second area in which deregulation has caused far-reaching implications for monetary management is the removal of exchange controls. Even with flexible exchange rates, a growing foreign integration of domestic and international financial markets can alter both the timing and scope of the effects that changes in monetary policy exercise on the domestic economy and external flows. In some major countries, relaxation of exchange control led to abandonment of longstanding credit controls, as external finance became a ready alternative to domestic credit.
The removal of exchange restrictions can also influence the implementation of policy through the use of monetary aggregates or interest rates. Although a flexible exchange rate would allow the authorities to control the growth of the domestic monetary base, such control may be accompanied by large exchange rate movements. It was frequently pointed out that gross capital movements, such as occurred in Japan, the United States, and the United Kingdom, have become quite large in comparison with the financial systems of many countries. Therefore, shifts in foreign portfolios can have more far-reaching implications than previously.
These recent structural changes in financial markets may also affect the conduct and international transmission of macroeconomic policies. Greater capital mobility implies that industrial countries may find it easier in the short run to finance fiscal and current account deficits. Nevertheless, they may also find it more difficult to pursue independent monetary policies. Heightened international financial integration may cause the impact of macroeconomic policies to spread more widely and quickly through the international community.
The increased speed at which financial markets adjust, and the surge in transaction volumes in these markets, contrasts with the rising protectionism and structural rigidities that hamper the ability of goods and labor markets to adjust in some industrial countries. A greater divergence in the adjustment speed between financial markets and goods markets could produce increased volatility of exchange rates and interest rates.
Most market participants and officials considered that the wide swings in financial market activity over the past decade reflected a response to—rather than a cause of—macroeconomic developments in the major industrial countries. The markets had, they considered, channeled the consequences of these changes more immediately, increasing interdependence, rather than providing an independent source of instability.
The impact of swings in macroeconomic conditions and policies has been evidenced in developments during the imbalances and inflation of the 1970s and 1980s. During the 1970s, deposit institutions channeled funds to deficit sectors in developing and industrial countries in a financing environment that favored commodities and tangible assets. Floating rate lending was developed to redistribute interest rate risk from lenders to borrowers. As a result, interest rate risk was transformed into credit risk, and credit risk proved less well diversified than expected. In the early 1980s, private flows to developing countries began declining as the perceived risks rose; at this stage official involvement increased to ease the adjustment path.
New imbalances, largely within industrial countries, grew during the early 1980s. Once again, private sector financial institutions intermediated to finance these imbalances. At times in 1987, however, many market participants in surplus sectors changed their perceptions of risks, and intermediation was forced (through foreign exchange intervention) to a larger degree than previously upon the public sector. The scale of current imbalances was widely viewed as unsustainable by officials and bankers.
Overall, most officials and market participants held a somewhat uniform view: that macroeconomic policies in the major countries were fundamental to the stability of the system. The disparity between trade restrictions and capital liberalization could best be addressed by liberalizing goods transactions rather than restricting finance. The flow of private savings from industrial countries to developing countries would best be enhanced by stronger macroeconomic and structural policies, and thus by higher trade volumes accompanied by more stable interest rates. In a more stable environment, market discipline could more fully be relied on to protect the soundness of the financial system. Losses could then be allowed to fall where they may, including on wholesale depositors—arguably the key group whose activities may to some degree be distorted by implicit guarantees.
Bankers and officials stressed that, by contrast, the consequences of policy failures in key currency countries could be very serious, given the highly developed state of financial markets. The increasingly interdependent and complex financial superstructure was considered to be as safe as the policies followed in these major currency countries. Where the legacy of weak macroeconomic policies translated into financial market disruption, the central remedy was seen as corrective economic policies, supported—where necessary—by additional official financing and suasion over private institutions to limit “overshooting” of market trends.
The implications of this assessment for the system—and specifically for the Fund—appear to lie principally in the crucial importance of policy coordination among the major countries. Such coordination would be seen as favoring growth both directly and by sustaining a market environment in which private sector financial intermediaries could function more effectively.
The Debt Situation
While developments in major securities markets dominated market psychology late in 1987, the continuing efforts to improve the situation of heavily indebted developing countries remained a major preoccupation of leading commercial banks and a focus of official policy. Concerns over the credit risk associated with claims on these countries were heightened during the first half of 1987 by the suspension of payments by Brazil, Côte d’Ivoire, and Ecuador and by the decline in prices in the secondary market for bank loan claims on certain developing countries.
In discussions, banks stressed that progress in resolving debt problems would be crucially dependent on the success of policies to achieve sustained expansion in the major industrial countries, and on the implementation of growth-oriented adjustment policies in developing countries. However, growth in world trade, lower interest rates, adjustment in many debtor countries, and successive financing packages have not unlocked significant spontaneous financing. A key reason for banks’ continued aversion to generalized exposure increases lies in a lack of confidence that most debtor countries will be able to sustain, over an extended period, policies sufficiently strong to restore their full creditworthiness, against a background including downside risks in the economic policy environment in the industrial countries.
In a financial market environment characterized by high liquidity and intense competition, banks are seeking to maximize post-tax returns on equity, to adjust their balance sheets to safeguard or enhance their credit standing, and to expand lines of business that minimize absorption of capital resources. Increases in book claims on countries in payments difficulties—as on troubled domestic sectors—appear uncertain in terms of risk-adjusted returns; problematic in terms of the market’s evaluation of banks’ liabilities; and expensive in terms of capital cover. These concerns have continued to strengthen, despite a very substantial dilution of banks’ exposure to the rescheduling countries, reflecting higher capital, increased provisions, for non-U.S. banks a sharp decline in the value of dollar-denominated claims in terms of domestic currency capital, and for U.S. banks a decline in claims.
The secondary market in loan claims reflects portfolio rationalization in light of these factors. The total volume of transactions in this market through mid-1987 reportedly amounted to some $10 billion. Discounts on the debt of most countries have widened during the first three quarters of 1987. The average discount on loan claims of the 15 heavily indebted developing countries was reported to be between 50 percent and 60 percent in September 1987, although activity was extremely thin. Within that group of countries, the discounts ranged from about 20 percent to 90 percent. Several countries continue to cluster at discounts of about 30 percent, while claims on another group (including the three major debtors) were quoted at discounts in excess of 50 percent. A number of banks and investment houses—notably in New York and London—have developed a role as intermediaries in transactions of loan claims.
Banks described the market as characterized by limited supply and demand. On the supply side, banks with larger exposures have been reluctant to transact a part of their portfolio at prices that may prejudice the valuation of their remaining assets. The recent increase in loan-loss reserves against claims on debtor countries may have influenced the price level, since it was perceived to increase banks’ flexibility in engaging in such sales. Smaller banks—particularly in continental Europe and the United States—have sought to reduce exposure to countries with debt-servicing difficulties through selling these assets at a loss. And banks, more widely, have consolidated their assets in a smaller number of countries, through exchanges of loan claims.
Demand has mostly come from residents of countries whose debt is trading at a discount and from institutions and corporations with business interests in a particular country that they wish to finance with the local currency proceeds of converted loan claims. Private investor demand in the secondary market for sovereign debt has been virtually nonexistent. Meanwhile, the implicit yield on these discounted sovereign loans is thought by some analysts to inhibit, of itself, new investment in debtor countries.3
Significantly greater international convergence in provisioning for loan losses transpired in May–June 1987. Following the suspension of interest payments by Brazil, a number of U.S. banks moved these loans to a nonaccrual basis, and subsequently increased their loan-loss reserves to cover some 20 to 30 percent of exposure to all countries experiencing payments difficulties. In contrast to practice elsewhere, these reserves are not tax deductible but may be included in primary capital. The spread of these levels of provisioning in the United States was due not primarily to new pressure from auditors or supervisors but to banks’ concern about market perceptions of their asset quality and a desire to strengthen their competitive position vis-à-vis other banks. Banks in other countries (e.g., the United Kingdom and Canada) have followed this move. Banks observed that provisioning levels may be converging toward those in continental Europe, that is, some 25 to 35 percent.
Questioned about the implications of this spread of provisioning, banks made four main points. First, to the extent these measures were motivated by competitive pressures among banks to improve their relative standing in debt and equity markets, they would not have a decisive impact on the present round of financing packages. Banks’ basic debt approach might initially remain rather similar: they would seek to improve the quality of these assets by avoiding a generalized deterioration of the debtor countries’ payments status, pressing for policy reforms, and obtaining as much creditor government financing as possible.
Second, provisioning would increase banks’ flexibility—as regards scale and timing—in disposing of loan claims at a discount. Third, notwithstanding some public statements to the contrary, banks expected that they might be constrained by market forces to increase their reserves in line with future claims increases; in the view of some banks this might, over time, lead to an environment less favorable to new lending. Fourth, banks emphasized that these provisions carried no implications of a willingness to forgive debt, but they admitted to uncertainty about their impact on the perceptions of debtor countries.
During the past year a further important change, supportive of provisioning, has been some convergence in tax regimes applied to general provisions against country risk. In particular in Canada, France, and the United Kingdom, tax deductibility for provisions was reaffirmed or increased. In Japan, the regime was not altered, but banks transferred some loan claims—at a discount—to an offshore company in the Cayman Islands, and the losses so incurred were deemed tax deductible. Exceptions to this trend toward greater deductibility would appear to include principally Belgium and the United States.
The senior management of leading banks have reviewed ways to improve the working of advisory committees during 1987. Although this review is likely to be a continuing process, a number of provisional conclusions have emerged. In particular, periodic exchanges among senior officials of leading institutions may be necessary to cut through specific problems and maintain momentum in the restructuring process. Banks also pressed strongly for greater involvement of advisory committees in negotiations relating to the size and distribution of financing gaps, although some bankers involved in rescheduling recognized that there are limits to the possibility of negotiating a financial program with many parties, including private banks.
In discussing the distribution of financing gaps, banks stressed that they will strongly lobby to limit their contributions to general purpose financings, thus restricting their lending as far as possible to specific purposes such as trade and project financing. They will clearly seek proportionately larger contributions from the official community, including from the Fund, the World Bank, the Paris Club, and creditor government agencies. They intend to press for increased financial protection through the strengthening of co-financing arrangements—ideally in the form of cross-default clauses with multilateral development bank loans (a concern felt particularly strongly by Japanese banks). The Institute of International Finance (IIF) among others articulated these views.4 While these points were put forcefully by banks, most major banks acknowledged that they would not think it realistic to press these concerns to a point where several major packages were unresolved and widespread arrears emerged.
Banks expressed concern about net Fund repurchases by developing countries. In discussions with staff, bankers suggested that the Fund’s financial involvement with the heavily indebted countries would likely need to continue on a significant scale. A number of major countries were currently carrying out adjustment policies supported by the use of Fund resources, and others were expected to do so in the future. Banks considered it important that there should not be a net withdrawal of Fund resources from countries still experiencing balance of payments difficulties, although they had been willing, in some cases, to continue to provide financing on the basis of Fund monitoring, rather than use Fund resources. Some bankers suggested that a longer-term planning horizon in the context of Fund arrangements may also be helpful, and noted that the move away from extended arrangements toward more stand-by arrangements had tended to shorten the maturities of countries’ obligations to the Fund.
Many institutions expressed concern that the present round of financings—and possibly the pursuit of orderly solutions more generally—could be jeopardized by a sudden deterioration in the general economic situation, especially if interest rates were to rise sharply. Since such a development would be beyond the control of banks and the debtor country, banks urged that the industrial country governments should largely bear the costs resulting from a rise in interest rates, either by facilitating interest rate swaps on a large scale or by providing temporary financing through the Fund.
Banks noted that financial modalities in restructuring have evolved considerably since 1982. The 1982–83 round of restructuring typically involved one-or two-year consolidation periods, maturities of up to ten years, and spreads of about 2 percent. New money was largely in the form of general purpose financing. The 1984–85 round saw a selective shift to multiyear consolidation periods, with maturities of up to 14 years, and sharply reduced fees and spreads. The new money mechanism was diversified to include medium-term trade facilities, and arrangements for onlending and relending to parastatals and the private sector. In the case of Chile, debt-equity conversions were pioneered and a World Bank cofinancing guarantee was included in the package.
The 1986–87 round, following the Baker initiative, sought to take a somewhat longer-term approach to restructuring, and to respond to a sharper divergence of banks’ interests. Packages have given prominence to the support of structural reforms and rebuilding of investment, with the assistance of the World Bank. Restructuring maturities have been extended to as long as 20 years and spreads have been reduced to half of the 1982–83 level. Modalities for financing have been expanded progressively, including debt conversions, securitization of certain new money claims, and provision of low coupon bonds as alternative instruments. In some cases, techniques have also been used to avoid or reduce approaches for new financing. In Chile, the bulk of financing to be provided by commercial banks during 1987–88 is to come from a retiming of interest payments.
Debt conversion schemes have been established in several countries (Argentina, Brazil, Chile, Costa Rica, Ecuador, Mexico, and the Philippines). Such schemes are also under active consideration in a number of other countries (e.g., Guatemala, Honduras, Morocco, Nigeria, and Venezuela). During the period January 1984–September 1987, an estimated $6.0 billion in bank debt was converted under officially recognized schemes. This amount represents about 3 percent of outstanding bank debt to those debtor countries with active conversion schemes, although in some cases a substantially larger share of bank debt has been retired (e.g., in Chile, some 16 percent of the bank debt has been converted).
Explicit development of a “menu” approach to financing was featured in the package for Argentina (and subsequently adopted, in terms of the broad framework, for Ecuador in late 1987). In addition to a trade facility, onlending, debt conversion, and co-financing, three new features were included in the Argentine package. Securitized new money claims (of up to $1 million a bank) with the same terms as the book claims provide an instrument that, given its bearer form and modest scale, banks view as less likely to be rescheduled than book claims. This instrument has been well received. In addition, Alternative Participation Instruments (APIs) (of up to $5 million a bank) provided a 25-year bond carrying a yield of 4 percent—substantially below the contractual interest rate on the book loans—that exempt the holder from future calls for new money. The availability of APIs was expanded—to $30 million a bank—for banks that wish to dispose of their entire holding (the valuation of which might be adversely affected by acceptance of APIs for some claims). Banks viewed the pricing of this “exit” option as rather unattractive. APIs, however, may make it more awkward for banks that dislike “new money,” and claim not to be “free riders,” to decline to participate.
Finally, a fee of ⅜ of 1 percent—to be lowered over time in two stages to zero—was offered for early participation in the new money package; bankers believed that these fees played an important part in speeding commitments. Among the other factors they cited for the relative quick mustering of this package were the concentration of claims among creditor banks that generally have been favorably disposed to the new money approach and also a greater degree of consultation with banks in determining the size and structure of the package.
Banks have also reviewed the appropriateness of the new money approach for low-income countries facing protracted debt-servicing problems. In the case of Bolivia, banks have agreed to permit direct buy-back of bank claims by the Government, if adequate donor funds can be assembled. This approach reflects Bolivia’s situation as a low-income country having large arrears, including interest, with loan claims being transacted at discounts of some 90 percent. The Fund temporarily approved arrears to commercial banks while negotiations on a financing package were under way and has established an account to help facilitate transfers for the buy-back. Banks indicated that some other low-income countries, albeit less dependent on bank credit than Bolivia, might also benefit from imaginative approaches to regularize their position.
Banks considered it important to encourage participation by banks with differing interests by a pragmatic expansion of the menu of financing options. The additional options most frequently cited by many less exposed banks would be to include enhanced exit bonds and optional interest capitalization. Certain major banks oppose any form of interest capitalization; a more common concern is that generalized interest capitalization could entail systemic risks, and that it would adversely affect the prospects for securitizing claims because liquidity of securitized claims depends on maintaining an income stream. Interest capitalization or rescheduling was viewed by some banks as a technique that could address the free rider issue.
There were some warnings against exaggerating the benefits that can be derived from adaptation of financing techniques. First, there are natural limits to the scope of a number of menu items, reflecting governments’ needs for general purpose financing, and constraints of fiscal and monetary management. Second, some problems of bank cohesion have reflected differences in domestic tax or regulatory regimes (which are discussed in Chapter IV). The scope for easing some problems through innovative instruments may be limited.
Staff asked bankers about the adaptation of menu items to countries’ prospects—for example, in the cases of countries whose situation recovers enough to seek spontaneous financing, or alternatively, countries whose economic situation worsens very seriously. Bankers pointed out that spontaneous finance had been available in modest amounts to certain countries that have been successfully pursuing appropriate policies. The examples of re-entry cited included the recovery of Turkey and the recent agreement by a group of banks to launch a loan of $1.06 billion for Colombia (which had used concerted financing but avoided rescheduling). There are also instances of banks taking on unguaranteed portions of project loans where key industrial customers are concerned. But the main category of spontaneous financing for countries that have experienced payments difficulties appears thus far to have been short-term trade lending.
Banks were somewhat more favorably disposed toward medium-term general purpose exposure if it took the form of transferable loan certificates or privately placed securities, instruments that offer banks a potentially more liquid asset. Other financial innovations—such as collateralization—can also facilitate re-entry, but ultimately the key to regaining access to foreign savings lies in the establishment of a climate favorable to foreign inflows, including capital market liberalization and the development of equity markets.
Given the constrained availability of bank financing, attention turns naturally to other forms of longer-term financing, including placing bonds with nonbank institutions. So far, however, there has been very little institutional or retail demand for claims on countries that have restructured. A second source of longer-term nonbank flows is equity financing. The International Finance Corporation (IFC) has been involved in several debt-equity swaps. It has also been engaged in exploratory work on the scope for developing closed end funds in countries that have restructured their debt, and for possibly linking these to debt and equity conversion schemes.
With regard to countries that experience a continued and very serious deterioration in their payments situation, virtually no major banks were prepared in the present environment to contemplate generalized forgiveness of principal. Some larger banks and many smaller institutions were prepared either to postpone or to capitalize interest. Some smaller banks were prepared to contemplate outright reduction in the contractual value of claims, but possibly subject to formulas that permit payments to banks to increase when the country’s circumstances improve. Other regional or local banks, however, were demonstrably attempting to secure the benefit of full contractual interest payments without participating in financing packages.
Banks indicated that the situation of such countries might eventually have to be regularized by a negotiated reduction of claims. Some cited the proposed buy-back of debt by Bolivia in that connection. Most banks suggested that such a resolution might in effect be preceded by considerable disorder and would be conditioned by banks on massive creditor government support.
A common thread runs through these discussions, notwithstanding varying degrees of cooperation and optimism among banks. This was that the modalities for providing financial relief needed to evolve progressively and to reflect realistically the current situation and prospects of a country. They also needed to be increasingly tuned to the business interests and regulatory and tax regimes of banks. Banks stressed that success in assembling financial packages will continue to depend crucially on the implementation of policies in creditor and debtor countries that would foster sustained growth in debtor country economies.
The country classification scheme used for economic analysis in the Fund and followed in this study is given in Appendix I.
As with previous publications on international capital markets, this study does not address in detail questions relating to concessional assistance or to medium-term prospects for the world economy. A discussion of the principal findings that have emerged from studies in the Fund relating to the world economy are contained in International Monetary Fund, World Economic Outlook, October 1987: Revised Projections by the Staff of the International Monetary Fund (Washington: International Monetary Fund, October 1987).
See, for example, Michael P. Dooley, “Market Valuation of External Debt,” Finance and Development (Washington), Vol. 24 (March 1987), pp. 6–9.
See, Institute of International Finance, Restoring Market Access—New Directions in Bank Lending (Washington, June 1987).