Abstract

Having successfully weathered several bouts of speculative pressures, the Bank of Thailand on July 2, 1997 let the baht float. Its immediate depreciation triggered, in relatively quick succession, the depreciations of several of the regional currencies—the Philippine peso, the Malaysian ringgit, and the Indonesian rupiah. Early characterizations of this first round of currency devaluations were as exchange rate “corrections” that were expected to lead to manageable external adjustment. At that point, no one predicted the large depreciations that would fundamentally call into question the underlying assumptions on which past cross-border borrowing, lending, and investment decisions had been based, and provoke a massive retrenchment of capital flows. Outside the region, the rest of the emerging markets remained relatively insulated from the events in Southeast Asia until late October 1997. Then, what began as a localized disturbance in Hong Kong SAR’s foreign exchange and equity markets was transmitted rapidly and forcefully across the emerging markets, bringing strong pressures to bear, most notably on Brazil and Argentina in Latin America, on Russia, and in Asia on Korea. It resulted in an across-the-board external liquidity squeeze for emerging market borrowers and a deepening of pressures on the already affected countries in Asia.

Having successfully weathered several bouts of speculative pressures, the Bank of Thailand on July 2, 1997 let the baht float. Its immediate depreciation triggered, in relatively quick succession, the depreciations of several of the regional currencies—the Philippine peso, the Malaysian ringgit, and the Indonesian rupiah. Early characterizations of this first round of currency devaluations were as exchange rate “corrections” that were expected to lead to manageable external adjustment. At that point, no one predicted the large depreciations that would fundamentally call into question the underlying assumptions on which past cross-border borrowing, lending, and investment decisions had been based, and provoke a massive retrenchment of capital flows. Outside the region, the rest of the emerging markets remained relatively insulated from the events in Southeast Asia until late October 1997. Then, what began as a localized disturbance in Hong Kong SAR’s foreign exchange and equity markets was transmitted rapidly and forcefully across the emerging markets, bringing strong pressures to bear, most notably on Brazil and Argentina in Latin America, on Russia, and in Asia on Korea. It resulted in an across-the-board external liquidity squeeze for emerging market borrowers and a deepening of pressures on the already affected countries in Asia.

These events raise a host of questions regarding the dynamics of the crisis and its spillover across the emerging markets. What caused the abrupt and massive swing in flows from Southeast Asia? Which flows—foreign direct investment, portfolio, or bank lending—turned around? Were there factors that exacerbated price pressures to create the eventual enormous depreciations? What were the channels for the rapid transmission of pressures across the emerging markets in October 1997 following the turbulence in Hong Kong SAR? Was it simply broad-based investor panic or did the form and structure of investment linkages play a role? How did the actions of the credit rating agencies affect market dynamics? And, finally, what was the role of different investor groups—the international macro hedge funds that some believe took speculative short positions against the Southeast Asian currencies; the international commercial and investment banks that were large investors of funds in the region; international mutual funds that had sizable equity investments; multinational corporations with substantial direct investments; domestic banks and corporates that had built up large foreign currency liabilities; and domestic retail investors?

Complete answers to these questions encompass several dimensions—the macroeconomic context, policy responses, and the capital market dynamics and spillover of the crisis. The macroeconomic context and outlook have been addressed in successive rounds of the World Economic Outlook1 while policy issues have been considered elsewhere. This chapter examines the Asian crisis from the perspective of international capital markets and is divided into three broad parts. The first discusses the behavior of the volume, composition, and geographical distribution of capital flows to the emerging markets; the pricing, volatility, and liquidity of emerging debt, equity, loan, and foreign exchange markets; and how these were affected by the Asian crisis. It establishes that the largest swing in capital flows to the affected countries in Asia was in bank lending flows, that capital inflows were generally sustained until the very brink of crisis, and that international banks’ retrenchment from the region took the form primarily of cuts in, and withdrawals of, interbank credit lines, and occurred at a very late stage. There was also considerable unrecorded capital flight from Asia, with anecdotal evidence suggesting it originated with domestic residents, both corporate and household entities.

The second part reviews developments in emerging market banking systems. The boom in capital inflows to Asia in the years leading up to the crisis was intermediated in large part by domestic banks, fueling rapid credit growth. When combined with the regulatory failure to strike a balance between the guarantees necessary for financial stability and bank supervision and regulation required to minimize excessive risk-taking, high loan leverage ratios relative to output rendered financial systems extremely vulnerable to liquidity, market, and credit risks. The depreciations of the region’s currencies and declines in asset values precipitated a reassessment of the creditworthiness of local banks, which in turn led to external and domestic liquidity pressures, and a further deterioration in banks’ asset quality. Several financial institutions in Thailand, Indonesia, and Korea were closed down, suspended or intervened in, and lending activity came to a standstill with severe consequences for real economic activity. The Asian crisis had a severe impact on some Latin American countries, but banking systems strengthened since the Mexican financial crisis—with revamped regulatory frameworks and an increased foreign presence—were able to weather the contagion effects relatively well.

The third part examines the market dynamics and spillover of the crisis, based in large part on extensive discussions held with a wide variety of market participants. The discussion highlights key characteristics of the boom period of capital inflows to Asia that preceded the crisis, including the activities of international commercial and investment banks, the due diligence carried out by these institutions with regard to local counterparties, investment strategies—in particular the “carry trade,” and the rapid growth of regional fixed-income and foreign exchange markets. This is followed by a review of the developments that gradually revealed the extent and nature of financial sector problems in Thailand, prompting capital outflows and bouts of pressure on the currency. The Bank of Thailand’s defense of the baht on the forward foreign exchange market, which provided credit to those wishing to take positions against the currency, provided attractive one-way bets, resulting in a rapid increase in the bank’s forward liabilities. Devaluation, the imposition of capital controls, or both, thus became inevitable. Contagion to other regional currencies, and several factors that acted to exacerbate the market response—the unwinding or deleveraging of carry trades by both domestic and foreign entities, the rush by domestic entities to hedge both their on-balance-sheet external debt exposures and their extensive off-balance-sheet swaps and options positions, and the thinness of foreign exchange markets—are discussed.

The transmission of the pressures on the Hong Kong dollar’s peg to the U.S. dollar and the turbulence in Hong Kong SAR’s equity market in late October 1997 across the emerging markets, in particular to Brazil and Korea, revealed a complex set of cross-border investment linkages. Domestic entities in both countries had taken leveraged positions through offshore intermediaries in emerging market securities. Margin calls on these positions triggered in the wake of Hong Kong SAR and the coincident downgrading of Asian credits by the major rating agencies put pressures on the Brazilian real and the Korean won, and the resulting liquidity squeeze prompted deleveraging by these entities exacerbating price pressures in emerging debt markets.

Part One: Emerging Markets Financing

Capital Flows, Reserves, and Foreign Exchange Markets

Capital Flows in the Balance of Payments

The Asian crisis marked 1997 as the first year in the 1990s of a significant reduction in net private capital flows to the emerging markets (Table 2.1 and Figure 2.1). The volume of such financing had proved remarkably resilient in the past. The Mexican peso crisis, which had previously represented the most serious disruption to emerging markets’ international financing in the 1990s, resulted in only a modest reduction of net private capital flows to emerging markets—by less than 3 percent—during 1994, as international investors quickly reallocated portfolios away from Latin America toward Asia and Eastern Europe. Moreover, overall flows rebounded quickly, growing by one-fifth in 1995. In the Asian crisis, there was a shift in the opposite direction, but not by enough to offset the decline of net private capital flows to Asia, the largest recipient of flows during the preceding three years, which shrank by almost $100 billion in 1997, implying a net decline for all emerging markets of $67 billion. The decline in total (private and official) flows was a more modest 12 percent, from $231 billion to $203 billion, reflecting the bilateral and multilateral official assistance extended to the Asian crisis countries. The sizable net official inflows to Asia offset outflows from Latin America, as Mexico, for the second year in a row, continued to make repayments of the official assistance extended in the aftermath of the Mexican peso crisis.

Table 2.1.

Private Capital Flows to Emerging Markets

(In billions of U.S. dollars)

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Sources: International Monetary Fund, International Financial Statistics and World Economic Outlook database.

Net foreign direct investment plus net portfolio investment plus net other investment.

Indonesia, Korea, Malaysia, the Philippines, and Thailand.

Figure 2.1.
Figure 2.1.

Net Private Capital Flows to Emerging Markets

(In billions of U.S. dollars)

Sources: International Monetary Fund, World Economic Outlook; and IMF staff estimates.1 Private plus official.2Total net private capital flows equal net foreign direct investment plus net portfolio investment plus net other investment.

A key characteristic of the surge in private capital inflows to the emerging markets during the 1990s, and one that has imparted a considerable resilience to total private flows, has been the steady growth of FDI flows, which expanded during 1991–96 at an average annual rate of about 40 percent. Such flows, which have accounted for the largest proportion of flows since 1995, continued to grow robustly during 1997, increasing by 20 percent. Unlike FDI flows, portfolio flows to the emerging markets have been volatile. From a peak of $104 billion in 1993, for example, they fell to less than one-fourth of this level in 1995 in the aftermath of the Mexican peso crisis, then more than doubled to $50 billion in 1996. During 1997 portfolio flows shrank by 14 percent to $43 billion. “Other” flows, which largely consisted of bank lending, were negative—that is, there were net outflows of $7.3 billion during 1997. This reflected a massive turnaround—from net bank lending inflows of over $70 billion in 1995 and in 1996.

The precipitous decline of almost $100 billion in net private capital flows to Asia in 1997 reflected a $75 billion turnaround in bank lending flows and $22 billion in portfolio flows, while FDI flows to the region remained stable. Most of the decline in total flows to the Asian region reflected declines in flows to the affected Asian countries—Thailand, Malaysia, the Philippines, Indonesia, and Korea—where net inflows of $73 billion in 1996 were replaced by net outflows of $11 billion in 1997. Most of the turnaround to these countries in turn arose from a $73 billion turnaround in net bank lending flows (Box 2.1), with the sharpest outflows recorded from Thailand and Korea of some $18 billion each. Portfolio flows to the affected countries fell but remained positive, while FDI flows remained relatively resilient (Box 2.2). It appears, however, that the extent of portfolio (and total) outflows from the Asian emerging markets during 1997 were understated by official statistics because of the systematic increase in errors and omissions in the balance of payments (see Box 2.3). Increased, and largely unrecorded, capital flight from the affected countries is consistent with plentiful anecdotal evidence of the booming private banking business in the regional financial centers of Hong Kong SAR and Singapore catering to clients from these countries.

Total private capital flows to Latin America reached a new peak of $91 billion in 1997. This reflected strong growth in both FDI (39 percent) and portfolio investment (33 percent), while bank lending flows—as was the case for Asia—declined by two-thirds. Private capital flows to the transition economies rose robustly (62 percent) to $35 billion, resulting from strong increases in all categories of inflows. The largest recipient of flows within the region was Russia, where flows increased fourfold to $10.5 billion, their highest level in the 1990s. Private capital flows to the Middle East and Europe rose modestly to $25 billion, reflecting increases in bank lending and FDI flows while portfolio flows declined. Private capital flows to Africa, which had fallen sharply in 1996, rebounded in 1997, almost doubling to $8.9 billion, with South Africa accounting for two-thirds of flows to the region.

Reserve Accumulation

Aggregate reserves of emerging market countries continued to grow during 1997 (see Table 2.1). Specifically, of the $203 billion total net capital flows to the emerging markets, $52 billion—26 percent—was accumulated as reserves, while the remainder was used to finance current account deficits. This compares with an average rate of about half during the 1990s, when $571 billion of the $1.1 trillion in total net flows to emerging markets was accumulated as reserves. For the first time since 1993, Asian central banks were not the largest amassers of reserves, though international reserves of the region as a whole rose by $10.7 billion, as substantial reserve losses in the affected countries ($34 billion, representing 27 percent of the existing stock at end-1996) were more than offset by increases in the reserves of China ($36 billion, the largest ever in a year), Hong Kong SAR ($12 billion), and India ($4.5 billion). For the first time since 1992, the increase in Latin American reserves exceeded those in Asia, though only modestly so. Brazil lost $7.5 billion in reserves during 1997, following a $8.3 billion loss in October in the spillover from Hong Kong SAR. All of the other major Latin American countries gained reserves, particularly Mexico, where reserves rose by $9.4 billion. Reserves of the Middle East and Europe grew by $14 billion, the transition economies by $6.4 billion, and Africa by $7.8 billion, their largest increases in the 1990s.

Capital Flow Reversals During the Mexican and Asian Crises

Both the Mexican and Asian crises were preceded by strong booms in capital inflows. A key difference during the boom periods, however, was the nature of capital inflows into the respective regions. Inflows into Mexico (and other Latin American emerging markets) were dominated by portfolio flows, while those to Asia were dominated by bank lending flows (see figure below). The reversals of capital flows in each case reflected these initial concentrations. In Mexico there was a sharp reversal in portfolio inflows, from a peak inflow of $23 billion in 1993 to a net outflow of $14 billion in 1995, a turnaround of $37 billion (13 percent of GDP). For the affected Asian countries in the aggregate—Thailand, Malaysia, the Philippines, Indonesia, and Korea—on the other hand, the reversal in 1997 represented predominantly a retrenchment of bank lending, from net inflows of $40 billion in 1996 to net outflows of over $30 billion, a turnaround of $70 billion (7 percent of GDP). As regards the behaviors of other flows, first, it is notable that net FDI inflows continued during both the Mexican and Asian crises to the affected regions, moderating only slightly in each case (also see Box 2.2 below). Second, while there were net bank lending outflows following the Mexican crisis, these were modest and paled in comparison to the level of portfolio outflows. Third, the data suggest that net portfolio inflows into the affected Asian countries fell, but remained positive for 1997 as a whole. These data, however, likely overstate net portfolio inflows (see Box 2.3 below).

uch02fig01
Source: International Monetary Fund, World Economic Outlook.1Indonesia, Korea, Malaysia, the Philippines, and Thailand.

The increase in 1997 raised emerging market central bank reserve assets to $871 billion at the end of the year, a more than threefold increase since end-1989, and represents about half of the world’s stock of reserve assets. This large buildup in reserves partly reflected intervention to prevent nominal exchange rate appreciation in the face of the substantial capital inflows. It also indicated concerns about the risks of a sudden reversal of capital flows. For example, in December 1994 the Central Bank of Mexico lost $5 billion in reserves within a few days. During the Asian crisis, Korea lost $10 billion in measured reserves and $25 billion in “usable” reserves, almost exhausting measured official reserves during November and early December 1997. Market participants report that Brazil lost around $10 billion in a matter of hours at the peak of pressures on the real in late October.

The level of reserves is one of the most closely watched indicators of external pressures and potential vulnerability of a country. During the Asian crisis, market participants expressed concerns about two sources of this uncertainty that limited the usefulness of the official measured and published level of reserves. First, reserve losses often understated the magnitude of central bank interventions in foreign exchange markets as central banks also intervened in forward foreign exchange markets. While some central banks have begun to disclose the extent of such interventions, market participants widely report similar interventions by other central banks. Box 2.4 discusses intervention by central banks in forward and other derivative foreign exchange markets (the reserve implications of such interventions are discussed in Box 2.11). Second, the experience of several of the affected countries revealed that the level of remaining measured official reserves overstated the extent of available reserves as these were sometimes held in forms that became illiquid precisely when they were needed, and usable reserves turned out to be much smaller. The case of Korea is described in Box 2.5.

The Resilience of FDI in Emerging Markets: An Update from the Asian Crisis

The 1997 Capital Markets report observed that the rapid and unfaltering growth of FDI to emerging markets during the 1990s, and the steady increase in the share of FDI in total private flows, had led many observers to conclude that in the event of a reversal of sentiment against emerging markets, the consequences would not be as severe. Underlying this belief is the notion that FDI flows, by their nature, tend to be “long term,” in that they are driven by positive longer-term sentiment and, therefore, more likely to be “stable” compared with “short-term” portfolio flows. In addition, to the extent that FDI entails physical investment in plant and equipment, it is difficult to reverse.

The 1997 report also observed last year that the events surrounding the Mexican crisis helped support these views—even as portfolio flows to Latin America fell from a net inflow of $61 billion during 1994 to approximately zero in 1995, substantial net inflows of FDI continued, actually increasing from $24 billion to $25 billion (see Table 2.1). The experience during the Asian crisis provides additional evidence in support of this view. In the face of a massive turnaround of bank lending flows of $73 billion to the affected Asian countries, and a notable decline in portfolio flows of $8.5 billion, FDI flows declined by a relatively modest $2.4 billion during 1997.

There are, however, a number of features of the data on FDI flows that suggest caution in interpreting the growth in importance of FDI. First, the balance of payments differentiation between FDI flows and portfolio flows is arbitrary. Foreign investment in the equity of a company above a critical proportion of outstanding equity is classified as FDI, whereas that below is classified as portfolio equity investment. In reality, small differences in share of ownership are unlikely to represent any substantially different investment horizons. Second, if the foreign company undertaking the FDI borrows locally to finance the investment, say from a local bank, depending on the form of incorporation of the company locally, the setup of the plant may count as FDI while the bank lending could show up as a capital outflow, reducing the proportion of net bank lending in overall flows and raising the proportion of FDI flows. Finally, there are sometimes tax or regulatory advantages to rerouting domestic investment through offshore vehicles and this has likely overstated the growth of FDI.

With regard to the stability of FDI flows, and the stability such flows impart to overall capital flows, several observations are in order. First, research by Claessens, Dooley and Warner (1995) indicates that historically, for both industrial and developing countries, FDI, and other flows labeled long term according to the traditional balance of payments definition, have generally been as volatile, and no more predictable, than flows labeled short term. Second, there is no reason to believe that a foreign investor wishing to undertake FDI in a country wishes to take an open position on the country’s currency. One way to hedge real assets is to finance them by domestic currency credit so that assets and liabilities in the currency are matched, and the point made above about the (mis)measurement of FDI applies. Finally, in the event a (unhedged) foreign direct investor decides to hedge, there will be an incipient capital outflow. If a counterparty with an exactly offsetting need does not emerge at the same time, such a transaction undertaken through a financial intermediary will, when it offsets its position, result in an actual capital outflow. Hedging by multinational corporations was ascribed a significant role by market participants in generating the pressures on the Brazilian real in late 1997.

Foreign Exchange Markets

The fall of the Thai baht on July 2, 1997 began a period of turbulence in emerging market currencies unparalleled in recent times (Figures 2.2 and 2.3). Five distinct phases can be identified. During the first phase, between July and early October 1997, pressures on emerging market currencies remained by and large restricted to Asia, and within the region to the Thai baht, the Malaysian ringgit, the Philippine peso, and the Indonesian rupiah, with these currencies depreciating by 25–33 percent. Other Asian currencies came under pressure—the Korean won (2.8 percent), the New Taiwan dollar (2.7 percent), and the Singapore dollar (6.8 percent)—but depreciated relatively modestly. The second phase of pressures, starting in late October 1997, was much less discriminating. It began with the Central Bank of Taiwan Province of China’s abandonment of intervention in support of the New Taiwan dollar in mid-October, which led to widespread speculation that the Hong Kong dollar’s peg was vulnerable. Pressures on the already affected Asian currencies then intensified, the Korean won began a steep decline, and in Latin America the Brazilian real and the Argentine peso came under severe speculative pressure. In this period, the Indonesian rupiah initially strengthened in early November on announcement of a stabilization and reform program supported by the IMF and the international community. However, a backing away from monetary tightening and other key elements of the program soon undermined the rupiah, and downward pressures intensified later on reports of the ill health of then President Suharto.

Figure 2.2.
Figure 2.2.
Figure 2.2.

Exchange Rates of Selected Emerging Markets, January 6, 1997–May 29, 1998

(January 6, 1997 = 100)

Sources: Bloomberg Financial Markets L.P.; and The WEFA Group.
Figure 2.3.
Figure 2.3.

Selected Asian Currencies: Exchange Rate Volatilities, January 1, 1996–May 29, 19981

(In percent)

Sources: Reuters; and IMF staff estimates.1Daily volatilities (20-day rolling window) using daily bid spot prices.

Unrecorded Capital Flight from Asia?

At a negative $64 billion, errors and omissions in the balance of payments for emerging markets were sizable in 1997, and amounted in absolute terms to 37 percent of net private capital flows (see table below). The statistics for the aggregate of emerging markets are, however, dominated by the large and persistently negative errors and omissions for China during the 1990s. Errors and omissions encompass a variety of items, including over-and underinvoicing of trade flows, omissions of payments and receipts for services, and capital flows that go unreported, often because they are seeking to avoid official controls or taxes.

The behavior of errors and omissions for the Asian emerging markets excluding China accords with the broad pattern of capital flows to the region and is, therefore, suggestive of unrecorded capital flows. Errors and omissions for the Asian emerging markets were persistently positive during 1990–95, coinciding with the boom in capital flows to the region, turning negative in 1996, and were a negative $24 billion during 1997. Errors and omissions for the countries affected most severely by the Asian crisis turned negative earlier, in 1994, and during 1996–97 accounted for the bulk of errors and omissions to the Asian emerging markets excluding China. The negative $20 billion in errors and omissions recorded for the affected Asian countries during 1997 indicates capital outflows from these countries well in excess of the recorded total net private capital flows in the balance of payments of $11 billion (see Table 2.1). Among the affected countries, the distribution of errors and omissions in 1997 was as follows: Korea (-$8.7 billion); Malaysia (-$6.6 billion); Indonesia (-$2.8 billion); Thailand (-$1.6 billion); and the Philippines ($0.1 billion). It is also notable (see table below) that in 1997, for the first time during the 1990s, errors and omissions were systematically negative for each and every emerging market region.

Errors and Omissions in the Balance of Payments of Emerging Markets

(In billions of U.S. dollars)

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Source: International Monetary Fund, World Economic Outlook database.

The third phase involved a further intensification of downward pressures on a number of Asian emerging market currencies beginning in early December 1997. A key factor was the revelation (along with agreement on an IMF-supported stabilization and reform program) of the very low level of Korea’s usable foreign exchange reserves, relative to short-term claims due before year-end. As information about Korea’s reserves and debt situation became known, rollover rates of interbank claims on Korean institutions declined sharply, accelerating downward pressures on the won, and contagion affected other currencies. Independently, the situation in Indonesia continued to deteriorate as Bank Indonesia injected liquidity to keep second tier banks afloat as credit drained from these institutions into cash and into larger institutions that were perceived as more likely to survive. By the time the affected Asian currencies reached their low points in January 1998, the Indonesian rupiah had fallen (relative to its July 1, 1997 level) by 81 percent, the Thai baht by 56 percent, the Malaysian ringgit by 46 percent, and the Philippine peso by 41 percent. During this period the Korean won depreciated (from October 1) to its low in late December 1997 by 55 percent, the New Taiwan dollar by 19 percent, the Indian rupee by 12 percent, and the South African rand by 9 percent.

The fourth phase saw significant recovery in the foreign exchange values of most Asian emerging market currencies, beginning in late December 1997 and early January 1998. Agreement in late December by most of Korea’s bank creditors to roll forward their short-term claims, arranged under the auspices of major industrial country central banks, contributed importantly to the change in sentiment, along with an acceleration of financial support from the IMF and other multilaterals and pledges of a “second line of defense” from bilaterals. Evidence of the rapid improvement in Korea’s current account reinforced confidence that the agreement could lead to a more prolonged extension of Korea’s credit terms. Pressures on other Asian currencies generally abated, along with those on the Korean won, with the Thai baht gaining ground additionally on confidence in the new government that took office in December. The Indonesian rupiah, however, followed a more independent course. Notwithstanding announcement of a reinforced program with the IMF in mid-January 1998, the rupiah declined sharply over the course of the month, until the introduction of a government guarantee on all banks’ deposits and third-party liabilities, and the announcement of bank restructuring and corporate debt initiatives provided the basis for a partial rebound at the end of the month. In ensuing weeks, the rupiah recovered on the basis of discussion of possible implementation of a currency board, but then depreciated again as viability of this proposal came into grave doubt amidst a very weak banking system (with broad government guarantees on all bank deposits), capital outflows motivated by fears of social unrest, and uncertainties about the survival of the Suharto regime.

With the exception of Indonesia, the fifth phase was one of renewed downward pressure on several Asian emerging market currencies beginning in mid-May. The key instigating factor in this instance was the weakening of the Japanese yen (especially against the U.S. dollar) that followed unexpectedly weak results for real GDP growth in Japan in the first quarter of 1998 and evidence of continuing weakness in the second quarter. By late June, however, most Asian emerging market currencies had stabilized in the face of this new disturbance.

The large gyrations in the affected Asian currencies meant that volatility shot up from essentially nonexistent levels to well above those observed for exchange rates among the major currencies (see Figure 2.3). While there have been reductions since January 1998, volatility remains high. Accompanying the increased volatility, and in large part reflecting it, the transaction costs of trading these currencies on spot, forward, and other derivative markets skyrocketed (Figure 2.4). Prior to the crisis, bid-ask spreads on these currencies had been similar, perhaps modestly higher, than those for the major currencies. Following the crisis, these spreads widened by factors of between 6 (ringgit) and 13 (rupiah), implying, for example, a hefty 1.7 percent average cost of carrying out a rupiah-dollar transaction on the spot market since the crisis, rising on occasion to as much as 10 percent. The bid-ask spread on these currencies has shown some tendency to decline since January 1998 but has remained at high levels.

Figure 2.4.
Figure 2.4.

Selected Asian Currencies: Bid-Ask Spreads, January 1, 1996–May 29, 19981

(In percent)

Sources: Reuters; and IMF staff estimates.1Daily bid-ask spread over midpoint spot rate in percent.

Higher volatility and transaction costs were associated with a drying up of liquidity. Average daily volumes fell, standard deal sizes shrank, and the number of market makers in these currencies dwindled. Prior to the crisis, the Thai baht had been perhaps the most liquid of the regional currencies with survey data from Singapore suggesting an average daily trading volume on the interbank market of $5 billion on the spot market and $9 billion in the swaps and forward markets, while volumes for the ringgit and rupiah were similar on the spot market but had smaller swaps and forwards volumes of about $3.5 billion each.2 Following the crisis, by April 1998 trading volumes for the rupiah are estimated to have shrunk by 90 percent, for the baht by 80 percent, and the ringgit by 70 percent. Similarly, the standard size of deals shrank, with standard interbank and interbroker amounts declining, for example, for the baht from $10–20 million to $3 million for spot transactions and from $20 million to $10 million on forward markets. The number of interbank players declined on average by more than half their previous number with, for example, the number trading on the spot market for ringgit down from 25 to 12 and on the forward market from 50 to 20. While the crisis presumably raised the demand for hedging exchange rate risk, the higher transactions costs discouraged hedging and, as evidenced by the reduced turnover on forwards and other derivatives markets, the volume of hedging actually declined.

Alternative Forms of Central Bank Intervention in Foreign Exchange Markets

In addition to direct intervention on spot foreign exchange markets, central banks, and sometimes federal entities widely perceived to be doing so on their behalf, have often “intervened” in, or taken positions contrary to, prevailing market sentiment in forward and other derivative foreign exchange markets. Such activities have encompassed a diverse set of central banks and instruments. The Bank of England, for example, intervened in the markets for outright forwards for pound sterling at the time of the ERM crisis in 1992, and the South African Reserve Bank conducted such interventions in the forward market for rand over extended periods. Most recently, the Bank of Thailand built up a substantial forward liability—in excess of $25 billion—to purchase baht and sell dollars, while the Bank of Korea also intervened in the forward market for won. Market participants report that the Banco do Brasil, a federally owned bank, took substantial positions on the currency futures market on Brazil’s futures exchange, the Bolsa de Mercadorias e Futuros, during the period of pressures on the real in late October 1997. The Bank of Korea was also reported to have been “testing the waters” in the offshore nondeliverable forwards (NDF) market for Korean won (that is settled between counterparties in U.S. dollars). There have, on occasion, also been suggestions for the introduction of other types of instruments and active central bank participation in such markets. These have most recently included the use of onshore NDFs settled in local currency. In other cases, such as that of Hong Kong SAR, there have been various proposals for the Monetary Authority to sell currency options to bolster confidence in the Hong Kong dollar.

Disclosure of such activities by most central banks has, at best, been grudging and after the fact. As contingent liabilities of typically uncertain value, the future implications of such interventions for the central bank’s reserves have been open to interpretation by market participants. Most recently, for example, the Bank of Thailand’s forward foreign exchange commitments were interpreted as a one-for-one claim on reserves, which was a considerable exaggeration. The implications for reserves of central bank intervention in forward markets are discussed in Box 2.11.

Bond Markets

Secondary Markets

After a temporary though notable widening in the period surrounding the increase in the U.S. federal funds rate in the spring of 1997, yield spreads on emerging market debt, as measured by the benchmark Emerging Markets Bond Index (EMBI), which had been declining steadily since the Mexican crisis, resumed their downward trajectory (Figure 2.5).3 The floating of the baht in July 1997, and the events in Asia that followed, had only a brief and imperceptible effect on spreads measured by the EMBI, which is dominated by Latin American sovereign credits. These spreads continued to decline, reaching an all-time low in the first week of October of 335 basis points. The financial market turmoil surrounding the events in Hong Kong SAR in late October, and the general deterioration in sentiment against emerging market credits that followed, led to a dramatic widening in EMBI spreads to 640 basis points. Spreads then recovered erratically through the end of the year, and continued to do so into 1998, reaching 460 basis points by end-April, before shooting up again to 549 basis points by end-May. At these levels they remained well above their early October 1997 levels.

Figure 2.5.
Figure 2.5.

Bond Markets: Selected Returns, Yields, and Spreads

Source: Bloomberg Financial Markets L.P.

The Liquidity of Measured Reserves and “Usable” Reserves: The Case of Korea

As the crisis in Korea unfolded, official reserves of the Bank of Korea fell from a reported $31 billion at end-October 1997 to $24 billion by early December. “Usable” reserves, however, were reported to be some $6 billion. This discrepancy between measured and usable reserves arose as a result of foreign currency deposits placed by the Bank of Korea with foreign branches of domestic banks that became illiquid. That is in light of the liquidity pressures faced by these institutions, these deposits could not be withdrawn. The practice of the Bank of Korea placing deposits with foreign branches of domestic banks was begun in the late 1980s with the purpose of encouraging globalization of domestic banks, and their offshore branches used these deposits to fund loans primarily to Korean entities, both off- and onshore. The practice remained relatively small, with some 10 percent of official reserves placed in such deposits, and by end-1996 amounted to $3.5 billion. However, in January 1997, as the overseas branches of Korean banks suffered liquidity problems in the wake of the Hanbo affair, the Bank of Korea extended liquidity support to them, and by the end of March the amount of such deposits had grown to $8 billion. Finally, as pressures grew in November, by early December such deposits had risen above $10 billion.

In addition to measured official reserves of $30 billion prior to the crisis, the Bank of Korea had deposits of $30 billion with banks onshore. As the central bank sought to draw on these deposits, it discovered that these deposits too could not be accessed as they had either been onlent to Korean corporates or invested in—primarily emerging market—assets that the commercial banks were either unable or unwilling to liquidate in prevailing market conditions.

On the Brady market, spreads for individual countries, both in Latin America—where the largest credits are—and across a diverse set of other credits such as Bulgaria, Nigeria, and Poland, closely followed the pattern observed for the EMBI (Figure 2.6). Among the Latin American credits, spreads on Brazilian debt were the most severely affected in the late October period. On the Eurobond market, unlike the other emerging market credits just discussed, spreads for the affected Asian credits began to increase earlier in 1997, though they did so gradually and modestly (Figure 2.6). During May 1997, when the Thai baht came under severe speculative pressure, spreads on Thai sovereign debt inched up by a mere 13 basis points to 92 basis points, and a barely noticeable further 3 basis points during June. During this period, spreads on Indonesian and Korean sovereign and quasi-sovereign debt remained essentially unchanged, while for the Philippines they widened by just 6 basis points.4 Between July and September, spreads for all of the affected Asian credits widened gradually. By end-September, however, the cumulative increase since the beginning of May was only 30 basis points for Indonesia (to 150 basis points) and Korea (to 106 basis points), while for the Philippines it was a more notable 50 basis points (to 226 basis points) and for Thailand 100 basis points (to 174 basis points). The events in late October then provoked a sharp widening of Asian spreads, which was followed by continued deteriorations through the end of the year. The secondary market spread for Korea peaked at 890 basis points in late December, and those for Indonesia (979 basis points), Thailand (555 basis points), and the Philippines (491 basis points) during January 1998. At end-May 1998, spreads on all of the affected Asian credits remained well above their early October 1997 levels.

Figure 2.6.
Figure 2.6.

Yield Spreads for Selected Brady Bonds and U.S. Dollar-Denominated Eurobonds

(In basis points)

Sources: Bloomberg Financial Markets L.P.; Salomon Smith Barney; and IMF staff estimates.1Yield spreads on Brady bonds are “stripped” yields.2Latin America and Europe: Republic of Argentina bond due 12/03, Republic of Brazil bond due 11/01, United Mexican States bond due 9/02, Ministry of Finance of Russia bond due 11/01, and Republic of Turkey bond due 6/99.3Asia: People’s Republic of China bond due 11/03. Republic of Indonesia bond due 8/06, Korea Development Bank bond due 11/03, Republic of Philippines bond due 10/16, and Kingdom of Thailand bond due 4/07.

Volatility of returns on the EMBI, which had been declining steadily from the peak of 2.8 percent reached in the spring of 1995 following the Mexican peso crisis, continued to fall through October 1997 to reach 1¼ percent (Figure 2.7). The sharp increase in volatility in late October was followed by further increases, but by early January 1998, volatility had leveled off at 2¼ percent, well below the previous peaks following the Mexican peso crisis. It is notable that not only has the volatility of returns on emerging market debt consistently and substantially exceeded those on the mature markets, measured volatility has also fluctuated considerably, making it difficult to estimate or predict volatility with much confidence.

Figure 2.7.
Figure 2.7.

Emerging Market Debt: Volatility of Returns

Sources: Bloomberg Financial Markets L.P.; and IMF staff estimates.1Computed as the standard deviation of weekly changes in (the logarithm of) the total return index over the preceding year.

The growing volume of new issuance in the early part of 1997, followed by the sell-off in the fourth quarter, combined to ensure active trading of emerging market debt instruments and derivatives, which grew to reach almost $6 trillion in 1997 (Table 2.2). The trend decline in relative importance of Brady bonds in favor of Eurobonds was given an added impetus during 1997 as several countries exchanged some $7 billion of their Brady bonds for Eurobonds. Local market instruments continued to account for about a quarter of overall activity.5 The volume of trading increased across instruments from all regions, with the notable exception of Asia. Trading in Asian instruments, which have always accounted for a relatively small proportion of market activity, fell from $166 billion in 1996 to $108 billion in 1997. The sharp increase in emerging market spreads and heightened volatility in the fourth quarter of 1997 was associated with a notable increase in trading. In the first quarter of 1998, activity moderated, reflecting declines in the trading of Latin American and Eastern European instruments, the two largest segments of the market. Again, however, Asia bucked the trend, with trading almost doubling.

Table 2.2.

Secondary Market Transactions in Debt Instruments of Emerging Markets

(In billions of U.S. dollars)

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Source: Emerging Markets Traders Association.

Data for 1993 do not include trading in short-term local market instruments.

Primary Issues

The gradual and modest deterioration in market sentiment against the international debt securities of the affected Asian countries during the first stage of the Asian crisis led to a reallocation of international investor portfolios to other emerging markets but did not fundamentally alter investor appetite for high-yielding emerging market credits. The shift out of Asia into Latin America was most evident in September when Argentina, Panama, and Venezuela brought to market large issues of 30-year uncollateralized global bonds, totaling some $7 billion, in exchange for part of their existing Brady bonds. While the portfolio reallocation away from Asia helped create the positive environment for these issues, and the exchanges offered investors added incentives—instruments with pure country risk exposures without the complications of pricing out collateral and repayment risk through call options embedded in Brady bonds—the success of these issues also indicated perceived improvements in the creditworthiness of these countries. Emerging markets’ issuance continued at a record-setting pace ($45 billion) in the third quarter of 1997, reflecting the surge in issuance from Latin America, which offset a relatively modest decline in Asian issuance (from $16 billion in the previous quarter to $14 billion) and a pause in Eastern European issuance following record volumes in the previous quarter (Table 2.3 and Figure 2.8).

Table 2.3.

Emerging Market Bond Issues, Equity Issues, and Loan Commitments

(In millions of U.S. dollars)

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Sources: BEL; and DCBEL database.

Includes note issues under Euro medium-term note (EMTN) programs.

Includes certificates of deposit.

Includes term, construction, mezzanine, and tax-spared loans.

Includes cofinancing and note issuance facilities, certificate of deposit programs, and commercial paper programs.

Includes revolving credits, bridge facilities, export/supplier/acceptance/buyer credits, and overdraft facilities.

Figure 2.8.
Figure 2.8.

Private Market Financing for Emerging Markets1

(In millions of U.S. dollars)

Sources: BEL; and DCBEL database.1Gross primary market financing.

A number of factors accounted for the relatively modest decline in Asian issuance in the third quarter of 1997. The crisis affected particular countries with varying lags and in different ways. A number of transactions had been arranged earlier. Some issuers, such as quasi-sovereign entities from Korea, benefited from implicit official support. To retain access or to improve the terms of access, some borrowers enhanced issues by linking spreads to future credit ratings and including put options allowing redemption in the event of threshold credit events (Box 2.6). Others collateralized borrowing or were able to raise funds against anticipated foreign currency earnings.

The sharp widening of spreads on secondary markets in the spillover from Hong Kong SAR in late October 1997 and continued increases in volatility forced a number of borrowers to postpone or withdraw issues, and new issuance came to a virtual standstill in November and December. Compared with an average monthly issuance during 1997 until October of $12.5 billion, emerging market entities raised a mere $1.5 billion on international debt markets in the last two months.6 Notable among the limited issues during the period was that by the Argentine Republic, which used an innovative structure designed to address volatility in credit spreads by issuing a resettable coupon bond determined by auction (see Box 2.6).

Bond issuance recovered in the first quarter of 1998 to $24 billion, with a sharp pickup in the share of sovereign borrowing. It is notable that from November 1997 through the end of March 1998, there were only two bond issues from the affected Asian countries—a Thai corporate issue that priced at a spread of over 900 basis points and a privately placed currency-linked won-denominated Korean corporate issue, which limited downside risks to investors from won depreciation but allowed them to share in the upside gains from currency appreciation. The portfolio shift against the affected Asian emerging markets was most apparent in the declining share in total issuance of these countries: from a high of 27 percent in the first quarter of 1997 to 18 percent in the second quarter, 12 percent in the fourth quarter, and a mere 1 percent in the first quarter of 1998. In April, in the first signs that international capital markets were again accessible for the affected Asian countries, the Republic of the Philippines launched a $500 million 10-year global bond that priced at a spread of 340 basis points over U.S. treasuries. It was followed by the Republic of Korea, which made a spectacular entry into the global bond market, attracting bids of $12 billion for a final issue of $4 billion, which priced at spreads of 345 basis points (5-year tranche) and 355 basis points (10-year tranche) over U.S. treasuries.

Reflecting the favorable conditions in emerging debt markets through the third quarter of 1997, average spreads on new issues remained relatively unchanged during the second and third quarters at around 280 basis points, while the new global issues in the Brady exchanges in September caused maturities to jump sharply from 10 years in the second quarter to 15 years in the third (Figure 2.9). The deterioration in terms for new issues in the fourth quarter is not evident in the average calculated spreads, because of the thin volumes and the sharp contraction in maturities. Terms on new issues worsened more noticeably in the first quarter of 1998 as average spreads increased by 66 basis points to 316 basis points, while maturities shrank by a year relative to the fourth quarter of 1997.

Figure 2.9.
Figure 2.9.

Spreads and Maturities for Sovereign Borrowers1

Source: DCBEL database.1Unenhanced U.S. dollar-denominated bonds.

The Asian crisis caused a flurry of ratings actions. There was also a host of new ratings, with 14 new countries rated by (at least one of) the major rating agencies: seven in the Western Hemisphere, four in Europe, one in Asia, and one in the Middle East. These new ratings, combined with the spate of downgrades in Asia, caused the average credit quality of emerging markets to deteriorate. The number of emerging markets that had been rated investment grade, having risen steadily from 44 percent in 1993 to 57 percent by end-1996, had deteriorated by end-1997 to about 50 percent, reflecting in particular the loss of investment grade status for Indonesia, Korea, and Thailand. By contrast, the average ratings of countries in the Western Hemisphere improved, with one-third of the countries having investment grade status, compared to only one-fifth at end-1996.

Enhancements and Innovations in Bond Structures in Response to the Asian Crisis

The deterioration in investor sentiment reflected in higher spreads and increased uncertainty in volatility of spreads inhibited both issuers and investors on emerging debt markets, prompting a number of enhancements and innovations in bond structures by borrowers in order to retain access.

• Among the affected Asian credits, in June 1997, the Korea Development Bank (KDB), in light of the considerable uncertainty at the time with regards to its future credit standing, issued a $300 million structured credit-ratings-based floating rate note. The note included a put option that could be exercised by bond holders on coupon dates should KDB’s credit rating fall below established threshold levels. To allow the issuer to benefit from future improvements in its credit quality, the structure also included a call option exercisable at the end of year three, or any coupon date thereafter, at par. In a similar vein, in August 1997 the Industrial Finance Corporation of Thailand placed a $500 million issue that encompassed credit-protection clauses—a two notch downgrade in its credit rating stepped up the coupon by 50 basis points, and every notch downgrade thereafter in a further 25 basis points. Were the rating to fall below investment grade, investors could put the bonds—redeem them—at par. In the event, credit thresholds were breached in each case, and it was reported that both bonds were redeemed.

• In the aftermath of the sharp depreciations of Asian currencies there were several currency-linked issues sold to foreign investors. Denominated in local currencies, these typically limited the downside risk to foreign investors from further currency depreciation, but allowed investors to share in the upside from currency appreciation. While market participants report several private placements of such notes, public reports are of a $500 million issue by the Central Bank of the Philippines in August 1997, and a $250 million issue by a Korean corporate in March 1998.

• There was increased use of bond structures with step-down coupons, that is, coupons decline over the life of the bond. As of end-May 1998 there had been 14 emerging market issues with step-down coupons. Of these, 13 were issued after mid-1997, and 8 of them in 1998.

• As issuers’ concerns about locking into expensive long-term funding rates and investors’ desire to limit their exposure to volatility caused emerging markets issuance to dry up during November and December 1997, the Republic of Argentina pioneered a novel structure that addressed both these concerns, placing $500 million of spread adjustable notes (SPANs). Under the structure, the spread is adjusted through a Dutch auction, while incorporating a spread cap and floor. At each reset date, bondholders have the choice of making a noncompetitive bid (rolling over their position), a competitive bid (where they risk losing their holdings if they do not receive an allocation), or no bid at all (they sell their holdings). With a similar objective, in March 1998 Argentina issued floating rate accrual notes (FRANs). The coupon on these adjusts every six months at the (secondary market) spread of its outstanding 2006 global bond less 25 basis points. In addition, when the spread on the outstanding 2027 global bond goes above a certain threshold (set at the beginning of every coupon period) investors in FRANs receive an additional premium. Unlike SPANs, FRANs provide a mechanism whereby both the underlying interest rate and the credit spread float.

International Bank Lending

Syndicated Loans and Facilities

Like the international bond market, the international syndicated loan market for emerging market borrowers was resilient to the Asian financial crisis during the first three quarters of 1997. It remained buoyant during the fourth quarter of 1997 (Table 2.3 and Figure 2.8). This remarkable resilience is explained by a number of factors. The effects of the Asian crisis remained localized during the third quarter. Even for the affected Asian countries during the third quarter, a number of deals had been arranged earlier. Overall growth to the Asian region reflected growth to countries and areas not significantly affected by the crisis such as China, India, Hong Kong SAR, Singapore, and the Taiwan Province of China, which offset a steady decline in syndications of new loans to the affected countries. The change in securities investors’ attitudes to emerging market debt in late October in fact encouraged borrowers to turn to the syndicated loan market. A notable example of this switch was the $3 billion loan facility arranged for Gazprom, a Russian gas company, following the postponement of a convertible bond issue.

The booming syndicated loan market through the first three quarters of 1997 was associated with terms moving in favor of borrowers—tighter spreads, longer tenors, lower fees, and looser structures as evidenced by weaker covenants. While overall activity remained buoyant in the last quarter of 1997, there were increasing signs of stress. There was some widening of spreads, in general stricter collateral requirements, and more frequent inclusion of “material adverse change” clauses in loan documentation. Further, some facilities were priced with adjustable spreads linked to credit ratings, such as Mexico’s $2.5 billion revolving credit, arranged in November.

In the first quarter of 1998, as emerging market bond issuance began to recover, volumes of new syndications of both loans and loan facilities for emerging markets collapsed. This contraction occurred across all regions, and was by no means sharpest in Asia. While part of the decline can be explained by the return of some borrowers to bond markets, the remainder suggested an increasing—and widening—retrenchment of international banks from the emerging markets that had not run its course.

Interbank Claims

In addition to syndicated lending, interbank loans have accounted for an important share of bank lending to emerging markets, particularly the Asian emerging markets. Table 2.4 documents the evolution of interbank claims of BIS-reporting banks on banks in several emerging markets.7 It is notable that, despite the pressures on the baht in May 1997, interbank claims on Thai banks continued to grow during the second quarter, as they did for each of the other countries—Malaysia, the Philippines, Indonesia, and Korea—that were eventually severely affected by the Asian crisis. In the third quarter, however, which began with the floating of the baht, there was a sharp retrenchment from Thai banks of $9.9 billion, and from Philippine banks of $3 billion. There was during the quarter also a modest reduction in claims on Korean banks of $0.8 billion, but flows to Indonesian and Malaysian banks were sustained at about $3 billion each. In the fourth quarter, following the turbulence in Hong Kong SAR, the reduction of international banks’ exposures to the region began in earnest and net claims on banks in each and every major emerging market in the Asian region shrank. Among the affected countries the retrenchment was most dramatic for Korea, where $18 billion in claims, representing about 30 percent of the total outstanding at the beginning of the quarter, were withdrawn. From Thailand, a further $7.7 billion was withdrawn, bringing the reduction in claims during the last two quarters of 1997 to $18 billion. As the stock of claims on Indonesian, Malaysian, and Philippine banks prior to the crisis were much more modest than in Thailand and Korea, so was the retrenchment. The contractions of bank claims implied sharp reductions in the outstanding stocks of claims of BIS-reporting banks on Thai and Korean banks. At end-1997, however, with $60 billion in claims on Thai banks and $40 billion on Korean banks, these stocks remained both sizable and, excluding the financial centers of Hong Kong SAR and Singapore, the largest among the emerging markets. It is also notable that with the exception of India, all of the major Asian emerging market banking systems were net debtors to BIS-reporting banks at end-1997.

Table 2.4.

Changes in Net Assets of BIS-Reporting Banks Vis-à-Vis Banks in Selected Countries and Regions

(In millions of U.S. dollars)

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Source: Bank for International Settlements (BIS).

Compared with the large and systematic buildup of claims on Asian banks prior to the crisis, all of the major Latin American emerging market banks, with the exception of Brazilian banks, were net creditors to BIS-reporting banks. In Brazil, banks remained net creditors through the third quarter of 1997, but there was a sharp increase in credit extended to them of $13 billion during the fourth quarter. Among the European countries, Russian banks were the largest debtors to BIS-reporting banks, with an outstanding amount of $30 billion, while Polish banks have been net lenders with a net stock of claims of $11 billion at the end of 1997.

The continued flow of syndicated loans to the affected Asian countries during the last quarter of 1997 combined with the sharp contraction in bank claims indicates that the bulk of withdrawal of international banks’ funds from Asia occurred in the form of contractions in interbank credit. As these are typically of shorter maturity, this suggests international banks’ primary concern at the time was with local banks’ short-term foreign currency liquidity.

Equity Markets

Returns on emerging equity markets fluctuated sharply during the course of 1997 and diverged markedly across regions (Figure 2.10). Latin American markets remained extremely buoyant during the first half of the year, turning in total dollar returns, as measured by the IFCI investable index, of 40 percent, about double that of the Standard and Poor’s (S&P) 500 index. Asian markets, on the other hand, declined modestly by 4 percent. During the second half of 1997, as sharp depreciations in exchange rates combined with declines in local currency equity prices, dollar returns on Asian equity markets went into a free fall, yielding a loss of 56 percent. Latin American markets, on the other hand, after suffering an early sympathetic correction with the Asian markets in July, rebounded, continuing to yield positive returns through the third quarter, albeit more modestly than earlier in the year. Having turned in returns of 46 percent during the first three quarters of the year, however, as a result of the spillover from Hong Kong SAR’s equity markets in late October, Latin American markets fell by 12 percent in the fourth quarter. In the first quarter of 1998, returns on Asian markets rebounded strongly, yielding 19 percent, again reflecting both exchange rate appreciations and local currency equity price increases, while Latin American markets declined modestly. Emerging equity markets generally, and especially in Asia, recorded further declines in the second quarter of 1998, evidence of the deepening economic consequences of the Asian financial crisis and spillovers from weakness in Japan.

Figure 2.10.
Figure 2.10.

Emerging Equity Markets: Selected Returns, Price-Earnings Ratios, and Expected Returns

Sources: Bloomberg Financial Markets L.P.; and International Finance Corporation, Emerging Markets Data Base.1 All return indices are expressed in U.S. dollars.2Price index.

As the steep declines in Asian equity prices exceeded declines in earnings and equity prices in the mature markets continued to increase, for the first time since mid-1993 price-earnings ratios for the Asian emerging markets during 1997 fell below those in the mature markets and remained so through May 1998 (see Figure 2.10, second panel). Price-earnings ratios for the Latin American emerging markets, which have remained well below those of the S&P 500 since late 1996, fell further in late 1997, and at end-May 1998 were less than half of those on the S&P 500. Figure 2.10 (third panel) shows that expected returns on equity in the emerging markets, as measured by price earnings ratios adjusted for expected earnings growth, have consistently exceeded those in the mature markets during the period, and despite the sharp slowdowns in forecasts for earnings (output) growth in Asia, they continue to remain so for both the Asian and Latin American emerging markets.8

The volatility of returns on emerging equity markets—in both Asia and Latin America—had declined steadily and dramatically during the course of 1996 and through early 1997 as recovery from the Mexican crisis continued (Figure 2.11). By mid-1997 these volatilities were comparable to, and in fact slightly below, those in the mature equity markets. This situation changed drastically in the second half of 1997, as the volatility of returns on Asian emerging markets rose steeply, to levels in excess of those on Latin American markets at the height of the Mexican peso crisis. While the volatility of returns on Latin American markets rose during the last quarter of 1997, it leveled off in early 1998 at a level below that reached at the height of the Mexican peso crisis. Uncertainty created by the Asian financial crisis was associated with increased trading activity on emerging equity markets. This was most apparent in Asia where, with the exception of China, turnover—calculated as the ratio of the value of shares traded to average market capitalization—rose across the board (Table 2.5). In China, trading continued at a frenetic pace of 231 percent, one of the highest in the world.

Table 2.5.

Annual Stock Market Turnover Ratios in Selected Countries and Regions1

(In percent)

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Source: International Finance Corporation, Emerging Markets Data Base.

Ratios for each market are calculated in dollar terms by dividing total value traded by average market capitalization.

Figure 2.11.
Figure 2.11.

Emerging Equity Markets: Selected Volatilities Comparisons

(In percent)

Sources: Bloomberg Financial Markets L.P.; and IMF staff estimates.

Reflecting the buoyant state of the mature equity markets, emerging market entities continued to rely on international placements of equity during the course of 1997, at a pace that was broadly unperturbed by the Asian crisis (see Table 2.3 and Figure 2.8). Issuance by entities in the affected Asian countries of Thailand, Malaysia, the Philippines, Indonesia, and Korea, however, which had already declined in 1996 by 40 percent, fell by a further 44 percent in 1997. International placements of equity from all other regions were buoyant in 1997, but declined during the first quarter of 1998.

Total flows into mutual funds dedicated to emerging markets were substantial in the first half of 1997 ($6 billion), reflecting strong flows into “nonregion-specific” funds ($4 billion) and Latin American funds ($1 billion), while those to Asia showed a modest decline (Figure 2.12). Following the devaluation of the Thai baht at the beginning of the third quarter, substantial redemptions ($2.5 billion) from Asian funds began. However, significant inflows ($1 billion) into nonregion-specific funds continued, while there were insignificant net flows from Latin American funds. Finally, in the fourth quarter, following the events in Hong Kong SAR there were large redemptions across all types of emerging market mutual funds.

Figure 2.12.
Figure 2.12.

Emerging Market Mutual Funds: Estimated Net Flows

(In billions of U.S. dollars)

Source: Lipper Analytical Services, Inc.1 Refers to nonregion-specific funds dedicated to emerging markets.

Part Two: Emerging Market Banking Systems

Developments in emerging market banking systems showed clearly defined regional patterns during 1997–98.9 The banking systems in many Asian emerging markets were at the core of the region’s financial crises and began a difficult and painful restructuring process. Despite volatile conditions in international financial markets, Latin American banking systems showed resilience to the contagion from Asia and continued a consolidation process fueled by the entry of foreign financial institutions. With the exception perhaps of Russian banks, the impact on Eastern Europe’s banks was limited, and restructuring and consolidation efforts continued with a view to eventual EU membership for several countries. Most emerging markets have made efforts to tighten their regulatory frameworks and are moving toward compliance with the Core Principles for Effective Supervision recently promulgated by the Basle Committee on Banking Supervision. Countries have made important improvements in accounting rules, disclosure of financial information, loan classification and provisioning, and capital adequacy. However, important challenges in implementation remain. A major source of concern in the regulatory community relates to the awareness and measures undertaken to address the year 2000 problem in emerging markets.10 In the absence of clear and detailed involvement by national bank regulators, including specific publicly disclosed guidelines, the risks of operational problems or even larger disruptions in financial markets are considerable.

The problems facing Asia’s distressed banking systems are the legacy of years of bad lending practices and inadequate supervision and regulation that led to high lending growth and risk taking. Although lending growth above that of GDP is a precondition for financial deepening in emerging markets, the sustained growth of bank lending in many Asian countries led to very high leverage ratios that increased financial fragility. Most of the countries in the region, and in particular some of the most severely affected by the crisis (Korea, Malaysia, and Thailand), displayed lending growth in excess of GDP growth for several years and had higher loan leverage ratios than industrial countries with better developed financial infrastructures (Figure 2.13).11 Empirical studies have shown that rapid credit growth and leverage are significant determinants of banking crises.12 Moreover, credit growth in some of these countries was led in part by underregulated nonbank financial intermediaries (Figure 2.14), such as finance companies in Thailand and merchant banks in Korea, that increased competitive pressures on banking systems.

Figure 2.13.
Figure 2.13.

Financial Sector Lending: Growth and Leverage, 1990–96

Sources: International Monetary Fund, International Financial Statistics, and World Economic Outlook.1Loan growth is the ratio of growth in loans to private sector (bank and nonbank) versus nominal GDP growth from year-end 1990 to year-end 1996.2Loan leverage is defined as the ratio of loans to private sector versus nominal GDP as of year-end 1996.3Loan growth from 1990–94 and loan leverage is as of year-end 1994.Note: Loan growth of the following countries and regions started at different years: Hong Kong SAR, Poland, and Slovenia (1991); Malaysia (1992); and Russia, the Czech Republic, Latvia, Lithuania, and the Slovak Republic (1993).
Figure 2.14.
Figure 2.14.

Bank and Nonbank Financial Intermediaries: Average Credit Growth, 1990–96

(In percent)

Source: International Monetary Fund, International Financial Statistics.

The large capital inflows to the region, driven by partial financial liberalization and implicit guarantees of stable exchange rates, fueled an expansion of banks’ balance sheets and led to increasing exposures to liquidity, market, and credit risks. In Korea, regulations limiting international issuance of securities to entities with high ratings, combined with the perceived official support for banks, encouraged the channeling of international borrowing through the financial system for onlending to corporates. In Thailand, the establishment of the Bangkok International Banking Facility in 1993, with the aim of developing a regional financial center, led to a substantial increase in mostly short-term offshore borrowing (and also opened the door to aggressive lending by foreign banks, still restricted in their local activities). These funds were channeled in part to finance real estate and stock purchases, and although banks seem to have had relatively matched foreign currency books, they held sizable maturity mismatches and faced increased credit risks from unhedged corporate borrowers. In Malaysia, restrictions on foreign borrowing left the corporate and banking sectors with relatively low exposures to foreign exchange risks, but highly leveraged corporates and bank exposures to the property and share financing sectors left the banking system in a vulnerable position.

The failure of Asia’s regulators to strike a balance between the guarantees needed to reduce financial instability and the regulations and oversight required to minimize excessive risk taking allowed bad lending decisions to proceed with impunity. The perception of implicit guarantees was probably strengthened by the bailouts in the resolution of earlier banking crises in some of these countries (Thailand, 1983–87; Malaysia, 1985–88; and Indonesia, 1994), where substantial support was provided to weak institutions, as well as by government-directed credit to the conglomerates (chaebol) in Korea. Poor accounting, regulatory, and supervisory standards failed to prevent the moral hazard problem generated by these implicit guarantees. Weak loan classification and provisioning rules, combined with lax enforcement of related-party lending restrictions inside large financial (and nonfinancial) groups and regulatory forbearance on securities’ exposures and unrealized losses on them, allowed excessive risk taking in Korea and Thailand. In addition, the reluctance to shut down insolvent banks in Indonesia raised doubts about the viability of the authorities’ strategy for a gradual consolidation of the country’s overstretched banking system. After the devaluation of the Thai baht, the fear that creditor losses in some banks may bring down even good banks led several governments to provide explicit assurances that depositors (and creditors) would suffer no losses on their savings.

Following the depreciation of the Thai baht in July 1997, investors focused increasingly on financial sector vulnerabilities, and liquidity problems (both external and domestic) spiraled as confidence in the region waned. The depreciation of the region’s currencies prompted a reassessment of local entities’ credit worthiness, and the banks’ weak financial fundamentals—as reflected, for instance, in low individual Bank Financial Strength Ratings (BFSR; see Table 2.6)—combined with a lack of transparency and of decisive response from the authorities, fueled the reluctance of foreign creditors to roll over short-term loans to banks across the region.13 Together with the drying up of liquidity in the international interbank market, the countries in crisis experienced depositor runs from weaker to stronger banks and from the banking system as a whole. A sharp segmentation in the domestic interbank market ensued, as stronger financial institutions became increasingly reluctant to lend to weaker ones, and central banks stepped in to recycle funds back to weaker institutions as well as to provide liquidity support to the financial system at large. In Indonesia, Bank Indonesia tightened liquidity initially but later eased its stance as domestic and foreign liquidity conditions deteriorated sharply. Following agreement on the IMF program at end-October, Bank Indonesia announced the closure of 16 small banks—accounting for about 3½ percent of bank assets—and indicated that no more banks would be liquidated “at this time.” As there was a widespread perception of insolvency at a number of other banks, however, these closures fueled a withdrawal of deposits from the financial system. The subsequent reopening of one of the banks—on the same premises and with the same staff—further hurt the credibility of regulators. The provision of substantial liquidity support—including to some large private banks—combined with the reluctance to raise interest rates for fear of further damaging banks’ positions led to a loss of monetary control. In retrospect, decisive action to intervene in a number of additional weak banks, combined with a general guarantee for bank creditors (other than subordinated debt holders) might have forestalled this process. In Thailand, liquidity support channeled by the Financial Institutions Development Fund (FIDF) reached about 15 percent of GDP during 1997, and although it declined during 1998, it contributed to a further depreciation of the baht.

Table 2.6.

Average Bank Financial Strength Ratings for Selected Countries and Regions1

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Source: Moody’s Investors Service.

The Bank Financial Strength Rating is Moody’s opinion of a bank’s intrinsic strength—the likelihood that the bank will require financial support from shareholders, the government, or other institutions. The ratings range from A (highest) to E (lowest). It should be noted that the coverage of banking systems is not generally complete, so that the ratings are not necessarily representative of the credit quality of the entire system.