Chapter

II Turbulence in Emerging Capital Markets

Author(s):
International Monetary Fund
Published Date:
January 1995
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Although sufficient historical distance has not yet been gained to present the definitive rendition of current events in key emerging markets, the broad outlines of the story are now coming into focus. Significant flows of capital, at relatively narrow spreads, surged into many of the emerging markets starting around 1990. These flows were largely due to improved economic performance and structural reforms in many recipient countries and a cyclical downturn in the early 1990s and structural changes in institutional portfolios in industrial countries. Most countries managed well the macroeconomic and prudential challenges posed by large-scale capital inflows. In others, however, these inflows may have masked weak economic fundamentals. The decline in inflows exposed these weaknesses, and, in Mexico, contributed to a serious exchange rate crisis.

The events in key emerging markets in late December 1994 and early 1995 initiated a re-evaluation of prospects for emerging markets and a rebalancing of international portfolios that are likely to continue throughout 1995. As this process evolves, several emerging market economies may continue to experience intermittent periods of turbulence. With this perspective in mind, this section examines the events in emerging markets in 1994 and early 1995, considers briefly a number of broader aspects of these events, and concludes with a discussion of the management of the risks to macroeconomic and financial stability that can be generated by sub-stantial capital flows.

Capital Inflows to Emerging Markets

Flows During 1990–94

After four years of sharp acceleration, flows to developing countries decreased modestly in 1994. Total net capital flows to all developing countries receded to $125 billion in 1994 after having increased markedly from $40 billion in 1990 to $155 billion in 1993 (Table 1). With the benefit of hindsight, it now appears that it would have been difficult to sustain the rate of growth of inflows—almost a quadrupling in three years.1 Some recipient countries should have expected a leveling off with the inevitable change in the cyclical position of the industrial countries.2 Furthermore, for some regions and countries, the turnaround in the availability of external financing was even more pronounced than is suggested by the aggregate numbers for all developing countries. Countries in the Western Hemisphere, which as a group had experienced a cumulative net capital outflow of $116 billion during 1983–89, received a cumulative net inflow of $200 billion during 1990–94. Perhaps, the most surprising turnaround was in Mexico, where capital flows changed from a cumulative net outflow of about $15 billion during 1983–89 to a cumulative net inflow of $102 billion during 1990–94. In 1993, Mexico received $31 billion of capital inflows, which amounted to 8 percent of Mexican GDP. It also implied that Mexico was receiving fully 20 percent of total net capital flows to all developing countries, although its share of GDP in total GDP of emerging markets was only 8 percent. In contrast, the change in flows was less pronounced for Asian countries, where flows increased from a cumulative net inflow of $117 billion during 1983–89 to cumulative inflows of $261 billion during 1990–94.

Table 1.Capital Flows to Developing Countries1(In billions of U.S. dollars)
1977–821983–89
Annual average19901991199219931994
All developing countries2
Total net capital inflows30.58.839.892.9111.6154.7125.2
Foreign direct investment plus portfolio investment (net)0.719.825.751.377.2141.1118.0
Net foreign direct investment11.213.319.528.838.052.856.3
Net portfolio investment–10.56.56.222.539.188.361.7
Other29.8–11.014.241.734.513.67.2
Asia
Total net capital inflows15.816.725.650.739.272.073.4
Foreign direct investment plus portfolio investment (net)3.36.69.418.027.359.565.0
Net foreign direct investment2.75.29.814.919.935.636.9
Net portfolio investment0.61.4–0.43.17.423.928.1
Other12.510.116.232.711.912.58.4
Western Hemisphere
Total net capital inflows26.3–16.617.928.652.662.338.6
Foreign direct investment plus portfolio investment (net)6.93.212.427.940.267.644.2
Net foreign direct investment5.34.46.811.212.913.814.8
Net portfolio investment1.6–1.25.616.727.353.829.4
Other19.4–19.85.50.712.4–5.3–5.6
Other2
Total net capital inflows–11.68.7–3.713.619.920.313.2
Foreign direct investment plus portfolio investment (net)–9.510.03.95.49.713.98.8
Net foreign direct investment3.23.72.92.75.33.34.6
Net portfolio investment–12.76.31.02.74.410.64.2
Other–2.1–1.3–7.68.310.26.44.4
Source: International Monetary Fund, World Economic Outlook data base.

There was a marked regional difference also in the composition of flows to developing countries. On average, since 1990, 41 percent of capital flows to developing countries has been in the form of portfolio investment in tradable bonds and equity shares and 37 percent has been foreign direct investment. In Asia, however, portfolio investment represented only 24 percent of inflows, while 45 percent was foreign direct investment. In the Western Hemisphere, capital flows were significantly more concentrated in yield-sensitive, and liquid, portfolio flows, which accounted for 66 percent of gross inflows in 1990–94, while foreign direct investment inflows represented 30 percent.

The inflows were accompanied by a decline in interest rate spreads over comparable U.S. Treasury securities to historically low levels. Average spreads for developing country borrowers declined from 346 basis points in 1991 to 243 basis points in the fourth quarter of 1993. The decline was most pronounced for private sector borrowers: average spreads fell from 650 basis points in 1990 to 315 basis points in late 1993. Yields on five-year Mexican government bonds came down from 800 basis points over the comparable yield on U.S. Treasury bonds in late 1989 to less than 150 basis points in late 1993.

Reasons Behind the Surge in Inflows

The supply of capital to developing countries appears to have been driven largely by three factors. First, the success of some Western Hemisphere countries and the Philippines in restructuring their commercial bank debt, combined with the implementation of sound macroeconomic policies and wide-ranging structural reforms, including financial sector reforms, facilitated their re-entry into international capital markets. Second, the cyclical position of industrial country economies stimulated the flow of capital into emerging markets. Specifically, the sluggishness in economic activity, the weak demand for funds, and the decline in interest rates in the industrial countries in the early 1990s contributed to investors having a greater interest in developing countries.3

Finally, the ongoing international diversification of rapidly expanding institutional portfolios (mutual funds, insurance companies, pension funds, proprietary trading of banks and securities houses) has contributed greatly to the flows into emerging markets. Institutional portfolios are absorbing a growing share of world saving, and hence investment decisions are becoming increasingly concentrated in the hands of professional fund managers who generally are more willing to diversify their investments to the international arena.4 As a result, there has been a gradual but persistent trend toward greater international diversification of institutional portfolios. At the same time, the share of international flows going to developing countries is also increasing. For example, institutional investors in the United States, Japan, Germany, France, and the United Kingdom together increased their international investments from around $100 billion (or 4.8 percent of assets) in 1980 to roughly $900 billion (7.2 percent of assets) in 1993, significantly outpacing the growth in total assets under management over the same period.5 In 1987, about $0.50 out of each $100 of foreign portfolio investment from industrial countries was invested in emerging markets, but by 1993 more than $16 out of each incremental $100 of foreign investment was invested in emerging markets. The $155 billion of net capital inflow to developing countries represented approximately 2 percent of world saving, compared with 0.8 percent in 1990. Developing countries are forecast to grow at approximately twice the growth rate of industrial countries over the 1995–2000 period. These growth prospects should continue to provide an impetus for growth in the share of institutional portfolios flowing into emerging markets.

Recent surveys of institutional fund managers in the United States indicate that the share of foreign investment going to emerging markets increased from 2.5 percent in 1989 to 10 percent in 1992 and to about 12 percent in 1993. Although this share is subject to cyclical developments, industry surveys suggested that it is unlikely to change radically in the coming years. The “Emerging Markets” have become a respectable asset class, together with real estate and high-yield bonds, among the dozen or so asset classes that make up the institutional investment universe. Institutional investment managers have been very clear that they intend to press steadily and purposefully ahead with the international diversification of their portfolios, although the regional allocation may change somewhat. And, indeed, there appears to be scope for further diversification in the institutional portfolios in industrial countries—not only into foreign securities, but also further diversification among the foreign holdings into emerging market assets over the next decade. For example, a frequently cited rule of thumb employed by fund managers is that an optimally diversified portfolio can be approximated by using country weights that correspond to the share of a country’s market capitalization in total world market capitalization. In 1993, institutional investors in the United States, Japan, Germany, France, and the United Kingdom invested, on average, less than 1 percent of their assets in emerging markets, significantly below the 12 percent share of emerging markets in total world equity market capitalization. Every additional 1 percentage point move in the direction of this rule of thumb would represent a net flow to emerging markets of about $130 billion.

Rebalancing Global Portfolios

The Correction in Emerging Markets

The reversal of the cyclical factors in industrial countries in 1994—strong growth momentum in the United States, accompanied by a tightening of financial conditions in several major countries—that had made emerging debt markets relatively attractive earlier, led to a general reassessment of investors’ global portfolios. The volume of international bond issues by emerging market countries fell from $18 billion in the first quarter of 1994 to $8 billion in the second quarter.6 Over February and March alone, spreads on Brady bonds issued by Argentina, Brazil, Mexico, and the Philippines widened by between 132 and 575 basis points. Emerging equity markets were also hard hit: share prices declined by more than 10 percent in Argentina, Venezuela, China, Hong Kong, Indonesia, Malaysia, the Philippines, and Thailand during the period from January to November 1994. Net portfolio investment in developing countries fell from $88 billion in 1993 to $62 billion, mostly due to a decline in investment in the Western Hemisphere from $54 billion in 1993 to $29 billion in 1994 (see Table 1).

Mexican Exchange Rate Crisis

The less favorable international capital markets environment in 1994 coincided with domestic political shocks in Mexico: the large net inflows that followed Mexico’s accession to the North American Free Trade Agreement (NAFTA) declined abruptly with the assassination of presidential candidate Colosio in March 1994. The spread of Mexican Brady bond yields over comparable U.S. Treasury securities widened to more than 400 basis points in April 1994. The Mexican Bolsa fell 9 percent in February, and by a further 14 percent in March. By April 1994, the inflow of capital was no longer sufficient to finance the outflow of funds and the current account deficit, which exceeded 8 percent of GDP, and the Mexican authorities had to intervene to prevent the peso from breaking through its lower intervention limit.7

The authorities sought to slow the sale of peso-denominated debt through an increased issue of a dollar-indexed, short-term security (the Tesobono). In this way, the foreign exchange risk associated with holding peso-denominated instruments was effectively transferred to the Mexican government. Domestic and foreign investors took the opportunity to exchange large amounts of their Cetes holdings—short-term, peso-denominated government obligations—for Tesobonos. From February to November 1994, Tesobonos outstanding expanded nearly tenfold to MexN$82 billion, while Cetes fell by 53 percent to MexN$42 billion. The Tesobonos, which sold at an average spread of 237 basis points above U.S. Treasury bills between January 29 and December 2, 1994, were popular with foreign bond funds, which looked upon them as dollar securities that could be used to enhance the yield on their U.S. fixed income portfolio.

Although reserves stood at $28 billion before the assassination of presidential candidate Colosio on March 23, they fell by more than $8 billion in April. Reserve levels improved slightly during the summer, but then an expansionary monetary policy contributed to further declines of $4.8 billion and $6.6 billion in November and December, respectively. By December 20, international reserves had fallen to $10.5 billion, and the Mexican authorities devalued the peso by 15 percent, but were forced to let the peso float on December 22, after losing another $4 billion of reserves in two days. The peso fell from its postdevaluation level of 4.0 pesos per dollar to a 1994 low of 5.7 on December 27, when a Tesobono refinancing auction had to be canceled because investors were no longer willing to carry the sovereign risk of these obligations at rates acceptable to the Mexican authorities.

The devaluation and the decision to allow the peso to float—after repeated pronouncements to the contrary—took international investors by surprise, despite warnings from several noted economists and market commentators. Mexico had made available only limited economic data during 1994 and now had difficulties preventing market participants from expecting the worst. This translated in early January into doubts about Mexico’s economic reform package and ultimately led to questions about Mexico’s ability to continue servicing its short-term debt. As a result, the quantities of bids at the Tesobono refinancing auctions in early January fell far short of the amounts offered.

The positive impact of the announcement of the U.S. support package on January 12 quickly dissipated with growing uncertainty about its approval in the U.S. Congress. Between January 13 and 30, the Bolsa fell 29 percent in dollar terms and the peso lost 17 percent of its value against the dollar. The international support package announced on January 31 temporarily calmed the waters, but uncertainty soon again continued to roil markets until the announcement of the new Mexican economic plan on March 9, when the peso hit a low of 7.45. The peso has since settled back to just below 6 pesos to the dollar as of the end of April.

Doubts about Mexico’s ability to service its international debt obligations forced domestic interest rates beyond what was justified by expectations of a further depreciation of the peso. A contractionary monetary policy added to the upward pressure. Short-term interest rates soared from below 40 percent in early February to a high of 80 percent in mid-March and have remained above 70 percent since then.8 The combined impact of the devaluation and the high interest rates produced a trade surplus of $240 million in February 1995 after a deficit of $530 million in January.

Aspects of Current Crisis and Its Management

The evolution and the resolution of the current crisis are being shaped by changes in global financial markets that have occurred since the 1982 debt crisis. First, the liberalization of capital flows to the major developing countries has meant that emerging markets have become, in essential ways, integrated into global capital markets. As a consequence, cross-border securities and banking transactions have become less costly and more accessible, not only at the wholesale, but also at the retail level. Second, securitization of international finance has meant that international syndicated bank lending is giving way to direct debt and equity as the preferred instrument of capital transfer to emerging markets. Third, the growth of global institutional investors has meant that capital flows to emerging markets are now predominantly driven by liquidity and performance considerations, rather than by longer-term banking relationships. This section discusses a number of consequences of this development.

Contagion from the Mexican Crisis

The substantial, albeit gradual, decline in equity prices and bond prices in the emerging markets in 1994 had been accepted by investors as a market correction that was not out of the ordinary. The Mexican crisis, however, produced a more fundamental re-evaluation of risk in emerging markets. This re-evaluation of risk led to a rebalancing of institutional portfolios that was the mechanism for transmitting the disturbance from Mexico to other emerging markets. Mexico had been the first country to regain substantial market access after restructuring its commercial bank debt in the 1980s. It had received the largest share of capital flows in the 1990s, and in addition, it had recently signed the NAFTA and joined the Organization for Economic Cooperation and Development (OECD). It was not surprising, therefore, that after the peso devaluation, market participants would ask, If it can happen to Mexico, then why wouldn’t it happen elsewhere? Such doubts led to an intensive re-examination of financial exposures in other emerging markets.

Immediately after the devaluation, most of the larger Western Hemisphere developing countries experienced varying degrees of turbulence in their foreign exchange markets and registered marked declines in their equity markets. In the financial centers in Asia, however, there was no significant reaction to the events in Mexico in December. The announcement of the U.S. support package on January 11, and the beginning of negotiations between the International Monetary Fund and Mexican authorities, calmed markets and forestalled greater spillovers; however, as the Mexican crisis deepened in early January and as growing doubts about the successful completion of the support package for Mexico once again raised the possibility that Mexico might not be able to service its short-term debt spillovers extended to Asia as well. Most Asian developing country currencies came under attack in mid-January, requiring intervention and defensive interest rate increases. Securities markets in some Asian countries also dropped sharply in mid-January 1995. For instance, stock markets in Hong Kong and Singapore fell by about 9 percent between January 18 and 24, and equity prices in Indonesia, Malaysia, and the Philippines fell by roughly 10 percent in January.9 Hong Kong’s currency board exchange rate arrangement also experienced strong speculative pressure, forcing the Hong Kong Monetary Authority (HKMA) to tighten liquidity to force overnight interest rates to rise by 5 percentage points on January 13. However, exchange rates, interest rates, and stock prices quickly stabilized in most Asian countries, but at discounted values from their earlier levels. The successful conclusion of negotiations with the IMF and the announcement of an international support package of nearly $50 billion (including $17.8 billion from the IMF) was instrumental in containing further spillovers into emerging markets in the Western Hemisphere and Asia.

Once the initial reaction subsided, the attitude of investors toward emerging markets became more discriminating. Broadly speaking, countries with low savings rates, large current account deficits, weak banking systems, and significant volumes of short-term debt experienced greater external pressure than countries that had sound fundamentals. This meant that within Asia, pressures centered on the Philippines, and to a lesser extent on Indonesia, and within the Western Hemisphere, pressures became focused on Argentina, and to some extent on Brazil.

Argentina, in particular, was seen as having some of the macroeconomic features that characterized Mexico in the run-up to the devaluation of the peso in December: a fixed exchange rate regime, a low domestic savings rate, a banking system with a large and growing volume of nonperforming loans, and a high current account deficit. Stock and bond prices in Argentina fell by as much as 50 percent from December 20, 1994 until they reached bottom in early March 1995. Yield spreads on Brady bonds (over U.S. Treasury bonds) for Argentina widened along with those of Mexico from December 1994 through the end of February 1995 (Table 2). Commercial bank deposits in Argentina fell by 16 percent (more than $7.5 billion) from mid-December 1994 to the end of March 1995. Because of the currency board system in Argentina, foreign currency withdrawals translated into contractions of the monetary base and, via the money multiplier, into a contraction of domestic credit and a rise in interest rates. Argentina’s foreign reserves declined by almost $5 billion over the same period and prime interest rates rose by 33 percentage points to nearly 50 percent in mid-March. The pressures subsided after a number of financial measures were implemented, including the relaxation of reserve requirements and the announcement of the creation of a bank support fund, and, most significantly, a revised economic program with support from the IMF was announced in March.10 Unlike Mexico, Argentina had not sterilized the capital inflows, and this precluded the buildup of a large stock of short-term foreign debt. This, the existence of the currency board, and the fact that structural policies had gone further in Argentina than Mexico may explain in part its ability to maintain the exchange rate parity.

Table 2.Brady Bond Spreads1(Changes in basis points)
Dec. 19–Dec. 30, 1994Dec. 30, 1994–Jan. 30, 1995Jan. 30–Jan. 31, 19952Jan. 31–Feb. 28, 1995
Argentina218183–266462
Brazil116281–283217
Mexico384190–212366
Philippines274310109
Venezuela374719–38345
Sources: Reuters and Salomon Brothers.

Growing Importance of Domestic Investors

The liberalization of cross-border financial transactions and the progressive integration of global capital markets have meant that domestic firms and individuals in the major developing countries are gaining access to low-cost transactions in international capital and banking markets. The more liberalized and internationalized is the domestic banking system, the greater is the ease and the lower is the cost of international financial transactions. If residents doubt the sustainability of the exchange rate regime, they can quickly, and at relatively low cost, adjust the currency denomination of their financial assets. The collective expectations of domestic and foreign holders of a country’s tradable financial wealth are now reflected more quickly, and possibly more accurately, in asset prices and currency values, than had been the case during earlier crises.

In addition, there exists a type of information asymmetry in developing countries that is not as pronounced in the major industrial country markets. Domestic residents in developing country emerging markets tend to be closer to sources of information about domestic economic events and prospects than foreign investors. They generally tend to be first in redenominating their domestic financial assets into foreign currency. They also often are the first class of investors back into the market: flight capital, for example, returned to many emerging markets long before foreign investors saw the investment opportunities.

Another reason why resident investors in emerging market countries tend to be the front-runners in a currency crisis is that the class of international investors that in the past five years has assumed this role in major markets—the hedge funds and the proprietary traders for international financial institutions—tend not to be able to participate, on a large scale, in developing country currency crises. The primary mechanism of leveraged speculative position-taking (borrowing the currency from domestic banks, against a small margin, and selling the proceeds forward) is not generally available to them. First, central banks in developing countries typically impose constraints on the ability of banks to make a large liquid forward market, or they use moral suasion to inhibit the banking sector from lending for speculative position-taking against the currency. Second, even when such forward markets exist, speculative position-taking by institutions such as hedge funds is frequently curtailed by concerns about the ability of the banking system to deliver on the forward contract after the devaluation. In contrast, during the ERM crisis in 1992, most of the initial speculative position-taking against currencies perceived to be weak came from hedge funds and other international institutional investors.11

The available data show that the pressure on Mexico’s foreign exchange reserves during 1994, and in particular just prior to the devaluation, came not from the flight of foreign investors or from speculative position-taking by these investors, but from Mexican residents. Foreign investors’ net purchases of peso-denominated debt and equity instruments and net foreign direct investment during 1994 came to just over $9 billion, and official capital inflows were $2.5 billion. Together with a decline in reserves of $19 billion, these inflows financed a current account deficit of $29.5 billion. In the run-up to the devaluation, that is, from November 30 to December 19, foreign investors had net sales of about $326 million in Mexican government debt securities, and there were net purchases of equity, while reserves fell by $2.8 billion. For the entire month of December 1994, foreign investors were net sellers of about $370 million of debt and equity, while Mexican foreign exchange reserves fell by $6.7 billion, only $1.7 billion of which was accounted for by the trade deficit. Indeed, foreign investors did not start to sell their Mexican equity holdings in any sizable quantity until February 1995.12

Furthermore, during the two weeks preceding the Mexican devaluation in December 1994, there was little or no traditional speculative position-taking in the peso forward market. Mexican banks could not make credit available to speculators to sell pesos forward, as the Mexican central bank prohibits banks from selling long-term contracts for forward delivery of pesos.13

One of the implications of this change in the financial environment is that the adequacy of a given stock of foreign exchange reserves under a regime of pegged rates cannot be gauged simply by tallying up external exposure: the authorities also need to consider the possibility that domestic investors can now readily redenominate their holdings of domestic financial assets into foreign currency. In addition, the general message emerging from these developments is that the room for policy slippage has been significantly reduced, because the disciplining mechanism of capital flight can be expected to be applied sooner and to be more potent in the future.

The Banking System as a Constraint on Crisis Management

Banking systems in emerging market countries have moved to center stage in resolving financial crises because the country’s banks bear the brunt of the interest rate increases that are inevitably necessary to defend a currency.14 It is not surprising, therefore, that solvency and liquidity problems in banking systems quickly move to the top of the agenda in countries that are experiencing financial stress.

The classical policy option for a central bank facing an attack on its pegged exchange rate is to use its foreign exchange reserves to buy its own currency and let domestic interest rates rise with the shrinking monetary base. The increase in short-term money market rates squeezes speculators by making them pay more for the funds they will need to deliver to make good on their short sales of the currency. The problem, however, is that the financial position of the banking system in many countries is such that authorities are frequently unable to let interest rates rise sufficiently to beat back the attack. It is common practice in most countries for banks to hold assets with longer maturities than their liabilities. To carry and manage such interest rate risk is, indeed, one of the main functions of the banking system. In practice, banks in developing countries may not be able to completely hedge such interest rate positions, and when short-term interest rates suddenly rise for a sustained period of time, the need to roll over the short-dated liabilities can seriously harm the income position of the banking system. In addition, other financial firms such as investment banks also tend to rely heavily on short-term borrowing to finance their trading positions.

A second and more indirect effect of a sudden increase in short-term rates is the increase in non-performing loan assets on banks’ balance sheets. Because bank debt is a key source of funding for industry in developing countries, any sustained increase in rates is likely to have a strong contractionary effect, which will bring with it an increase in the volume of nonperforming loans. Real estate and other asset prices often weaken with interest rate increases; thus, interest rate increases also reduce the value of the collateral against which loans were made. Similarly, household debt, for example, mortgages and credit cards, tends to be indexed to short-term rates, and, depending on its size and duration, an increase in rates will increase the rate of default on such debt. In Mexico, for example, most mortgage loans and consumer credit carry interest charges that are tied to the banks’ short-term cost of funds. The growth in nonperforming assets and the decline in interest margins are all the more painful when the banking system is already struggling with poor asset quality, such as when the economy is in recession. Under such circumstances, the central bank’s hands may be tied by the political unpopularity and economic effects of interest rate increases.

The recent Mexican experience is a case in point. The Mexican banking system began experiencing an increase in nonperforming loans well before the crisis. From 4.6 percent at the end of 1991, the ratio of past-due loans to total loans increased steadily, peaking at 8.5 percent in mid-1994. In response to the weakening of the banking sector following the devaluation, the Mexican authorities introduced in early 1995 a measure to strengthen the capital position of the banking system.15 At the time of the exchange rate crisis at the turn of the year, the banking system had already been sufficiently weakened by a growing stock of nonperforming loans that the authorities were reluctant to let the contractionary impact of its foreign exchange intervention be reflected fully in short-term interest rates. The need to stabilize the exchange market, however, as well as to achieve a contraction in domestic absorption, forced the Mexican authorities to let short-term interest rates rise to unprecedented levels. As the share of nonperforming loans continued to worsen in February and March 1995, and the risk of large-scale insolvencies increased, a plan to remove and restructure nonperforming loans totaling about MexN$148 billion was introduced.16 A bank restructuring of such a magnitude also has fiscal and monetary implications that go beyond the immediate concern of how to recapitalize the banking system.

Where necessary, as in Mexico, a recapitalization of banking systems can be accomplished in three ways. First, loan losses can be monetized; inflation will reduce the real value of the bad loans relative to assets. In this case, the bank’s creditors, mostly its depositors, would bear most of the losses. But the adjustment in inflationary expectations is likely to increase the pressure on the exchange rate, and further increases in real interest rates might be necessary. If loan losses are large, this solution might not produce a stable outcome. Second, the banking system can be recapitalized by exchanging nonperforming claims with explicit or implicit government claims in sufficient quantities to allow the bank to meet regulatory capital requirements. For this scheme to work, depositors must be persuaded that the economy will be able to generate sufficient real tax revenues to service the debt held by the banking system. Recapitalization of this form is usually accompanied by restrictions on banks: downsizing of balance sheets, streamlining of operations, reduced operating costs, possibly new management, and write-downs of equity positions. Third, a country can borrow from abroad to recapitalize its banking system. For example, in March 1995, Argentina and Mexico borrowed $2.5 billion and $2.25 billion, respectively, from the Inter-American Development Bank and the World Bank to finance bank recapitalization.17

An additional challenge exists under a currency board arrangement, such as in Argentina, Estonia, and Hong Kong. In these cases, the central bank cannot easily act as the lender of last resort. Because, at a minimum, central bank liabilities in domestic currency have to be backed one-for-one by foreign exchange reserves, the central bank is restricted in the amount of liquidity it can provide to the banking system by the amount of reserves it holds over and above what is necessary to back the currency.18 Hence, for a currency board arrangement to work effectively, the banking system has to be able to tolerate significant movements in domestic interest rates. Indeed, a weak banking system in a currency board arrangement may well carry the seed of destruction: it will induce a conversion of deposits into foreign exchange, shrink the monetary base further, and cause interest rates to rise higher, thereby making the banking problem worse.

The Argentine banking system came under pressure immediately after the Mexican crisis, as investors fled the currency by converting their peso-denominated bank deposits into dollar-denominated bank deposits in Argentina. The currency board in Argentina converted commercial bank reserves into foreign currency so that capital outflows—that is, increased demand for foreign currency—quickly led to pressure on the interbank interest rate, as banks tried to replenish their reserves by borrowing in the interbank market. As demand for domestic currency increased, banks replenished their liquid reserves with sales of domestic assets. Interest rates rose automatically, initiating all of the negative effects on the financial system discussed above. Moreover, concerns about the ability of banks to meet cash demands led depositors to reduce their exposure to domestic banks by converting peso and dollar deposits held in Argentina into foreign currency deposits abroad, thereby producing further pressure on interest rates. Following recent increases in interest rates, 33 small financial institutions have requested credit assistance from the central bank in Argentina.

Stability of Global Banking and Payment Systems

The progressive integration of the major developing countries into the global financial system has also meant that disturbances in any other market, industrial or emerging, are transmitted more rapidly to developing country markets. Empirical evidence confirms that the growth of gross cross-border capital flows over the past ten years has bound national equity and bond markets more closely together and that the transmission of disturbances occurs at a greater speed. This was amply demonstrated by events in the aftermath of the Mexican crisis: almost all of the major markets experienced major price adjustments and an increase in volatility as well as in trading volume. Even countries with sound fundamentals, for example, Singapore and Hong Kong, experienced significant, albeit temporary, exchange market turbulence in January, and in some countries this turbulence lasted for the better part of January. However, although the spillover from the Mexican exchange rate crisis was global in nature, and severe in many instances, the changed nature of capital flows to emerging markets implied that, unlike the 1982 debt crisis, the stability of the global banking and payments system in the major international financial centers was not as much at risk as it had been during the 1982 crisis.

The large exposure of the international banking system to developing countries in 1982 meant that Mexico’s moratorium on debt-service payments in September 1982 posed a serious threat to the stability of the system. It became necessary for the major central banks to reassure markets and to press for an orderly resolution of the crisis. The stress was vividly apparent in the international interbank markets.

Today, a large volume of claims on developing countries takes the form of securitized lending by institutional investors, while the international banking system has a relatively small exposure in the form of syndicated loans to emerging market countries, and much of that tends to be in the form of short-term trade credits and project financing. Losses in mutual funds, however large, take time to work their way through the system and are likely to be only a small part of the end-investors’ portfolios, and in any event such widely dispersed losses would not have any systemic implications for the global banking and payment systems.19

Furthermore, the equity and bond markets in the developing countries worked well. Although market liquidity became impaired in some countries, there was no evidence of a freezing up, despite the fact that a number of equity markets were confronted with historically large price declines and large volumes. Many of the major emerging market countries have undertaken significant reforms to strengthen operational capabilities, (e.g., settlement and clearance systems, trading mechanisms) of their capital markets, and these reforms are now paying dividends. Finally, the international support packages for Mexico, assembled during January, forestalled further price declines and thus limited the potential risk of a breakdown in one of the major emerging markets.

Resolution of Debt-Service Problems

The changes in the nature of the financial claims and in the investor base, which have occurred as a consequence of the growing integration of emerging markets into global capital markets, are likely to have important implications for the restructuring and burden sharing in the resolution of sovereign debt-service problems. In this regard, the most relevant change in developing country financing is the shift in the composition of cross-border investments from syndicated bank loans to tradable securities—bonds, equities, and money market instruments. Reflecting this change, outstanding commercial bank loans to developing countries declined as a share of total developing country private debt, from 62 percent in 1980 to 46 percent in 1993. During this same period, the share of securitized debt increased from 8 percent to 32 percent. The ascendancy of international institutional investors—replacing the banking syndicates of earlier years and ranging from conservative pension funds to speculative hedge funds—has become a major factor in this development. Indeed, it would be very difficult to replicate the concerted debt restructuring of 1982 given the growing dispersion of creditors and their differences in attitudes toward risk and liquidity and the absence of a facilitator with influence over these investors, such as the major central banks in 1982. In contrast, the relatively small number of creditor banks made it possible, though by no means easy, to negotiate restructuring agreements during the debt crisis in the 1980s.20

In the absence of a voluntary and comprehensive restructuring agreement, a country with debt-servicing difficulties has two options. First, it can initiate a credible economic adjustment program in return for official financing. This is the approach adopted by the Mexican authorities. The adjustment program is designed to convince private external lenders that the country will be able to generate sufficient future export earnings to service its external obligations. Multilateral financial institutions have traditionally played the role of the lender of last resort in these situations. The benefit of this approach to the country is that the economic program and the associated official funding allow a lengthening of the period of adjustment, while at the same time helping to avoid unnecessary or excessive damage from an overly hasty and disorderly adjustment process. External obligations to private creditors that fall due before full access has been restored are replaced with external obligations to official creditors. Because official funding will necessarily tend to be limited by budgetary and political considerations, in most cases it will still be necessary for the country to undertake an adjustment program that is sufficiently stringent to produce rapidly a current account surplus to signal its creditworthiness and to facilitate its return to private markets.

Second, when a country’s debt-servicing capacity has been sufficiently impaired so that there is little prospect that an economic adjustment program cum official financing could restore financial stability any time soon—even with drastic compression of domestic absorption and a substantial devaluation—then countries might decide to resort to an involuntary restructuring of their external debt. Involuntary restructuring can take the form of a lengthening of maturities and a lowering of interest rates, as well as debt-reduction operations. Such debt restructuring may or may not be accompanied by official financial support. Because there exists no well-defined and accepted legal process that is applicable in such cases, the process of debt resolution by involuntary restructuring is necessarily ad hoc with an uncertain outcome. Bond holders may try to seek redress, on an individual or coordinated basis, by attempting to seize the assets of the borrowers or by threatening to disrupt their trade and payments systems. This threat will be more effective the greater the size and importance of the countries’ export sector. “Free riders” may also undermine any negotiated solutions by trying to attempt to enforce their individual claims. In addition, involuntary debt restructuring will damage creditworthiness and may increase the cost of accessing international capital markets in the future.21 Nevertheless, there may be sound economic and political reasons for an involuntary restructuring supported by an economic calculus that trades off higher future financing costs against the deadweight loss of rapid and deep domestic economic adjustment.

The fact that a major country with debt-service difficulties will in all likelihood face one of these two choices, rather than be able to secure a voluntary restructuring, places a premium on successful macro-economic and macroprudential management.

Managing the Risks from Volatile Capital Flows

The increase in capital flows to emerging markets from 1990 to 1994 was a welcome global financial development. It helped recipient countries finance the current account deficits associated with domestic investment in export-enhancing infrastructure and it provided diversification opportunities to industrial country investors. However, flows that are large relative to GDP carry with them certain risks that, when managed properly, do not seriously diminish the economic advantages of greater integration into global capital markets. One of the risks is that a surge in capital inflows produces an appreciation of the real exchange rate, an inflationary expansion of domestic money and credit, an unsustainable current account deficit, and a more vulnerable banking system.22 Likewise, as the Mexican case demonstrates, a sudden and large outflow can, inter alia, produce an exchange rate crisis, a liquidity problem brought on by the need to refinance a large volume of short-term external debt, and difficulties in the banking system caused by the increase in domestic interest rates. The management of these risks is the key challenge associated with capital inflows.

Macroeconomic Risks

To manage the macroeconomic risks associated with large inflows and sudden outflows, many developing countries have found it desirable to attempt to limit the impact of inflows. The menu of policy responses to capital inflows includes intervention in foreign exchange markets—with or without sterilization of the monetary impact of such intervention—fiscal consolidation, and capital controls. In countries with a flexible exchange rate regime, an appreciation of the nominal exchange rate during periods of heavy capital inflows can insulate the money supply, domestic credit, and the banking system from such inflows. Abrupt movements in the real exchange rate, however, may impose substantial adjustment burdens on the economy, particularly if such an appreciation is reversed as capital exits.23 Even if the real exchange rate appreciation turns out to be temporary, it may have long-lived hysteresis effects on trade and investment.24

Most of the developing economies that received sizable inflows during the early 1990s have tried to resist the nominal appreciation that might accompany such inflows, even within a regime of floating or managed exchange rates (Table 3). The policy most often used for this purpose (Chile, Colombia, Indonesia, Korea, Malaysia, Mexico, the Philippines, Sri Lanka) was sterilized intervention. The advantages of this policy are readily apparent: intervention avoids the nominal appreciation (Table 4), and sterilization avoids the monetary expansion associated with the central bank’s accumulation of foreign exchange. The most straightforward way to sterilize is through open market operations. In effect, the intervening central bank obtains the capital inflow in exchange for an increase in the holdings of domestic assets by foreigners, and it avoids a change in the monetary base by reducing its holdings of domestic assets in the form of public sector obligations to residents. Increases in reserve requirements, which reduce the money multiplier, have also been used to sterilize the monetary expansion associated with foreign exchange market intervention (Chile, Colombia, Costa Rica, Malaysia, Peru, Sri Lanka).

Table 3.Policy Responses to Capital Inflows, 1988–94
CountryFiscal

Restraint
RevaluationIncreased

Exchange

Rate

Variability
Sterilized

Intervention
Controls

on Capital

Inflows
Liberalization

of Capital

Outflows
Trade

Liberalization

Accelerated
Argentina (1991)1No2NoNoNoNoNoNo
Chile (1990)YesYesYesYesYesYesNo
Colombia (1991)NoYesYesYesYesYesYes
Indonesia (1990)NoNoNo3YesYesNoNo
Malaysia (1989)YesNoYesYesYesYesYes
Mexico (1990)No2NoNo3YesNo5YesYes
Philippines (1992)NoNoYes4YesNoYesNo
Sri Lanka (1991)No2NoNo4YesNoNoYes
Thailand (1988)YesNoNoYesNoYesYes
Source: Staff analysis in the background paper “Policy Responses to Previous Surges of Capital Inflows,” pp. 80–94.
Table 4.Reserve Accumulation and Capital Inflows

(Changes in reserves as a percent of the balance in the capital account)1

CountryFirst

Year
Second

Year
Third

Year
Fourth

Year
Fifth

Year
Average
Argentina (1991)8242461246
Chile (1990)77167862211092
Colombia (1991)26313,261943,384
Indonesia (1990)486323–931
Malaysia (1989)92126186712185
Mexico (1990)43341221–159282
Philippines (1992)1391713
Sri Lanka (1991)172937593034
Thailand (1988)753439414747
Sources: International Monetary Fund, International Financial Statistics and World Economic Outlook.

The difficulty with this policy is that sterilized intervention has proved to be neither fully effective nor free of negative side effects. Sterilization through open market sales of government securities or central bank bills prevents the interest rate differential from narrowing, and in some cases increases the domestic-international interest rate spread sufficiently so as to attract more short-term capital. This occurs because the domestic-currency assets that investors want to hold (e.g., bank CDs, equities, bonds) are imperfect substitutes for the short-term central government or central bank paper being supplied through the sterilization operation by the central bank. In addition, sterilization often involves significant quasi-fiscal costs resulting from the difference between the yield on foreign exchange acquired by the central bank and the higher interest rate paid on government or central bank securities. In fact, sterilization policies had to be scaled back in Chile, Colombia, Indonesia, and Malaysia as it became clear that high domestic interest rates were attracting more short-term inflows and were changing the composition of inflows toward the short end.

Fiscal consolidation is another possible response to capital inflows: the deflationary impulse will offset the expansionary impact of the unsterilized portion of foreign exchange intervention, which may put downward pressure on interest rates, particularly if the government borrowing requirement is perceived to be declining. The use of contractionary fiscal policy in response to capital inflows is most clear in Thailand, which over 1988–91 turned a modest fiscal deficit into a surplus of 5 percent of GDP. Chile and Malaysia have also initiated fiscal restraint as a means of dealing with capital inflows.

There are limits, however, on the use of fiscal policy in this context—fiscal policy may be less flexible than other policy instruments. Most capital-importing countries have not explicitly employed fiscal consolidation as a response to inflows, but as part of medium-term adjustment programs. More problematically, fiscal consolidation may also encourage capital inflows by easing concerns about possible future liquidity problems.

It is, therefore, not surprising to find that in addition to altering monetary, fiscal, and exchange rate policies in response to large swings in international capital flows, many countries have employed measures that discourage capital inflows or seek to influence their character. These measures are often generically referred to as “capital controls.” In fact, such measures range from prudential controls on the banking system, to market-based measures, all the way to quantitative controls on inflows and outflows (Box 1). In particular, these measures have included imposing or tightening prudential limits on banks’ offshore borrowing and foreign exchange transactions (Indonesia, Malaysia, and the Philippines), as well as taxing some types of inflows by requiring non-interest-bearing reserves deposits against foreign currency borrowing by firms (Brazil, Chile, and Colombia). For example, in Chile, the measures have taken the form of non-interest-bearing 30 percent reserve deposits placed at the Central Bank for a period of one year on direct foreign currency borrowing by firms.

In some instances, measures have taken the form of quantitative restrictions. For example, Colombia restricts foreigners from investing in the domestic bond market. Malaysia responded to the inflow of speculative short-term bank deposits with the imposition of several quantitative measures. The most successful of these measures was the prohibition on domestic residents selling short-term money-market instruments to foreigners. In this case, abandoning the sterilization of foreign exchange intervention and imposing capital controls appear to have been successful in reducing domestic interest rates and short-term inflows. A number of countries, particularly Asian developing countries, have restrictions on foreign borrowing by domestic companies and some have maintained prudential restrictions on financial institutions, such as restrictions on the open foreign exchange positions of banks.

It is dangerous to draw general conclusions about the consequences of “capital controls” without reference to the nature of such measures and the circumstances under which they were employed. On the one hand, comprehensive and detailed restrictions on capital inflows and outflows can have highly distorting effects, and such restrictions tend to erode over time. As the effectiveness of controls becomes weaker, authorities may be tempted to intensify them, increasing their distortionary effect. On the other hand, measures to discourage excess short-term, foreign currency denominated borrowing by banks, such as increased reserve requirements, can be justified on prudential grounds—bank failures can have significant real effects, as well as fiscal consequences, when deposits are de facto guaranteed. Such measures also tend to have a more permanent effect. Some strong measures, such as taxes on short-term capital flows and bans on the purchase of particular types of securities, may be justified only as temporary measures until domestic financial markets and institutions become well established and resilient, while some other types of prudential measures and reserve requirements can be justified as more permanent features of the regulatory framework.

For example, a review of the Chilean and Malaysian experiences reveals that, in the short run, the volume of inflows was reduced by capital controls during episodes of higher exchange rate volatility and little or no sterilization, in 1991 and 1994, respectively. Furthermore, capital controls were undoubtedly less important than sound fundamentals in explaining the long-run success of several countries cited above in dealing with capital inflows.

In this regard, it should be noted that both Hong Kong and Singapore have managed large capital inflows without recourse to capital controls. Therefore, although capital controls may be helpful at times, they are not the distinguishing feature characterizing countries that have dealt successfully with capital inflows and outflows. Imposing capital controls on outflows during a crisis is interpreted as a measure of despair and hence is counterproductive. Furthermore, market participants tend to view the control of capital outflows as a confiscatory measure, which can be expected to increase future borrowing costs, whereas preannounced taxes on short-term inflows avoid this stigma.25

Box 1.Restrictions on Capital Inflows and Prudential Requirements1

Brazil (1992)

October 1994. A 1 percent tax was imposed on foreign investment in the stock market. It was eliminated on March 10, 1995.

The tax on Brazilian companies issuing bonds overseas was raised from 3 percent to 7 percent of the total. Eliminated on March 10, 1995.

The tax paid by foreigners on fixed interest investments in Brazil was raised from 5 percent to 9 percent, and reduced back to 5 percent on March 10, 1995.

The Central Bank raised limits on the amount of dollars that can be bought on foreign exchange markets.

Chile (1990)

June 1991. Nonrenumerated 20 percent reserve requirement to be deposited at the Central Bank for a period of one year on liabilities in foreign currency for direct borrowing by firms.

The stamp tax of 1.2 percent a year (previously paid on domestic currency credits only) was applied to foreign loans as well. This requirement applied to all credits during their first year, with the exception of trade loans.

May 1992. The reserve requirement on liabilities in foreign currency for direct borrowing by firms was raised to 30 percent. Hence, all foreign currency liabilities have a common reserve requirement.

Colombia (1991)

June 1991. A 3 percent withholding tax was imposed on foreign exchange receipts from personal services rendered abroad and other transfers, which could be claimed as credit against income tax liability.

February 1992. Banco de la República increased its commission on its cash purchases of foreign exchange from 1.5 percent to 5 percent.

June 1992. Regulation of the entry of foreign currency as payment for services.

September 1993. A nonrenumerated 47 percent reserve requirement to be deposited at the Banco de la República on liabilities in foreign currency for direct borrowing by firms. The reserve requirement is to be maintained for the duration of the loan and applies to all loans with a maturity of 18 months or less, except for trade credit. August 1994. Nonrenumerated reserve requirement to be deposited at the Banco de la República on liabilities in foreign currency for direct borrowing by firms. The reserve requirement is to be maintained for the duration of the loan and applies to all loans with a maturity of five years or less, except for trade credit with a maturity of four months or less. The percentage of the requirement declines as the maturity lengthens; from 140 percent for funds that are 30 days or less to 42.8 percent for five-year funds.

Indonesia (1990)

March 1991. Bank Indonesia adopted measures to discourage offshore borrowing. It began to scale down its swap operations by reducing individual banks’ limits from 25 percent to 20 percent of capital. The three-month swap premium was raised by 5 percent.

October 1991. All state-related offshore commercial borrowing was made subject to prior approval by the government and annual ceilings were set for new commitments over the next five years.

November 1991. Further measures were taken to discourage offshore borrowing. The limits on banks’ net open market foreign exchange positions were tightened by placing a separate limit on off-balance-sheet positions.

Bank Indonesia also announced that future swap operations (except for “investment swaps” with maturities of more than two years) would be undertaken only at the initiative of Bank Indonesia. September 1994. Bank Indonesia increased the maximum net open position from 20 percent of capital to 25 percent, on an average weekly basis. Individual currency limits were no longer applied.

Malaysia (1989)

June 1, 1992. Limits on non-trade-related swap transactions were imposed on commercial banks.

January 17, 1994–August 1994. Banks were subject to a ceiling on their non-trade- or non-investment-related external liabilities.

January 24, 1994–August 1994. Residents were prohibited from selling short-term monetary instruments to nonresidents.

February 2, 1994–August 1994. Commercial banks were required to place with Bank Negara the ringgit funds of foreign banking institutions (Vostro accounts) held in non-interest-bearing accounts. However, in the January-May period, these accounts were considered part of the eligible liabilities base for the calculation of required reserves, resulting in a negative effective interest rate in Vostro balances.

February 23,1994–August 1994. Commercial banks were not allowed to undertake non-trade-related swap and outright forward transactions on the bid side with foreign customers.

Mexico (1990)

April 1992. A regulation that limited foreign currency liabilities of commercial banks to 10 percent of their total loan portfolio was passed. Banks had to place 15 percent of these liabilities in highly liquid instruments.

Philippines (1992)

July 1994. Bangko Sentral ng Pilipinas began discouraging forward cover arrangements with nonresident financial institutions. The Central Bank also required prior approval for all forward foreign exchange transactions.

November 1994. Banks’ minimum oversold foreign exchange position was reduced from 15 percent of unimpaired capital to 5 percent.

Approvals for foreign loans were granted only to cover foreign exchange costs, with the exception of exporters and the public sector.

Liabilities of banks to their head offices were counted as unimpaired capital only if converted into pesos.

Thailand (1988)

May 1980. Banks and finance companies’ net foreign exchange positions cannot exceed 20 percent of capital.

Residents were not allowed to hold foreign currency deposits except only for trade-related purposes.

April 1991. Banks and finance companies’ net foreign exchange positions limit raised to 25 percent of capital.

1 The year next to the country name denotes the first year of the surge in inflows.Sources: Alfiler (1994); Banco Central de Chile, Evolución de la Economia (1991 and 1992); Banco de la República, Colombia (1993 and 1994); Banco de México (1992); Bank Indonesia, Annual Report, various issues; Bank Negara Malaysia, Annual Report, various issues; and Conselho Monétario Nacional, Brazil (1994 and 1995).

In sum, shifting international capital flows can represent large shocks to small open economies, occasionally amounting to more than 10 percent of GDP in one year. The policy response to large and volatile capital flows may require multiple instruments, including measures that seek to discourage capital inflows or change their character, and coordination of policies, monetary, fiscal, and exchange rate, to ensure that recipient countries can derive benefits without incurring much of the costs.

Financial Sector Risks

Financial systems in many emerging market countries have only recently been liberalized or privatized, and the ability of banks to manage financial risk is still relatively limited. Resilient and liquid capital markets that could absorb shocks are frequently not fully developed. The accounting and legal infra structure may not be sufficiently developed to monitor and enforce loan contracts effectively. In many developing countries, credit- and market-risk management in the banking system is still in the early stages of development. At the same time, it is likely that the bank supervisory and regulatory agency has not yet grown into an independent, highly competent agency. The legal framework for effective banking supervision also may not be well established. In some countries, supervisors are hampered by a lack of political independence and an inability to close delinquent institutions or to implement prompt corrective actions. Finally, market discipline over bank management may be weakened by the fact that banks are frequently benefiting from extensive implicit solvency guarantees from the public sector; that is, the public sector is more likely to recapitalize a bank than to allow losses to depositors.

In this environment, capital inflows generate a number of risks in the banking sectors of recipient countries. Foreign exchange market intervention that is not fully sterilized exposes the banking system to the additional credit risk generated by the expansion of bank balance sheets.26 Experience suggests that a rapid expansion in banks’ loan books can easily be accompanied by slippage in credit quality, even with effective regulatory and supervisory control over banking systems. Fast growth in credit tends to be concentrated in only a few sectors and a cyclical reversal will frequently lead to a deterioration of the credit quality of such sectors. In Mexico, the ratio of past due loans to total loans increased from 4.6 percent at the end of 1991 to 8.5 percent in mid-1994. The ratio of past due loans to capital increased sharply, from 46 percent to 97 percent over the same interval. It should be noted that periods of rapid expansion in bank lending also have led to problems in some Group of Ten countries’ banking systems.27 For example, extensive lending to real estate has on several occasions resulted in major banking problems in a number of well-regulated industrial countries.28

In addition to the increased credit risk, banks in emerging market countries frequently assume market risks—exchange rate, interest rate, equity price risks—that cannot be fully hedged. For example, there are frequent instances where banks, as major foreign borrowers, carry a significant foreign exchange exposure,29 and where banks are exposed to volatility in equity prices by holding sizable equity portfolios.30

If a banking system practices adequate risk management and is financially resilient, and if the supervisory and regulatory agencies are well equipped to enforce prudential requirements, then the internationally active banking system may not be adversely affected by its enlarged intermediary role. This can be seen from the experiences in Hong Kong and Singapore, where international-quality supervisory and regulatory agencies have been established and where banking systems can cope with large capital inflows and outflows, as well as with large swings in asset prices. Recent history, however, provides ample evidence that these conditions are not always fully met, and the need to ensure that banking systems can safely intermediate capital flows remains an important policy challenge.31

Debt Management and Liquidity Risk

The recent events in Mexico illustrate how reliance on short-term debt finance indexed on foreign currency can make a country vulnerable to liquidity crises. As mentioned above, Mexican Tesobono liabilities had expanded rapidly since April 1994. By the end of November, they totaled $24 billion (MexN$83 billion, or about 6 percent of 1994 GDP) and comprised 50 percent of Mexico’s domestic government debt. The depreciation of the peso in December and January meant that the peso value of these dollar-indexed liabilities skyrocketed, reaching MexN$149 billion, or 66 percent of total domestic debt. Investors’ concern that Mexico might not be able to service its Tesobono obligations made them reluctant to roll over these bonds as they fell due in the early part of 1995, forcing significant increases in yields, as well as the outright cancellation of some Tesobono refinancing auctions. This in turn meant that scarce foreign exchange reserves had to be used to redeem the issues that were falling due. Domestic rates had to be raised to prevent a further capital outflow to halt the drain of reserves. The knowledge that of the $28.7 billion in Tesobono debt outstanding at the end of December $9.9 billion was scheduled to mature in the first quarter of 1995 put significant pressure on interest rates and on the exchange rate. The lesson here is that a longer maturity structure could have provided more breathing space for an orderly resolution of the crisis after the decision to float the peso in December. The exchange rate crisis may not have turned into a debt-service crisis had the maturity of the foreign currency indexed debt been longer.

The need to refinance a substantial volume of short-term debt at a turbulent time in exchange markets creates significant additional market pressure. Investors’ doubts about the ability of the authorities to service their external debt is quickly translated into higher debt-servicing costs for the fraction of debt that is being rolled over during the turbulent period, and the larger the share of short-term debt, the more debt will have to be rolled over during that time, and the larger will be the increase in the debt-service burden. The increase in debt-servicing costs itself will also contribute to doubts about the countries ability to service debt. At some point, further increases in yields will lead investors to avoid the market altogether, and refinancing will become impossible.

The events in Mexico and the rest of the emerging markets during 1994 demonstrated that the existing market mechanisms can absorb significant losses owing to declines in the value of equity and longer-term bonds. Major additional challenges arise, however, when, during periods of extreme turbulence—such as in the wake of a devaluation—a large volume of short-term debt must be refinanced. In the case of Mexico, the postdevaluation financial stress would have been easier to resolve without the necessity to refinance a large volume—relative to the existing stock of foreign exchange reserves—of maturing Tesobonos.

The growing access of developing countries to international capital markets has been chronicled in past capital markets reports. Further details of capital flows to developing countries are provided in the background paper “Capital Flows to Developing Countries,” pp. 33–52.

In the United States, for example, the Federal Funds rate declined from 9.8 percent in April 1989 to 2.9 percent in November 1992, as the U.S. economy entered a period of sluggish growth andthen recession.

The assets under management by the most important institutional investors (pension funds, insurance companies, mutual funds) in the major industrial countries stood at about $13 trillion in 1993, with U.S. institutional investors accounting for more than two-thirds of this total. The fastest growing segment has been the mutual fund industry (including hedge funds), which managed about $3 trillion of private wealth in the five largest industrial countries in 1993.

The growth of institutional investors is discussed more fully in the background paper “Increasing Importance of Institutional Investors,” pp. 165–74.

Total international bond issues declined from $128 billion in the first quarter of 1994 to $87 billion in the second quarter, so the developing countries’ share in total new issues declined from 12 percent to 8 percent during this period.

For further details on the evolution of the financial situation in Mexico, see the background paper “Evolution of the Mexican Peso Crisis,” pp. 53–69. See also the background paper “Mexican Foreign Exchange Market Crises from the Perspective of the Speculative Attack Literature,” pp. 70–79.

By comparison, money market rates in the United Kingdom fell after the devaluation of sterling during the European Exchange Rate Mechanism (ERM) crisis in 1992.

In December 1994, nonresident investors in Indonesia made net sales of equity for the first time in three years.

A change in market expectations, for example, regarding the credibility of future fiscal programs, may force the authorities to adopt a different set of policies. Depending on the nature of market expectations, several macroeconomic outcomes may be possible—a phenomenon of multiple equilibriums. In such a case, policy designed to influence expectations can be used to guide the economy to a particular (favorable) equilibrium.

For details see International Monetary Fund (1993a).

These data should be interpreted with caution as the breakdown by residents versus nonresidents is subject to uncertainty.

Most of the world’s major currencies are traded in over-the-counter forward foreign exchange markets. In the absence of such a forward market, investors have to liquidate their long positions in domestic securities and sell the proceeds in the spot foreign exchange market to avoid losses due to devaluation. On April 26, 1995, the Chicago Mercantile Exchange opened trading in a futures contract in Mexican pesos. It is still too early to tell whether this effort will succeed in providing a liquid market in which to hedge peso exposures.

For further details, see the background paper “Financial Sector Constraints on Crisis Management,” pp. 120–27.

Banks with capital below 8 percent of risk-weighted assets can borrow funds from the deposit guarantee fund, the Fondo Bancario de Protección al Ahorro (Fobaproa), by issuing five-year convertible subordinated debt with explicit conversion rules. The funds so obtained are held in blocked accounts at the Banco de Mexico to neutralize their effect on the monetary base. As of the end of March 1995, six banks had obtained assistance from Fobaproa equal to about 15 percent of total end-of-1994 commercial bank assets.

Under this new plan, banks would restructure some of their nonperforming loans into new instruments based on units of investment (UDIs) and transfer these new instruments to special off-balance-sheet trusts that would purchase, and then administer, the newly created UDIs. The trusts would pay for them by using the proceeds from sales of long-term UDI-indexed bonds to the Federal Government. The principal of UDI instruments would be indexed to the rate of inflation, while monthly payments would be the real interest rate applied to the indexed principal.

It is also possible to recapitalize a banking system that is still solvent by borrowing in private capital markets. Argentina borrowed $1 billion from foreign, and $1 billion from domestic, private capital markets.

Foreign exchange reserves of the Hong Kong Exchange Fund are more than five times the amount of currency in circulation, which provides the HKMA with greater latitude in providing liquidity assistance to banks.

Nevertheless, market participants told of a significant volume, estimated in excess of $20 billion of notional value, of options-like contracts with payoffs related to the future value of the peso that had been written by U.S. investment houses. These contracts are dollar bets on the peso/dollar exchange rate and are cash-settled in dollars without any immediate impact on the peso/dollar exchange rate, and again, the losses on these contracts are fairly widely dispersed.

The 1982 debt crisis was resolved through a concerted restructuring of commercial debt, and new external financing provided from the official sector and from commercial bank creditors was used to facilitate the economic adjustment programs. Most countries with debt-servicing difficulties in the early 1980s regained full access to international capital markets within eight years after the onset of the crisis.

Recall that countries that restructured their debt in the 1980s have not yet received investment grade credit ratings.

The policy problem of how to deal with the exchange rate impact of capital inflows is akin to the so-called Dutch disease policy problem of preventing an erosion of the manufacturing base as a result of the discovery of natural resources.

In practice, most developing Western Hemisphere countries have witnessed marked appreciation of the real exchange rate during periods of capital inflows, while for most Asian countries real exchange rates have remained largely unchanged.

A detailed discussion and analysis of monetary and fiscal policy responses to capital inflows is contained in the background paper “Policy Responses to Previous Surges of Capital Inflows,” pp. 80–94.

For further discussion of capital controls, see the background paper “Controls on Capital Flows: Experience with Quantitative Measures and Capital Flow Taxation,” pp. 95–108.

Examples of rapid credit expansion during periods of strong capital inflows include Mexico, where commercial bank loans to the private sector increased from 27 percent of GDP in 1991 to 47 percent in 1994. The same ratio increased in Indonesia from 25 percent in 1988 to 53 percent in 1994, and in Thailand from 51 percent to 89 percent over 1988–94.

Group of Ten countries consists of the United States, Japan, Germany, France, Italy, the United Kingdom, Canada, the Netherlands, Sweden, Belgium, and Switzerland.

See the discussion below on the continuing resolution of banking problems in several industrial countries, pp. 21–25; and in previous capital markets reports.

The gross foreign liabilities of commercial banks have expanded rapidly in many capital importing countries. In Malaysia, foreign liabilities as a percentage of GDP increased from 7 percent to 19 percent between 1990 and 1993. In Indonesia, banks’ external liabilities increased from 2 percent of GDP in 1989 to 6 percent the following year. The same ratio increased from 8 percent in 1991 to 13 percent in 1994 in Mexico, and in Thailand it increased from 4 percent in 1988 to 20 percent in 1994.

The pattern of inflows into the emerging securities markets has tended to be associated with increased volatility of equity prices. Equity markets in developing countries tend to lack sufficient liquidity to absorb and release such sizable flows of capital. For example, foreign investors’ net purchases of Mexican shares declined from the high levels of $1.8 billion in January and $1.4 billion in February 1994, to purchases of $292 million in March and then net sales of $321 million in April. Over that period, equity prices in dollar terms rose by 13 percent between December 31, 1993 and February 8, 1994, and then declined by 24 percent by the end of April 1994.

For further details, see the background paper “Role of Domestic Financial Institutions in Intermediating Foreign Capital Inflows,” pp. 109–19.

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