- International Monetary Fund
- Published Date:
- January 1995
Turbulence in Emerging Markets
The recent turbulence in emerging financial and foreign exchange markets has to be seen in the context of the broader trends that have been shaping developments in international financial markets during the past ten years. Principal among these are the growth of securitized global capital markets and the increasing dominance of performance-oriented institutional investors in these markets. The ongoing international diversification of institutional portfolios, the return of flight capital, and the cyclical developments in industrial countries combined to generate a significant volume of capital flows into emerging markets in the developing world. In keeping with developments in global markets, these flows have increasingly been in the form of purchases of tradable bonds, equities, and money market instruments—securities that can readily be sold when sentiments change. These developments have brought with them a number of important implications—some of which surfaced during the recent crisis in Mexico—for the macroeconomic and financial sector policies of the emerging market countries.
First, the liberalization of cross-border financial transactions of emerging market countries, along with the modernization and gradual internationalization of domestic banking systems in many of these countries, has meant that domestic investors can now far more easily sell domestic assets to acquire foreign assets, and vice versa, than was the case only a few years ago. Indeed, the pressure on Mexico’s foreign exchange reserves in the run-up to the devaluation came primarily from residents rather than foreign investors selling their holding of Mexican securities. The volume of financial wealth that can flee a developing country is now sufficiently large that it can overwhelm any attempt to maintain an exchange rate incompatible with fundamentals. Thus the possibility for investors—domestic and foreign—to exert discipline over policy has strengthened significantly. The room for policy maneuvers not in line with fundamentals has shrunk, and the challenge is to adjust policies before investors force a more costly resolution.
Second, the increasing integration of developing countries into global capital markets has meant that emerging markets can expect to be more vulnerable to external developments, such as cyclical swings in industrial countries and disturbances in any of the major markets. The experiences with the 1987 equity market crash and now with the Mexican crisis demonstrate that disturbances in one market will spread across regional and global markets. Most countries were tested in the wake of Mexico’s devaluation, particularly in Latin America, but even financially strong markets with sound fundamentals, such as Hong Kong, Singapore, Chile, and Malaysia, faced pressure. The massive international financial support package for Mexico, put together in January 1995, prevented further erosion of confidence and forestalled stronger contagion. Recent events suggest that once the panic trading subsided, markets discriminated, albeit imperfectly, among countries according to the quality of their economic fundamentals.
Third, the resolution of sovereign debt-servicing difficulties has become more complicated with the changes in instruments and participants in international markets. In particular, the shift away from syndicated bank lending toward securitized capital flows has made voluntary restructuring of external debt more difficult to complete now than during the negotiations in the early 1980s. An international investor base with a diversity of investors with different risk-reward preferences and different legal arrangements will make it difficult to secure agreement among creditors. Furthermore, the threat of legal action from external claimants has become more credible with the expansion of international trade and payments in recent years. It is likely, therefore, that if a major emerging market country is experiencing debt-servicing difficulties, it will be forced to seek official funding to allow it to continue servicing its external debts in full, rather than force creditors to the table to renegotiate its obligations. The recent Mexican experience is an example of this approach.
The limited scope to achieve a negotiated debt restructuring with private creditors adds urgency to the need for emerging market countries with significant foreign currency debt to manage the macroeconomic and financial risks that are part and parcel of becoming integrated into global capital markets. If properly managed, such risks need not diminish the substantial benefits that come with increased access to international capital in any significant way.
Macroeconomic policy in emerging market countries will have to be used to mitigate the adverse effects of capital inflows on the real exchange rate and on inflation. First, intervention can be employed to smooth excessively volatile real exchange rates. Intervention can be sterilized to limit the impact on domestic credit. Full and prolonged sterilization, however, may distort domestic interest rates sufficiently to invite more capital inflows, create a quasi-fiscal deficit, and, worse yet, distort the composition of capital inflows toward short-term assets. In this respect, tightening fiscal policy can offset the expansionary effect of the unsterilized part of capital inflows. Finally, during times of surges in inflows a country might consider measures to influence the level and characteristics of capital inflows, such as taxes on short-term bank deposits and other financial assets, reserve requirements against foreign borrowing, prudential limits on banks’ offshore borrowing, and limits on consumption credit. In this regard, the experiences of Chile, Colombia, and Malaysia have been revealing. It should be noted, however, that comprehensive restrictions on capital flows can be highly distorting and their effectiveness tends to erode over time. Capital controls on outflows are generally viewed as confiscatory taxes and, if applied during periods of exchange market stress, may aggravate a crisis of confidence. In countries facing large and potentially unsustainable capital flows, a mix of intervention, sterilization, fiscal consolidation, and some direct measures to discourage short-term portfolio flows or to influence their composition may be appropriate. The mix of policies will, naturally, vary from country to country.
Prudential policies have to be geared to containing the increased risks coming from greater integration into global markets. An expansion of bank credit in emerging markets due to partial sterilization has in some instances led to a decline in credit quality, particularly in banking systems that have recently been liberalized. Financial liberalization combined with capital inflows and without strengthened supervision and increased monitoring produce fertile ground for a future banking crisis. The authorities will need to make sure that there are sufficient prudential requirements to limit the interest rate, exchange rate, and equity price exposures of banking systems in recipient countries. In addition, the domestic banking system will need to be strong enough to absorb the interest rate increases that might be necessary to defend the exchange rate. In this regard, the experiences of Mexico and Argentina illustrate vividly how a fragile banking system can become a constraint on the ability of the authorities to raise domestic rates in response to exchange market pressure.
Debt Management and Liquidity Risk
Mexico’s experience with short-term debt demonstrates that emerging markets will need to manage the maturity structure of their debt in such a way as to minimize the risks of a liquidity crisis. The longer is the maturity of debt, the less likely it will be that major refinancing operations will coincide with periods of market turbulence, and the smaller will be the volume of debt that will need to be refinanced during a turbulent period. The need to refinance a significant volume of Tesobonos greatly contributed to the financial stress in the wake of the devaluation of the Mexican peso. With this in mind, emerging market countries should favor direct foreign investment over long-term portfolio investment, and long-term portfolio investment over short-term debt. If short-term exposures are necessary, then the rollover risk will need to be reduced through sufficient reserves and access to liquidity facilities, either official or private.
Supervisory and Regulatory Issues
The supervision and regulation of international capital markets continue to be challenged by the possible spillovers from the string of major failures and losses in the expanding derivatives industry. However, the efforts undertaken by the key industrial countries in strengthening the regulatory and supervisory infrastructure in derivative markets have been largely successful. A significant abatement in the risk inherent in the large intraday credit positions in wholesale payment systems has been achieved with the ongoing shift toward real-time gross settlement. A proposal for fundamental redesign of the capital requirement regime for the off-balance-sheet and trading activities of international banks, the key players in international markets, has been put out for comments by the Basle Committee on Banking Supervision and is likely to be adopted by year-end. The new approach marks a radical departure from established procedures. It will create incentives for international banks to refine their own risk-management models, since the ability of these models to reduce overall risk will determine their regulatory capital requirements. The supervisors’ role would be to validate the process of risk management in banking institutions, rather than to determine whether the bank’s trading book satisfies certain regulatory ratios. It is likely that the new system of regulatory capital requirements will have a profound effect on how financial institutions manage risk, and, indeed, on what activities they will undertake.
Serious challenges remain, principally in the area of international cooperation and coordination of regulatory and supervisory, legal, accounting, and disclosure rules. Although capital markets are becoming increasingly global, the rules under which these markets and institutions operate remain largely national. The failure of Barings illustrates this point. If information about Barings’ activities had passed freely among its five supervisors—the Bank of England, the Securities and Futures Association, the Monetary Authority of Singapore, and the futures exchanges in Osaka and Singapore—then it would have been possible to obtain a consolidated picture of Barings’ exposure and the failure may well not have occurred.
A further example is given by the differences in approach of the Basle Committee and the EU Commission in the important area of capital requirements for financial institutions. The EU is now proceeding with the implementation of its own capital adequacy rules for credit institutions, while the Basle Committee is proposing a new and significantly different set of rules for international banks for adoption by year-end. It is likely that there will be two different capital regimes in effect for some time, one for European banks and one for international banks. Similarly, the coordination among securities regulators in the area of information sharing and the harmonizing of disclosure standards are progressing only slowly.
One key lesson emerges from the recent experience with resolving banking difficulties in several industrial countries. In the event that significant losses are incurred, the supervisory authority should act decisively to limit the activities of institutions that have an impaired capital base. It is essential that capital-impaired institutions not be allowed to operate without very close supervision, particularly if the government explicitly or implicitly insures deposits, lest they continue to put depositors’ money at risk. The danger is that the incentives facing insolvent or nearly insolvent institutions are radically different—such as collecting deposits with high interest rates and investing in high-risk projects—from those facing institutions that meet capital standards. The recent case of two failed credit cooperatives in Japan illustrates this lesson.
Although a policy of regulatory forbearance, waiting for a gradual write-down of losses, may have fewer direct costs, it has potentially greater indirect costs. The drawn-out resolution of credit problems at the housing finance companies in Japan, and the case of state-owned Crédit Lyonnais in France, illustrates the difficulties that can arise with a forbearance policy. The weakness of the financial system, burdened by nonperforming loans, may become a drag on the economy, thereby prolonging the problem further. Moreover, the losses may not be recovered with forbearance, but may snowball instead. Once the institution’s balance sheet is clearly beyond repair, a burden-sharing scheme—among management, depositors, other creditors, shareholders, and taxpayers—should be put in place quickly, while paying due attention to containment of a systemic disturbance and moral hazard.
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