IV Developing Country Finance Issues
- International Monetary Fund
- Published Date:
- January 1994
The year 1993 was a boom year for private financing to developing countries, with a sharp increase in the volume of flows, a further improvement in the terms of borrowing, and strong increases in equity prices in many local stock markets. Most of this financing took the form of securitized flows. Bonds continued to be the financing instrument of choice, with almost $60 billion issued. For the third year in a row, bond placements in 1993 doubled relative to the preceding year. International equity placements rose only moderately (to $12 billion, up from $9 billion in 1992), although direct purchases of equity in local stock markets are thought to have displayed stronger growth. Most of the bond and equity flows went to Latin America, Asia, and Europe. Other regions received significantly less financing from international capital markets, although the range of countries accessing the market continued to expand in 1993. Banks continued to participate in this market primarily through short-term trade credits, although their medium- and long-term lending to most developing countries also picked up in 1993. The market ran into turbulence in the first four months of 1994, as the increase in U.S. interest rates, as well as the political uncertainty in Mexico, helped bring bond and equity flows down sharply from their peaks of the last quarter in 1993.36
The strong expansion of this market in 1993 reflected a significant broadening of the investor base to include more active participation by mainstream institutional investors in providing financing to a wider range of developing countries. In particular, assets from a number of Latin American countries, which had previously appealed mainly to flight capital investors and wealthy individuals, began to make the transition to an investment acceptable to even the more conservative of the institutional investors. In this sense, they joined a group of Asian countries that have maintained access to international capital markets and that have been able to attract pension funds, insurance companies, and the like from a relatively broad spectrum of investor countries.
Hedge funds and other highly leveraged speculators have generally remained on the sidelines of this market, but have entered for short periods when they have perceived a good profit opportunity. Starting in late 1992, some U.S. pension funds, and to a lesser extent insurance companies, reportedly began to purchase investments in Latin America, including Brady bonds. In mid-1993, U.S. mutual funds, even those with no specific mandate to invest in emerging markets, reportedly made sizable increases in their investments in many emerging markets. Pension funds and insurance companies increased their participation further. European institutional investors also invested more in this market, although more moderately, perhaps taking a cue from the heightened interest of the U.S. institutions.
These investors were attracted by the high yields on these assets compared to returns in most industrial countries, particularly after the decline in U.S. long-term interest rates early in 1993. U.S. mutual funds experienced a net inflow of about $250 billion in 1993—the largest annual increase ever—as households and other investors shifted savings out of bank deposits. The returns available in emerging markets were so high and so well publicized that many institutional investors simply could not afford to ignore these assets. Some private pension funds were reported to be motivated also by the prospect of unfunded liabilities, which created the need to target a higher total return on the funds’ portfolio. The strong policy track record of many developing countries and the availability of several developing countries with investment grade ratings gave investors some confidence that the risks in this market were manageable. Also, there was a growing perception that developing country assets offered good possibilities for risk diversification, because returns in these countries have been relatively uncorrelated with industrial country returns. Institutional investors in source countries are often subject to limitations—ranging from government regulations to self-imposed prudential restrictions—on their holdings of paper from developing country issuers, but in most cases their investments in developing countries were still meager enough to render these restrictions not binding.
This further expansion of the investor base could help many countries consolidate the gains they have made in regaining and improving their access to private international capital markets. The entrance of major institutional investors greatly enlarges the potential pool of resources developing countries can tap to finance productive investment, particularly if many of these countries sustain sound policies and gain investment grade ratings. U.S. mutual funds currently manage about $2 trillion of assets, while the combined portfolios of U.S. pension funds and insurance companies stand at almost $6 trillion.37 Institutional investors in other countries likewise manage large portfolios; the combined assets of pension funds and insurance companies in France, Germany, Japan, and the United Kingdom are in the vicinity of $5.7 trillion (as of the end of 1991).38 Moreover, many large U.S. investors—such as pension funds and insurance companies—still invest probably less than 1 or 2 percent of their portfolios in emerging markets; a modest increase in that share would be a significant boost in the financing available to developing countries. Investors in Japan, Canada, Europe, and many developing countries have a large scope for increasing their participation. After all, over the long term, the potential returns to capital should be higher in developing countries than in industrial ones, and industrial country investors are becoming increasingly familiar with the nature of the risks associated with investing in these markets. Also, to the extent that major institutional investors do increase their participation in developing country financial markets, this could serve as an impetus for improvements in disclosure, as well as in the regulatory and legal environment.
By now, there is sufficient diversification of the creditor base that supervisory authorities in the industrial countries no longer regard financial flows to developing countries as presenting a serious potential source of systemic risk; that is, any losses arising on financial holdings in developing countries would likely be spread widely enough throughout their financial systems to keep the impact of any disruption fairly modest.39 These authorities noted that the banking systems in their countries have substantially cut their exposure to developing countries since the early 1980s, more reflecting banks’ own preference to avoid risky claims than the need to maintain provisions on loans to certain countries.
While an expanded investor base holds out the promise of large benefits to the developing country recipients of such financial flows, this market is also likely to remain vulnerable to significant risks—risks that would be reflected not only in the risk premiums that these countries pay in the market but also in the volatility of financial flows. The market correction observed in the fourth quarter of 1992, as well as the volatility in emerging-market bonds and equities in early 1994, are illustrative of the reactive nature of this market. The sources of this volatility are numerous and well known; they include fluctuations in the pace and scope of policy reform in the host countries themselves, terms-of-trade shocks, and variations in industrial country growth, imports, interest rates, exchange rates, and trade policies.
With a combined portfolio probably amounting to $10–15 trillion or more, the pool of funds managed by the major financial institutions in the major industrial countries easily dwarfs the market capitalization of all emerging markets countries, which is approximately $1 trillion. As such, changes in investor preferences, particularly when these preference changes are one-sided, can have a significant impact on the financial markets of the issuing countries. Also, major institutional investors are not necessarily long-term “buy and hold” investors. U.S. mutual funds need to meet performance standards over a very short time horizon, and open-ended funds face the risk of sizable net redemptions if their quarterly performance lags behind their competition. As a result, these funds actively trade their holdings in order to meet their performance standards; there is little reason to suggest that they would hesitate to sharply cut their holdings of emerging markets assets if they considered that a deterioration in the risk/return outlook was in the offing. In fact, a number of mutual funds were reported to have reduced substantially their holdings of emerging markets assets in the recent market downturn. The investment performance of pension funds is often measured in terms of annual return or the average return over several years; they thus tend to hold assets for somewhat longer than mutual funds—a practice that is also encouraged by their desire to hold longer maturity assets so as to match the maturity structure of their liabilities. Insurance companies too tend to have a somewhat longer-term perspective, but take very seriously the need to preserve their reputation as safe investments—to say nothing of constraints imposed on their holding of risky assets by their charters. This more conservative branch of the institutional investor community has little incentive to repeatedly trade in and out on their emerging market holdings, but again, if a perceived deterioration in the underlying quality of those assets were in store, they would move quickly to reduce their holding of emerging market bonds and equities.
Pricing and Assessment of Risk
It needs to be kept in mind that the recent growth of emerging market securities notwithstanding, this market as a whole is still in its formative years and remains less familiar to industrial country investors than their own capital markets. Although many of the large banks and securities houses in industrial countries have recently expanded substantially their market research on emerging markets, foreign investors report that they find it a challenge to assess risk/ return prospects when large-scale structural changes like privatization reduce the inferences that can be drawn from historical data, when standards of disclosure—though improving steadily—are lower than in some other markets, and when the number of bond issues is expanding so rapidly.
Because of the complexities of processing information, the market appears to look for certain benchmarks to help decide on an appropriate price for a particular bond. During discussions, market participants noted that Mexico, as the first debt-restructuring country to regain access to voluntary financing in recent years, came to serve as a benchmark for measuring the risk of new sovereign debt issues in Latin America and in other regions, particularly for those with subinvestment grade ratings. The sovereign bond issues in each country then serve as a benchmark for the bonds issued by other borrowers in that country, which trade at some margin above the sovereign. The spread paid on Mexican sovereign bonds has come down from about 800 basis points over the comparable U.S. Treasury interest rate in 1989 to roughly 200 basis points in late 1993. Many market participants saw no particular logic to a spread of 200 basis points for Mexico. Others disagreed and noted that this spread was similar to the spread paid by a U.S. corporate issuer of roughly the same credit quality.
Examination of spreads on developing country bonds—in both the primary and secondary markets—suggests that the market displays a broad rationality—albeit one characterized by frequent trial-and-error adjustments. Countries that are generally regarded as weaker economic performers tend to pay higher spreads and the spreads themselves appear to react over time to new information about the borrower’s prospects. Of the major Latin American borrowers, Mexico has consistently paid the lowest spread, while Brazilian bonds have consistently paid the highest ones. Bonds from countries that avoided debt reschedulings tend to carry a lower spread than bonds from restructuring countries, and spreads are usually higher on private sector issues than on sovereign issues. Many market participants felt that spreads—both between sovereign borrowers and between sovereigns and corporates—should be much wider than they have been to capture accurately the differences in risk; by the same token, many participants felt that the levels of the spreads sometimes got out of line with risk considerations, especially during periods of euphoria or extreme pessimism about emerging markets more generally.
The decline in bond and equity flows was particularly marked in April 1994.
Board of Governors of the Federal Reserve System (1993). The information on mutual funds includes open-end and closed-end funds and money market mutual funds.
The impact of any disruption of financial flows to developing countries would of course not be modest for the host countries themselves.