Sección o Parte de un Documento 1995 es 382.3 B584L(58739) Corden, W. Max Coediciones NAFTA AMERICA LATINA LIBERALIZACION DEL INTERCAMBIO NEGOCIACIONES COMERCIALES TRATADOS ZONAS DE LIBRE COMERCIO FREE TRADE AREAS LATIN AMERICA TRADE LIBERALIZATION TRADE NEGOTIATIONS TREATIES NAFTA Una zona de libre comercio en el Hemisferio Occidental: posibles implicancias para América Latina Incluye Bibliografía En: La liberalización del comercio en el Hemisferio Occidental - Washington, DC : BID/CEPAL, 1995 - p. 13-40 Proyecto Apoyo al Proceso de Liberalización Comercial en el Hemisferio Occidental http://hdl.handle.net/11362/1510 2014-01-02T14:51:16Z 2014-01-02T14:51:16Z Made available in DSpace on 2014-01-02T14:51:16Z (GMT). No. of bitstreams: 0 Previous issue date: 1995 POLÍTICA COMERCIAL Y ACUERDOS COMERCIALES TRADE NEGOTIATIONS COMERCIO INTERNACIONAL E INTEGRACIÓN INTERNATIONAL TRADE AND INTEGRATION Texto F r o m C a p i t a l S u rg e s t o D r o u g h t Seeking Stability for Emerging Economies Edited by Ricardo Ffrench-Davis UN Economic Commission for Latin America and the Caribbean Santiago and Stephany Griffith-Jones Institute o f Development Studies Brighton, Sussex in a s so c ia t io n w ith th e U n it e d N a t io n s U n iv e r s it y /W o r ld In s t itu te fo r D e v e lo p m e n t E c o n o m ic s Research Studies in Development Economics and Policy G e n e ra l E d ito r: A n t h o n y S h o r r o c k s U N U W O R L D IN S T IT U T E F O R D E V E L O P M E N T E C O N O M IC S R E S E A R C H ( U N U / W ID E R ) w a s e sta b lish e d b y th e U n ite d N a t io n s U n iv e r s it y as its first research a n d t r a in in g cen tre a n d started w o rk in H e ls in k i, F in la n d , in 1985. T h e p u rp o se o f th e in st itu te is to u n d e rtak e a p p lie d research a n d p o lic y a n a ly s is o n s truc tu ra l c h a n g e s a ffe c t in g d e v e lo p in g a n d t ra n s it io n a l e co n o m ie s, to p ro v id e a fo r u m fo r th e a d v o c a c y o f p o lic ie s le a d in g to robust, e q u itab le a n d e n v ir o n m e n ta l ly su sta in a b le g ro w th , a n d to p ro m o te cap a c ity - s t re n g th e n in g a n d t r a in in g in th e f ie ld o f e c o n o m ic a n d so c ia l p o lic y -m a k in g . It s w o rk is carried o u t b y sta ff researchers a n d v is i t in g sch o la r s in H e ls in k i a n d v ia n e tw o rk s o f c o l la b o ra t in g sc h o la r s a n d in s t itu t io n s a ro u n d th e w o rld . UNU World Institute for Development Economics Research (UNU/WIDER) Katajanokanlaituri 6B, FIN-00160 Helsinki, Finland Titles include: R ic a rd o F fre n c h -D a v is a n d S te p h a n y G r iff ith -J o n e s (editors) F R O M C A P IT A L S U R G E S T O D R O U G H T S e e k in g S ta b il ity fo r E m e r g in g E c o n o m ie s A ig u o L u a n d M a n u e l F. M o n t e s (editors) P O V E R T Y , I N C O M E D IS T R IB U T IO N A N D W E L L - B E IN G I N A S IA D U R IN G T H E T R A N S IT IO N R o b ert J. M c In t y r e a n d B r u n o D a l la g o (editors) S M A L L A N D M E D I U M E N T E R P R IS E S I N T R A N S IT IO N A L E C O N O M IE S V la d im ir M ik h a le v (editor) IN E Q U A L IT Y A N D S O C IA L S T R U C T U R E D U R IN G T H E T R A N S IT IO N E. W a y n e N a fz ige r a n d R a im o V â y r y n e n (editors) T H E P R E V E N T IO N O F H U M A N IT A R IA N E M E R G E N C IE S L a ix ia n g S u n (editor) O W N E R S H IP A N D G O V E R N A N C E O F E N T E R P R IS E S R e ce n t In n o v a t iv e D e v e lo p m e n ts S tu d ies in D e v e lo p m e n t E co n o m ics a n d P o licy Series S ta n d in g O rd e r ISBN 0 -3 3 3 -9 6 4 2 4 -1 (outside North America only) You can receive fu tu re title s in th is series as th e y are p u b lish ed by p lac ing a s tan d in g order. Please c o n ta c t y o u r bookseller or, in case o f difficulty, w rite to us a t th e address be low w ith y o u r n am e a n d address, th e title o f th e series a n d th e ISBN q u o te d above. C u sto m er Services D ep artm en t, M acm illan D is tribu tion Ltd, H oundm ills , Basingstoke, H am psh ire RG21 6XS, England From Capital Surges to Drought All rights reserved. No reproduction, copy or transmission o f this publication may be made w itho u t w ritten permission. No paragraph o f th is publication may be reproduced, copied or transm itted save w ith w ritten permission or in accordance w ith the provisions o f the Copyright, Designs and Patents Act 1988, or under the terms o f any licence perm itting lim ited copying issued by the Copyright Licensing Agency, 90 Tottenham Court Road, London W1T 4LP. Any person who does any unauthorized act in relation to th is publication may be liable to crim inal prosecution and civil claims fo r damages. The authors have asserted the ir rights to be identified as the authors o f th is work in accordance w ith the Copyright, Designs and Patents Act 1988. First published 2003 by PALCRAVE MACMILLAN Houndmills, Basingstoke, Hampshire RG21 6XS and 175 Fifth Avenue, New York, N.Y. 10010 Companies and representatives throughout the world PALCRAVE MACMILLAN is the global academic im prin t o f the Palgrave Macmillan division o f St. Martins Press, LLC and o f Palgrave Macmillan Ltd. Macmillan® is a registered trademark in the United States, United Kingdom and other countries. Palgrave is a registered trademark in the European Union and other countries. ISBN 1 -4039 -1631 -4 This book is printed on paper suitable fo r recycling and made from fu lly managed and sustained forest sources. A catalogue record for this book is available from the British Library. Library o f Congress Cataloging-in-Publication Data From capital surges to drought:seeking stab ility fo r emerging econom ies/edited by Ricardo Ffrench-Davis and Stephany Criffith-Jones. p. cm. — (Studies in development economics and policy) Includes bibliographical references and index. ISBN 1 -4039 -1631 -4 I. Capital movements— Developing countries. 2. Monetary policy— Developing countries. 3. Capital market— Developing countries. I. Ffrench-Davis, Ricardo. II. Griffith-Jones, Stephany. III. Series. HG3891.F765 2003 332.042— dc21 2003049831 10 9 8 7 6 5 4 3 2 1 12 11 10 09 08 07 06 05 04 03 Printed and bound in Great Britain by Antony Rowe Ltd, Chippenham and Eastbourne © United Nations University 2003 C ontents List of Tables List of Figures Preface Acknowledgements List of Abbreviations Notes on the Contributors 1 Capital Flows to Emerging Economies: Does the Emperor Have Clothes? Stephany Griffith-Jones 2 Financial Crises and National Policy Issues: An Overview Ricardo Ffrench-Davis Part I The Supply of Capital 3 Liquidity Black Holes: Why Modern Financial Regulation in Developed Countries is Making Short-Term Capital Flows to Developing Countries Even More Volatile Avinash Persaud 4 International Bank Lending: Water Flowing Uphill? John Hawkins 5 Bank Lending to Emerging Markets: Crossing the Border David Lubin 6 Derivatives, the Shape of International Capital Flows and the Virtues of Prudential Regulation Randall Dodd 7 Ratings since the Asian Crisis Helmut Reisen 8 Proposals for Curbing the Boom-Bust Cycle in the Supply of Capital to Emerging Markets John Williamson vi C o n te n ts 9 Corporate Risk Management and Exchange Rate Volatility in Latin America Graciela Moguillansky 10 The New Basel Capital Accord and Developing Countries: Issues, Implications and Policy Proposals Stephany Griffith-Jones and Stephen Spratt 11 The Instability of the Emerging-Market Assets Demand Schedule Valpy FitzGerald Part II National Policy Responses 12 Capital Account and Countercyclical Prudential Regulations in Developing Countries José Antonio Ocampo 13 How Optimal are the Extremes? Latin American Exchange Rate Policies during the Asian Crisis Ricardo Ffrench-Davis and Guillermo Larrain 14 Countercyclical Fiscal Policy: A Review of the Literature, Empirical Evidence and Some Policy Proposals Carlos Budnevich 15 Financial Regulation and Supervision in Emerging Markets: The Experience of Latin America since the Tequila Crisis Barbara Stallings and Rogerio Studart List of Tables 1.1 Emerging market economies: net capital flows, 1994-2003 2 1.2 International banks involvement with all developing countries, 1998-2001 5 2.1 Latin America and East Asia: stock exchange prices, 1990-2002 23 2.2 Latin America and East Asia: GDP, 1971-2002 28 4.1 Emerging market economies net external financing, 1996-2002 59 4.2 Consolidated international claims of BIS reporting banks for developing countries, June 2002 61 4.3 Concentration ratios 62 4.4 Borrowing by domestic non-banks from international banks: percentage denominated in domestic currency, June 2002 63 4.5 International financing of developing economies, 1990-2000 63 4.6 Real GDP, actual and forecast, 1950-2010 64 4.7 Correlations between changes in claims of BIS-reporting banks on developing economies, June 1990-June 2000 69 4.8 International banks involvement in developing countries, June 1998-December 2000 71 A4.1 BIS reporting banks exposure to developing countries 77 5.1 Banks net cross-border exposure to developing countries, 1997 and 2001 81 5.2 Accounting for the fall in banks gross cross-border exposure to developing countries, 1997-2001 83 5.3 Yesterdays problem: ratio of short-term debt to foreign exchange reserves, 1996 and 2000 84 5.4 Foreign ownership of banking sector assets in selected emerging markets, 1994 and 1999 87 5.5 Banks in-country lending versus cross-border lending, i995 and 2001 88 6.1 Private capital flows to developing countries, 1973-81 and 1990-97 96 6.2 Maturation of East Asian stock markets, 1990-99 97 6.3 Net long-term flows to developing countries, 1990-98 98 6.4 Capital instruments, their associated risks and the derivatives used to manage the risks 99 6.5 Putable debt issued from East Asia 107 7.1 Explanatory power of the conventional determinants of sovereign ratings, 1995-98 121 vii viii L i s t o f T a b le s 72 The new Basel Capital Accord 130 7.3 Regulatory incentives for short-term interbank lending 133 9.1 Latin America: FDI and net capital transfer volatility, 1980-99 164 9.2 Most important subjects of hedging strategies 164 9.3 Most used instruments in the derivative market 167 9.4 Forward contracts in Chile, 1996-2000 169 11.1 Investment regulation of pension funds in nine OECD countries, 2001 208 13.1 Volatility in selected countries during international financial turmoil, 1997-99 247 13.2 Argentina: capital flows, real exchange rate and macroeconomic performance, 1994-99 254 13.3 Chile: capital flows, exchange rate and macroeconomic performance, 1990-2000 258 13.4 Mexico: capital flows, real exchange rate and macroeconomic performance, 1992-2000 262 15.1 Money supply as share of GDP, 1992-2000 295 15.2 Foreign bank assets as share of total bank assets, 1994-2000 296 15.3 Indicators of concentration in the banking sector, 1994 and 2000 297 15.4 Outstanding amounts of debt securities issued in domestic markets, 1989-2000 298 15.5 Bank regulation: selected indicators 300 15.6 Bank supervision: selected indicators 302 List of Figures 2.1 Latin America: cost and maturity of issues of bonds, 1992-2002 25 2.2 Argentina and Mexico: country risks, 1994-2002 26 2.3 Latin America: GDP and aggregate demand, 1990-2001 27 2.4 Latin America: gross fixed investment, 1977-2002 27 3.1 Liquidity index for emerging equity markets, 1997-2002 47 3.2 Cross-border portfolio flows to emerging equity markets as a proportion of market capitalization, 1995-2002 48 3.3 Liquidity black holes: number of days per first quarter that the US, Japanese and British broad stock indices moved by two standard deviations more than the average daily price move, 1978-2002 49 3.4 Liquidity black holes: number of days per first quarter that US$/yen moved two standard deviations more than the average daily price move, 1970-2002 50 4.1 Banks external positions vis-à-vis emerging economies, 1997-2001 64 4.2 Bank lending to emerging market economies and policy interest rates, 1985-2001 66 4.3 Push influences on international bank lending, 1978-2001 66 4.4 Banks external positions vis-à-vis emerging economies, 1998-2001 67 4.5 Japanese international bank lending to Asian economies, 1985-2001 67 5.1 Combinations of short-term debt to reserves ratio and short-term debt to total debt ratio 85 6.1 Foreign exchange forward 101 7.1 Turkeys exchange rate and sovereign ratings, 1990-2001 124 7.2 Argentinas sovereign spreads and ratings, 1990-2001 125 9.1 Chile: total forward contracts with non-financial corporations, 1995-2001 170 9.2 Chile: forward contracts for more than 42 days with non-financial corporations, 1995-2001 170 9.3 Chile: daily foreign exchange rate and interest rate, 1996-2001 172 9.4 Actors in a foreign exchange derivative market 174 9.5 Multinational companies currency risk management and the foreign exchange market 175 11.1 Aggregate trends in emerging-market asset stocks, 1994-2001 197 ix x L i s t o f F ig u re s 11.2 Aggregate asset demand composition, 1990-2001 198 11.3 Aggregate trends in contagion, 1998-2001 198 11.4 Global risk aversion 203 12.1 Index of expansionary monetary pressures, 1990-2000 226 12.2 Fiscal deficit and public debt: Brazil, Colombia and Mexico 231 13.1 GDP volatility versus various financial volatilities 249 13.2 Real and financial volatility in three episodes 251 13.3 Exchange rate regimes since 1994 252 15.1 Overall regulation index (ORI) 301 15.2 Overall supervision index (OSI) 303 Preface This book consists of two complementary parts: (1) an analysis of new trends in various categories of capital flows to emerging economies since the Asian crisis, their determinants and their international policy implications, and (2) an evaluation of national policies to reduce the volatility of capital flows and the negative impact of such volatility on domestic economies. The book aims to help fill the gap in knowledge on what determines lenders/investors decisions to enter or withdraw from individual developing countries. It exam­ ines how the decision-making process has been modified in light of recent crises and by subsequent measures for a new financial architecture. It con­ siders the policy implications for developing countries, especially in respect of macroeconomic and financial regulation policies, their interconnections, and volatile and reversible capital flows. Key conclusions are that the volatility of capital flows has constrained the ability of developing countries to implement countercyclical policies in times of both surge and drought. Since the Asian crisis the drought in private flows (which has already lasted five years), plus the high stock of existing debt, has severely constrained growth in developing countries; for example in Latin America there has been no per capita growth since 1998. This book explores policy options at the national and international levels to remedy this highly unsatisfactory situation. The book is the result of a UNU/WIDER project on Capital Flows to Emerging Markets since the Asian Crisis: How to Manage their Volatility, codirected by Ricardo Ffrench-Davis and Stephany Griffith-Jones. An initial workshop was held at the ECLAC headquarters in Santiago in March 2001. The workshop, whose purpose was to coordinate the participants research projects, was inaugurated by José Antonio Ocampo, Executive Secretary of ECLAC. A final seminar took place at the WIDER Institute in Helsinki in October 2001, with the participation of the Director of WIDER and the Executive Secretary of ECLAC. We thank the contributors to this book and other participants for creative and fruitful discussions. We appreciate the stimulating environment provided by ECLAC and WIDER for the development of the project, the contributions made by several specialists at ECLAC, the financing provided by WIDER and the support of staff at ECLAC and WIDER in the organization of the workshop and the seminar. Ricardo Gottschalk and Jenny Kimmis (at IDS) and Heriberto Tapia (at ECLAC) provided very useful assistance and advice. R ic a r d o F f r e n c h - D a v is St e p h a n y G r if f it h -J o n e s xi Acknow ledgem ents This study has been prepared within the UNU/WIDER project on Capital Flows to Emerging Markets since the Asian Crisis: How to Manage their Volatility, codirected by Ricardo Ffrench-Davis and Stephany Griffith-Jones. UNU/WIDER gratefully acknowledges the intellectual contribution and substantial support given to the project by the United Nations Economic Commission for Latin America and the Caribbean (ECLAC). ECLAC, the Economic Commission for Latin America and the Caribbean (Comisión Económica para América Latina CEPAL), is one of five regional commissions of the United Nations, each of which is concerned with assisting and promoting economic and social development in a major region of the world. Created in 1948, ECLAC currently serves 33 governments from Latin America and the Caribbean, together with several nations of North America and Europe that maintain historical, cultural and economic ties with the region. ECLAC serves as a center of excellence in the region. It collaborates with its member states and with a variety of local, national and international institutions in undertaking a comprehensive analysis of development pro­ cesses based on an examination of the design, follow-up and evaluation of public policies. Many of the ECLAC divisions that carry out these analysis and research tasks also provide technical assistance, training and information services in selected cases. Economic Commission for Latin America and the Caribbean (ECLAC) Comisión Económica para América Latina y el Caribe (CEPAL) Av. Dag Hammarskjöld s/n, Casilla de Correo 179-D, Santiago, Chile www.eclac.org xii List of Abbreviations ALM asset liabilities model BCRA The Argentine central bank BCBS Basel Committee on Banking Supervision BIS Bank for International Settlements CEPA Center for Economic Policy Analysis CEPR Center for Economic and Policy Research CPSS Committee on Payment and Settlement Systems DEAR daily earnings at risk ECAIs external credit assesment institutions ECB European Central Bank ECLAC/CEPAL Economic Commission for Latin America and the Caribbean/Comisión Económica para América Latina y el Caribe EMBI Emerging Markets Bond Index (JP Morgan) ESCAP Economic and Social Commission for Asia and the Pacific EU European Union EDI foreign direct investment FSF Financial Stability Forum HLIs Highly leveraged institutions IAIS International Association of Insurance Supervisors IDB Inter-American Development Bank IDS Institute of Development Studies, University of Sussex IIF Institute of International Finance IMF International Monetary Fund IRB internal ratings based (assessment) IOSCO International Organisation of Securities Commissions LCPI Liquidity and Credit Premia Index LIBOR London interbank offered rate LTCM Long Term Capital Management NAFTA North American Free Trade Agreement NBER National Bureau of Economic Research NDF non-deliverable forward OECD Organisation for Economic Co-operation and Development OPEC Organization of the Petroleum Exporting Countries ORI Overall regulation index OSI Overall supervision index PERLs principal exchange rate linked notes ROSC Report on the Observance of Standards and Codes (World Bank and IMF) xiii xiv L i s t o f A b b r e v ia t io n s SMEs small and medium-sized enterprises UDROP Universal debt rollover option with penalty UF Unit of Fomento (Chile) UNDP United Nations Development Programme UNU United Nations University US SEC United States Securities and Exchange Commission VaR value at risk WIDER World Institute for Development Economics Research WTO World Trade Organization Notes on the C ontributors Carlos Budnevich is Economics and Finance Consultant, Interamerican Development Bank, International Monetary Fund and the World Bank, and Professor of Economics, Universidad Finis Terrae, Santiago, Chile. Randall Dodd is Director of the Derivatives Study Center, Washington, DC, United States. Ricardo Ffrench-Davis is Principal Regional Adviser to the United Nations Economic Commission for Latin America and the Caribbean (ECLAC/ CEPAL), Santiago, Chile, and Professor of Economics at the University of Chile, Santiago. Valpy FitzGerald is a Reader in International Economics and Finance at the University of Oxford, UK. Stephany Griffith-Jones is Professorial Fellow at the Institute of Devel­ opment Studies, University of Sussex, Brighton, UK. John Hawkins is Senior Economist at the Monetary and Economic Department, Bank for International Settlements, Basel, Switzerland. Guillermo Larraín Rios is Chief Economist at BBVA Banco Bhif, and Associate Fellow, Centro de Economía Aplicada, Departamento de Ingeniería Industrial, University of Chile, Santiago. David Lubin is Emerging Market Economist at HSBC, London, UK. Graciela Moguillansky is Economist at the Unit for Investment and Corporate Strategies, United Nations Economic Commission for Latin America and the Caribbean (ECLAC/CEPAL), Santiago, Chile. José Antonio Ocampo is Executive Secretary of the United Nations Economic Commission for Latin America and the Caribbean (ECLAC/CEPAL), Santiago, Chile. Avinash Persaud is Managing Director of the State Street Bank and Trust Company, and Visiting Fellow at the Cambridge Endowment for Research in Finance, Judge Institute, UK. XV xvi N o te s o n th e C o n tr ib u to r s Helmut Reisen is Head of the Research Division, OECD Development Centre, Paris, France. Stephen Spratt is DPhil student at the Institute of Development Studies, University of Sussex, Brighton, UK. Barbara Stallings is Director of the Economic Development Division, United Nations Economic Commission for Latin America and the Caribbean (ECLAC/ CEPAL), Santiago, Chile. Rogerio Studart is Economic Affairs Officer at the United Nations Economic Commission for Latin America and the Caribbean (ECLAC/CEPAL), Santiago, Chile. John Williamson is Senior Fellow at the Institute for International Economics, Washington, DC, United States. 1C ap ita l Flows to Em erging Econom ies: Does the Em peror Have Clothes?* Stephany Griffith-Jones Introduction This chapter considers how capital flows to developing countries (and especially emerging markets) have changed since the Asian and other crises. It attempts to further our understanding of how investors, lenders and other financial actors make their decisions to supply capital to developing coun­ tries, and how this decision making influences or determines their main features, in particular their tendency for procyclicality and short-termism. The discussion draws on the chapters in this book on the supply of capital flows and extracts overall conclusions from them. Finally, it makes policy proposals to deal with the two most problematic current aspects of capital flows to developing countries: their very low levels and strong reversibility. Since the Asian crisis there has been a drastic change in both the level and the structure of private capital flows to developing countries. To date insuffi­ cient emphasis has been placed by analysts and policy makers on the nature, causes and policy implications of these changes. A key question is whether the changes in capital flows - particularly their sharp decline, but also their composition - are mainly structural or cyclical. If they are cyclical, how long is the flow likely to remain low? Although this is a difficult question to answer, it is very important to attempt to do so, given the policy implications for all involved, but particularly for developing countries. One scenario is that the recent trends will continue for a long time: net private capital flows to all emerging economies have declined since 1997, and were extremely low in 2000 and 2001, according to the IMF (2002) (see Table 1.1). As the IMF (2001a) asks, was the resurgence of such flows in the first half of the 1990s, after the debt crisis, a one-off portfolio stock adjust­ ment that has now run its course? This implies that the presence of foreign companies, banks and other investors in emerging economies will contribute very little foreign exchange or external savings to the emerging economies, 1 T a b le 1 .1 Emerging market economies: net capital flows, 1994-2003 (US$ billion) 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 Private ca p ita l flow s, o f w h ic h 150.9 2 1 2 .0 234.2 111.9 65.4 69 A 7.7 31.3 58.0 76.8 Private d irect in v e s tm e n t 80.8 1 0 0 .1 117.0 142.7 154.7 163.8 153.4 175.5 157.1 165.7 Private p o r t fo lio in v e s tm e n t 113.0 41.2 86.9 46.3 - 4 . 6 33.9 - 4 . 3 - 3 0 . 2 14.6 15.8 O th e r* - 4 2 .9 70.7 30.3 -7 7 .2 - 8 4 . 7 -1 2 8 .2 -1 4 1 .4 - 1 1 4 . 0 - 1 1 3 .7 - 1 0 4 .7 O ff ic ia l f lo w s 3.5 26.9 - 1 . 5 64.9 60.5 13.7 5.7 37.2 32.7 15.2 C h a n g e in reserves - 6 9 .1 -1 1 6 .7 - 1 0 8 . 8 - 5 9 . 8 - 4 5 . 0 - 8 5 . 8 -1 1 4 .3 - 1 3 4 . 3 - 8 7 . 6 - 6 0 . 6 C u r re n t a c c o u n t - 7 2 . 2 - 9 2 . 4 - 9 6 . 8 -6 9 .0 - 5 2 . 6 32.9 128.3 89.4 16.9 - 1 6 . 7 * M ainly b a n k lend ing . Source: IMF (2002). S t e p h a n y G r i f f i th - J o n e s 3 and that their only contribution will be via the transfer of technology, man­ agement know-how and other expertise. The value of a foreign presence for developing countries - and especially but not only the more advanced ones - is in the blend of capital flows and the transfer of expertise; if only the transfer of expertise were to remain, the balance of benefits and costs would change quite significantly, as would the number of policy measures and other efforts to attract such flows. The emperor would have no clothes, or more accurately, would be half-naked. On the other hand, if the other scenario is more likely and the sharp decline is mainly driven by general cyclical factors and the memory of recent crises (and if crises stop happening), then the pay-off will be far greater for policy makers (in developed and developing countries, as well as in international organizations) if they make an effort to attract private flows to developing countries and encourage more of those which are stable. In the following sections we shall first examine the new pattern of private flows, particularly to emerging countries, and then the extent to which the recent changes are likely to be permanent or temporary. We shall then look briefly at some of the new features that make different capital flows to devel­ oping countries so procyclical and easily reversible, and conclude with policy implications. New pattern of private flows Sharp decline of flows As briefly sketched out above, and as shown in Table 1.1, capital flows to developing countries have undergone a major change since the East Asian crisis. According to the IMF (2002), net private capital flows to emerging market economies, which peaked at almost US$240 billion in 1996 (having grown consistently throughout the first half of the 1990s), more or less halved to less than US$ 120 billion in 1997, fell by around 40 per cent to less than US$70 billion in 1998 and 1999, collapsed to less than US$10 billion in 2000 and recovered only very slightly to US$31 billion in 2001. As a result, emerging markets current accounts have also shifted dramatically, from significant deficits to very large surpluses since 1999. FDI maintains its level but is increasingly hedged At the same time there has been a dramatic change in the structure of flows. FDI tripled between the early 1990s and 2001, when it peaked at US$175 billion. Since 1998 it has been the only large source of foreign capital inflow for emerging markets, and in terms of the net transfer of resources it has been the only source for emerging markets. Overall this change in the struc­ ture of flows is a very positive development as FDI includes the transfer of expertise and tends to be long term. However there are important caveats. 4 C a p i ta l F lo w s to E m e r g in g E c o n o m ie s The first is that the FDI flow to developing countries may not be sustained at its current high levels because of changes in the developed economies and because the easy purchase of companies being privatized or large attractive companies already in the private sector may gradually come to an end. In successful dynamic economies or sectors this may be followed by additional FDI to seize profitable opportunities for expansion (for example as occurred in telecommunications in several Latin American countries) or for green­ field investment. However in less dynamic economies or sectors FDI may just decline, as it is beginning to do in Latin America. The second caveat has been explored less in the literature but has become a major new issue. Although FDI is relatively more stable than other forms of investment it does have a volatile component. Historically this has taken the form of variability in the remittance of dividends, but it now relates to increased and variable external debt financing of FDI. The latest concern is that multinational companies, especially those producing for the domestic market, are hedging their short-term foreign exchange risk (see Chapter 9). This could reduce the positive net foreign exchange impact of FDI through, for example, the purchase of US dollars or dollar-denominated government paper in a country (for example Brazil, Mexico), or by hedging offshore. Particularly problematic would be companies dramatically increasing their hedging of exchange rate risk if devaluation seemed likely. As there might be no one who was willing to take the other side, this could lead to an outflow of foreign capital and/or put pressure on the exchange rate. As Dodd explains in Chapter 6, if there were an unbalanced market in which most participants wanted to be short in the local currency, the forward exchange rate might have to fall so risk takers would be willing to hold greater amounts of the long positions or dealers could create a synthetic forward by borrowing locally and buying as well as investing in foreign exchange. This could result in a temporary outflow equal to the size of the hedge. Although the intention would be to hedge and not to speculate, the impact on reserves and/or the exchange rate might be the same. Reportedly the increased use of hedging by foreign direct investors whose sales are in the local currency has been an important factor in Latin America in recent years, significantly intensifying the pressure for devaluation. A matter of concern is that such hedging takes place with both fixed and floating exchange rate regimes. Bank lending: water flowing upwards In sharp contrast to FDI, whose levels have remained high since the East Asian crisis, net international bank lending has not only collapsed but also became highly negative during 1997-2001 (Tables 1.1 and 1.2: see also Chapters 4 and 5). The decline was across the board, but far deeper in the crisis-hit East Asian economies. The main reason was banks greater perception of the risk of S t e p h a n y G r i fp th - fo n e s 5 T a b le 1 .2 International banks involvement with all developing countries, 1998-2001 fune 1998 (US$ bn) Dec. 2001 (USS bn) Percentage change (a t annual rate) L o a n s o u t s t a n d in g 92 4 742 - 7 . 0 O th e r assets* 1 1 0 157 9.1 L o a n s b y su b s id ia r ie s in lo c a l cu rre n cy 248 434 23.7 * Includes h o ld in g o f d e b t securities, som e derivative po sitio n s a n d equities. Sources : C h ap te r 4; BIS, w w w .bis.org. lending to developing countries, especially to Asia. A secondary reason was that, once recession or lower growth hit the countries concerned, their demand for international loans fell. Hence the increased perception of and aversion to risk in international lending to developing countries is due to the frequency and scale of recent crises. Bankers argue that currency mismatch is dangerous for lenders and borrowers alike. As Kumar and Persaud (2001) argue persuasively, for investors and bank lenders, at any point in time their appetite for risk is in one of two states: risk loving or risk averse, although in the boom phase there is little percep­ tion of risk. Recent experiences, particularly the losses made in Russia and Argentina and on developing-country corporates1 (especially in the East Asian crisis countries), have contributed to bankers aversion to developing- country risk. This is occurring in a context where banks have generally become more risk sensitive and therefore more reluctant to assume risk. This is related to a greater emphasis on shareholder value, which is forcing banks to reassess the balance of their activities against the criterion of rate of return, and not the volume of business. This pressure on shareholder value is being further encouraged by the growing importance of and com­ petition from capital markets. Banks are increasingly behaving more like portfolio investors and are using similar instruments, such as credit risk derivatives. Furthermore the increasing trend amongst banks to use VaR (value at risk) models has not only increased risk sensitivity but also, according to some analysts, contributed to herding and procyclicality (see Chapter 3). A second, positive, change is that the average maturity of bank loans has increased. Thus for all developing countries the ratio of short-term to total debt fell from 54 per cent in 1996 to 46.5 per cent in 2000, according to World Bank data. The decline was particularly sharp in East Asia and the Pacific. One reason for this change is that borrowers have, as a result of the painful experience of suddenly losing bank credit during the recent crises, become reluctant to depend overly on short-term loans. Indeed several countries have adopted specific guidelines restricting short-term borrowing 6 C a p i ta l F lo w s to E m e r g in g E c o n o m ie s by banks and lengthening debt maturities.2 Some of the bank officials inter­ viewed said that they would like to increase their short-term exposure to developing countries, especially to large banks (which they consider safe), but there is insufficient country demand. In the case of low-income countries, especially in Sub-Saharan Africa, banks have traditionally concentrated on short-term lending, typically related to trade finance, and on the whole have avoided medium-term international bank lending. Their reluctance to make medium-term loans to poor coun­ tries holds even if a country has improved its fundamental and structural features. A third major change is that international banks have significantly increased their lending via domestic subsidiaries in the local currency (Table 1.2). This has been made possible by the dramatic increase in the ownership by inter­ national banks of bank subsidiaries in developing countries, that is, banks are crossing the border (see Chapter 5). The greater foreign ownership of banks is also partly a result of the recent crises, which have significantly reduced the entry costs for foreign banks, not only through currency devalu­ ations but also because the crises caused an erosion of the net worth of banks (see Chapter 4). From the perspective of international banks, lending through subsidiaries has the advantage of allowing better quality control by lending officers located in specific emerging economies. However the main advantage for banks is the ability to avoid a currency mismatch, and there­ fore exchange rate risk. Such loans are funded locally via deposits in the domestic currency. While some bankers argue that local currency lending by foreign subsidiaries can be complementary to international bank lending, recent trends suggest the opposite, that is, there is a substitution effect. Indeed bankers argue that there has been a large redistribution of banks’ overall emerging-market port­ folios, in which banks have substituted onshore lending for cross-border lending. From the perspective of developing countries, this may have some advantages, for example the possibility of stronger and more efficient banks, as well as less vulnerability to crises (however the latter point seems far more doubtful since the Argentinean crisis). Foreign bank ownership also has large costs and other disadvantages. One cost, which can be very significant, is a smaller capital inflow to the developing country (with the one-off purchase via FD1 of the bank, replacing a far larger stream of international bank lending). Another potential dis­ advantage is that domestic lending by international bank subsidiaries may have certain biases that are not suited to developing countries. For example, in comparison with the domestic banks they have taken over, they may be more inclined to lend mainly to large companies and less oriented towards lending to small and medium-sized enterprises (SMEs), which account for a high proportion of employment in developing countries. Furthermore they may give greater priority to consumer lending (for example credit cards), S te p h a n y G r i f f i th - J o n e s 7 especially to middle- and high-income persons, and less to lending to com­ panies, especially for long-term investment. Given the need in developing countries for greater and more efficient investment, this may be very prob­ lematic.3 The effects on development, in different categories of developing country, of these new trends - increased foreign ownership of banks, and bank lending crossing the border - needs careful empirical research. To conclude, clearly the decline in international bank lending has a temporary element that is largely linked to the memory of recent crises and reinforced by the subsequent slowdown in the world economy and its negative effects on developing countries prospects. If crises stop occurring, the memory of them fades and the world economy recovers, this element could be reversed. However more structural, and therefore more permanent, factors seem to be playing a fairly large part in the decline of international bank lending to developing countries. The main factor seems to be the increased ownership by international banks of subsidiaries in developing countries, which allows them to lend in the local currency. Although this local currency lending could be complemented by international lending, there may be a strong incentive for banks not to do so on a significant scale, especially given the increase in risk sensitivity and the relatively high degree of exchange rate risk in international lending to developing countries. Portfolio flows Equity flows Portfolio equity flows to developing countries, which had grown significantly in 1990-97, fell after the East Asian crisis, although the decline was far less dramatic than that of bank lending. Furthermore equity flows became increasingly concentrated in a handful of developing countries. According to the World Bank (2001), in 2000 just four countries - Brazil, China, Mexico and Turkey - accounted for around 85 per cent of all equity flows to devel­ oping countries. An equally important issue is the volatility of equity flows. As the World Bank (ibid.) points out, in three of the recent crises - those in Mexico, East Asia and Russia - mutual funds (which constitute some of the most significant equity investors in emerging markets) withdrew large sums of money.4 The recent trends in portfolio equity flows to developing countries are in sharp contrast to global cross-border equity portfolio flows, which have increased dramatically; indeed according to Kumar and Persaud (2001), between 1995 and 2000 they rose fivefold from US$268 billion to an estimated US$1,100 billion. Thus developing countries now receive a far lower percentage of global equity flows than they did in the mid 1990s. The process of allocating investors funds to equity - both globally and in developing countries - is quite complex, particularly as it involves a range of actors. We shall briefly outline it here before examining recent changes. Institutional investors (such as pension funds and insurance companies), 8 C a p i t a l F lo w s to E m e r g in g E c o n o m ie s retail investors (wealthy individuals) and charities are major global invest­ ment actors. In the case of pension funds, the ultimate responsibility for allocating funds falls on the trustees. However, particularly in the United States and United Kingdom, trustees rely on consultants advice on how - given the structure of their liabilities - they should broadly allocate their assets (typically including the percentage to be allocated to emerging markets). This is done via specialized asset liability models (ALMs). Once the broad allocative decisions have been taken, one or several fund managers are chosen. These fund managers may have a global, regional or country mandate, and they may specialize in bonds and/or equities. In the case of developing countries, they may be a small part of a global fund, there may be specialized funds for all emerging markets, there may be regional ones (for example for Latin America, the Far East, Sub-Saharan Africa or Eastern Europe), or there may even be country funds. One of the more important new trends is that since the mid 1990s there has been a sharp reduction of so-called dedicated investors: emerging-market country funds (which have practically disappeared) and regional emerging- market funds.5 This is particularly the case for Sub-Saharan African funds. A far higher proportion of equity flows to emerging markets go via so-called cross-over investors, that is, those originating from global funds, where only a very small proportion of their portfolios goes to emerging markets. This is problematic because dedicated investors reportedly tend to have a more long-term commitment than cross-over investors, and therefore lower rota­ tion and volatility.6 The problem of reversibility and volatility is therefore made more acute. With regard to the evolution of equity flows to developing countries, the 1990s can be split into two halves. In the first half there was great optimism about the prospect for emerging markets, with the expectation that higher returns would compensate for higher risks, and with the perception that emerging markets offered an interesting opportunity for portfolio diversi­ fication due to their low correlation with developed economies. As a result equity flows to emerging markets grew systematically. The optimism even extended to Sub-Saharan Africa, which was described as the last frontier of emerging markets.7 However since the East Asian and other crises this optimism has declined, as have equity flows. The main reasons for this were that, in the second half of the 1990s, volatility in emerging markets was very high and the returns were not only very low (and on occasion negative) but also lower than in the developed markets - especially the United States. Moreover, as the stock markets became more integrated into the global financial market, the correlation between emerging and developed markets increased, though it remained lower than between developed economies; thus the gains from diversification declined. As a result the promise that emerging markets would offer higher economic growth and therefore high returns, as well as S t e p h a n y G r i f f i th - ] o n e s 9 a lower correlation to compensate for higher risk, was fulfilled only partially; and the risks were certainly seen as high, as one crisis in emerging markets followed another with alarming speed. There seemed to be particularly little interest in investing in low-income countries in Sub-Saharan Africa, as the overall disappointment with emerging markets was particularly focused on these countries, even though they themselves did not have currency crises. There is an additional, more structural, factor that has inhibited equity flows: from the point of view of portfolio investors there are no longer enough large companies in which to invest. Many of the most attractive, large and profitable companies (for example in telecommunication, energy and so on) have been sold to foreign direct investors; this is particularly the case in Latin America. As a result there is no room for portfolio investors. The remaining companies are seen as too small or not attractive enough. Smaller and poorer economies are perceived to have very few or no large and attractive companies for equity investors to put their money into. An important new trend that has emerged in recent years is that an increasing proportion of the issuing and trading of developing-country stocks is taking place in New York and London, via the issuance of American and Global Drawing Rights (ADRs and GDRs). Consequently, a smaller proportion of these activities is taking place in developing countries stock markets. It could even be said that, to some extent, developing countries are exporting their stock markets! There is a contrast here, between inter­ national banking, where the analysis of and decision making on loans by international banks to developing countries is increasingly taking place in the latter countries (in local currency), and international equity investment in emerging markets, which is increasingly taking place in the major inter­ national financial centres. The increasing issuance and trading of developing-country stocks in the big financial centres is not unique; indeed a similar trend can be detected for the smaller European countries. Factors such as the deregulation of capital flows, falling information costs and a growing preference for liquidity are driving this trend. The main factor seems to be investors increased preference for liquidity. The increased preference for liquidity has some temporary elements in that investors responded strongly to the collapse of LTCM and the terrorist attacks on New York and Washington on 11 September 2001. However, besides the temporary after-effects of recent crises and problems, there are also important structural factors that suggest that investors will continue to be biased towards more liquid - and therefore larger - markets. A key factor is that the crowd of international investors has grown; there is a great con­ centration of huge institutional investors, who argue they are too large for small markets liquidity. As a result, if they switch a significant part of their funds they will have a large effect on prices. A second factor is that investors, particularly cross-border investors, are herding more. According to Persaud 10 C a p i ta l F lo w s to E m e r g in g E c o n o m ie s in Chapter 3, the increased tendency to herd is due to greater uncertainty about valuation (as the new economy is based on ideas and knowledge, which are more difficult to value than bricks and mortar), and to the encouragement given by the regulators of short-term, market-sensitive risk management systems to investors with different mandates to act in a simi­ lar way. Given that the latter factors are part of a more long-term trend, this implies that liquid markets will become more liquid while illiquid markets will become even less liquid. This has been the subject of growing complaints in developing countries such as Chile and South Africa, where large local companies are either issuing ADRs or switching their primary listings to New York or London. This is further undermining liquidity in these developing- country markets, as overseas investors no longer need to invest there. A particular problem from a development perspective is that while very large companies will have access to international liquidity, relatively smaller companies will not; they will be restricted to small stock markets with declining liquidity. Because medium-sized companies are not only often more dynamic but also an important source of employment, this could have negative development implications. One policy implication that we shall discuss below is that stock markets in developing countries may need to concentrate on improving their efficiency in raising capital for small companies. Bond flows Bond markets continued to fund emerging economies in the post-Asian crisis period, although at a significantly lower level. For those countries which continued to have access to bond finance, four problems have emerged since the East Asian crisis. First, the cost of borrowing and cost volatility have risen well above the precrisis levels. Second, there have been frequent market closures when issuance has dried up. The IMF (2001b) defines market closures as weeks during which bond issuance falls below 20 per cent of the previous years weekly average issuance. Under this definition, US dollar emerging bond markets were closed for 16 weeks in 2000-1. One of the main reasons for the on-off nature of recent market access is the increasing dominance of emerging-market investment by cross-over investors, who can easily reduce or eliminate their emerging-market holdings if their out­ look deteriorates, if there are better opportunities elsewhere or if their risk aversion increases. The third problem is the reduction of average maturities, and the fourth is the high concentration of bond lending to sovereigns, which is also a reflection of increased risk aversion and is problematic for developing-country corporates. Reportedly, for corporates to be able to issue bonds internationally they not only have to be very creditworthy but must also have international partnership or ownership, as well as foreign exchange earnings.8 S t e p h a n y G r i fp th - J o n e s 11 On balance there is a greater preference, particularly among institutional investors, for fixed-income instruments, which are seen as less risky. However in the case of emerging-market bonds there is a reduced appetite for this type of paper because of the increased perception of risk. As a result of recent crises, and especially since the Russian default, the market for bonds has become far more prone to panic in individual countries. If panic sets in among investors, this can even undermine countries with relatively good fundamentals. Because of the Russian default, investors learned that having the wrong bond, at the wrong time, with the wrong counterparty could lead to complete destruction. Reportedly, the lesson drawn by many fund managers is that if problems emerge in a country they should abandon it entirely, and they explain to their clients that the country abandoned could be a repeat of Russia. This clearly has very negative implications for developing countries. Another important point to stress is that some US investors mark their performance against benchmarks on a daily basis. Large falls in bond values can quickly affect their careers, so they are unwilling to stay in bonds that may fall sharply. Since the Russian default it seems that there has been a tendency among analysts towards a negative bias in their country analysis, as there was strong criticism of analysts who wrote positive reviews on Russia. Besides the problems emanating from the Russian and Argentinean defaults, bond holders - and their associations - tend deeply to resent discussions on orderly debt work-out procedures within the framework of a new international bankruptcy legal procedure, which reportedly would further discourage new bond lending to emerging markets. On the other hand the inclusion of collective action clauses is not seen as a major problem, especially as the British and Canadian Treasuries have issued paper with such clauses. This is true even in the New York market, where there has been little tradition of using such clauses but investors have become more relaxed about their inclusion. Recently a number of major developing countries have issued bonds with collection action clauses, which is very positive. Financial markets have traditionally been inherently short-termist and volatile (see for example Keynes, 1936; Kindleberger, 1978; Minsky, 1982). However the evidence gathered in this book seems to indicate that these markets have become more volatile and that this volatility has the potential to be transmitted in harmful ways to macroeconomic trends in developing countries. Indeed, although the conventional view is that developing-country fundamentals determine the behaviour of international financial markets, there is increasing evidence that in many cases it is the endogenous behaviour of international financial markets that conditions or strongly 12 C a p i ta l F lo w s to E m e r g in g E c o n o m ie s influences fundamentals in developing countries (see Chapter 11). Thus the demand and supply curves for emerging market assets are not inde­ pendent; a supply-led, large capital inflow affects the domestic economic situation (for example by generating an asset price bubble or an over­ valued exchange rate) in a way that can increase the demand for assets. This can lead to costly macroeconomic crises, which makes regulation and other state intervention in international financial markets essential. The ever-increasing complexity of the international financial markets complicates effective regulation, but we hope that this book will con­ tribute to the understanding of different markets and provide useful policy suggestions, including for the design of appropriate international regulation. An important element in the increased volatility of international bank lending is the use of modern risk management models (such as VaR or the related daily earnings at risk). As Persaud points out in Chapter 3, the intrinsic problem with market-sensitive risk management systems is that they incorrectly assume that banks act independently when in fact their decisions are interconnected. When many banks try to sell the same asset at the same time, and there are few or no buyers, prices fall and volatility increases. As prices collapse, for liquidity reasons banks try to sell another asset, which may have been previously uncorrelated with the first. This not only increases the volatility of the second asset, but also correlation. This prompts repeated rounds of selling among agents who use similar models, and generalized herding takes place. The adoption of banks own risk management models to determine their required levels of capital in the internal ratings approach, as proposed in the new Basel Capital Accord, could seriously increase banks tendency for procyclicality in lending, exacerbating both booms and crashes (see Chapter 10). An additional source of concern with regard to the procyclicality of flows is the evidence that the VaR models first developed by banks are being extensively adopted by fund managers and pension funds, leading to similar herding patterns and to procyclicality in their investment (see Chapter 3). Therefore herding is not restricted to one class of actor (banks), but is spreading among many actors. The problem is not just one of procyclical flows, but also of increasingly frequent boom-bust cycles. As Williamson points out in Chapter 8, this is linked to the fact that financial markets are currently dominated by invest­ ment managers with a short-termist approach who are willing - and able - to move in and out of different markets in a relentless quest for short-term returns. This is strongly influenced by the fact that fund managers are evaluated at very short intervals (Griffith-Jones, 1998). Not only is it doubt­ ful that this behaviour maximizes long-term returns, it is also clear that it does not maximize the usefulness of financial markets to the developing countries that raise funds from them. S t e p h a n y G r i f f i th - J o n e s 13 The problem of procyclicality is further exacerbated, especially in relation to bond flows to developing countries, by the increased influence and impact of rating agencies on the terms (and magnitude) on which developing countries can tap world bond markets. As Reisen shows in Chapter 7, sovereign ratings still lag behind rather than lead markets, and they have an important procyclical effect, especially on the bond market. Improved ratings reinforce euphoric expectations and cause excessive capital inflows during booms, whilst during crises the downgrading of ratings causes panic among investors, resulting in capital outflows and increased spreads. Unfortu­ nately, and despite criticisms after the East Asian crisis, procyclical indicators still play a very large part in determining ratings, rather than the use of indicators that can see through the cycle (see Chapter 7). The impact on flows is increased by the practice of certain institutions (for example pension funds) to sell once ratings fall below a certain level; this is particularly marked in the fall from investment grade to non-investment grade ratings. Implementation of the proposed Basel Capital Accord could similarly increase the procyclicality of bank lending, both domestically and, to a lesser degree, internationally (see Chapter 10). The large growth of derivatives in recent years may have positive effects on hedging or managing the risks associated with capital flows for individual investors and lenders. During normal times the unbundling of risk, and the increased liquidity offered by derivatives, is positive. However derivatives - even if used by foreign and domestic companies to hedge their investment - can put downward pressure on emerging-market currencies, and can even precipitate or seriously deepen a devaluation, as investors rush to hedge their currency exposure in anticipation of a possible currency crisis or to meet collateral requirements once the currency and asset prices fall. We have already discussed the use of foreign exchange forwards and swaps (for example by foreign direct investors), and their possible negative impact on capital flows and/or the exchange rate in the lead-up to a crisis. Perhaps more damaging - as Dodd explains in Chapter 6 - is the use of total return swaps (TRS). A TRS is a contract where one leg is based on the total rate of return of some underlying asset, security or security index, and the other leg is based on an interest rate, usually LIBOR. As the swap replicates positions, and thus does not involve ownership or debt, the only capital it involves is the posting of collateral. It is not subject to regulatory restrictions on foreign exchange exposure. TRS can be more problematic than short-term loans if the sudden value of the swap drops (for example because the exchange rate falls), at which point the local swap holder must immediately post additional collateral with its counterpart. Typically this necessitates the sale of other assets, which can result in large and immediate currency outflows. As Dodd points out, if short-term bank loans are considered hot money, then payments to meet margin and collateral are microwave money - they get hot far more quickly. 14 C a p i ta l F lo w s to E m e r g in g E c o n o m ie s Policy implications We have seen from our analysis that capital flows to developing countries pose two clearly separate though related problems. One is that there may be a structural decline in capital flows to both emerging and low-income countries (especially to the former) for a considerable period. The second is the strong tendency - reinforced in recent years - for capital flows to developing countries to be procyclical and short-termist. We shall there­ fore divide our policy suggestions into two sections, the first focusing on encouraging the recovery of private flows to developing countries, especially long-term ones, and the second on measures to diminish the procyclicality and short-termism of such flows. A clear conclusion from our analysis is that private capital flows to dif­ ferent categories of developing countries have fallen significantly since the East Asian crisis. The decline in private flows seems to have been caused to a significant extent by the structural factors outlined above, and therefore may be more permanent. An important and high-priority task therefore is to design measures that will encourage a sufficient return of private flows to developing countries, especially more stable flows, and particularly to low-income countries. It is also important to reduce existing or prevent future international measures that will serve to discourage private flows to developing countries. For example it will be necessary to ensure that the new Basel Capital Accord will not discourage bank lending to developing countries, or increase its cost and procyclicality.9 With regard to policy measures to encourage lending to and investment in developing countries, we can distinguish between those to be taken by (1) recipient countries and (2) developed countries. We shall concentrate on the latter here. Encouraging lending to and investment in developing countries An important issue in respect of bank lending and bond issuance, is how to develop and expand public guarantees or the collateralization of loans, especially during periods when the perception of country risk increases. Mechanisms such as guarantees only on interest payments could be explored, as these could provide additional leverage. A particularly important role that improved public guarantees could play would be to encourage private invest­ ment in infrastructure, especially (but not only) in low-income countries. The possibility of using tax incentives also needs to be evaluated carefully, in both source and recipient countries. In developed countries, for example, could tax relief on contributions to personal pension plans be made some­ what higher if pension funds invested a somewhat higher proportion of their capital in long-term investments in developing countries for a mini­ mum holding period? Could tax incentives also be used to encourage other S t e p h a n y G r i f f i th - J o n e s 15 investment/lending to developing countries? And could other mechanisms, such as ethical investment, which is an increasingly important part of pen­ sion fund activities, be modified so that one criterion for eligibility would be long-term investment in developing countries? In the case of taxation, how in practice would such a mechanism work? With regard to bonds, market participants have made some specific policy suggestions whose net benefits for developing countries as well as their feasibility may need to be explored further. A specific proposal is that developing-country governments should emulate developed-country governments and have preannounced a schedule of borrowing; this, it is suggested, would lead to a more efficient and liquid market for their paper, but it could have - especially in the short term - unfavourable effects on their cost. A more ambitious suggestion relates to the possibility of estab­ lishing a regional mechanism - for example a Latin American borrower authority - that would pool the risks of the various countries in the region and would be capitalized up front; possibly with the capitalization being funded or cofunded by developed economies. Such a mechanism could lower the cost of bond borrowing for developing countries. The positive experience of the Andean Development Corporation (Corporación Andina de Fomento), which is able to issue paper at a significantly lower cost than its member countries and whose capital is funded only by member governments, provides an important precedent. There is also the difficult policy issue of how radical and how formalized should be the ex ante rules for orderly debt work-outs and standstills in times of distress. This issue has been amply debated, but it seems worthwhile stressing here that there may be a significant trade-off between (1) the posi­ tive effects from the greater flexibility in and speed of debt resolution in times of crisis (including the existence of an international legal mechanism to reduce debt in cases of insolvency via international bankruptcy procedures, which may be very helpful for avoiding declines in output or growth during crises) and (2) the possible negative effect on the ability to raise future new money, at increased cost. The inclusion of collective action clauses and the use of exit consent mechanisms offer an intermediate solution that may be effective in rescheduling and reducing debt, as well as in allowing access to new money. This intermediate solution may also have the advantage of greater speed of implementation. Turning now to portfolio equity flows and equity markets, policy actions seem desirable not only to attract more equity flows (though care must be taken to ensure that foreign equity inflows deepen the liquidity of domestic stock markets and do not increase their volatility) but also to ensure that a higher share is traded in developing countries own stock markets. One measure to consider is the creation of regional or subregional stock markets. In this regard important lessons can be learned from Europe, where the smaller stock markets are uniting to pool their liquidity. Another important 16 C a p i ta l F lo w s to E m e r g in g E c o n o m ie s point is that, given the possibility that large companies may leave, smaller exchanges may need to focus on helping to raise foreign capital for some­ what smaller but potentially dynamic companies. Further study is required in all these areas, but above all urgent action is needed, given the sharp fall in private flows. Reducing procyclicality and the short-termism of flows A major challenge is to create countervailing forces in both source and recipient countries that will dampen the natural tendency of financial markets for procyclicality and short-termism, a tendency that has been accentuated by the changes outlined above. In this section we shall focus on issues relating to procyclicality in source countries. There are two complementary means of creating countervailing forces: action taken by the financial industry itself; and measures taken by public authorities, especially regulatory ones. An innovative way to counteract the markets tendency for volatility would be to create market stabilizers, via for example, the greater use of insurance instruments. Similarly, to deal with liquidity holes in emerging markets there is a need to create market makers. Other measures that market actors could take include those already taken by final investors, especially institutional investors with long-term liabilities, such as pension funds. As the Myners Review (2001) argues, to over­ come the problems that arise from the overly frequent (quarterly or monthly) evaluation of fund managers it is crucial for pension fund trustees to recon­ sider the length of the evaluation period and to make it more relevant to their particular liabilities. For example in the case of emerging-market assets the yields over longer periods are likely to be higher than in other markets. More broadly, pension fund trustees - and other institutional investors - should link their investment objectives to what is necessary to meet their future liabilities, and to set targets for their fund managers that accord with these objectives. In turn fund managers should use different risk management systems and models for different clients, making them a better match for the diversity of investment objectives. Furthermore, particularly if the ultimate investor has long-term liabilities, it is crucial to use risk models that see through the cycle. The latter and the greater diversity of risk-management models would encourage stability and discourage the herding and short-termism that are engendered by the current practice of using the same models, and by their problematic nature (see also Chapter 3). A key question is whether market actors will, by themselves, take such actions, or whether encouragement - or indeed formal regulation - by regulators may be required. At the very least regulators should encourage a diversity of risk-management systems and models that better match the diversity of investment objectives, as well as the characteristics of different S te p h a n y G r i f f i th - J o n e s 17 investors and lenders. Equally, as Persaud points out in Chapter 3, regulators could research structural, non-market-sensitive measures of risk (such as degree of duration or currency mismatch), and encourage fund managers to use them. As stated above, the use of more appropriate and diverse models would discourage herding. Furthermore regulators could encourage a longer assessment period for fund managers performance (well beyond the trad­ itional one to three months). Mere encouragement may not be sufficient, and mandatory regulatory action may need to be taken. Because there may be institutional gaps in these areas and/or the regulators do not normally attend to them, a special effort will be needed by those regulatory authorities which do not pay sufficient attention to issues such as cyclicality, herding and short-termism. Another factor that requires attention is the stipulation that investors - like insurance companies - cannot hold bonds that are less than investment grade. The problem is that this requirement is specified in terms of what paper they may hold, and not what they can acquire. As a result, in crises investors mechanically sell (thus deepening the crisis), even if the long-term prospect of the country is good (see Chapter 8). The requirement should be modified to limit what investors can buy rather than what they can hold; this would not only make bond lending more stable, but would also reduce the premium on short-term assessment of whether and when ratings may change. In one area where regulators do have the power to act - bank regulation - it is important that: (1) they are careful not to cause greater procyclicality when they introduce market-risk-sensitive models or the use of ratings by rating agencies to determine capital to asset ratios; and (2) that they introduce explicit countercyclical elements into bank regulation, such as forward-looking general provisions in boom times or even higher capital adequacy ratios in good times, which would discourage excessive expansion of bank lending in good times and provide a cushion to facilitate sustained bank lending in bad times. The Spanish provisioning system is a concrete practical example of the implementation, at least partially, of such princi­ ples of countercyclical regulation. More generally, regulators could require prudential provisions (or capital) when the growth of loans - and/or key asset prices, such as stocks - either accelerates sharply or exceeds some long­ term average measured over at least one cycle. Similarly, charges could be imposed if loan growth fell below this average, decelerated sharply or became negative (see Chapter 12). With regard to rating agencies, in Chapter 7 Reisen shows that their methodology is still procyclical. Hence these seems to be a strong case for regulating rating agencies, and especially their methodology, to ensure that the sovereign ratings they produce focus on objective indicators, particularly variables that see through the cycle. Given the influence and power of rating agencies, and the problem with the quality and procyclicality of their 18 C a p i ta l F lo w s to E m e r g in g E c o n o m ie s assessment of sovereigns, there is an obvious need for transparency in the criteria they use to determine ratings. Finally, derivatives have recently enjoyed considerable growth, but regu­ lation of them has lagged somewhat. As Dodd points out in Chapter 6, it is necessary to improve the reporting and registration requirements; improved transparency will contribute to greater market efficiency and is a sine qua non for appropriate regulation. Second, it is necessary to prevent or discourage market practices that are procyclical and could act as a crisis accelerator. This means imposing appropriate capital requirements on all financial insti­ tutions, including derivative dealers, particularly in developing countries, where such requirements often do not exist. Of equal or greater importance, is the necessity to post and maintain adequate and appropriate collateral or margin on all derivatives transactions at all times. This would replace the current, rather dangerous, method of managing collateral. The initial collat­ eral requirement would be small, but firms should be required to become super-margined if their credit ratings drop substantially, especially below investment grade. This will require a derivatives counterparty to post sub­ stantial amounts of additional collateral, although in the case of developing countries this could force capital outflows if a crisis approached or exploded. In summary, regulators need to focus on generating countervailing or countercyclical measures and actors in order to compensate for the natural tendency of financial markets for procyclicality, accentuated by modern trends. This they have not yet done, or only to a very limited extent. Procyclical and herding behaviour can lead to complex and problematic interactions between different actors and flows. For example a downgrade by a rating agency of a particular sovereign (especially from investment to non-investment grade) can cause investors immediately to sell the bonds of the country in question; simultaneously domestic derivative counterparties may be called on to meet margin calls, leading to capital outflows, and banks may stop lending following their own risk evaluation, which may be reinforced by the proposed Basel Accord. This implies that regulators need to look not just at the risks of particular actors but also at the interaction between the risks of different actors, as they may affect the same borrower or capital recipient, as well as at the possibility of risk increases spreading among borrowers. This will be a complex task, so there is a strong argument for increased coordination - or even better, integration, where feasible - between regulators in different financial sectors. Besides regulatory measures, tax incentives could be used to encourage more stable, longer-term investment, as well as investment in developing countries. Such incentives could be tapered so as to increase with the term of the investment.10 There are legislative precedents for this in the United Kingdom and France in respect of domestic investment. What we propose is that a similar tapering of tax incentives be applied to investment in developing countries. S te p h a n y G r i f f i th - J o n e s 19 * I t h a n k R ic a rd o G o t t sc h a lk fo r u se fu l in p u ts. I a m a lso v e ry g rate fu l t o José A n to n io O c a m p o , R ic a rd o F fre n c h -D a v is a n d J o h n H a w k in s fo r th e ir v a lu a b le c o m m e n ts . 1. In te rv ie w m ateria l. 2. N e u m a n n a n d T u rn e r (2001); in te rv ie w m ateria l. 3. I t h a n k R ic a rd o F fre n c h -D a v is fo r th is p o in t. 4. For th e East A s ia n crisis, see G r iff ith -J o n e s et al. (2002). 5. In te rv ie w m ateria l. 6 . In te rv ie w m ateria l; IM F (2001b). 7. For a m o re d e ta ile d d is c u s s io n see B h in d a et al. (1999). 8 . In te rv ie w m ateria l. 9. See G r iff ith -J o n e s a n d Sp ratt (2001); R e ise n (2001); G o o d h a r t (2001). 10. I t h a n k J e n n y K im m is fo r th is p o in t. References B h in d a , N ., S. G riffith -Jo n e s, J. Leap e a n d M . M a r t in (eds) (19 99 ) Private Capital Flows to Africa, T h e H a gu e : F o n d a d . G o o d h a r t , C . (20 01) T h e In te r -T e m p o ra l N a tu re o f R isk , L o n d o n : F in a n c ia l M a rk e t s G ro u p , L o n d o n S c h o o l o f E c o n o m ic s . G riffith -Jo n e s, S. (1 9 98 ) Global Capital Flows: Should they be Regulated?, B a s in g s to k e a n d N e w York: M a c m i l la n a n d S t M a r t in s Press. a n d S. Sp ratt (20 01 ) T h e P ro -cy c lic a l Effects o f th e N e w B ase l A c c o rd , in J. J. T e u n is se n (ed.), New Challenges o f Crisis Prevention, T h e H a gu e : F o n d a d . R. G o t t s c h a lk a n d J. C a i l lo u x (eds) (20 02) International Capital Flows in Calm and Turbulent Times, A n n A rb or, M I : U n iv e r s it y o f M ic h ig a n Press. In te rn a t io n a l M o n e t a r y F u n d ( IM F ) (20 01a) Emerging Market Financing Quarterly, W a s h in g to n , D C : IM F . (2 0 0 1 b ) International Capital Markets, Developments, Prospects, and Key Policy Issues, W a s h in g to n , D C : IM F . (20 02) World Economic Outlook, W a s h in g to n , D C : IM F . K eyn es, J .M . (1 9 36 ) The General Theory o f Employment, Interest and Money, L o n d o n : M a c m il la n . K in d leb erge r, C . (19 78) Maniacs, Panics and Crashes: A History o f Financial Crisis, N e w York: B a s ic B o o k s. K u m ar, M . a n d A. P e rsau d (2001) Pu re C o n t a g io n a n d In v e sto rs S h if t in g R isk A ppetite : A n a ly t ic a l Issu e s a n d E m p ir ic a l E v id e n ce , IMF Working Paper 0 1 /1 34 , W a s h in g to n , D C : IM F . M in s k y , H . (19 82) T h e F in a n c ia l In s ta b ilit y H y p o th e s is , C a p ita lis t P rocesses a n d the B e h a v io u r o f th e E c o n o m y , in C . K in d le b e rge r a n d J. P. La ffa rgu e (eds), Financial Crisis, Theory, History and Policy, C a m b r id g e : C a m b r id g e U n iv e r s it y Press. Myners Review (20 01) In s t itu t io n a l In v e s tm e n t in th e U K : A R ev iew , L o n d o n : H M Treasury, (h ttp :/ /w w w .h m -tre a su ry .go v .u k /m e d ia //8 4 3 F 0 /3 1 .p d f). N e u m a n n , U . a n d P. T u rn e r (2 0 01 ) M a rk e ts , R e g u la t io n a n d B a n k in g in E m e r g in g M a rk e ts , u n p u b l ish e d paper. Re isen, H . (2001), W i l l Base l I I C o n t r ib u te to C o n v e rg e n c e in In te rn a t io n a l C a p it a l F lo w s? , p ape r p repared fo r th e 2 9 th E c o n o m ic s C o n fe re n ce o f th e A u s tr ia n N a t io n a l B an k , 31 M a y - 1 June, V ie n n a . W o r ld B a n k (20 01) Global Development Finance, W a s h in g to n , D C : W o r ld Ban k . Notes Financial Crises and N a tio n a l Policy Issues: A n O verview Ricardo Ffrench-Davis Introduction In recent years a new type of crisis has developed in Asia and Latin America, with four features that differentiate it from the old type. First, international capital markets have been the major source of shocks, both positive and negative, to emerging economies. Second, capital flows have largely taken place between private suppliers and demanders; fiscal deficits have played only a secondary role, and indeed in most cases public finance has been in balance or surplus (Korea and Thailand before 1997; Argentina and Mexico before the Tequila crisis in late 1994). Third, this type of financial crisis has been suffered by emerging economies that were deemed to be highly successful by international financial institutes, risk evaluation agencies and the financial press. Fourth, flows have been characterized by a lack of regu­ lation and supervision on both the supply and the demand sides. Domestic financial systems in recipient markets have often been liberalized without the parallel development of a significant degree of prudential regulation and supervision, while the new sources of supply have grown, usually unregulated. This chapter discusses the interplay of supply and demand, especially pro­ cyclical interrelations. These involve processes rather than one-off changes, with short-termist agents being the more active dealers, and the natural, long-lasting, differences between relative prices in emerging economies and developed economies are crucial in explaining flows and their macroeconomic effects. The discussion then moves onto capital flows, fiscal, monetary and exchange rate policies and bank regulations, and their implications for the sustainability of macroeconomic balances. The chapter concludes with selected policy implications. The interplay between the supply and demand of funds Since the 1970s international financial flows have increased dramatically and become more diversified (see Chapter 1). But the outcome is potentially 20 R ic a r d o F fr e n c h -D a v is 21 unstable, in that there has been a shift from long-term bank credit, which was the predominant source of financing in the 1970s, to portfolio flows, medium- and short-term bank financing, time deposits and non-greenfield FDI (acquisitions). In fact a very high proportion of the newer supply of financing is of a liquid nature. Thus, paradoxically, there has been a diversi­ fication towards volatile sources of financing in the 1990s. The relative improvement after the Tequila crisis, with a rising share of FDI,1 still included a significant proportion of volatile flows.2 The foundations of the broad liquid market for portfolio investment that were laid down with the Brady bonds in the late 1980s developed vigorously in the 1990s, with Latin America as a major destination for both bond and stock financing; this mar­ ket offered the expectation of high rates of return during the upswings of the two cycles in the 1990s (see Ffrench-Davis and Ocampo, 2001). Meanwhile East and South-East Asian countries were just starting to enter vulnerability zones during the first half of the 1990s (Akyiiz, 1998; Furman and Stiglitz, 1998; Radelet and Sachs, 1998; Jomo, 1998; Agosin, 2001), with mismatches in the maturity structure of the balance sheets of domestic financial intermediaries proving to be even more severe than the worsening net debt position (Krugman, 1999). As a con sequence, in contrast to the 1980s debt and 1995 Tequila crises, both regions moved into vulnerability zones (a combination of large exter­ nal liabilities with a high short-term or liquid share, a significant external deficit, an appreciated exchange rate and high price-earnings ratios in the stock market, plus low domestic investment ratios in Latin American coun­ tries). The outcome, then, was economies that were increasingly sensitive to adverse political or economic news (Calvo, 1998; Rodrik, 1998). The longer and deeper an economys penetration into these zones, frequently encour­ aged by capital surges, the more severe the financierist trap3 in which the authorities could be caught, and the lower the probability of leaving it with­ out undergoing a crisis and incurring long-lasting economic and social costs. By the end of the second upswing in 1997, several economies in Asia and Latin America had penetrated deep into the vulnerability zone, which was reflected in severe crises in both regions when the mood of the external financial market changed, first with respect to East Asia and then to Latin America. One of the strong features of capital flows in the last quarter of the century was the overshooting of supply on both sides of the cycle. There was con­ tagion of both optimism and pessimism. Today the latter feeds the view that the market dryness in emerging economies is permanent, but it is suggested here that the present drought, even though it has lasted quite a long time, is temporary and that the financial setting will tend to generate a new boom and subsequent crisis unless policies and institutions are reformed domes­ tically and internationally (see Ocampo, 2002a; ECLAC, 2002a, 2002b; United Nations, 2002). 22 F in a n c ia l C r is e s a n d N a t i o n a l P o l ic y I s s u e s The literature emphasizes, as sources of financial instability, the asymmetries of information between creditors and debtors and inadequate internalization of the negative externalities that each agent generates (through growing vulnerability) and that underlie the cycles of abundance and shortage of external financing (Rodrik, 1998; Krugman, 2000; Stiglitz, 2000).4 Beyond these issues, as stressed by Ocampo (2002c), finance deals with the future, and concrete information about the future is unavailable. As he states, the tendency to equate opinions and expectations with information is confus­ ing. All the above contribute to herd behaviour, transborder contagion and multiple equilibria. Over and above these facts there are two additional features of the creditor side that are crucially important. One is the particular nature of the agents on the supply side. There are asymmetries between the behaviour and object­ ives of different economic agents. The agents that predominate in the financial markets specialize in short-term liquid investment and are highly sensitive to changes in variables that affect returns in the short term.5 In fact short time horizons are a significant part of the story of the 1990s, as reflected in the volatility of flows that characterized the boom-bust cycles. The second feature is the gradual spread of information on invest­ ment opportunities. Agents from different segments of the financial market are gradually drawn into international markets as they take note of the profitable opportunities offered by emerging economies. This explains, from the supply-side, why the surges of flows to emerging economies in 1977-81, 1991-94 and 1995-97 were processes that went on for several years rather than one-off changes in supply (Ffrench-Davis and Ocampo, 2001). On the domestic side, high rates of return were potentially to be gained from capital surges directed to Latin American economies that were experi­ encing recession, depressed stock and real estate markets, high real interest rates and initially undervalued exchange rates. Indeed in the early 1990s the prices of equity stocks and real estate were extremely depressed in Latin America, which allowed for a 300 per cent average capital gain (in current US dollars) in the stock markets of Latin America between late 1990 and September 1994 (Table 2.1), with rapidly rising price-earnings ratios. After a sharp drop in prices - over 40 per cent - around the time of the Tequila crisis, with the contagion spreading to all Latin American stock markets, average prices nearly doubled between March 1995 and July 1997, pushed up by portfolio inflows (see IMF, 1998). The case of East Asia was different from that of Latin America in one respect - unlike the Latin American countries, the East Asian economies were growing vigorously and had a high ratio of capital formation, financed by domestic savings - but otherwise several similarities were shared by the two regions. When many countries opened their capital accounts in the early 1990s the international supply of funds was booming, equity stock was cheaper than in capital-rich countries (low price-earnings ratios) and external Table 2.1 L a t in A m e ric a a n d East A sia : s to c k e x c h a n ge prices, 1 9 9 0 -2 0 0 2 (in dexe s, J u ly 1997 = 100)* 1990 (Dec.) 1992 (Sept.) 1994 (Sept.) 1995 (March) 1997 (July) 1998 (Aug.) 2000 (March) 2001 (Sept.) 2002 (March) 2002 (June) Latin America 21.7 44.6 92.5 52.3 1 0 0 .0 47.2 88.3 54.8 71.8 60.8 A rg e n t in a 13.4 46.9 78.2 53.5 10 0 .0 53.4 90.3 37.8 23.5 13.5 B raz il 8 .0 2 2 .1 71.8 42.8 1 0 0 .0 44.4 76.9 39.0 54.6 44.6 C h i le 24.5 51.4 93.1 89.4 10 0 .0 48.0 78.4 54.2 61.8 56.4 C o lo m b ia 16.6 65.0 113.1 96.3 1 0 0 .0 49.9 41 .2 29.0 31.2 33.3 M e x ic o 38.6 72.7 132.1 45.9 10 0 .0 49.7 118.5 83.3 116.2 98.7 Peru n.a. n.a. 72.9 56.4 1 0 0 .0 57.3 67.7 54.1 60.2 57.6 V e n e z u e la 84.9 82.2 50.8 37.9 1 0 0 .0 26.2 36 .2 46.3 31.7 27.3 East Asia n.a. 49.9 1 1 0 .0 97.9 1 0 0 .0 37.0 107.9 45.1 77.0 73.9 In d o n e s ia n.a. 53.7 84.2 71.6 1 0 0 .0 1 1 . 1 27.6 13.7 17.3 2 2 .0 K o rea n.a. 87.6 187.2 161.9 10 0 .0 30.2 1 2 0 .1 54.9 109.6 111.9 M a la y s ia n.a. 63.7 119.0 103.5 1 0 0 .0 16.8 61.3 35.6 46.1 47.3 P h il ip p in e s n.a. 67.1 134.6 108.6 10 0 .0 30.4 47.9 25.5 30.9 27 .7 T a iw a n n.a. 37.1 80.9 73.5 10 0 .0 47.6 99.1 31.6 55.5 48 .8 T h a i la n d n.a. 133.9 279.8 236.3 10 0 .0 19.0 48 .0 25.2 3 6.1 42 .2 * The averages are w eigh ted b y a m o u n t o f transac tions . The values a t th e en d o f e ach p e rio d a re expressed in cu rre n t US dollars, exclud ing d is trib u ted earn ings. T he selected dates co rresp o n d to peaks a n d m in im u m levels for th e average o f L atin A m erica (excep t fo r Sep tem ber 1992). Source: Based o n IFC /S tandard Poors, Em erging Stock M arket Review , several issues. Nu 24 F in a n c ia l C r is e s a n d N a t i o n a l P o l ic y I s s u e s liabilities were low. The expected outcome in any emerging economy that moves from a closed to an open capital account should be similar to that recorded in the Latin American countries. Naturally, the rate of return tends to be higher in the productive sectors of capital-scarce emerging economies than in mature, capital-rich markets, so there is scope for very profitable capital flows from the latter to the former. This outcome did in fact occur in East Asia, whose stock prices doubled between 1992 and 1994 and the deficit on the current account and real exchange rates rose. Domestic interest rates, particularly in Latin American countries, tended to be high at the start of surge episodes, reflecting the binding external constraint faced by most countries during periods of low capital inflows, their restrictive monetary policies and the short-termist bias of the financial reforms (see Ffrench-Davis, 2000: ch. 2). Finally, the increased supply of external financing in the 1990s generated an exchange-rate appreciation in most Latin American countries, and more moderately in East Asia. The expectation of continued appreciation encouraged additional inflows from dealers operating with maturity horizons located within the expected appre­ ciation of the domestic currency. The increased supply of external funding in three episodes (1977-81, 1991-94 and 1995-97) generated a greater demand for such financing. This was associated with procyclical domestic policies. Recipient countries that formally adopted such policies or took a passive stance experienced real exchange-rate revaluation, a boom in domestic credit and large deficits in the current account, which were often financed by short-term and liquid capital flows. As a consequence they tended to become increasingly vul­ nerable to changes of mood among creditors; the outstanding cases were Mexico in 1991-94 (Ros, 2001) and Argentina after the Asian crisis. Given the high exposure of financial assets placed in the region, creditors became more sensitive to bad news. This sensitivity rose steeply with the size of net short-term liabilities (Rodrik and Velasco, 2000; Stiglitz, 2000). In summary, the interaction between two factors - the nature of agents and a process of adjustment - explains the dynamics of capital flows over time. When creditors discover an emerging market their initial exposure is negli­ gible or non-existent. But as their stock of financial assets in the emerging market increases their sensitivity to negative news grows. Given their degree of dependence on additional flows, which are associated with the magnitude of the current account deficit, the refinancing of maturing liabilities and the volume of liquid liabilities that is likely to flow out of the country in the event of a crisis it is not surprising that, after a significant increase in asset prices and exchange rates, accompanied by rising stocks of external liabilities, their expectation of the future trend reverses sharply. The accumulation of stocks and the subsequent reversal of flows can both be considered as rational responses by individual suppliers, given the short time horizon of the main agents on the supply side. This is because investors R ic a r d o F fr e n c h -D a v is 25 with short horizons are not concerned about whether (long-term) funda­ mentals are being improved or worsened with capital surges as long as they continue to bring inflows. What is important to these investors is that the crucial indicators from their point of view - real estate, bond and stock prices, and exchange rates - continue providing them with profits in the short term, and that the liquid markets will allow them, if necessary, to reverse their decisions in a timely fashion. Hence they will continue to pour in money until expectations of an imminent reversal start to grow. Indeed for the most influential financial operators, the more relevant variables are not related to long-term fundamentals but to short-term profitability. This explains why they may suddenly display a radical change of mind about the economic situation of a country whose fundamentals, other than liquidity in foreign currency, remain more or less unchanged. The opposite process tends to take place when the debtor markets have adjusted sufficiently down­ ward. This inverse process may be sustained, as in 1991-94 and 1995-97, or short-lived, as in 1999-2000.6 It is no coincidence that in all three significant surges of the last quarter century loan spreads underwent a sustained fall while the stock of liabilities rose sharply: for five to six years in the 1970s, four years before the Tequila crisis, and for a couple of years after that crisis (Figure 2.1). This implies that during the expansion side of the cycle there will be a downward-sloping, medium-term supply curve, a highly destabilizing feature indeed. In this regard it is interesting to note the evident parallel between spreads in Mexico 14 13 _ 12 «11 o O 10 9 8 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 Figure 2.1 L a t in A m erica : cost a n d m a tu r ity o f issues o f b o n d s, 1 9 9 2 -2 0 0 2 (percentages a n d years)* * T he cost is equal to th e average spread o n issues o f b o n d s p lu s th e ra te o f re tu rn o f US Treasury 10-year bonds. Sources: ECLAC; W orld Bank; IMF. A nnua l m o v in g averages. 26 F in a n c ia l C r is e s a n d N a t i o n a l P o l ic y I s s u e s (praised as a well-behaved reformer in the 1990s) and Argentina (which today is classified, incorrectly, as being a non-reformer in the 1990s) (Figure 2.2). Apparently creditors did not perceive any significant difference between these two economies until 1999. One particularly relevant issue is that, as stressed by Ffrench-Davis (2000), economic agents who specialize in the allocation of financial funding (we shall call this microfinance, as opposed to macrofinance) and may be highly efficient in their field but operate with short horizons by training and by reward, have come to play the leading role in determining macroeco­ nomic conditions and policy design in emerging economies. This leads to unsustainable macroeconomic imbalances, with wrong or outlier macro prices and ratios. Figure 2.3 shows the notoriously unstable GDP growth in Latin America as a whole in 1990-2001; obviously, that of the individual countries tended to be even more unstable. The changes in GDP were led by rises and falls in aggregate demand. The changes in demand were stronger in private expenditure and were associated with the evolution of net capital inflows. The resulting real macroeconomic instability undermined the environ­ ment for productive investment and was a strong force behind the poor achievement of investment ratios in the 1990s, when they latter surpassed the 1980s average (19 per cent) by less than one percentage point of GDP and were more than five points below that in the 1970s (Figure 2.4). This significant variable partly explains why GDP growth was 5.6 per cent in the 1970s and a mere 2.4 per cent in 1990-2002 (Table 2.2). What is irrational, and evidently inefficient from the perspective of resource allocation and total factor productivity, is for the decisions of the authorities, which should obviously have a long time horizon, to become 45 0 0 40 0 0 3 5 00 3 0 00 25 0 0 2000 1500 1000 500 0 1994 1995 1996 1997 1998 1999 2 0 00 2001 2002 Figure 2 .2 A r g e n t in a a n d M e x ic o : c o u n t ry risks, 1 9 9 4 -2 0 0 2 (base p o in ts ) Source: JP M organ. C o u n try risk m easu red by th e sovereign spread over th e US zero co u p o n curve. R ic a r d o F fr e n c h -D a v is 27 Figure 2.3 L a t in A m erica : G D P a n d aggregate d e m a n d , 1 9 9 0 -2 0 0 1 (average a n n u a l g r o w th rates, per cent) Source: ECLAC, based o n official figures for 20 co u n trie s in c o n s ta n t 1995 dollars. Latin America: Gross fixed investment, 1977-2002 (% of GDP) N ® 0 ) 0 - N W 4 W ( B N ( C f l ) 0 - N n t L - 1- » S N N ( 0 I S ( 0 ( 0 O I 0 I S f f i f f i O 0 ) 0 1 0 ) 0 I Q 0 ) 0 l 0 I Ö ) . . 0 ) 0 ) 9 3 ) 0 ) 0 ) 0 ) 0 ) 0 ) 0 ) 0 1 0 ) 0 9 l 0 l 0 1 9 ) 0 ) 9 l 0 l 0 ) 0 0 l . . Figure 2 .4 L a t in A m e ric a : g ro s s fix e d in v e s tm e n t, 1 9 7 7 -2 0 0 2 (pe rcen tage o f G D P ) * * P relim inary d a ta for 2002. Source: Based o n ECLAC figures for 19 coun tries , scaled to 1995 prices. entrapped with the lobbying and policy recipes of microfinance, leading to irrational exuberance (to use Alan Greenspan’s expression). Thus in the next cycle the macroeconomic authorities should ensure that funda­ mentals (sustainable external deficit, moderate stock of external liabilities with a low liquid share, the crowding in of domestic savings, limited real exchange rate appreciation) prevail in order to achieve macroeconomic balances that are both sustainable and functional for long-term growth. This Table 2 .2 L a t in A m e ric a a n d East A sia : G D P , 1 9 7 1 -2 0 0 2 (a n n u a l g ro w th rates, percent) 1971-80 1981-89 1990 1991-94 1995 199 6 -9 7 1 9 9 8 -2 0 0 2 1 199 0 -2 0 0 2 1 Latin America2 5.6 1.3 - 0 . 6 4.1 1.1 4.5 1.2 2.4 A rg e n t in a 2.8 - 0 . 7 - 2 . 0 8.0 - 2 . 9 6.7 - 3 . 3 1.7 Brazil 8.6 2.3 -4 . 6 2.8 4.2 2.8 1.7 1.9 C h ile 2.5 3.0 3.3 7.5 9.0 6.8 2.3 5.2 C o lo m b ia 5.4 3.7 3.2 3.9 4.9 2.6 0.4 2.4 M e x ic o 6.7 1.5 5.1 3.5 - 6 . 2 6.1 3.2 3.1 Peru 3.9 - 0 . 7 - 5 . 4 5.1 8.6 4.6 1.6 3.0 V enezu e la 1.8 - 1 . 5 5.5 3.2 5.9 3.4 - 1 . 2 1.9 1971-80 1981-90 1991-92 1993-96 1997 1998 1 9 9 9 -2 0 0 2 1 1 9 9 0 -2 0 0 2 1 East Asia3 8.1 7.0 7.3 7.3 4.6 - 5 . 4 4.7 5.3 In d o n e s ia 7.7 5.5 8.1 7.7 4.7 -1 3 .1 3.1 4.4 K orea 9.0 8.8 7.3 7.3 5.0 - 6 . 7 7.1 6.1 M a la y s ia 7.8 5.2 9.2 9.7 7.3 - 7 . 4 4.8 6.5 P h il ip p in e s 5.9 1.7 - 0 . 1 4.2 5.2 - 0 . 6 3.6 3.0 T a iw an 9.3 8.5 7.5 6.7 6.7 4.6 3.0 5.4 T h a ila n d 7.9 7.9 8.3 8.0 - 1 . 4 - 1 0 . 8 3.5 4.6 Notes: 1 Provisional figures. 2 Average o f 19 coun tries. 3 In each period , each co u n try s GDP was w eigh ted b y its share in reg ional o u tp u t, expressed in c u rren t US dollars. Sources: For L atin America: ECLAC (expressed in US dollars a t 1980 prices fo r 1971-80, a t 1990 prices for 1980-89 an d a t 1995 prices for 1989-2002). For East Asia: IMF, In te rna tiona l F inancia l Statistics; A sian D evelopm en t Bank; JP M organ. R ic a r d o F fr e n c h -D a v is 2 9 requires them to avoid entering vulnerability zones during economic booms cum capital surges. Once inside these zones, much-needed countercyclical policies become impossible during a period of dryness, as discussed in next section. Domestic policies and a macroeconomics for growth As discussed in Chapter 12, the association between capital flows and domestic economic activity has been an outstanding feature of emerging market economies during the past 25 years or so. This highlights the central role played by the mechanism by which externally generated boom-bust cycles in capital markets are transmitted to the developing world, and the vulnerabilities they generate. The high costs generated by business cycles in emerging economies are thus related to the strong connections between domestic and international capital markets. This implies that an essential objective of macroeconomic policies is to reap the benefits from external savings while reducing the intensity of capital account cycles and their negative effects on domestic economic and social variables. In Chapter 12 Ocampo discusses two complementary policy instruments to achieve this objective: capital account regulations and countercyclical prudential regula­ tion of domestic financial intermediation.7 Capital account cycles are associated with the twin phenomena of volatility and contagion. Significant shifts in expectations, usually reinforced by subse­ quent risk-rating changes, lead to sharp procyclical changes in the availability of financing, maturities and spreads (Figure 2.1).8 The most damaging, as already argued, are medium-term fluctuations rather than very short-term volatility, as shown by the several years of abundant financing (1991-94 and mid 1995-97) followed by several years of dryness (1998-2002, with a brief upsurge around 2000). Capital account regulations can serve as a prudential macroeconomic tool, working at the direct source of boom-bust cycles: unstable capital flows. If effective, they provide the ability to lean against the wind during periods of financial euphoria through the adoption of a contractionary monetary policy and reduced appreciation pressures. They should be accompanied by measures to encourage flows in periods of drought, both internationally (see Chapter 1) and nationally. If effective, they will also reduce or eliminate the quasifiscal costs of sterilized foreign exchange accumulation. What is extremely important is that, during the subsequent period of binding exter­ nal constraints, the domestic economy is left with scope for expansionary monetary and fiscal policies. Capital account regulations also serve as a liability policy. The market rewards sound external debt structures, because during times of uncertainty it responds to gross financing requirements, which means that the rollover of short-term liabilities is not financially neutral. This indicates that economic 30 F in a n c ia l C r is e s a n d N a t i o n a l P o l ic y I s s u e s policy management during booms should aim to improve the maturity structures of both private and public sector liabilities. Chapter 12 also discusses recent innovations in capital account regulations. Overall the results of the innovative practice in the 1990s of across-the- board price restrictions on liquid and short-term financial inflows indicate that these can be useful instruments, in terms of both improving debt profiles and facilitating the adoption of countercyclical macroeconomic policies. The basic advantages of a price-based instrument applied to inflows, as pioneered by Chile and Colombia, are its simplicity and its applicability during boom periods. The more quantitative-type Malaysian system, which is geared to outflows, has proved to have stronger short-term macroeconomic effects. Traditional exchange controls, such as those in China and India (for example prohibition on short-term financial borrowing) may be superior if the objective of macroeconomic policy is to reduce significantly domestic macroeconomic sensitivity to international capital flows.9 These direct, price-based or quantitative, regulations on capital flows can be partly substituted by prudential regulation and supervision of domestic financial institutions. The main problem with this option is that it does not attend to the external borrowing of non-financial agents, and may actually encourage them to borrow abroad (that was a severe problem, for instance, in the crises in Korea and Thailand). Accordingly it needs to be supplemented with other disincentives to external borrowing by these agents, deterrents that may become cumbersome and extremely difficult to implement. They may include restrictions on the class of firms that can borrow abroad, restrictions on the terms of corporate debts that can be contracted, and tax arrangements that raise the cost of direct borrowing in foreign markets. Price-based capital account regulations may thus be a superior alternative and much simpler to administer. Prudential regulation and supervision should take into account not only microeconomic risks but also the macroeconomic risks associated with boom-bust cycles. In particular, countercyclical devices should be intro­ duced into prudential regulation and supervision, involving a mixture of the following: • Forward-looking provisions for latent risks, made when the credit is granted on the basis of the credit risks that are expected throughout the full business cycle (an approach adopted by the Spanish authorities). • More discrete countercyclical prudential provisions decreed by the authorities on the basis of objective criteria (for example the rate of growth of credit). • Countercyclical regulation of the prices used for assets given in guarantee. • Capital adequacy requirements that focus on long-term solvency criteria rather than cyclical performance. R ic a r d o F fr e n c h - D a v is 31 Aside from the macroeconomic implications, prudential regulation and supervision of domestic financial systems are needed for the sake of trans­ parency, honesty and microeconomic efficiency. The record was bad in many countries where the liberalization of domestic finance took place without the reform and strengthening of regulation and supervision. Interestingly the severe banking crisis in Chile in 1983, which had cost the Treasury one third of GDP, was forgotten by the financial reformers of the 1990s in Latin America and most of the errors were replicated. The financial crises of 1994-95 and 1997-98 sounded a wake-up call to Latin America and East Asia, respectively, that regulation and supervision needed to be strengthened substantially. As reported in Chapter 15, since then important steps have been taken to improve the rules and ensure their implementation, but financial regulation and supervision do not take place in a vacuum. Financial policies need a consistently supportive macro- economic environment in which to operate, as the Argentinean crisis of 2001-2 showed only too well. Problems in individual banks can set off chain reactions because of the direct links between banks, and because of the effects that bank collapses can have on borrowers capacity to honour their commitments. Moving from systems where the authorities had set interest rates, directed credit and held a large share of bank deposits as required reserves, governments freed com­ mercial banks to make their own decisions on borrowers, loan volumes and prices. At approximately the same time, in both Latin America and East Asia, capital account liberalization enabled local banks to engage in transactions in foreign currencies and allowed foreign institutions to enter local markets. The lack of an adequate regulatory and supervisory system compounded the problems of bankers who lacked sufficient experience in conducting credit analyses of local borrowers and had an inadequate understanding of financial mismatches and the complexities of international financial markets. The typical results were credit booms, maturity and currency mismatches, and eventually banking crises. As seen in the paradigmatic Chilean case (but also later in Mexico, East Asia and Argentina), errors by domestic actors provided the basis for such crises, and if this was combined with external shocks the situation became far more severe (Ffrench-Davis, 2002: ch. 6). Government rescues tended to follow a standard procedure. The first steps were to take over non-performing loans, recapitalize banks and conduct liquidations and mergers, usually involving foreign institutions.10 Later, in an attempt to prevent future crises, regulation and supervision were stepped up; moreover greater information and transparency were required. In Chapter 15 Stallings and Studart, on the basis of World Bank data (see Barth et ah, 2001), review the recent situation in Latin America, particularly in Argentina, Brazil, Chile and Mexico. According to the authors, these countries have made considerable progress with restructuring their financial system and putting in place prudential 32 F in a n c ia l C r is e s a n d N a t i o n a l P o l ic y I s s u e s regulation and supervision since the initial phase of more naive financial liberalization. Supposedly, with the reform to the previous reform, these countries are now better able to withstand external shocks, with their financial systems showing greater resilience than before. It was a common belief among international financial institutions that Argentina had pro­ gressed enormously in terms of improving its financial system. This is con­ firmation that Argentina, as evaluated by financial markets, was classified as a well-behaved and dedicated reformer. Argentinas regulations appeared to be the strictest in the region. However very strong macroeconomic shocks can undermine even the strictest regula­ tions and lead to banking crises, as Argentinas experience in 2001-2 showed. In this case a particularly crucial domestic variable was an outlier macro price - the exchange rate - in a highly but far from fully dollarized economy. The sharp rise in spreads faced by Argentina severely complicated its fiscal stance. The exchange-rate regime has become a much more influential variable in emerging economies in terms of trade and finance. It is subject to two conflicting demands, which reflect the more limited degree of freedom that authorities face in a world of reduced policy effectiveness (see ECLAC, 2000; Ocampo, 2002b). The first demand comes from trade: with the dismantling of traditional trade policies the real exchange rate has become a key determin­ ant of international competitiveness and a crucial variable in the efficient allocation of resources into tradables. The second demand comes from the capital account. Boom-bust cycles in international financial markets generate a demand for flexible macroeconomic variables to absorb, in the short term, the positive and negative shocks generated during the cycle. Given the reduced effectiveness of traditional policy instruments, particularly monetary policy, the exchange rate plays an essential role in helping to absorb shocks. This objective cannot be easily reconciled with the trade-related goals of exchange rate policy. The relevance of this dual demand is ignored in the call to limit alterna­ tives to the two extreme exchange rate regimes: a totally flexible exchange rate or a currency board (or outright dollarization). Intermediate regimes of managed exchange rate flexibility - such as crawling pegs and bands, and dirty floating - attempt to reconcile these conflicting demands (see Frankel, 1999; Williamson, 2000; Ffrench-Davis and Ocampo, 2001; Ocampo, 2002b). As argued by Ffrench-Davis and Larrain in Chapter 13, completely rigid exchange rate systems tend to amplify external shocks because they put heavy and unrealistic demands on domestic flexibility, particularly on wage and price flexibility in the face of negative shocks. Currency boards cer­ tainly introduce built-in institutional arrangements that provide for fiscal and monetary discipline, but they radically reduce the ability to stabilize monetary, credit and fiscal policies, which is necessary to prevent crises or facilitate recovery in a post-crisis environment. Currency boards therefore allow the domestic transmission of external shocks, generating strong R ic a r d o F fr e n c h -D a v is 33 swings in economic activity and asset prices, with corresponding domestic financial vulnerability. There is an amplification effect when agents consider that the external shock is strong enough to induce the authorities to modify the exchange rate policy. This is particularly grave when the rate appears to be an outlier price, too appreciated. Notwithstanding the pitfalls of nominal pegs, there are cases in which they can work efficiently. The currency board in Argentina, assisted by the capital surge to Latin America since the early 1990s, was quite effective in stopping hyperinflation, which was the more harmful problem in that economy in 1991. The worst mistake was not to use the opportunities provided in 1992 and 1993 to make the rate more flexible when inflation and the budget were evidently under control, capital inflows were vigorous and spreads to emerging economies, including Argentina, were falling. On the other hand the volatility characteristic of freely floating exchange rate regimes is not a problem when market fluctuations are short-lived; they are easily dealt with by derivatives (see Chapter 6). But fluctuations become a major concern when there are longer waves, as has been typical of the access of emerging economies to capital markets in recent decades. In this case exchange rate volatility tends to have perverse effects on resource allocation in irreversible capital formation. Moreover under freely floating regimes with open capital accounts, anticyclical monetary policy exacer­ bates cyclical exchange rate fluctuations, with their associated allocative and income effects. The ability of a flexible exchange rate regime to smooth out the effects of externally induced boom-bust cycles thus depends on the authorities capacity to manage countercyclical monetary and credit policy without enhancing procyclical exchange rate patterns. The effectiveness of this is strengthened under intermediate exchange rate regimes cum capital account regulations, as in the case of Chile in the first half of the 1990s (Le Fort and Lehmann, 2000; Ffrench-Davis, 2002: ch. 10). However, as discussed by Ffrench-Davis and Larrain in Chapter 13, bands did not behave well during the Asian crisis. In many cases this was partly the result of mismanagement of the band. The huge increase in capital inflows to emerging economies in 1990-97 put severe upward pressure on exchange rates. The response, in terms of expanding the size of the band or appreci­ ating it, resulted in a credibility loss. Subsequently bands that already had an overly appreciated rate had trouble adapting to the sharp shift brought by the Asian crisis, when capital inflows suddenly stopped. This added to the mismanagement of bands, thereby causing a further credibility loss. The main benefit of managed flexibility, including bands, emerges in times when there are no strong shocks. In such cases, bands induce real exchange rate stability and maintain the ability to absorb, at least partly, the effects of moderate shocks. Consequently the exchange rate more efficiently fulfils its allocative role between tradables and non-tradables. 34 F in a n c ia l C r is e s a n d N a t i o n a l P o l ic y I s s u e s Obviously, intermediate regimes also have shortcomings and can generate costs (Ocampo, 2002b). First, all intermediate regimes are subject to specu­ lative pressure if they do not enjoy credibility in the markets, and the cost of defending the exchange rate from such pressure is very high. Second, sterilized reserve accumulation during long booms can be financially costly. Finally, the capital account regulations needed to manage intermediate regimes efficiently are only partially effective. But all things considered, intermediate regimes offer a sound alternative to costly volatility. The review in Chapter 13 of the Argentinean, Chilean and Mexican experiences shows that a policy that is suitable for one macroeconomic environment may not be so for another. In this sense, a crucial point to bear in mind when adopting a policy is how costly it would be to switch to an alternative one. Credible pegged systems can be useful when a crisis with hyperinflation has bottomed out and there is a plentiful supply of external funding. Floating systems are useful in times of financial distress when the authorities have doubts about the level of the real exchange rate or the nature of the shock they face; flotation allows them not to put their reputation in jeopardy by defending the wrong real exchange rate. Finally, bands help to stabilize the real exchange rate, which in turn has a positive effect on the quality of exports and on growth (see ECLAC, 1998a: ch. 4). But bands are subject to weakness if a big shock appears and the authorities have failed to avoid vulnerability zones during the previous boom. In such cases they open the way to speculation, inducing significant financial instability. The latter can be tackled more efficiently by temporarily moving to a fully flexible rate. Chapter 13 summarizes why corner solutions do not have symmetric con­ sequences. With a capital surge, the current account deteriorates, asset prices increase and the real exchange rate appreciates. Each exchange rate policy will deliver different combinations of these three elements. With pegged systems a capital surge creates a demand boom, forcing up asset prices and probably crowding out domestic savings and worsening the external balance. With floating regimes a nominal appreciation will take place, thus making the process of real appreciation faster (and potentially more disruptive) than with the peg. Pegs tend to work better in the upward phase of the cycle, but after the inflection point the float does it better in terms of the necessary expenditure switching. But in this type of cycle there is the possibility of multiple equilibria based on self-fulfilling prophesies: expectations of more inflows (outflows) may further appreciate (depreciate) an already appreciated (depreciated) currency. Large deviations from equilibrium by the real exchange rate are costly. Central banks should be concerned with both the level and the stability of the exchange rate. In this sense, and despite what has happened since the Asian crisis, managed flexibility - with or without bands - is still a policy to R ic a r d o F fr e n c h -D a v is 35 be considered. Policy makers need to be wary about across-the-board lib­ eralization of the capital account as the behaviour of capital flows may be inconsistent with macroeconomic stability, particularly in terms of the stability of the exchange rate and economic activity. In this sense the authorities need to have a flexible policy package rather than a single, rigid policy tool. Fiscal policy should be part of the flexible policy package. As discussed by Budnevich in Chapter 14, fiscal policy has two macroeconomic objectives: sustainable public accounts and the regulation of aggregate demand. It is obvious that policy efforts have tended to concentrate on the first objective, leaving the stabilizing role to monetary policy. Given the vulnerability of emerging economies to global economic down­ turns, overreliance on monetary policy may bring poorer macro results than a more balanced framework of countercyclical fiscal, exchange rate and monetary policy, as well as prudential regulation of capital flows. The use of countercyclical fiscal policy requires solvent and sustainable fiscal accounts as a precondition. A more active role for countercyclical fiscal policy may emerge when transmission channels of monetary policy to the output gap are weak or show significant lags. Moreover spreading the adjustment burden between fiscal and monetary policy may bring better macroeconomic results, with macro prices staying closer to sustainable equilibria. Fiscal policy has been at the heart of the debate on adjustment programmes in emerging economies (see ECLAC, 1998b; Ocampo, 2002b). In both East Asia and Latin America the more conventional recipes recommended achiev­ ing current or annual fiscal balances, when in recessionary conjunctures that depressed tax proceeds. This is typically procyclical behaviour. In Latin America fiscal policy has not played a proper countercyclical role. During recessions it has typically been directed at keeping financial solvency under control, while during booms expenditure has tended to expand with the cycle. In countercyclical policy packages, structural balance is the most import­ ant fiscal component. There are different definitions, but the essential component is the measurement of the balance across the business cycle, estimating at each point of time what would be the public expenditure and income in a framework of sustainable full employment of human and physical capital. If terms of trade fluctuations are of relevance to tax proceeds - via the profits of public or private exporters - the purchasing power of potential GDP should be estimated at the trend terms of trade as well as public income. Chile has advanced significantly in achieving a structural fiscal balance (see Tapia, 2003). Developing countries typically concentrate their international trade on a few commodity exports that are subject to highly volatile market prices. When a significant export - such as copper in Chile and oil in Mexico and 36 F in a n c ia l C r is e s a n d N a t i o n a l P o l ic y I s s u e s Venezuela - is public property the establishment of a stabilization fund can contribute to macroeconomic sustainability. For a long time the Coffee Fund has played an important macroeconomic stabilizing role in Colombia. Above trend or normal public receipts from coffee are saved in the fund in order to finance public expenditure when the receipts are below normal. As argued by Budnevich in Chapter 14, most commodity prices tend eventually to revert to their trend - a requirement for a stabilization fund to be viable - but only very slowly, the average reversal time being measured in years. Thus a commodity stabilization fund has to be very large to be effective in the long term. Furthermore in the case of an export stabilization fund it is wise to initiate it when prices are high in comparison with the trend prices, so that the fund can finance subsequent negative price scenarios. The stabilization fund principle can also be used for deviations in tax proceeds from their structural level, and flexible tax rates have been pro­ posed as a countercyclical device. The suggestions tend to concentrate on VAT and contributions to pension funds. For instance when the external deficit is above a sustainable level because of excess domestic absorption, then the proceeds of VAT will exceed the structural level. That excess could be automatically put into a fund, which would help to push aggregate demand downward towards equilibrium. The disadvantage of using VAT (an inflationary impulse in the short term, when the rate is increased) must be weighed against the advantages (a broad tax base and effects on con­ sumption rather than investment). A VAT adjustment will not bring about a significant misallocation of resources and the taxes are collected regularly. However it is likely to involve some transaction costs. Another policy tool to consider is some short-term variation in compulsory pension fund or unem­ ployment insurance contributions. An effective unemployment insurance scheme is not only socially desirable, but it can also serve as an important countercyclical stabilizer. Of course the most direct tool is the regulation of flows when they are the source of disequilibria. Some policy lessons and pending issues Dominant features of the new generation of business cycles in emerging economies are the sharp fluctuations in private spending and balance sheets associated with boom-bust cycles in external financing. Of course external shocks, both positive and negative, will be amplified domestically if the exchange rate, fiscal and monetary policy stances are also procyclical, as is expected to be the case by financial market agents and even multilateral agencies (particularly the IMF). Changes in expectations and the credibility of domestic macroeconomic authorities and domestic financial intermediaries play a key role throughout the process. We have observed that emerging economies have moved into vulnerability zones that include high external liabilities with a large liquid R ic a r d o F fr e n c h - D a v is 37 share, high external deficits, high exchange rates and high prices of domestic financial assets and real estate. Policy lessons Ffrench-Davis and Ocampo (2001) summarize what they consider to be robust policy actions, grouped into five areas: • Maintain a sustainable volume and composition of external liabilities and capital flows; sustainability is closely related to the use made of inflows. • Avoid outlier exchange rates and price-earnings ratios of equity stock. • Ensure that there is flexible, comprehensive, prudential macroeconomic regulation, including of the financial system, fiscal accounts and capital flows. • Press for a reform of the international financial architecture in the interest of a more efficient and balanced globalization process. • Implement a crisis-prevention policy, based on the prudential manage­ ment of booms. If these lessons have not been learned and a country or region is in a critical conjuncture, as is the case today in Latin America, what policy recommen­ dations can be made to address pending issues? Pending issues In the domestic realm there are three issues to consider: the quality of recovery; capital account opening and the sustainability of real macroeco­ nomic equilibria; and the constituencies served by the authorities. With regard to the quality of recovery, here again the approach taken during the precrisis stage is crucial. Countries that have undergone severe crises - including Korea, where recovery was very strong - are usually pushed onto a lower GDP path. There are three particularly important medium-term effects on GDP: • A sharp reduction of productive investment during the crisis naturally damages the path of potential GDP. • The deterioration of balance sheets (Krugman, 1999), as illustrated by the experience of emerging economies, shows that restoring a viable financial system can take several years, generating adverse effects throughout the period in which it is being restored. • There is a growing body of evidence that boom-bust cycles have ratchet effects on social variables (Rodrik, 2001). The deterioration of the labour market (through unemployment, a decline in the quality of jobs or in real wages) is generally very rapid, whereas the recovery is painfully slow and incomplete. This was reflected in the long-lasting deterioration of real wages in Mexico after the Tequila crisis (Ros, 2001). 38 F in a n c ia l C r is e s a n d N a t i o n a l P o l ic y I s su e s These three problems point to the policy priorities that should be estab­ lished during a crisis: sustaining public investment and encouraging private investment; helping to reschedule liabilities and solve currency and maturity mismatches; and reinforcing the social network by using the opportunity to improve the productivity of temporarily underutilized factors. With regard to the second issue, it is commonly argued that fully opening the capital account discourages domestic macroeconomic mismanagement. This is partly true for domestic sources of instability - large fiscal deficits, permissive monetary policy and arbitrary exchange-rate overvaluation - but volatile market perceptions make this type of control highly unreliable in emerging economies with responsible authorities: lax demand policies or exchange rate appreciation tends to be encouraged by financial markets during booms, whereas excessive punishment during crises may force the authorities to adopt overly contractionary policies (irrational overkill). As we have argued, this is associated with the nature of agents and the nature of cycles. Indeed market actors such as credit rating agencies and investment banks usually operate in a procyclical fashion (for a related discussion on rating agencies see Chapter 7). In reality, opening the capital account can lead to a deterioration of economic fundamentals. Thus although market discipline can serve as a check to domestic sources of macroeconomic instability, it can also be a source of externally generated instability. The market may actually induce the deviation of fundamental variables from their sustainable levels, thus entering into a vulnerability zone. Financial operators, perhaps unwittingly, have come to play a role with significant macroeconomic implications. With their herd-like expectations they have helped to intensify financial flows to successful countries during capital surges, thus causing rapid increases in the price of financial assets and real estate, as well as a sharp exchange rate appreciation. When added to the substandard prudential regulation and supervision in these markets, these macroeconomic signals serve to prolong a process that wrongly appears to be efficient and sustainable (with good profits and loan guarantees, supported by high stock prices and the low value in domestic currency of dollar-denominated debt). But in fact bub­ bles are being generated, with outlier macro prices that sooner or later will burst. Excessive indebtedness and massive outflows ensue, often prompting admonishment by the very agents who praised the economic performance of these countries during the boom. There is a broad consensus that fundamentals are the most relevant variables. However there is disagreement about what constitute sound fundamentals and how to achieve and sustain them. A comprehensive definition of sound fundamentals should include (alongside low inflation, a sound fiscal balance and dynamic exports) sustainable external deficits and net debts, low net liquid liabilities, a non-outlier real exchange rate, a crowding in of domestic savings, high investment in human and physical R ic a r d o F fr e n c h -D a v is 39 capital, strong prudential regulation and supervision, and a transparent financial system. In recessive periods this requires the achievement of a structural fiscal balance (recognizing that during recessions tax proceeds are abnormally low and that public expenditure should not follow suit) and strong encouragement of demand, with a switch of policies when domestic activity is clearly below productive capacity (see Ffrench-Davis, 2000: ch. 6). Finally, there is a growing duality, worrisome for democracy, in the constituencies served by the authorities. The increasing complexity of and course taken by economic globalization are increasing the distance between decision makers, financial agents and the agents (workers and firms) who bear the consequences. One consequence of the path being taken by globalization is that experts in financial intermediation - which requires only microeconomic training - have become a determining factor in the evolution of countries macroeconomy; instead a good economic system needs to reward productivity improvements rather than speculation and rent seeking. The integration of capital markets has strong implications for the gover­ nance of domestic policies and the constituencies of national governments. In fact most leaders of emerging countries have a dual constituency: on the one hand they seek reelection by their countries voters, and on the other they seek the support of those who vote for their financial investments (Pietrobelli and Zamagni, 2000). Recent cycles in financial markets have revealed a significant contradiction between the two in a negative sum game. A positive outcome requires institutions and policies that can achieve consistency between the level and composition of financial flows, and real macroeconomic sustainability. Notes * I a m grate fu l fo r the c o m m e n ts m a d e b y the p a rt ic ip a n ts in th e U N U / W ID E R project, p a rt ic u la r ly José A n t o n io O c a m p o a n d S te p h a n y G riffith -Jo n e s; b y th e p a r t ic ip a n ts in a se m in a r at th e D E S A / U N h ead qu arte rs; a n d b y th e M a c r o e c o n o m ic G r o u p o f th e In it ia t iv e fo r P o lic y D ia lo g u e , d irected b y J o se p h S t ig litz . I a lso ap p rec ia te the v a lu a b le a ss ista n ce o f a n d s u g g e s t io n s b y R ic a rd o G o t t s c h a lk ( ID S ) a n d H e rib e rto T a p ia (E C L A C ) . T h e re sp o n s ib ility fo r a ll in te rp re ta t io n s is s o le ly m in e . 1. T h e d irect p o s it iv e l in k b e tw een E D I a n d p ro d u c t iv e in v e s tm e n t (F fre n c h -D a v is a n d Re isen, 1998: ch . 1) w a s w e ak e n e d b y th e fact th a t a s ig n if ic a n t share o f F D I co r re sp o n d e d to m erge rs a n d a c q u is it io n s in ste a d o f c re a tin g n e w capac ity . It is e stim a te d th a t m e rge rs a n d a c q u is it io n s a c c o u n te d fo r 49 per ce n t o f F D I to L a t in A m e r ic a in 1 9 9 5 -2 0 0 0 ( U N C T A D , 2001). 2. T h e accelerated g r o w th o f d eriva tive s m arke ts h e lp e d to so ften m ic ro in stab ility , b u t te n d e d to in crease m a c ro in s ta b il ity a n d to reduce tran sp aren cy . For a n a n a ly s is o f th e c h a n n e ls b y w h ic h s ta b ility a n d in s ta b il ity are tran sm itte d , see C h a p te r 6. 3. B y f in a n c ie r is t w e m e a n a m a c r o e c o n o m ic p o lic y a p p ro a c h th a t le ad s to a n extrem e p re d o m in a n c e o f o r d e p e n d e n c y o n a ge n ts w h o sp ec ia lize in m ic ro e c o ­ n o m ic aspects o f fin an ce , p la c e d in th e sh o rt-te rm o r l iq u id se g m e n ts o f cap ita l m arkets. 40 F in a n c ia l C r is e s a n d N a t i o n a l P o l ic y I s s u e s 4. Th ere is a d if fe re n t issue, b u t a lso re levant, a sso c ia te d w ith th e g a p b e tw een average (p riva te ) a n d m a rg in a l (so c ia l) co sts o f b o r ro w in g b y e m e rg in g e co n o m ie s. See H arb e rge r (1985). 5. In C h a p te r 3 Pe rsau d a rgu e s th a t m o d e rn r isk m a n a g e m e n t b y in v e s t in g in s t i ­ tu t io n s (su c h as fu n d s a n d b a n ks), b a se d o n v a lu e -a t-r isk m e a su re d d a ily a n d w ith lim it s set fo r d a ily e a rn in g s a t risk, w o rk s p ro c y c lic a l ly in b o o m s a n d busts. P ro cy c lic a lity is re in fo rce d b y a tre n d to w a rd s th e h o m o g e n iz a t io n o f cre d ito r agents. 6. V u ln e ra b ilit ie s w ere s t ill s ig n if ic a n t in e m e rg in g e c o n o m ie s w h e n n e ga t iv e s ig n a ls reappeared in th e w o r ld e c o n o m y , in c lu d in g th e d o w n w a r d a d ju s tm e n t in th e U n ite d States. 7. N e ith e r o f these is a su b st itu te fo r th e r isks th a t p ro c y c lic a l o r ir re sp o n s ib le m a c r o e c o n o m ic p o lic ie s generate. 8. T h e m ark e ts h a v e m a d e so m e p ro gre ss to w a rd s s ta b ility b y in t r o d u c in g c o u n te r ­ c y c lic a l a d ju s tm e n t c lau se s fo r lo an s : fo r in sta n c e tied to e xp o rt p rice s (see C h a p te r 14) a n d co lle c t ive a c t io n c lau se s (see C h a p te r 8). O n th e o th e r h a n d r isk -ra t in g a ge n c ie s c o n t in u e to b e h a ve p ro c y c lic a l ly a n d to fo l lo w ra th e r th a n le ad th e f in a n c ia l m a rk e ts (see C h a p te r 7). 9. See fo r in s ta n c e Le Fort a n d L e h m a n n (20 00) a n d A g o s in a n d F fre n c h -D a v is (2001) o n C h ile , a n d K a p la n a n d R o d r ik (20 01) o n M a la y s ia . 10. T h ere h a v e b e e n s izab le a c q u is it io n s o f b a n k s in e m e rg in g e co n o m ie s , p a rt ic u la r ly i n C e n t ra l E u ro p e a n d L a t in A m e rica . For in s ta n c e in 2 0 0 0 h a lf o f A rg e n t in a s b a n k assets b e lo n g e d to fo re ig n c o n tro lle d b an ks. In te re stin g ly , fo re ig n o w n e r ­ s h ip im p lie s th a t o ffsh o re le n d in g b y these b a n k s h a s b e e n co n ve rte d to o n sh o re le n d in g (see C h a p te r s 4 a n d 5). T h e c o n v e n t io n a l a rg u m e n t th a t th e lo c a l p resence o f fo re ig n b a n k s w o u ld h e lp e m e rg in g e c o n o m ie s to c o n fro n t f in a n c ia l s h o c k s h a s a p p a re n t ly n o t b e e n su p p o r te d in A rg e n t in a . References A g o s in , M . (20 01) K o re a a n d T a iw a n in th e F in a n c ia l C r is is , in R. F fre n c h -D a v is (ed.), Financial Crises in Successful Emerging Economies, W a s h in g to n , D C : E C L A C / B r o o k in g s In s t itu t io n . A g o s in , M . a n d R. F fre n c h -D a v is (20 01) M a n a g in g C a p it a l In f lo w s in C h ile , in S. G riffith -J o n e s, M . F. M o n t e s a n d A . N a s u t io n (eds), Short-Term Capital Flows and Economic Crises, O x fo rd : O x fo rd U n iv e r s it y Press fo r U N U / W ID E R . A kytiz , Y. (19 98) T h e Ea st A s ia n F in a n c ia l C r is is : B a c k to th e Fu ture , in K. S. J o m o (ed.), Tigers in Trouble, L o n d o n : Z e d Bo oks. B arth , J. R., G . C a p r io Jr a n d R. L e v in e (20 01) T h e R e g u la t io n a n d S u p e rv is io n o f B a n k s A r o u n d th e W o r ld : A N e w D a ta Base , Policy Research Working Paper Series, n o . 2588, W a s h in g to n , D C : W o r ld B an k . C a lv o , G . (19 98) V a r ie t ie s o f C a p it a l-M a r k e t C r ise s , in G . C a lv o a n d M . K in g (eds), The D ebt Burden and its Consequences for Monetary Policy, L o n d o n : M a c m il la n . E C L A C (1998a) Políticas Para Mejorar la Inserción en la Economía M undial, 2 n d edn, Sa n t ia g o : F o n d o de C u ltu ra E c o n ó m ic a . (19 98b ) The Fiscal Covenant: Strengths, Weaknesses, Challenges (L C /G .2 0 2 4 ), Sa n t ia g o : U n it e d N a t io n s . (20 00 ) Equity, Development, Citizenship, S a n t ia g o : U n ite d N a t io n s . (2002a) Growth w ith Stability: Financing for Development in the New International Context, L ib ro s de la C E P A L , n o . 67, Sa n t ia g o : C E P A L . R ic a r d o F fr e n c h - D a v is 41 (2 0 0 2 b ) Globalization and Development (L C /G .2 1 5 7 [SE S .2 9 /3 ]), S a n t ia g o : U n ite d N a t io n s . F fre n c h -D a v is , R. (20 00) Reforming the Reforms in Latin America: Macroeconomics, Trade, Finance, L o n d o n a n d N e w York: M a c m i l la n a n d St M a r t in s Press. (ed.) (20 01) Financial Crises in Successful Emerging Economies, W a s h in g to n , D C : E C L A C / B r o o k in g s In s t itu t io n . (2 0 02 ) Economic Reforms in Chile: from Dictatorship to Democracy, A n n Arbor, M I : U n iv e r s it y o f M ic h ig a n Press. a n d J. A . O c a m p o (20 01) T h e G lo b a liz a t io n o f F in a n c ia l V o la t i l it y , in R. F french - D a v is , Financial Crises in Successful Emerging Economies, W a s h in g to n , D C : E C L A C / B r o o k in g s In s t itu t io n . a n d H . R e ise n (eds) (19 98) Capital Flows and Investm ent Performance: Lessons from Latin America, Paris: E C L A C / O E C D D e v e lo p m e n t Centre . Franke l, J. A . (19 99) N o S in g le C u r re n c y R e g im e is R ig h t fo r A l l C o u n t r ie s o r at A l l T im e s , Essays in International Finance, n o . 215, P r in ce to n , NJ: In te rn a t io n a l F in an ce Sectio n , D e p a r tm e n t o f E c o n o m ic s , P r in c e to n U n ive rs ity . Fu rm an , J. a n d J. St ig litz (1998) E c o n o m ic Crises: E v id e n ce a n d In s ig h t s f ro m East A sia , Brookings Papers on Economic Activity, n o . 2, W a s h in g to n , D C : B r o o k in g s In stitu te . Harberger, A. (1 9 85 ) L e s so n s fo r D e b to r -C o u n tr y M a n a g e r s a n d P o lic y -M a k e rs , in G . S m it h a n d J. C u d d in g t o n (eds), International D ebt and the Developing Countries, W a s h in g to n , D C : W o r ld B an k . In te rn a t io n a l M o n e t a r y F u n d ( IM F ) (19 98) World Economic Outlook, 1998. Financial Crises: Characteristics and Indicators o f Vulnerability, W a s h in g to n , D C : IM F , ch . 7. (2 0 0 2 ) Global Financial Stability Report: M arket Developments and Issues, W a s h in g to n , D C : IM F (June). J o m o , K. S. (ed.) (1 9 98 ) Tigers in Trouble, L o n d o n : Z e d Bo o ks. K a p la n , E. a n d D . R o d r ik (20 01) ‘D id th e M a la y s ia n C a p it a l C o n t r o ls W o r k ? ’, NBER Working Paper, n o . 8142, C a m b r id g e , M A : N B E R , February. K ru g m a n , P. (19 99) ‘B a la n ce Sheets, th e T ransfe r P ro b le m , a n d F in a n c ia l C r ise s , in P. Izard, A. R a z in a n d A. R o se (eds), International Finance and Financial Crises, D o rd re c h t: K luw er. (20 00) C rise s: T h e Price o f G lo b a liz a t io n ? , p a p e r p re sen ted at th e Federal Reserve B a n k o f K a n sa s C i t y S y m p o s iu m o n G lo b a l E c o n o m ic In te g ra t io n : O p p o r ­ tu n it ie s a n d C h a l le n g e s J a ck so n H o le , W y o m in g , 2 4 -2 6 A u gu st. Le Fort, G . a n d S. L e h m a n n (20 00) E l Encaje, lo s F lu jo s de C a p ita le s y e l G a sto : u n a E v a lu a c ió n E m p ír ic a , Documento de Trabajo, n o . 64, S a n t ia g o : C e n t ra l B a n k o f C h ile , February. O c a m p o , J. A . (20 02a ) R e c a s t in g th e In te rn a t io n a l F in a n c ia l A g e n d a , in J. E a tw e ll a n d L. T a y lo r (eds) International Capital Markets: Systems in Transition, N e w Y ork: O x fo rd U n iv e r s it y Press. (20 02b ) D e v e lo p in g C o u n t r ie s A n t i-C y c l ic a l P o lic ie s in a G lo b a liz e d W o r ld , in A. D u t t a n d J. R o s (eds), Development Economics and Structuralist Macroeconomics: Essays in Honour o f Lance Taylor, A ld e rsh o t: E d w a rd Elgar. (20 02c ) R e fo rm in g th e In te rn a t io n a l F in a n c ia l A rch itec tu re : C o n s e n su s a n d D ive rg e n c e , in D . N a y y a r (ed.), Governing Globalization: Issues and Institutions, O x fo rd : O x fo rd U n iv e r s it y Press fo r U N U / W ID E R . Pie trobe lli, C . a n d S. Z a m a g n i (20 00) T h e E m e r g in g E c o n o m ie s in th e G lo b a l F in a n c ia l M a rk e t: S o m e C o n c lu d in g R e m arks , in J. A. O c a m p o , S. Z a m a g n i, R. F fre n c h -D a v is a n d C . P ie trob e lli (eds), Financial Globalization and the Emerging Economies, Sa n t ia g o : E C L A C /J a c q u e s M a r ita in . 42 F in a n c ia l C r is e s a n d N a t i o n a l P o l ic y I s s u e s Radelet, S. a n d J. S a c h s (19 98 ) T h e Ea st A s ia n F in a n c ia l C r is is : D ia g n o s is , Rem ed ie s, Prospects , Brookings Papers on Economic Activity, 1, W a s h in g to n , D C : B r o o k in g s In s t itu t io n . R o d rik , D . (19 98) W h o N e e d s C a p it a l A c c o u n t C o n v e r t ib il ity ? , i n P. K e n e n (ed.), Should the IMF Pursue Capital Account Convertibility?, Princeton Essays in International Finance, n o . 207, P r in c e to n , NJ: P r in c e to n U n iv e r s it y Press. (2001), W h y is there so m u c h E c o n o m ic In se c u r ity in L a t in A m e ric a , CEPAL Review, 73, S a n t ia g o : C E P A L , A p ril. a n d A. V e la sc o (20 00 ) S h o rt -te rm C a p it a l F lo w s , A nnual World Bank Conference on Development Economics 1999, W a s h in g to n , D C : W o r ld Ban k . Ros, J. (20 01) F ro m th e C a p it a l Su rge to th e F in a n c ia l C r is is a n d B e y o n d : M e x ic o in the 19 9 0 s’, in R. F fre n c h -D a v is (ed.), Financial Crises in Successful Emerging Economies, W a s h in g to n , D C : E C L A C / B r o o k in g s In s t itu t io n . Stig litz , J. (20 00) C a p it a l M a r k e t L ib e ra liz a tio n , E c o n o m ic G r o w t h a n d In s ta b ility , World Development, 28, 6 (June). Tap ia, H . (2 0 03 ) B a la n c e E stru c tu ra l d e l G o b ie r n o C e n t ra l de C h ile : A n á lis is y P ro puesta s, Serie Macroeconomia del Desarrollo, 25, Sa n t ia g o : C E P A L . U N C T A D (20 01) World Investm ent Report 2001: Promoting Linkages, N e w Y o rk a n d G e n e v a : U n ite d N a t io n s . U n ite d N a t io n s (2 0 02 ) The Monterrey Consensus, N e w York: U n it e d N a t io n s . W i l l ia m s o n , J. (20 00) E x c h a n g e Rate R e g im e s fo r E m e r g in g M a rk e ts : R e v iv in g the In te rm e d ia te O p t io n ’, Policy Analyses in International Economics, 6 0 (Sep tem ber), W a s h in g to n , D C : In s t itu te fo r In te rn a t io n a l E c o n o m ic s . P art I T h e S u p p ly o f C a p ita l 3L iq u id ity Black Holes: W h y M o d ern Financial R egulation in Developed C ountries is M ak in g Short-Term C ap ita l Flows to D evelop ing Countries Even M ore V o la tile Avinash Persaud Since the early 1990s financial regulation has been about the spread of market-sensitive risk-management systems for banks, the spillover of this approach to other financial institutions and, in general, the retreat of regu­ latory ambition. There is growing evidence that these trends are leading to a more fragile financial system that is prone to concentration, crisis and liquidity black holes. This problem has not been sufficiently addressed because, although it is born of the regulation of financial institutions in developed countries, its most glaring effects are the procyclicality and volatility of capital flows to emerging markets (Griffith-Jones, 1998; Ffrench- Davis and Reisen, 1998). The root of the problem is that the liquidity of financial markets requires diversity, but all these trends are serving to reduce the diversity of behaviour among market participants. Regulators should have a more global per­ spective on the implications of their local regulation. In order to encourage, and perhaps impose, greater diversity in the financial system as a whole, regulators need to place less reliance on internal ratings-based approaches to bank risk management; they must encourage the adoption of alternative, countercyclical risk management systems by long-term investors and, within limits, should temper their discouragement of offshore, leveraged institutions. W hat is Liquidity? Confusingly, liquidity has many different though often related meanings. As an instrument of monetary policy, central banks influence the amount of liquidity in the money markets through the sale and repurchase of Treasury 45 46 L iq u id i t y B la c k H o le s bills. In popular commentaries on the equity market, liquidity conditions often refer to new demand for equities coming from the flow of savings from investors. In this chapter we are not concerned with the grand subjects of monetary policy or the flow of private savings, but with liquidity conditions for trading in capital markets. This liquidity is about the speed and cost of buying or selling loans, bonds or equities (Bank of Japan, 1999). If I were selling an instrument in a liquid market, I would not expect my selling in itself to lower the price I was paid. In an illiquid market, on the other hand, I might have to push the market price down in order to find a buyer. Investors try to avoid illiquid markets. Pushing the price up when you are buying and pushing it down when you are selling will erode your returns. Moreover these trading costs are often variable, hard to measure and intro­ duce uncertainty. As well as being a major obstacle to encouraging overseas capital, illiquid financial markets are bad at converting local savings into local investment. Liquidity matters more than the sparse literature on the subject would suggest. Liquidity is under-researched because it is hard to measure the price impact of trading without detailed information on who sold what, when and at what price. Consequently most measures of liquidity in the securities markets focus on the size of the bid-ask spreads quoted by market makers on electronic brokerage systems, and in the loan markets on the amount of new loans that are issued. Comprehensive loan issuance and turnover data are not very timely - they are often available only quarterly - and so when trying to understand the behaviour of liquidity most analysts study the time series of bid-ask spreads in the foreign exchange, equity or government bond markets (Engle and Lange, 1997; Borio, 2000). In a competitive market this spread should represent the estimated cost to the market maker of getting out of a position, which in turn should relate to the markets liquidity. If market makers begin by not having a position in a stock and they expect their buying of that stock to push its price up and/or to take time, they will try to pass on that future price - and the risks of being short on the stock as they try to buy it - to clients who wish to buy the stock from them. They will do this through the bid price they quote for the stock. Similarly if they believe that selling the stock will push the price down, they will want to pass on that new price and the risk of being long on the stock to clients who wish to sell the stock to them, and they will do this through the ask price they quote. Often the market makers will already have a position and this will influence their preference for buying or selling more, but on average, across market makers, the spread between the bid and ask price should reflect their forecasts of the price of getting out of a position in the stock, which in turn reflects the underlying liquidity conditions (OHara, 1995; Fleming and Remolona, 1999). The problem with using reported bid-ask spreads, however, is that they are only quoted on small trades, and the larger the size of trade and the more market conditions are under stress, the wider the Avinash Persaud 47 spreads. Bid-ask spreads are a good m easure o f liqu id ity during good liqu id ity con d ition s, but n o t during poor co n d itio n s - w h ich o f course is exactly w h en a m easure is needed . O ne so lu tio n to th is data p roblem is to use custod ia l databases that record b o th qu an tity and price in form ation o n purchases and sales b y investors. State Street is o n e o f th e w orlds largest custod ians, w ith approxim ately U S$6 trillion o f assets under custod y or 10 per cen t o f th e w orlds tradable securities. U sing th is database at an aggregate level, Ken Froot and Paul O C on n ell o f Harvard U niversity and State Street A ssociates (State Street Bank and FDO Partners, 2000) have d evelop ed an in d ex o f th e price im pact faced b y overseas investors w h en b u y in g and se llin g equ ities in 42 m arkets. Figure 3.1 show s th e average percentage price im pact faced b y an overseas in vestor w h en b u y in g or sellin g o n e basis p o in t o f th e cap ita lization o f an em erging eq u ity market. This graph suggests th at liq u id ity is returning. T he bad new s is that it has taken an extraordinarily lo n g tim e to d o so - 3 0 m on th s, fo llo w in g a series o f liq u id ity d rain ing even ts in 1998: th e u n w in d in g o f th e U S $/yen carry trade in July, th e Russian defau lt in A ugust and th e collapse o f Long Term C apital M an agem ent (LTCM), an overly lever­ aged h ed ge fund , in Septem ber. In 1999 liq u id ity was probably h eld d ow n by tw o o th er factors. First, there w as con cern about th e m illen n iu m bug, w h ich was p oten tia lly o f greatest threat to em erging markets. Second, in v estm en t banks, hurt by th e even ts o f 1998, rem oved their trading infrastructure from m a n y em erging m arkets. It w as said th a t o n e large US (July) (Apr.) (Jan.) (Oct.) (July) (Apr.) (Jan.) Figure 3.1 L iq u id i t y in d e x fo r e m e rg in g e q u i ty m a rk e ts , 1 9 9 7 -2 0 0 2 (p e rce n ta g e r e tu r n p e r bas is p o in t o f m a rk e t cap ) Source: State Street Bank. 48 Liquidity Black Holes in v estm en t bank h ad 4 0 0 em p loyees in its M oscow office trading Russian debt and stocks in A ugust 1998, just before th e Russian default, bu t just four in A ugust 1999. Figure 3.1 sh ow s a striking variability in liquidity. T he F root-O C onnell m eth o d o lo g y m oderates th is to som e ex ten t b y m easuring price im pact over a period o f 100 days, b u t it is clear th at sharp d eclin es in liq u id ity w ere n o t just a feature o f 1998. Over th e past five years there h ave b een tw o occa­ sion s each year w h en th e average price im pact o f se llin g em erging eq u ity m arkets has risen sharply. This is an average: som e m arkets suffer m ore th an others. This variability is particularly trou b lin g for investors. Indeed there is ev id en ce th at th e rude aw aken in g to liqu id ity issues in 1998 led to an increased preference b y investors for m arkets w ith h ig h and stable liquidity. This has kept overseas investors o u t o f em erging m arkets for an ex ten d ed period, even th o u g h m an y o f th ese markets have offered, o n a historical basis, attractive in v estm en t y ield s (Figure 3.2). L iq u id ity b la c k h o le s If a m arket is co n sisten tly and m easurably illiquid , investors w ill dem and a liq u id ity prem ium b u t w ill probably n o t avoid th e m arket altogether. If a m arket appears liqu id , especia lly w h en o n e buys in to it, b u t b ecom es illiqu id just w h en o n e w an ts to sell, th is generates a degree o f u ncerta in ty Figure 3.2 C ro s s -b o rd e r p o r t f o l io f lo w s to e m e rg in g e q u i ty m a rk e ts ( e x c lu d in g H o n g K o n g , K o re a , T a iw a n a n d S in g a p o re ) as a p r o p o r t io n o f m a rk e t c a p ita l iz a t io n , 1 9 9 5 -2 0 0 2 (c u m u la t iv e basis p o in ts o f m a rk e t c a p ita l iz a t io n , J a n u a ry fig u re s ) Source: State Street Bank. Avinash Persaud 49 th at investors and creditors strongly dislike, especia lly w ith th e current em p hasis o n q uan titative risk controls. M easurem ents o f liq u id ity th at are m ean in gfu l to m arket participants sh ou ld in clu d e n o t just th e average level o f liq u id ity bu t also th e vo la tility o f liquidity. O f course liquidity, especia lly w h en d efin ed in term s o f h o w m u ch th e price m oves for a g iven flow, is a m easure o f th e v o la tility o f price (and so in m easuring th e v o la tility o f liq u id ity w e are m easuring th e vo la tility o f vo la tility - th e th ird derivative o f price). In th is chapter, ep isodes w here liq u id ity sud d en ly disappears w ill b e called liqu id ity black holes, partly because liq u id ity appears to be sucked o u t o f m arkets that are in th e v ic in ity o f th e o n e at th e centre o f a liq u id ity event. Investors are concerned that w h ile , in general, th e level o f liqu id ity has fin a lly returned to levels last seen in 1 9 9 6 -9 7 , th e num ber o f liq u id ity black h o les m ay h ave increased. O ne sim ple m easure o f th e frequency o f liqu id ity black h o les is to cou n t the num ber o f tim es there is a spike in vo latility . Figure 3 .3 tracks th e num ber o f days in a quarter th a t th e broad m arket in d ices for US, UK and Japanese stocks (SP 500, FTSE and Topix, respectively) m o v ed b y tw o standard d ev ia tion s m ore th a n th e average daily m arket m ove. To capture th e trend better w e h ave p lo tted a five-year m o v in g average o f th is quarterly tally, and replaced th e outliers - th e three largest and three sm allest readings - w ith th e average reading. There appears to be a regular cycle to th is m easure o f volatility , bu t b o th th e quarterly bars and th e sm o o th ed average suggest th at th e num ber o f extrem e events or liq u id ity black h o les h ave risen sign ifi­ can tly sin ce th e m id 1990s. It is reasonable to q u estion h o w m u ch th is is 60 -. — Five-year smoothed average 50 - Figure 3.3 L iq u id i t y b la c k h o le s : n u m b e r o f da ys p e r f i r s t q u a r te r th a t th e US, Japanese a n d B r it is h b ro a d s to c k in d ic e s m o v e d b y tw o s ta n d a rd d e v ia t io n s m o re th a n th e average d a i ly p r ic e m o v e , 1 9 7 8 -2 0 0 2 Source: State Street Bank. 50 Liquidity Black Holes a trend and h o w m u ch it is related to th e great rise and su bsequent fall in eq u ity prices b e tw een 1998 and 2001 . It is hard to be sure, bu t it is eq ually reasonable to ask w h eth er liq u id ity factors h elp ed to produce th is surge and collapse. It is a lso in terestin g to observe th at th e upw ard trend in black h o les con tin u ed b ey o n d th e peak and b o tto m in eq u ity prices in M arch and Septem ber 2000 , respectively. M oreover a sim ilar trend in b lack h o les can b e seen ou tside th e eq u ity m arkets in th e U S$/yen foreign exch an ge m arket (Figure 3.4). W e have focused o n ev id en ce o f liqu id ity black ho les in th e m ajor markets because their presence in large, grow ing m arkets is m o st striking, h ow ever th ere is certain ly ev id en ce o f liq u id ity black h o les in em erging m arkets to o (Persaud, 2001b ). T he q u estion is, w h y are liq u id ity black h o les b eco m in g m ore frequent in general? L iq u id ity is a b o u t d iv e rs ity , n o t s ize , a n d th e tw o a re n o t s y n o n y m o u s T he assum ption th at th e bigger a m arket th e m ore liqu id it is, is so prevalent th at turnover and liq u id ity are o ften seen as syn on ym ou s. In fact th e tw o are o n ly ind irectly related. Im agine a m arket place w ith tw o assets (govern­ m en t b on d s and cash) and just tw o players (A nish an d Ishan), an d im agin e th at w hen ever A n ish w an ted to b u y bon d s w ith h is cash, Ishan w an ted cash for h is bonds, and vice versa. This w ou ld b e a very liq u id m arket w ith th e price im pact o f trading b e in g n il for b o th A nish and Ishan. N o w im agin e th at A nish, bored w ith such provincial bliss, m oves to a b igger m arket place 1970 1972 1974 1976 1978 1980 1982 1984 1986 19881990 1992 1994 19961998 2000 2002 Figure 3 .4 L iq u id i t y b la c k h o le s : n u m b e r o f d a ys p e r f i r s t q u a r te r t h a t U S $ /y e n m o v e d tw o s ta n d a rd d e v ia t io n s m o re t h a n th e a v e ra g e d a i ly p r ic e m o re , 1 9 7 0 -2 0 0 2 Source: State Street Bank. Avinash Persaud 51 w ith 10 0 0 0 players, and that w h en ever h e w an ted to b u y b on d s for cash so did th e other 9 999 , and w h en ever h e w an ted to sell so d id th e other 9 999. W h en b u yin g , A nish w ou ld have to b id up th e price o f b on d s a lo n g w ay to turn o n e o f th e o th er buyers in to a seller. The sam e w ou ld be true w h en h e tried to sell. T he price im pact o f b u y in g or selling w o u ld be h igh . The m arket m ay have b een bigger in term s o f th e num ber o f players and th e am ou n t o f b on d s and cash b e in g m anaged , and ev en in term s o f th e turnover, but it w o u ld have b een less liq u id in term s o f th e price im pact o f trading. Markets can b e bigger and yet th inner: liq u id ity requires diversity. O f course th is is an extrem e exam p le and it is sensib le to assum e th at th e m ore m arket players there are, th e greater th e d iversity o f o p in io n s and desired trades. T he lin k b etw een liq u id ity and size m ay b e indirect, b u t it certain ly exists. T he problem is th at a lth ou gh m arkets are generally gettin g bigger, a num ber o f separate forces have consp ired to reduce diversity. T hese forces have grow n strongly since th e m id 1990s, a period in w h ich , according to th e data w e have just considered , m a n y m arkets appeared to b e grow ing larger and yet th inner, or at least m ore vo la tile . T he three m ain forces reducing d iversity are th e collap se o f in form ation costs, th e co n so lid a tio n o f m arket players and m odern risk-m anagem ent and regulatory practices. The fo llo w in g d iscu ssion w ill to u ch o n th e first tw o forces and dw ell longer on th e last. F orces r e d u c in g th e d iv e r s i ty o f b e h a v io u r i n f in a n c ia l m a rk e ts The collapse o f in fo rm a tio n costs In th e past, o n e source o f d iversity o f v iew s w as th e cost o f in form ation: th e higher th e cost o f o b ta in in g in form ation th e greater th e d iversity o f v iew s, especially b etw een market insiders and outsiders. A num ber o f factors, such as th e exp o n en tia l rise in th e co m p u tin g pow er o f com puter ch ips, m ass access to th e Internet an d deregu lation o f th e airwaves and te leco m m u n ica tio n s netw orks, h ave led to th e co llapse o f in form ation costs, w h ich in turn has dram atically reduced th e d iversity o f in form ation . A rm ed w ith th e n ew tech n o logy , regulators h ave accelerated th is process th rou gh in itia tives su ch as th e US SECs Fair D isclosure R egulation, w h ich requires com p an ies to broadcast price-sensitive in form ation to everyon e at th e sam e tim e (in practice, via th e Internet) an d n o longer g ive preferential treatm ent to a sm all co m m u n ity o f professional analysts. T he encou ragem en t o f d eve lop in g countries to m eet specific codes and standards is also causing investors to possess and use sim ilar in form ation sets (see Archarya, 2001). T hanks to such regu lations and popular financial new s broadcasters such as B loom berg and CNN, th e outsiders have, to a large ex ten t, step ped in sid e . If there is a favourable p iece o f in form ation about a com panys stock or a countrys fu n d am en ta ls and th is is m ade 52 Liquidity Black Holes available to everyon e at th e sam e tim e, everyone w ill w an t to b u y at th e sam e tim e and th e price o f th e stock has to rise a lo n g w ay to co n v in ce som e buyers to b e sellers (W ermers, 1998). In th e bad old days th e insiders w ou ld have b ou gh t th e stock ch eap ly from th e b lissfu lly ign oran t outsiders. The m arkets are m ore equitab le and transparent tod ay - and less liqu id because o f it. M arket co nso lida tion Even before th e 1999 G ram m -L each-B iley Act, w h ic h repealed th e 1933 G lass-Steagall Act, th e attem pt b y US Senator Carter Glass and R epresentative H enry Steagall to separate d ifferent finan cia l activ ities in to separate firm s h ad b een w atered d ow n . C on so lid atin g d ifferent b u t related financial activities, o ften w ith th e sam e clien ts, led to substantial savings and positive synergies (w h ich is w h y an Act had b een required to enforce th e earlier separation), and served as a strong in cen tiv e for con so lid a tio n . D iversity has b een reduced b y there b e in g fewer, m ore vertically in tegrated players in th e market. This co n so lid a tio n can be seen clearly in th e foreign exch an ge m arket. In th e 1995 BIS survey o f foreign exch an ge activity, so m e 2 417 banks from 26 countries participated. By 2001 th is num ber had dropped by 2 0 per cen t to 1 9 4 5 . In th e U n ited States in 1995, 20 o f th ese banks accou n ted for 75 per cen t o f forex transactions. By 2001 just 13 banks accou n ted for 75 per cen t o f forex transactions. The foreign exch an ge m arket rem ains th e largest, w ith a daily turnover o f U S$1.5 trillion , but in 2001 o n ly 2 0 banks around th e w orld qu oted tw o-w ay prices o n a w id e range o f currency pairs (BIS, 2001). M arket-sensitive risk m an ag em en t system s There is an in terestin g d iscrepancy b etw een th e large degree to w h ich financia l crises are external and system ic and relate to th e herd behaviou r o f creditors in d evelop ed countries, and th e focus o f p o licy m akers o n th e n eed for d om estic reform s (Eatwell, 1997). It is argued b y m a n y develop ed - cou n try p o licy makers, an d is currently perhaps m ost strongly espoused b y th e U n ited K ingdom , th at if banks and countries w ere to adopt tighter prudential, supervisory an d risk-m anagem ent controls, liq u id ity or so lven cy crises w ou ld n o t h app en , and if there was n o in itia l crisis, there w ou ld be n o subsequent co n ta g io n - w h atever th e flaws in th e current fin an cia l archi­ tecture. This m ay be true, b u t th e real prob lem has co m e w ith th e attem pt to im prove th ese contro ls b y stepp ing aw ay from th e previous system o f a few regulatory risk buckets o u tlin ed in th e original Basel C apital A dequacy A ccord (1988) an d th e stride tow ards m arket-sensitive risk m an agem en t system s. This has b een m otivated b y a num ber o f factors. First, there is con cern th at u sin g a few broad categories o f risk w h en regu lating th e activ ities o f participants in fin an cia l m arkets, is prone to regulatory arbitrage th rough Avinash Persaud 53 th e in n o v a tio n o f financial in stru m ents th at appear to sit in a low-risk category b ut have th e characteristics o f a high-risk in strum en t. Second, th e previous broad risk-bucket approach failed to capture th e grow ing com p lex ity and range o f n ew fin ancia l instrum ents, even w h en regulatory arbitrage was n o t a m o tiv e for their in n o v a tio n . Third, there is a b e lie f th a t has sp illed over from oth er w alks o f life th at public officia ls can n ot presum e to k n ow m ore th an th e m arket w h en assessing risk. W h ile th is m ay in d eed b e true in general, it is least applicable to th e w ork o f th e regulators o f financial m arkets. After all, financial crises occur because m arkets fail, and th is is w h y th e in creasing u se o f m arket-sensitive risk m an agem en t system s has n o t led to a m ore robust and effic ien t finan cia l system , b u t to o n e that is m ore pron e to finan cia l crisis and in d u ces m ore con cen tra tion o f fin an cia l risks (Persaud, 2000). M o d e m r is k m a n a g e m e n t th e o ry : v a lu e a t r is k a n d d a i ly e a r n in g s a t r is k In essen ce value-at-risk (VaR) system s estim ate th e am ou n t o f a banks daily earnings th at are at risk, at a g iven probability, u sin g th e d istribution o f th e vo la tility and correlation o f th e p ortfo lio o f assets and liab ilities w ith w h ich th e bank has exposure. T he m ore vo la tile an asset th e greater th e lik elih ood o f a loss, u n less it is in verse ly correlated w ith a n o th er asset in th e p ort­ fo lio . Lower v o la tility o f assets, and correlation b etw een assets, reduce daily earnings at risk (DEAR). A rise in vo la tility and correlation does th e opposite . M ost o ften th e banks risk m an agem en t process is to set a lim it for DEAR, and if th e lim it is reached, to take action to reduce DEAR b y sellin g th e m ost v o la tile or m ost h ig h ly correlated assets. T he in trinsic p rob lem w ith m arket-sensitive risk m an agem en t system s - a p roblem th at ca n n o t b e so lved b y increasingly sop h istica ted statistical m od els and th e use o f stress tests - is th a t th ey assum e th at banks and m arket participants act in d ep en d en tly and th at th e p ositio n s o f o n e bank are in d ep en d en t o f th ose o f another. In a w orld o f in d ep en d en t m arket players there is a strong probability th at th e se llin g o f securities b y o n e bank cou ld b e m et b y th e purchases o f another. T he reality, o f course, is d ifferent. M arket participants an d banks b eh ave in strategic relation w ith o n e another. O ften th ey herd in to o n e or a sim ilar set o f m arkets or instrum ents. There are a num ber o f in d iv id u a lly rational reasons for herd ing behaviour, n o t least because there is safety in num bers, b o th fin an cia lly and in term s o f reputation (Shiller, 1990). If o n e bank m akes an in v estm en t m istake th e regulators m ay let it go under, as in th e case o f Barings in th e U n ited K ingdom . If all banks m ake th e sam e m istake, th e regulators w ill bail th em o u t in order to preserve th e fin an cia l system . M oreover in a w orld o f un cer­ ta in ty th e cheapest strategy for ca tch in g up w ith th ose y o u th in k are better in form ed is to fo llo w them . 54 Liquidity Black Holes W h en vo la tility rises in o n e market, increasing DEAR and p rom p tin g a bank to sell its risky assets, it is likely th at th e DEAR lim its w ill b e reached b y m an y banks. T he dynam ics th en go from bad to w orse. As m a n y banks try to sell th e sam e asset at th e sam e tim e, there are few or n o buyers and so th e price gaps narrow an d vo la tility rises further, w h ich increases DEAR again and triggers further sales. Faced w ith a gap ing market, som e banks w ill try to reduce DEAR b y sellin g an oth er asset that is h e ld by th e herd partly because it is uncorrelated w ith th e first. H ow ever th is n o t o n ly increases vo la tility in th e seco n d asset, b u t also increases correlation. Higher volatility , and n o w correlation too , n o t o n ly raise DEAR at th e first set o f banks, but also at a secon d set o f banks th at m ay n o t h ave had th e first asset, and so m ore banks and m ore m arkets are sucked in to th e process. T he resu lting co n tag ion o f se llin g m ystifies m ost analysts because th e m arkets th at are h it are fu n d am en ta lly unrelated . T he step p in g-ston e path o f th e A sian financial crisis from T hailand to Ind onesia and M alaysia, th en to Korea and o n to Russia, and fin a lly to Brazil, w as n o t related to th e p ath o f trade flow s, b u t to th e path o f shared creditors and bankers (Persaud, 2001a). A p e r p le x in g p a r a d ig m In th e co n tex t o f u ncerta in ty and investor behaviour, th e VaR approach n o t o n ly leads to co n ta g io n w h en it com b in es w ith herd behaviour, b u t also contributes to herd in g in th e first p lace. VaR system s h ig h lig h t th o se sets o f m arkets w h ich currently offer lo w vo la tility and lo w correlation, and thus safe returns, w h ic h prom pts m a n y players to sw itch in to th ese m arkets over tim e, u n til at som e p o in t there is a large co n so lid a tio n o f p o sitio n s - a herd. The o p p osite also occurs. VaR system s h ig h lig h t th e current set o f m arkets th at offer h igh v o la tility and correlation and as a con seq u en ce investors stay clear o f th ese m arkets, m aking th em less correlated and less vo la tile over tim e and less prone to con tag ion . Here is a perp lexing paradigm: th e observation o f safety creates risk (as th e herd chases after w h at w as safe and investors b ecom e overly concentrated) and th e observation o f risk creates safety (as th e herd avoid s w h at w as risky). In th is w ay m arket-sensitive risk m an agem en t system s dangerously add to th e procyclica lity o f capital flow s (Persaud, 2000; Turner, 2000). We are in th e latter en v iro n m en t today. L ooking th rou gh a five-year w in d o w o f returns, vo la tilities and corrections, em erging m arkets still appear to be th e last places o n earth an investor w ou ld w an t to be, w ith their lo w to negative returns, h ig h risks and volatility , and h ig h correlation . C on ­ seq u en tly investors h ave aban d on ed th is space and so w h en accidents happ en , such as in Turkey in D ecem ber 2 0 0 0 and February 2001 , and A rgentina in D ecem ber 2001 , there is n o con tag ion . T he regulators th in k that th is is a sign o f a m ore robust system , but th ey are m istaken . The five-year Avinash Persaud 55 w in d o w w ill so o n sh o w th at em erging m arkets are safer, less correlated and m ore profitable, and th e herd w ill return. A lready in 2001 th e advan ce party, com prising em erging-m arket h ed ge funds, p osted th e best in vestm en t perform ance ou t o f a broad range o f in v estm en t sectors and styles. Far from b ein g robust, th e in tern ation a l fin an cia l system appears to deliver either to o m u ch capital to em erging m arkets or to o little (Gurria, 1995; Griffith-Jones, 1998). This supports neither econ om ic d evelop m en t nor th e necessary reform process in m an y em erging financia l m arkets (W illiam son, 1993). T h e c r e e p in g in f lu e n c e o f b a n k r e g u la t io n T hroughout th is chapter w e h ave lu m p ed th e behaviour o f banks w ith th a t o f o ther creditors and investors in general. H ow ever th e Basel C apital A dequacy Accord is designed for th e regu lation o f banks, n o t all investors. W h y is th e herd ing o f banks n o t o ffset b y longer-term investors lo o k in g to pick up a bargain in th e w ake o f th e forced sellin g triggered b y VaR m odels? T he problem is th at th e vast m ajority o f investors and creditors n o w use th e VaR approach. This is n o t en tirely ou t o f free ch o ice . To b eg in w ith there is regulatory creep. Regulators are ca jo lin g other financial in stitu tion s, espe­ cia lly in surance com p an ies and fu n d m anagers, to adopt th e VaR approach in th e m istaken b e lie f th at co m m o n standards are good . W here herd ing is prevalent, h igh standards are good; co m m o n standards are bad. H ow ever even w h ere regulators are n o t breath ing d o w n th e necks o f investors, m a n y ch o o se to fo llo w th e VaR approach. W hy? In a w orld of u n certa in ty w ith a lo n g h istory o f fin ancia l crises and rogue traders, it is hard for in vestors to te ll their trustees th at th ey are u sin g a risk m an agem en t system th at n o b o d y else uses. Investors generally approve o f exp erim en ­ ta tion , b u t o n ly w ith other peop les m on ey . T he irony, o f course, is th at a d iversity o f risk m an agem en t system s, w ith long-term investors and creditors fo llo w in g a risk m an agem en t approach th at is m ore suitable for their objectives, w o u ld n o t o n ly reduce th e num ber o f liq u id ity black h o les bu t w ou ld also enab le long-term investors to profit. T he fo llo w in g exam p le illustrates th is p o in t. Im agine a long-term investor called Felicity Foresight. Each year Felicity know s w h ich are th e ten best currency trades for th e year. She puts th em o n at th e b eg in n in g o f th e year and uses a state-of-the-art, daily m ark-to-m arket, value-at-risk, risk m an agem en t system . Over th e past ten years sh e w ou ld have lo s t m o n ey in a lm ost every year, stop ped-out b y her risk system w h en th e trades had g o n e against her. W hatever you th in k your in v estm en t sty le is, in reality it is largely d eterm ined b y your risk m an agem en t system . Investors proudly proclaim a raft o f d ifferent styles, m od els and approaches, bu t th e vast m ajority adopt th e sam e risk m an ­ agem en t approach and so th ey b eh ave like everybody else, lead in g to little diversity and m a n y black h o les . 56 Liquidity Black Holes W h a t a re t h e s o lu tio n s ? H aving analyzed th e problem s, three so lu tion s com e to m in d . First, regu­ lators n eed to h ig h lig h t as a risk th e duration m ism atch b etw een long-term in vestm en t ob jectives and short-term risk m an agem en t system s. T hey can facilitate a narrow ing o f th is gap an d in so d o in g encourage a greater diversity o f b ehaviou r by g iv in g their considered stam p o f approval to a few and varied risk m an agem en t approaches. For exam p le in th e a ttem p t to be th e first to get ou t o f assets b e in g dragged d ow n in a crisis, risk m an agem en t system s are increasingly focusing o n very short-term correlations an d vo la til­ ities, and w h en th ese rise risk lim its are h it, triggering further sales. H ow ever a bank th at m anages short-term liab ilities m ay be m ore in terested in a rise in th e short-run correlation o f assets during a crisis th an a long-term investor, w h o m ay be c o n te n t to assum e that th e current correlations w ill fall back to their long-term average. A risk m an agem en t system for th e long-term investor m ay therefore be less sensitive to short-term ch an ges in vo la tility and correlation and m ore sen sitive to th e underly in g , perhaps fun dam ental, correlation. There is th e p o ten tia l here for a v irtuous cycle . T he m ore that short-term and long-term investors behave differently, th e shorter th e market disruptions w ill b e and th e m ore th is d ifferent b ehaviour w ill be profitable for long-term investors. G iv in g a stam p o f approval to a variety o f risk m an ­ agem en t system s d esign ed for d ifferent types o f investor w o u ld so lve a coor­ d in a tio n problem : it w o u ld b eco m e easier for fu n d m anagers to go to their trustees and say th at th ey are n o t fo llo w in g a short-term , m arket-sensitive risk m an agem en t system , bu t another, a lon g th e lin es proposed b y th e regulators specifica lly for lon g-term investors. Second, there n eed s to b e less reliance o n m arket-sensitive m easures o f risk. Regulators sh ou ld pursue research in to countercyclical or structural m ea­ sures o f risk, su ch as th e degree o f d iversity or fragm entation in a financial m arket as w ell as th e degree o f duration and currency m ism atch o f assets and liabilities. M arkets th a t are n o t vo la tile or h ig h ly correlated w ith others bu t w here there is a h igh con cen tra tion o f p osition s b y o n e type o f player in o n e in stru m en t sh ou ld be v iew ed as risky and require m ore regulatory capital th an h istorical vo la tilities and correlations m ig h t suggest. T he large con cen tration o f foreign currency len d in g to th e property and b an k in g system in A sian m arkets is a case in p o in t (Perry and Lederm an, 1998). Third, a lth ou gh m u ch regu lation is about lim itin g losses, liq u id ity needs losers. If a m arket is to be liqu id there n eed s to be a buyer w h en everyone else is sellin g and th e price is falling. In itia lly th e buyer w ill lose, b u t she or h e w ill h op e to profit w h en th e m arket turns around and w ill be m ore in c lin ed to take th is gam ble if sh e or h e is n o t w orried th at her or h is risk m an agem en t system w ill take her or h im o u t o f th e trade just as it is go in g to m ake m oney. Regulators n eed to address th is prob lem b y regu lating w h o th e unregulated in vestor can be. T hey w ill w an t to lim it th e losses o f retail Avinash Persaud 57 investors for fear th at th ey w ill b e abused for their relative lack o f in form a­ tion , and to encourage th em to save for their future. F inancial instru m ents used b y retail investors sh ou ld be strictly regulated - as th ey are - an d their losses lim ited th rou gh short-term risk system s. F inancial in strum ents used b y professional investors, how ever, sh ou ld be lig h tly regulated and their ability to buck th e trend sh ou ld be facilitated. T his fram ework provides a d ifferent perspective o n h ed ge fu n d s - in v estm en t veh ic les d esign ed for in v estm en t professionals w ith w ea lth to lose. H edge funds som etim es lose m oney, som etim es b low up and som etim es are part o f th e herd, bu t th ey are a lso best su ited to th e role o f unregulated investors w h o can b u y w h en everyone else is selling, and in th e process m ake th e fin ancia l m arket liqu id . T he cost o f m aking it hard for th em to do th is - b y regulating their leverage and credit - is a redu ction in m arket liquid ity. The regu lation o f hed ge funds and their requirem ents o f d isclosure to their counterparties sh ou ld therefore b e governed b y to u g h q u estions such as: w ou ld a fu n d w ith th is am ou n t o f leverage endanger th e finan cia l system ? T his w o u ld catch an y future LTCM w ith o u t causing th e others to w ithdraw from p rovid in g th e necessary liquidity. N o te 1. T h a n k s are d u e t o Jam es C u r t is a n d N a ta lia A lv a re z -G r ija lb a fo r t h e ir s ta t is t ic a l w o rk . R e fe re n c e s A rc h a ry a , S. (2 0 0 1 ) ‘N e w In te r n a t io n a l S ta n d a rd s fo r F in a n c ia l S ta b il i ty : D e s ira b le R e g u la to ry R e fo rm o f R u n a w a y J u g g e rn a u t? , i n S. G r if f i th -J o n e s a n d A m a r B h a tta c h a ry a (eds), Developing Countries and the Global Financial System, L o n d o n : C o m m o n w e a lth S e c re ta ria t. B a n k fo r In te r n a t io n a l S e tt le m e n ts (BIS) (2 0 0 1 ) w w w .b is .o rg . B a n k o f J a p a n (1 9 9 9 ) Risk Measurement and Systemic Risk, P ro c e e d in g s o f th e S econ d J o in t C e n tra l B a n k R esearch C o n fe re n c e , T o k y o : B a n k o f J a p a n . B o r io , C . (2 0 0 0 ) M a rk e t L iq u id i t y a n d Stress: S e lec ted Issues a n d P o lic y Im p l ic a t io n s ’ , BIS Quarterly Review, N o v e m b e r : 3 8 -5 1 . E a tw e ll, J. (1 9 9 7 ) In te r n a t io n a l F in a n c ia l L ib e ra lis a t io n : T h e Im p a c t o n W o r ld D e v e lo p m e n t ’ , ODS Discussion Paper 12 , N e w Y o rk : O f f ic e o f D e v e lo p m e n t S tu d ie s , U N D P . E n g le , R. F. a n d J. L a n g e (1 9 9 7 ) M e a s u r in g , F o re c a s t in g a n d E x p la in in g T im e V a ry in g L iq u id i t y in th e S to c k M a rk e t , NBER Working Paper n o . 6 1 2 9 , C a m b r id g e , M A : N BER . F fre n c h -D a v is , R. a n d H . R e isen (eds) (1 9 9 8 ) Capital Flows and Investm ent Performance: Lessons from Latin America, Paris: O E C D D e v e lo p m e n t C e n tre /E C L A C . F le m in g , M . a n d E. R e m o lo n a (1 9 9 9 ) P r ice F o rm a t io n a n d L iq u id i t y in th e US T re a su ry M a rk e t: T h e R esponse t o P u b lic I n fo r m a t io n , Journal o f Finance, 5 4 , 5 : 1 9 0 1 -1 5 . G r if f i th -J o n e s , S. (1 9 9 8 ) Global Capital Flows, L o n d o n : M a c m il la n . G u r r ia , J. A . (1 9 9 5 ) C a p ita l F lo w s : th e M e x ic a n C ase , in R. F fre n c h -D a v is a n d S. G r if f i th -J o n e s (eds), Coping w ith Capital Surges, B o u ld e r , C O : L y n n e R ie n n e r. O H a ra , M . (1 9 9 5 ) M arket Microstructure Theory, C a m b r id g e , M A : B la c k w e ll. 58 Liquidity Black Holes P erry , G . a n d D . L e d e rm a n (1 9 9 8 ) F in a n c ia l V u ln e ra b i l i ty , S p il lo v e r E ffe c ts a n d C o n ta g io n : Lessons f r o m th e A s ia n C rises fo r L a t in A m e r ic a , World Bank Latin American and Caribbean Studies Viewpoints, W a s h in g to n , D C : W o r ld B a n k . Persaud, A . (2 0 0 0 ) ‘S e n d in g th e H e rd o f f th e C l i f f E dge , World Economics, 1, 4 (O c to b e r -D e c e m b e r ) . (2 0 0 1 a ) Fads a n d F a sh io n s i n th e P o lic y R esponse to F in a n c ia l M a rk e t C ris e s , in L. Jacq ue a n d P. M . V a a le r (eds), Financial Innovations and the Welfare o f Nations, N e w Y o rk : K lu w e r. (2 0 0 1 b ) C o h a b it in g w i t h G o lia th : H o w S m a ll E xch a n g e s w i l l S u rv iv e in th e F u tu re , World Economics, 2 , 4 (O c to b e r-D e c e m b e r) . S ta te S tre e t B a n k a n d F D O P a rtn e rs (2 0 0 0 ) L iq u id i t y In d e x , te c h n ic a l d o c u m e n t, L o n d o n : S ta te S tre e t B a n k a n d F D O P a rtn e rs . S h ille r , R. (1 9 9 0 ) In v e s to r B e h a v io u r i n th e O c to b e r 1 9 8 7 S to c k M a rk e t C ra s h : S u rv e y E v id e n c e , NBER Discussion Paper n o . 2 4 4 6 , C a m b r id g e , M A : N BER . T u rn e r, P. (2 0 0 0 ) P ro c y c l ic a l i ty o f R e g u la to ry R a tios? ’ , in J. E a tw e ll a n d L . T a y lo r (eds), Global Finance a t Risk: The Case for International Regulation, N e w Y o rk : T h e N e w Press. W e rm e rs , R. (1 9 9 8 ) M u tu a l F u n d H e rd in g a n d th e Im p a c t o n S to c k P rices , Journal o f Finance, 5 4 , 2. W il l ia m s o n , J. (1 9 9 3 ) A C o s t-B e n e f i t A n a ly s is o f C a p ita l A c c o u n t L ib e ra l iz a t io n ’, in H . R e isen a n d B. F is c h e r (eds), Financial Opening, Paris: O E C D . 4 I n t e r n a t i o n a l B a n k L e n d i n g : W a t e r F l o w i n g U p h i l l ? * John Hawkins B a n k l e n d in g a n d o th e r c a p i ta l f lo w s International b ank len d in g is a very im portan t co m p o n en t o f capital flow s to em ergin g econ om ies. M oreover bank len d in g has b een th e m ost variable type o f capital flow. Table 4.1 sh ow s h o w foreign direct in vestm en t, and even portfo lio in vestm en t, h eld fairly steady th rou gh ou t th e A sian crisis. H ow ever th e in tern ation a l banks w en t from len d in g large am ou n ts before th e crisis to w ithdraw ing large am ou n ts after it. T he Bank for International S ettlem en ts (BIS) com p iles and p u b lish es th e m ost com p reh en sive data o n in tern ation a l bank len d in g ,1 w h ich were used w h en p u ttin g togeth er th e Institu te o f In ternational F inance (IIF) estim ates used in Table 4.1 and th e statistics o n external debt pub lished jo in tly w ith th e W orld Bank, IMF and OECD. T he great advantage o f th ese data is that th e y are com p iled from th e creditor side in a co n sisten t way. T he d isadvan­ tage is th at th ey cover o n ly part o f capital flow s, albeit perhaps th e vo la tile part. IMF data o n capital flow s are based o n th e b alance o f p aym en ts reports b y th e recipient countries and are m ore com prehensive. H ow ever it is kn ow n th at th e reporting o f capital flow s is in ev itab ly rather inaccurate (a lth ough Table 4.1 E m e rg in g m a rk e t e c o n o m ie s n e t e x te rn a l f in a n c in g , 1 9 9 6 -2 0 0 2 (US$ b i l l i o n ) 1996 1997 1998 1999 2 000 2001 2 0 0 2 e D ire c t e q u i ty in v e s tm e n t 93 11 6 121 149 135 135 113 P o r t fo l io e q u i ty in v e s tm e n t 35 25 14 19 14 11 11 B a n k le n d in g 118 4 4 - 5 5 - 5 2 - 0 - 2 6 - 1 1 N o n -b a n k p r iv a te le n d e rs 8 9 8 4 64 3 6 3 8 7 10 O f f ic ia l f lo w s 5 47 5 2 13 - 4 14 17 T o ta l e x te rn a l f in a n c in g 3 4 0 3 1 6 195 166 184 140 14 0 Source : In s titu te o f In te rn a tio n a l F inance (2001, 2002). 59 60 International Bank Lending m ajor progress has b een m ade in recent years as a result o f th e efforts o f th e IMF C om m ittee o n Balance o f P aym ents Statistics). T he BIS data (w h ich are described in m ore detail in A ppend ix 4 .1) are com p iled o n tw o bases. T he locational statistics report o n th e activ ities o f banks in th e reporting econ om y, regardless o f their ow nersh ip , bu t n o t in c lu d in g their foreign subsidiaries. T he consolidated statistics report o n th e global activ ities (in clu d in g foreign subsidiaries) o f banks w h o se head office is located in th e reporting econom y. W h en appropriately scaled, th e BIS data can be h elp fu l in id en tify in g eco n o m ies w here th e accu m u lation o f borrow ing from in tern ation a l banks is leav in g th em vu lnerable to a loss o f con fid en ce (see H aw kins and Klau, 2000 ). It has o ften b een th e case th at excessive capital in flow s h ave fu nded d om estic specu lative b oom s. T he central bank governors o f th e G 10 co u n ­ tries h ave b een regularly briefed over th e years o n signs o f im p en d in g trouble. A recently p u b lish ed accou n t b y an em in en t insider, A lexandre Lam falussy (2000), w h o w as eco n o m ic adviser at th e BIS from 1976 an d th en general m anager, p o in ts o u t th at in th e 1970s th e governors agreed to pub lish country-by-coun try data o n external bank debt accu m u lation o n ly after som e h esita tion because n a m in g countries cou ld in itse lf precip itate crises. Yet even th o u g h th ese data w ere p u b lic ly available before th e A sian crisis, at th e tim e th ey attracted relatively little a tten tion desp ite efforts b y th e BIS to draw a tten tio n to th e w arnings it w as g iv ing. H aw kins (1999) p o in ts o u t th at in early 1997 th e BIS data revealed th e large, rapidly grow ing and increasingly short-term debt incurred b y th e five A sian em erging eco n o m ies w h ich so o n after suffered m assive depreciations. T h e p a t t e r n o f in t e r n a t io n a l b a n k le n d in g Specialization b y len d in g countries T he BISs con so lid a ted statistics are p u b lish ed by n a tio n a lity o f reporting bank, so, for exam ple, it is possib le to see th e exposure o f G erm an-ow ned banks to Russia, or S p an ish -ow ned banks to Brazil. T he d istribution o f len d in g to em ergin g eco n o m ies is sum m arized in Table 4 .2 . As can b e seen, E uropean-ow ned banks are th e largest lenders to all reg ion s,2 but there is also a degree o f specia lization . Japanese-ow ned banks m a in ly len d to th e Asia-Pacific reg ion w h ile U S-ow ned banks concentrate o n Latin America. W ith in Europe, G erm an-ow n ed banks are th e m a in lenders to C entral and Eastern Europe, w h ile F rench-ow ned banks are th e m a in lenders to Africa and Spanish banks are large lenders to Latin America. Two recent trends are o f particular sign ificance. The first is th e w ithdraw al o f Japanese banks from Asia (b oth from th e d eve lop in g coun tries an d from H on g Kong): from its peak in June 1995, b y m id 2001 th is had fa llen by around tw o thirds, a d ec lin e o f a lm ost U S$200 b illion , a lth ou gh som e o f th is w as b ook in g Japanese len d in g bu siness w ith in Japan rather th an offshore. John Hawkins 61 Table 4.2 Consolidated international claims of BIS reporting banks for developing countries, June 2002 (US$ billion) Asia-Pacific Europe Latin America Middle-East and Africa Total E u ro p e , o f w h ic h 194 2 4 4 3 0 2 109 8 4 9 G e rm a n y 47 88 3 4 2 2 191 Fran ce 29 21 21 3 6 107 U n ite d K in g d o m 64 11 2 7 2 7 129 S p a in 1 1 157 2 161 U n ite d S tates 76 21 131 15 2 4 3 Ja p a n 52 4 10 5 71 O th e r 73 28 49 25 175 T o ta l 395 2 9 7 4 9 2 154 1 3 3 8 Source: BIS (2002). T he secon d is th e rapid grow th o f Spanish banks exposure in Latin Am erica. In th e five years to m id 2001 , th is a lm ost quadrupled, an increase o f a lm ost U S$40 b illion . M aturity o f b an k len d in g A round a third o f in tern ation a l bank len d in g to em ergin g eco n o m ies is short term , th at is, w ith a rem ain in g m aturity o f less th a n o n e year (see Table A 4.1). T he p roportion rose in th e first h a lf o f th e 1990s - Jeanneau and M icu (2002) attribute th is to the grow th o f trade fin an cin g , th e liberal­ isation o f financial sectors, th e estab lishm ent o f offshore financial centres and th e advantages offered b y short-term loan s in th e m on ito r in g and m an age­ m en t o f in tern ation a l exposures. Short-term borrow ing is u sually cheaper bu t exp oses th e borrow er to refinan cing risks. As borrowers fo u n d that short-term credit was som etim es cut o ff during th e A sian and other crises, th ey have increasingly felt th at th e h igh er in terest rates are w orth p aying and so m aturities h ave len g th en ed again. Som e borrow ing cou ntries have ad opted specific gu id elin es to len g th en debt m aturities. C o n cen tra tio n o f b a n k len d in g It is o ften cla im ed th at in tern ation a l bank fin an ce to em erging eco n o m ies is u n d u ly concentrated . At first sigh t th is appears to be th e case, as over h a lf o f in ternational bank loans to em erging eco n o m ies go to just ten econ om ies. In order, these are Brazil, Korea, M exico, C hina, Turkey, Argentina, Indonesia, Russia, Saudi Arabia and Taiwan. H ow ever it is less con cen trated th an pop u la tion , GDP or o ther form s o f capital in flo w (Table 4 .3). T he list o f th e top ten recip ients o f bank len d in g is very sim ilar to th e ten largest em erging econ om ies, w ith th e ex cep tio n th at India receives m u ch less len d in g th an th e size o f its e co n o m y w ou ld suggest. T he OECD m em bers receive m ore 62 International Bank Lending Table 4.3 C oncentration ratios (percentage shares of emerging economies)1 Share o f top 5 Share o f top 10 I n te r n a t io n a l b a n k le n d in g (e n d 2 0 0 0 )2 4 0 62 In te r n a t io n a l b o n d is su a n ce (e n d 2 0 0 0 ) 65 83 S to c k o f in w a rd fo re ig n d ire c t in v e s tm e n t (2 0 0 0 ) 53 68 P o p u la t io n (1 9 9 9 ) 55 66 G D P (PPP basis) (1 9 9 9 ) 53 67 N otes : 1 D ata cover 126 em erg ing econom ies w ith a p o p u la tio n over o n e m illio n a n d p e r cap ita GDP of be low a ro u n d U S$15000 ( th a t is, a b o u t th e level o f S o u th Korea). 2 C o nso lidated basis (for a n e x p la n a tio n see A ppendix 4.1). Sources: W orld B ank A tlas (2001); UNCTAD (2001); BIS (2001). (perhaps partly because o f their favoured treatm en t under th e Basel C apital Accord - see b elow ). At th e other en d o f th e d istribution , th e 25 poorest eco n o m ies (m ostly African countries w ith per capita in com es b elow US$1 000) receive o n ly about 1 per cen t o f in tern ation a l bank len d in g . W h ile th ese eco n o m ies accou n t for 10 per cen t o f th e p op u la tion o f em erging econ om ies, th ey o n ly accou n t for 2 per cen t o f GDP. M oreover len d in g to m a n y o f th e poorest countries is a lm ost entirely short term , creating add ition al vu lnerabilities. T hese charac­ teristics suggest that in ternational bank len d in g m ay n o t b e th e ideal veh ic le for provid in g fin an ce to th e sm allest and poorest countries. C urrency d en o m in a tio n o f bo rrow ing b y em erging econom ies M ost em erging econ om ies, particularly th ose w ith a h istory o f h ig h in fla tion and depreciation , face a sign ifican t lacuna in financia l m arkets. As a result o f w h at E ichengreen and H ausm ann (1999) call original sin, th e y have great d ifficu lty m arketing long-term securities d en o m in a ted in th e d om estic currency. In ad d ition foreign lenders w ill n o t len d in th e d om estic currency (Table 4 .4) and ten d to b e u n w illin g to stand o n th e o th er side o f a h ed ge contract.3 In th ese circum stances firm s can o n ly ch o o se b etw een a currency m ism atch and a m aturity m ism atch . R e c e n t t r e n d s i n n e t b a n k f in a n c e to e m e rg in g e c o n o m ie s B ank len d in g The cutbacks in in tern ation a l bank loans to em erging eco n o m ies after th e A sian crisis m oderated during 2 0 0 0 and 2001 (Table 4 .5 and Figure 4.1). T here were co n tin u in g , a lbeit m u ch m ore m odest, d eclin es in loan s to em erging A sian eco n o m ies4 but som e increase in loan s to Latin America, a lth ou gh th is w as partly a reflection o f th e purchase b y Spanish banks o f John Hawkins 63 Table 4.4 B o r ro w in g b y d o m e s t ic n o n -b a n k s f r o m in te r n a t io n a l b a n k s : p e rc e n ta g e d e n o m in a te d in d o m e s t ic c u r re n c y ,* J u n e 2 0 0 2 Asian emerging Latin American Other Advanced economies emerging emerging economies economies economies C h in a 4 A rg e n t in a 0 C ze ch Rep. 14 A u s tra lia 2 7 In d ia 2 B ra z il 1 H u n g a ry 5 G e rm a n y 18 In d o n e s ia 6 C h ile 0 Is ra e l 1 H o n g K o n g 17 K o re a 4 C o lo m b ia 0 P o la n d 6 Ja p a n 57 M a la y s ia 4 M e x ic o 1 Russia 1 S in g a p o re 11 P h i l ip p in e s 3 P eru 1 S o u th A fr ic a 13 U K 23 T h a ila n d 4 V e n e z u e la 0 T u rk e y 1 U S A 8 4 * For som e em erg ing econom ies th e figures m ay be overestim ates as it is assum ed th a t all loans an d b o n d s n o t d e n o m in a ted in a m a jo r cu rrency are d e n o m in a te d in th e d om estic currency. Source: BIS (2002). Table 4.5 In te rn a t io n a l f in a n c in g o f d e v e lo p in g e c o n o m ie s , 1 9 9 0 -2 0 0 0 (U S$ b i l l io n s , a n n u a l ra te ) International bank lending1 International debt securities2 1990-97 1998-99 2000 1 990-97 1998-99 2000 A l l d e v e lo p in g e c o n o m ie s 3 4 8 - 7 4 - 1 3 54 37 4 0 A s ia -P a c if ic ,3 o f w h ic h 39 - 7 9 - 2 9 21 - 1 2 C h in a 8 - 1 4 - 5 2 - 1 0 c r is is -h it A s ia 4 27 - 5 9 - 1 7 17 0 3 L a t in A m e r ic a a n d C a rr ib e a n 8 - 1 2 14 26 2 4 28 Notes: 1 Exchange ra te ad ju sted change in claim s o f BIS rep o rtin g banks. 2 N e t issuance. 3 Excludes H ong K ong a n d Singapore. 4 Indonesia , Korea, M alaysia, th e P h ilipp ines a n d T hailand . privatized Brazilian banks. For m ost o f 2 0 0 0 Turkey received sign ifican t am ou n ts o f n ew len d in g , bu t th is w as sharply reduced in early 2001 . It is striking th at even five years after th e A sian crisis, bank len d in g to em erging eco n o m ies has n o t recovered. Several possib le reasons h ave b een suggested .5 There w as an unu sual period in recent years w h en Latin Am erica and m u ch o f Asia grew m ore slow ly th an th e global average (Table 4.6). M any em erging m arket borrowers in Asia ran current accou n t surpluses, as after th e 1 9 9 7 -9 8 crises im ports were h eld d o w n b y w eak d om estic con su m p tion 64 International Bank Lending Total bank flows Bank flows by region2 3 Figure 4.1 B a n k s e x te rn a l p o s it io n s vis-à-vis e m e rg in g e c o n o m ie s , 1 9 9 7 -2 0 0 1 (e x c h a n g e ra te a d ju s te d c h a n g e s i n a m o u n ts o u ts ta n d in g , US$ b i l l i o n ) Notes : 1 A negative (positive) va lue ind ica tes a n increase (decrease) in BIS rep o rtin g b a n k s liab ilities vis-à-vis em erg ing econom ies. 2 C hanges in claim s m in u s changes in liabilities. 3 T w o-quarter m o v in g average. Source: BIS (2002). T a b le 4 .6 R ea l G DP, a c tu a l a n d fo reca st, 1 9 5 0 -2 0 1 0 (average a n n u a l p e rce n ta g e c h a n g e ) 1 950-96 1996-2001 2 0 0 1 -1 0 5 W e s te rn E u ro p e 1 3 .7 2 .6 2 .2 U n ite d States 3 .4 3 .4 3 .1 E m e rg in g A s ia ,2 o f w h ic h 6.7 5 .3 6 .2 c r is is -h it 6 .2 1.5 4 .8 L a t in A m e r ic a 3 4 .8 2 .5 3 .3 W o r ld 4 4 .8 3.3 3 .6 N otes : 1 W eigh ted average o f 15 W estern E uropean econom ies. 2 W eigh ted average o f C h in a , H o n g Kong, India , Indonesia, Korea, Malaysia, Philippines, Taiw an a n d Thailand, o f w h ich th e co u n trie s in italics are classified as crisis-hit. 3 W eighted average o f A rgen tina , Brazil, C hile, C o lom bia, M exico, Peru a n d V enezeula. 4 W eigh ted average o f 45 econom ies w ith over 85 per c en t o f global GDP. 5 C onsensus forecasts. and in vestm en t w h ile exports b en efited from im proved com p etitiven ess fo llo w in g th e large devaluation s. M ore recen tly th e s low d ow n in th e US eco n o m y has in d u ced further w ariness o n th e part o f lenders. T he Asian eco n o m ies in particular are suffering from th e w eakness in US tech n o lo g y John Hawkins 65 industries. Furthermore, as d iscussed below , banks in th e industrial countries have increasingly sought credit exposure in em erging econ om ies by purchas­ in g loca l banks, rather th an th rou gh cross-border len d in g . R ecent problem s in A rgentina and Turkey are likely to be d am p en in g banks en th u siasm for len d in g to em erging econ om ies, a lth ou gh th e extrem es o f co n ta g io n seen in earlier crises have n o t b een observed. D eposits from em erg ing econom ies D eposits from em erging eco n o m ies h ave b een grow ing strongly. In 2000 , d eposits w ere eq u iva len t to 2 per cen t o f em erging econ om ies GDP, th e largest proportion since 1 9 7 9 -8 0 , w h en o il-exp orting countries p laced w in d ­ fall revenues w ith in tern ation a l banks. T he m a in sources o f th ese deposits w ere Taiwan, m ain lan d C hina and th e o il-exporting countries (notab ly Saudi Arabia, Iran, M exico and Russia). In th e case o f C hina, a w eak d em an d for foreign currency loan s and in terest rate differentials were im portant reasons. M ore generally, a sharp rise in residents d eposits in overseas banks is o ften regarded as sym p tom atic o f capital flight, w h ile a m ore gradual rise in th ese d eposits m ay just reflect p ortfo lio reallocations. M any countries d iscouraged or prohib ited fu n d m anagers (un it trusts, p en sio n and m utu al fund s and so on) from in vestin g abroad so as to retain scarce capital for d om estic d evel­ o p m en t. This m le has b een gradually eased in a num ber o f countries. For exam ple in C h ile th e a llow able prop ortion o f assets in vested abroad w as raised from 2 per cen t in 1992 to 16 per cen t in 2 0 0 0 as th e authorities w ish ed to reduce their con cen tration o f risk. In m a n y cases fu n d m anagers h ave taken advantage o f th is greater freedom to p lace fun ds w ith in ter­ n ation a l banks.6 N et b a n k fu n d in g W ith len d in g at best flat and d eposits rising, funds flow ed from em erging eco n o m ies to th e banks (Figure 4 .1). T he IIF estim ates in Table 4.1 sh o w that banks w ithd rew m ore m o n ey from th e em erging eco n o m ies in 2001 and 2 002 . In ternational bank loans ou tstan d in g to Asia are exp ected to co n tin u e fa lling. W h ile th is partly reflects less d em and for credit, or m ore o f it b e in g m et dom estically, it also reflects co n tin u in g caution by lenders about political uncerta in ties an d th e slow pace o f restructuring in som e countries. C y c lic a l a sp e c ts o f i n te r n a t io n a l b a n k le n d in g In tern a tion a l b an k len d in g to em erg in g e c o n o m ie s is subject b o th to p u sh factors (in th e source cou n tries) an d to p u ll factors (in th e user cou n tr ies). A sim p le com p arison o f th ree o f th ese forces - th e strength o f th e ad van ced an d em erg in g e co n o m ies , w h ic h m ig h t be associa ted w ith th eir resp ective ex p ec ted returns, and in terest rates in th e advan ced e co n o m ies - are sh o w n in Figures 4 .2 , 4 .3 and 4 .4 . In term s o f th e activ ity 66 *n c3 Q.4 5(B © 2 J2. a Figure 4.2 B a n k le n d in g to e m e rg in g m a rk e t e c o n o m ie s a n d p o l ic y in te re s t ra tes, 1 9 8 5 -2 0 0 1 N otes: 1 L eft-hand scale. 2 R igh t-hand scale. Sources: N ationa l da ta ; BIS. Figure 4.3 P u s h in f lu e n c e s o n in te r n a t io n a l b a n k le n d in g , 1 9 7 8 -2 0 0 1 Notes: 1 L eft-hand scale. 2 R igh t-hand scale. Sources: N a tio n a l data: BIS. John Hawkins 67 Total bank flows Bank flows by region3-4 Figure 4.4 B a n k s e x te rn a l p o s it io n s vis-à-vis e m e rg in g e c o n o m ie s ,1 1 9 9 8 -2 0 0 1 Notes : 1 Exchange ra te a d ju sted changes in a m o u n ts o u ts tan d in g , in b illio n s o f US dollars. 2 A negative (positive) value ind ica tes a n increase (decrease) in BIS rep o rtin g b an k s liabilities vis-à-vis em erg ing econom ies. 3 C hanges in claim s m in u s changes in liabilities. 4 T w o-quarter m o v in g average. Source: BIS. Figure 4.5 Japanese in te r n a t io n a l b a n k le n d in g t o A s ia n e c o n o m ie s , 1 9 8 5 -2 0 0 1 Sources: N a tiona l da ta ; BIS. m easures, th e graphs su ggest th a t th e p u ll factor is gen era lly stronger th a n th e p u sh , th a t is, banks le n d in g is m ore resp on sive to c o n d it io n s in th e borrow in g e c o n o m ie s th a n in th e le n d in g e co n o m ies , b u t th ere are som e ex c e p tio n s . T he starkest recen t ex a m p le o f th is has b een th e sharp c u t­ back in le n d in g to A sian e c o n o m ie s b y Japanese banks b ecau se o f th eir d o m estic d ifficu lties (Figure 4 .5 ). It has b een su ggested th a t th e p u sh factor d o m in a tes in Latin A m erica an d th e p u ll factor in Asia. In their survey o f th e literature, Jeanneau and M icu (2002 ) c o m m en t th a t som e o f th e m ore recen t stu d ies h a v e ten d ed to em p h a sise th e co m p lem en ta r ity o f 68 International Bank Lending p u sh and p u ll factors, w ith th e first set o f factors d e term in in g th e tim in g and m a g n itu d e o f flow s an d th e seco n d set d eterm in in g their geograp h ic distrib ution . Jeanneau an d M icu present em pirical ev id en ce, u sin g BIS ban k in g data, that o n e p ush factor - real short-term in terest rates in industrial countries - is th e d om in an t in flu en ce (but real GDP in th e len d in g countries does n o t h ave a sign ifican t in flu en ce). O f th e p u ll factors, th ey fin d a role for eco n o m ic grow th in borrow ing countries, their exch an ge rate variance and ch anges in foreign reserves and th e current account. T he results are broadly sim ilar for Asia and Latin Am erica. Tests u sin g a crisis d u m m y suggest th at th e A sian crisis h ad th e effect o f redirecting len d in g from Asia to Latin Am erica. T hese factors exp la in m ore o f short-term th an long-term len d in g . It is n otew orth y th a t th e previously observed ten d en cy for capital flow s to em erging eco n o m ies to rise w h en activ ity in th e industrial w orld w eakened is n o t h ap p en in g in th e current slow dow n; all th e signs are that flow s are declin in g . Interest rates in m ost advan ced eco n o m ies were lo w in th e early 1990s (in th e U n ited States, partly due to th e w eakness o f th e ban k in g sector at th at tim e). This encouraged banks to seek h igher returns from len d in g to em erging eco n o m ies. Interest rates stayed very lo w in Japan in th e 1990s, g iv in g rise to yen carry trade: borrow ing in y en (at perhaps 0 .5 per cent) and len d in g elsew h ere in Asia (perhaps at 2 0 per cen t in Indonesia). The sheer size o f th e in terest rate differential and co n fid en ce in th e A sian eco ­ n o m ic m iracle tem p ted lenders to ignore th e exch an ge rate and credit risks in vo lved . A nother exam p le w here in terest rates p layed an im portant role w as th e rise in US rates in early 1994, w h ich acted as an im p ortan t trigger for M exicos su b seq uent problem s. H ow ever th is also provides a cou n terex­ am ple as th e in terest rate increase seem ed to d o n o th in g to curb len d in g to th e A sian econ om ies. Just look in g at in terest rates in advanced eco n o m ies is, o f course, very sim plistic. A m ore relevant m easure w ou ld be th e risk-adjusted exp ected return, w h ich sh ou ld b e com pared w ith exp ected returns in em erging m arket econ om ies. Furtherm ore len d in g m ay also respond to th e degree o f variation and uncerta in ty about th e return or th e ex ten t to w h ich returns are correlated across countries an d regions. A ddressing th ese issues em pirically is w ell b eyon d th e scop e o f th is chapter. T he relative im portance o f pu sh and pu ll factors w ill a lso d ep en d o n th e ex ten t to w h ich banks are in form ed about in d iv id u a l em erging eco n o m ies and d iscrim inate b etw een th em . To test for th is, th e percentage ch an ge in th e outstand ing claim s o f banks ow n ed b y th e five m ain len d in g countries on th e ten m ain em erging eco n o m ies was calculated over s ix -m o n th ly periods from June 1990 to June 2000 . T he correlations are sh o w n in Table 4 .7 . There are qu ite a few n egative correlations, suggesting th at th e len d in g flow s were n o t u n iform b u t h ad m a n y id iosyncratic features. It can also b e observed John Hawkins 69 Table 4 .7 C o r re la t io n s b e tw e e n c h a n g e s in c la im s o f B IS - re p o r t in g b a n k s o n d e v e l­ o p in g e c o n o m ie s , J u n e 1 9 9 0 -J u n e 2 0 0 0 * Lenders France Germany Japan UK US Standard deviations Borrowers C h in a 0 .0 8 0 .01 0 .11 0 .1 2 0 .0 1 0 .1 In d o n e s ia - 0 . 0 6 0 .0 2 - 0 . 0 4 - 0 . 1 7 - 0 . 0 3 0 .1 In d ia - 0 . 0 0 - 0 . 1 0 0 .3 3 - 0 . 0 7 - 0 . 0 8 0 .2 M a la y s ia - 0 . 1 2 0 .1 4 - 0 . 3 2 0 .0 9 - 0 . 1 8 0 .2 K ore a 0 .0 3 - 0 . 2 0 - 0 . 2 8 - 0 . 1 0 - 0 . 1 5 0 .1 T h a ila n d - 0 . 2 0 - 0 . 3 7 - 0 . 1 4 - 0 . 3 3 - 0 . 3 9 0.1 A rg e n t in a 0 .51 0 .2 5 0 .1 0 0 .9 0 0 .1 2 0 .3 B ra z il 0 .4 5 0 .4 6 0 .1 2 - 0 . 0 3 0 .1 1 0 .2 C h ile 0 .4 2 0 .1 9 - 0 . 0 2 0 .41 0 .3 9 0 .2 M e x ic o 0 .0 3 0 .0 6 0 .1 4 - 0 . 1 5 - 0 . 3 0 0 .2 S ta n d a rd d e v ia t io n s 0 .3 0 .2 0 .2 0 .4 0 .2 * C orre la tion betw een percen tage ch an g e in le n d in g over s ix -m o n th ly p eriods b y b anks ow n ed by le n d in g co u n try i to bo rrow er / w ith all loans to all develop ing eco n o m y borrow ers. th at th e correlations ten d to b e m ore sim ilar across th e rows (borrowers) th a n d o w n th e co lu m n s (lenders), again su ggesting th at p u ll factors w ere generally m ore im portant. In a similar study th at focuses o n periods o f currency crisis, Van Rijckeghem and W eder (2000 , 2001 ) use BIS con so lid ated b ank ing statistics to ex a m in e th e role o f bank len d in g in con tag ion . N o tin g th e specia lization illustrated in Table 4 .2 , th ey test for a co m m o n lender effect. T he h y p oth esis is that banks th at m ake losses due to their exposure to a crisis cou n try respond by cu ttin g back len d in g to o ther em erging econ om ies. As a result, em erging eco n o m ies th at h ave th e sam e lenders as a crisis e co n o m y suffer from c o n ­ tag ion . T hey fin d ev id en ce for su ch an effect after th e M exican and A sian crises b u t n o t after th e Brazilian crisis. G iven th e pattern o f co m m o n lenders sh o w n in Table 4 .2 , th is form o f co n ta g io n is m ost likely to affect o ther eco n o m ies in th e sam e region . From a p o licy p o in t o f view , th ese find ings im p ly that em erging eco n o m ies cou ld reduce their co n ta g io n risk b y d iver­ sify ing th e sources o f their fu n d in g and carefully m on ito r in g their vu ln er­ ab ility th rou gh shared b ank creditors. N otw ith stan d in g th e fact th at private banks ch o ice o f creditors is th e d ecis ion o f in d iv id u a l banks, th e authorities can still p lay a role b y provid ing in form ation o n aggregate p osition s and by adjusting th e co m p o sitio n o f their o w n creditors. Som e recent studies o n determ inants o f th e destination o f bank len d in g are sum m arized b y Buch (2000). For G erm an banks, len d in g is h ig h ly correlated 70 International Bank Lending w ith trade links, a lth ou gh th is does n o t appear to b e fo llow th e custom er behaviour as m u ch o f th e len d in g studied was to banks, rather th an co m ­ panies, in th e recip ien t countries. A study o f OECD banks fou n d th at market grow th and d iversification prospects were m ost im portant. In th e U n ited States, sm all banks ten d to fo llo w th e lead o f large banks in their overseas len d in g . Based o n BIS data, B uch finds th at in tern ation a l b ank loan s are greater to countries that h ave trade links w ith th e lender, strong grow th in industrial production , m em bersh ip o f th e OECD (assum ed to reflect th e corresponding low er capital requirem ents under th e Basel A ccord) and are geographically c lose to th e lender. C apital contro ls deter len d in g . In add­ ition , Spanish banks len d far m ore th an th ese variables a lon e w ou ld predict to Spanish-speaking countries (th e o n ly case w h ere c o m m o n language appears to be im portant). Interest rate differentials are n o t sign ificant. T he in tern ation a l len d in g behaviou r o f ind iv idu al US banks is stud ied by G oldberg (2001). M u ch o f th is len d in g is con cen trated in Latin Am erica, and G oldberg sh ow s th at th is is especially true o f sm aller banks. She con clu d es th at US banks foreign len d in g to Latin Am erica expands m ore w h en th e US e co n o m y is grow in g strongly, b u t th is is n o t th e case for len d in g to Asia. H ow ever in tern ation a l len d in g b y US banks is n o t sen sitive either to real in terest rates or to d em an d co n d itio n s in th e recip ient em erging econ om ies. Structural aspects of international bank lending C h a n g es in b a n k o p era tio n s G lobal banks h ave reduced th eir len d in g to em ergin g eco n o m ies in favour o f fee-based activ ities and len d in g via subsidiaries (Table 4 .8). T he m ove tow ards fee-based activ ities m ay b e due to banks trying to m eet their aspir­ a tion for h igh returns o n eq u ity w ith o u t adding assets to their balance sheet, w h ich w ou ld require m ore eq u ity to be raised. It also m ay reflect a m ore conservative attitude tow ards tak ing risks o n to th eir o w n balance sh eets (possib ly due to a greater appreciation o f th e ex ten t o f th ese risks) and a desire for m ore stable in co m e sources. L ending th rou gh subsidiaries m ay a llow better quality con tro l b y len d in g officers located in specific em erging econ om ies. It m ore readily a llow s in ter­ n ation a l banks to len d in d om estic currency, as a subsidiary can raise deposits in th e d om estic currency to avoid a currency m ism atch . In som e countries (for exam ple C hina an d M alaysia) direct len d in g in d om estic currency from th e head office is p roh ib ited b y capital controls. In som e cases, h o st bank supervisors prefer in tern ation a l banks to len d th rou gh such subsidiaries. M any em erging m arket eco n o m ies are n o w encouragin g th e en try o f foreign banks to m ake u p for d efic ien cies in their d om estic b an k in g system , such as lack o f capital, lack o f com m ercial bank ing skills and an in effic ien t bank ing structure. Foreign banks usually John Hawkins 71 Table 4.8 In ternational banks involvem ent in developing countries, June 1998-December 2000 June 1998 (US$ bn) Dec 2000 (USS bn) % change (at annual rate) A ll developing countries L o a n s o u ts ta n d in g 9 2 4 739 - 8 . 8 O th e r assets1 110 155 14 .7 L o a n s b y s u b s id ia r ie s 2 2 4 8 4 35 2 5 .2 Developing Asia L o a n s o u ts ta n d in g 3 5 8 2 43 - 1 4 . 4 O th e r assets1 36 41 5 .3 L o a n s b y s u b s id ia r ie s 2 72 11 8 2 1 .8 Latin America L o a n s o u ts ta n d in g 2 7 8 2 1 3 - 1 0 .1 O th e r assets1 43 74 2 4 .3 L o a n s b y s u b s id ia r ie s 2 134 231 2 4 .3 In te r n a t io n a l d e b t s e c u rit ie s o n issue 3 4 5 4 1 7 7.9 Notes: 1 Inc ludes h o ld in g s o f d eb t securities, som e derivative p o sitio n s a n d equ ities. See BIS (2000), p a rt I.C. 2 Local cu rrency claim s o f BIS rep o rtin g b a n k s fo reign affiliates w ith local residents. Source: BIS (2000), p a rt I.C. bring state-of-the-art tech n o logy and train ing for d om estic bankers. M oreover th ey are fam iliar w ith soph isticated fin ancia l in strum ents and tech n iq u es, and h ave faster and cheaper access to in tern ation a l capital m arkets and liqu id funds. Their presence m ay also encourage other foreign firms to invest in th e d om estic econ om y. Empirical studies h ave fou n d th at foreign bank entry im proves th e fu n ctio n in g o f n ation a l ban k in g m arkets b y increasing th e degree o f com p etition , and b y in trod u cin g a variety o f n ew financia l products an d better risk m an agem en t tech n iq u es .7 A liberal approach to foreign bank entry has b een laid d o w n b y in tern ation a l trade agreem ents (WTO, NAFTA), is a co n d itio n o f m em bersh ip o f th e OECD and th e EU, or is part o f reciprocity requirem ents for d om estic banks to exp an d in to foreign markets. As a result, foreign banks n o w h ave a large presence in m ost em erging eco n o m ies. Indeed for a sm all e co n o m y it m ay m ake sense n o t to h ave any d om estica lly o w n ed banks at all, as th ey m ay n o t be able to diversify their risks sufficiently. N on eth eless in practice there are o n ly a few eco n o m ies w ith fu lly foreign -ow ned ban k in g system s, w ith th e degree o f foreign ow n ersh ip m ore n orm ally ly in g som ew h ere b etw een 2 0 per cen t and 5 0 per cen t.8 W h en an n o u n c in g a m ajor liberalization program m e, th e authorities in Singapore stated exp lic itly th at th ey w an ted loca l banks to retain at least 72 International Bank Lending h a lf th e m arket. A nother exam p le is th e P hilipp ines, w here a law restricts foreign banks share o f assets to 30 per cen t or less. Foreign banks o ften enter b y tak ing over a troubled d om estic bank. H ow ­ ever there m ay b e pub lic resistance to th is, especially if taxpayers m o n ey has b een used to clean up th e banks balance sh eet ahead o f privatization. G overnm ents a lso face d om estic pressure to lim it th e role o f foreign banks because o f fears th a t foreign banks w ill qu ick ly d om in ate th e loca l m arket and n eg lect sm all businesses or rural custom ers, or cause a low ering o f credit standards b y increasing com p etition , especially if th ey use their deep pockets to subsidize early losses. E vidence o n w h eth er th e b u sin ess focus o f foreign and d om estic banks diverges is rather m ixed . In m ost em erging m arket econ om ies, how ever, foreign banks appear to be very cautious about len d in g to sm aller firm s because o f their lim ited k n ow led ge o f loca l industry. A n im portant issue has b een foreign banks b ehaviour during recessions in h o st countries and th e foreign banks h o m e base. O n e o p in io n is that d om estic banks are m ore co m m itted to th e d om estic econ om y, in th e sense o f hav in g b o th longer-term business relations w ith custom ers and a patriotic affin ity w ith th e n ation a l interest. Foreign banks, b y contrast, are said to lo o k at len d in g op p ortu n ities around th e w orld an d m ay n eg lect th e h o st cou n try e co n o m y if its prospects deteriorate or if prospects im prove in other countries. Foreign banks m ay also be less likely th an d om estica lly o w n ed banks to h eed exh orta tion s b y th e d om estic authorities to m ain ta in len d in g during recessions. In som e cases foreign banks have b een less cooperative in rescheduling loan s in tim es o f crisis. It is d ifficu lt to assess th e truth o f th ese criticism s. T hey m ay w ell app ly m ore to foreign banks w ith o n ly a sm all and recent presence in th e d om estic ban k in g system . H ow ever, larger, longer-estab lished foreign banks m ay be less in c lin ed to risk their reputation and beh ave m ore like th e d om estic banks. There is also ev id en ce th a t local m an agem en ts are u su ally strongly com m itted to th e loca l operations, and th at th ey id en tify m ore w ith d om estic interests over tim e. T he contrary o p in io n is th at foreign banks are better p laced to ride ou t d om estic recessions because th ey can m ore readily access in tern ation a l financia l m arkets or draw o n credit lin es from their parents. Furtherm ore th ey h ave m ore diversified balan ce sheets. T he em pirical ev id en ce from Latin America suggests that foreign banks have generally had low er vo latility o f len d in g th an d om estic banks and n otab le credit grow th during crisis periods, and th at o n ly offshore len d in g tend s to contract in bad tim es. Foreign bank operations m ay also keep in ternational m arkets better inform ed about d om estic co n d itio n s and so h elp d am p en p an ic w ithdraw als o f in tern ation a l fu n d in g (as in Saudi Arabia during th e G ulf War in 1991), or can h elp reduce resident capital ou tflow s during crises because th ey are usually perceived as safer. G overn m en ts m ay also be reluctant to h ave their d om estic bank ing system s d om in ated b y banks from a single coun try lest th ey su d d en ly cut John Hawkins 73 their activ ities w h en faced w ith problem s at h o m e (for exam p le Japanese banks in Asia) or exert p o litica l pressure for favourable treatm ent. For th is reason em erging eco n o m ies m ay seek to diversify foreign ow ners. For exam p le th e Saudi authorities h ave b een selective and licen sed foreign banks from d ifferent parts o f th e w orld, w ith d ifferent m an agem en t cultures, system s and tech n o log ies . Sim ilarly th e authorities in C h ina h ave b een con cern ed about th e im pact o f foreign banks o n th e com p etitiven ess o f d om estic banks, and have sou gh t to lim it their m arket share b y licen sin g banks from d ifferent countries, restricting their activ ities to b u sin ess in foreign currencies on ly , or restricting their business in loca l currency to tw o cities. T hey have also ensured th at banks are fam iliar w ith th e local m arket by requiring th em to have a representative office for tw o years before co m m en c in g bank ing operations. P o lic y to w a rd s in te r n a t io n a l b a n k le n d in g Since th e A sian crisis there has b een greater aw areness a m on g p o licy makers o f th e risks in vo lved in excessive external borrow ing. Supervisors m ay th ere­ fore d iscourage banks from b orrow ing offshore and restrict their foreign exch an ge exp osure.9 Som etim es, how ever, banks try to restrict their o w n foreign exch an ge exposure b y len d in g in foreign currency to d om estic custom ers w h ose cash flow s are in th e d om estic currency. H ow ever th ey th en face a large credit risk if there is a sharp depreciation . This w as a m ajor problem during th e M exican and A sian crises in th e 1990s. In som e countries restrictions have b een p laced o n in tern ation a l bank fin an cin g , such as th e recent tig h ten in g o f lim its o n non-residents ability to borrow d om estic currency in Indonesia , th e P h ilipp ines and T hailand. O ften th ese have b een directed at su ch activ ities as non -resid en ts short- se llin g th e currency as part o f a sp ecu lative attack, bu t th e restrictions m ay reduce len d in g for other, m ore in n o cen t, purposes as w ell. In te r n a tio n a l b a n k le n d in g a n d th e B asel C ap ita l A ccord T he Basel C om m ittee o n Banking Supervision is currently in th e process o f adapting th e Basel C apital Accord to n ew m arket realities (it issued co n su l­ ta tion drafts in June 1999 and January 2001). This cou ld have im p lica tion s for th e qu an tity or d istribution o f bank len d in g to em erg in g econ om ies. Som e argue th at banks are already reacting to th e proposals. A prim ary goal o f th e proposals is to a lign m ore c lose ly th e capital required to support a loan and th e risk o f th e loan . In particular it replaces th e OECD/ non-O EC D d istin ction w ith an approach based o n banks in ternal credit ratings or th ose set b y credit assessm ent agencies. This m ean s th at loan s to low er-rated OECD eco n o m ies such as Korea, M exico, Poland and Turkey w ou ld require m ore capital w h ile loans to higher-rated non-O EC D econ om ies such as C hile, H on g K ong and Singapore w ou ld require less. 74 International Bank Lending Risk w eigh ts for banks and corporates w ou ld also b e d ep en d en t o n their credit ratings. This sh ou ld reduce th e fu n d in g costs o f som e o f th e sou n d est banks and com p an ies in em ergin g econ om ies. T he low er risk w eigh ts assigned to corporations rated A m in u s or above cou ld lead to m ore len d in g to th em at th e exp en se o f weaker credits. As weaker credits ten d to b e m ore prevalent in em erging econ om ies, th is cou ld reduce th e overall flow o f bank len d in g to em erging eco n o m ies. It m ig h t w ell b e in em erg in g econ om ies in terests if th e riskiest borrowers were to fin d credit m ore exp en sive , but con cern has b een expressed - for exam p le b y Griffith-Jones and Spratt (C hapter 10) - th a t th e m ap p in g b etw een credit assessm ents and capital required m ay b e so steep th a t th e low est-rated borrowers w ou ld fin d loan s from banks proh ib itive ly exp en sive. A particular prob lem for corporate borrowers in m a n y em ergin g eco n o m ies is th at few o f th em have a credit rating; for exam ple Pow ell (2001) reports that in A rgentina o n ly 150 o f 80 0 0 0 corporate borrowers are rated. T he n ew Accord envisages th at th e m ore sop h isticated banks w ill u se an advanced in ternal ratings-based approach. This m ay reduce th e ex ten t o f herd ing if it causes banks to base their loan s o n in d iv id u a l assessm ents o f cou n tries.10 H ow ever th e proposed role for external credit assessm ent agen ­ cies (n o t just ratings agencies bu t also n ation a l export credit agencies) has led to som e con cern . Sovereign ratings h ave ten d ed to lag b eh in d eco n o m ic d evelop m en ts as rating agencies have b een slow to dow ngrade coun tries in th e run-up to crises, w h en und erly in g im balances are b u ild in g up and w arn­ in gs w ou ld be usefu l b o th to borrowers and to lenders, and th en pu t th e countries th rou gh several dow ngrades o n ce th e crises h ave broken ou t. This m ay m ake th em a procyclical e lem en t (as th e y w ere during th e A sian crisis), encouragin g banks to w ithdraw even further from em ergin g eco n o m ies just w h en their support is m ost n eed ed . H ow ever it is n o t clear w h at w ou ld be a better alternative. Sovereign credit spreads ten d to b e ev en m ore vo la tile th an ratings. O ne approach w o u ld be to adjust regulatory risk w eigh ts o n ly gradually in response to chan ges in credit ratings. F inancial m arkets are likely to be procyclical regardless o f h o w regulations are structured. It is to be h op ed that a greater focus o n m easuring risk b y banks and their supervisors w ill m ean a m ore careful and less short-term focus. Under th e present accord, in ternational interbank len d in g o f up to o n e year to non-O EC D eco n o m ies has a 2 0 per cen t risk w e ig h t w h ile longer-term len d in g carries a 100 per cen t risk w eigh t. O ne possib le con seq u en ce o f th is d istin ction is th at bank len d in g to em erging m arkets is too short term , and th u s m ore subject to cyclical forces.11 W h ile a low er risk w eig h t for short­ term len d in g th an for long-term len d in g m ay m ake sense for th e len d in g o f an in d iv idual bank (w h ich is th e focus o f th e supervisors), it m akes less sense if all banks len d short term so th at th e borrower is vu lnerable to a su dden loss in liquidity. In o ther w ords th e system ic (or m acro) con sid eration s m ay to som e ex ten t run cou n ter to supervisory (or m icro) considerations. John Hawkins 75 T he con su lta tive d o cu m en t issued by th e Basel C om m ittee (2001) recog­ n ized th e p o ten tia l for u n in ten d ed con seq u en ces o n len d in g markets from settin g low er capital requirem ents for short-m aturity loan s and sought co m m en ts o n th is qu estion . It suggested low ering th e th resh o ld for pre­ ferable treatm ent o f short-term debt to three m on th s, th e upper m aturity ban d in th e interbank m o n ey market. W h ile th e proposed risk w eigh ts for short-term len d in g to banks rated b etw een A p lus and B m in u s are low er th an th ose applied to lon g-term loan s to th ose banks, th e difference is 3 0 -5 0 percentage p o in ts rather th an th e current 80 percentage p o in ts. Conclusions Since th e A sian crisis fund s have co n sisten tly flow ed to in tern ation a l banks from em erging econ om ies. Previously th is w ou ld h ave seem ed as lik ely as w ater flow in g u p h ill. A n um ber o f factors are responsib le for th is surprising event, b o th cyclical and structural: • T he A sian crisis cam e as a shock to com p lacen t banks th at had assum ed th e g ood tim es in Asia w ou ld g o o n in d efin ite ly and therefore ignored th e m o u n tin g debt in th e region . Su bsequently th e Russian crisis w eakened th e co n v ic tio n that lenders to im portant countries w ou ld alw ays be bailed out. This has led to reduced len d in g . • Som e com p lacen cy w as a lso rem oved from borrowers in em erging econ om ies. M any borrowers b ecam e k een to repay debt. In Asia, currency d evalu ation s and strong d em an d (until recently) for their e lectron ic exports a llow ed th em to repay excessive debt. • C yclical factors p layed som e role; u n til recen tly grow th prospects in th e U n ited States w ere seen as excep tion a lly strong. G row th prospects looked poorer in dam aged A sian econ om ies, as w ell as in A rgentina, Brazil and Turkey. M any A sian eco n o m ies have a legacy o f overin vestm en t so are n o t k een to borrow. • D ep osits in in tern ation a l banks b y em erging m arket eco n o m ies h ave b een grow ing, reflecting th e deregu lation o f fast-grow ing fu n d m anagers, capital fligh t and th e savings from h ig h o il revenues. • A structural ch an ge exaggerating th e p h e n o m e n o n is th a t banks, encou r­ aged b y p o licy makers, are increasingly d o in g their len d in g in em erging eco n o m ies th rou gh subsidiaries there, u sin g deposits raised there, rather th a n from h ead office. It is hard to apportion th e turnaround in in tern ation a l bank len d in g b etw een th ese factors. But there is a risk th at in stead o f excessive capital in flow s th e em erging eco n o m ies w ill face in adequ ate in flow s. T he water flow in g u p h ill w ill m o v e th em from flo o d to drought. 76 International Bank Lending Appendix 4.1 BIS in te r n a t io n a l b a n k in g sta tis tic s Data are gathered quarterly from n ation a l authorities, u sually central banks, in 32 econ om ies, in c lu d in g th e w orlds m ain ban k in g cen tres.12 There are tw o m ain quarterly co llection s, k n ow n as th e location a l and con so lid ated co llection s. T he location a l data, w h ich co m m en ced in 1964, are co n sisten t w ith balance o f p aym en ts p rincip les and cover banks, b o th d om estic and foreign- ow n ed , located in th e 32 econ om ies (but n o t their overseas subsidiaries). T he data relate to banks in tern ation a l b an k in g business, d efin ed as gross financial claim s or liabilities vis-à-vis non-residents as w ell as foreign currency p osition s vis-à-vis residents. To m in im ize reporting burdens th e co llec tio n is b u ilt o n ex istin g n a tion a l data co llection s. A lth ou gh th e data u su ally cover w ell over 9 0 per cen t o f in tern ation a l len d in g , there is som e variation in th e coverage o f in stitu tio n s and som e d efin ition a l in co n s isten c ies .13 T he assets and liab ilities (and a narrower con cep t o f loan s and deposits) are broken d o w n by: • currency, in to d o m estic currency, US dollar, euro, y en , sterling, Swiss franc and other. O n e reason for th is is to m easure th e ex ten t to w h ich changes in stock expressed in US dollars are attributable to va lu a tion effects arising from exch an ge rate flu ctuations rather th an b e in g d ue to transactions; • sector, in to banks and non-banks; • e co n o m y (in tern ational organizations such as th e IMF, OPEC and so on are in clu d ed as special countries rather th an b e in g allocated to th e cou ntry in w h ich th ey are headquartered). A sn ap shot sum m ary o f th ese data, w h ich are pu b lish ed for over 160 in d i­ vidual em erging econ om ies, as o f m id 2 0 0 2 is provided in th e upper part o f Table A 4.1. For som e countries there are sign ifican t discrepancies b etw een th e data pu b lish ed b y th e BIS (based o n in form ation from lenders) and th e external debt statistics p u b lish ed by n ation a l statistical agencies (based o n in form ation from borrow ers). In som e cases th is is k n o w n to be due to d efin ition a l d ifferences rather th an m isrep orting .14 T he con so lid a ted co llec tion , lau n ch ed in 1977 b ut reported o n ly sem i­ an n u ally u n til 2 000 , focuses o n banks w orldw ide credit and cou n try risk exposure. It g ives in form ation o n banks in ternational len d in g activ ities broken d ow n b y m aturity, sector and borrow ing cou n try o n a w orld-w ide con so lid ated basis. Banks w ith head offices in th e reporting cou n try provide in form ation o n all their o ffices at h o m e and abroad (in clu d in g an y oper­ a tion s in w h ich th e y o w n m ore th an 50 per cen t o f th e capital), w ith th e p osition s b etw een d ifferent offices o f th e sam e bank n etted ou t. E xam ples o f John Hawkins 77 Table A4.1 BIS reporting banks exposure to developing countries (US$ billion, June 2002) Asia-Pacific Europe Latin America Middle East and Africa Total Assets 2 7 7 173 28 1 15 6 8 8 7 o f which lo a n s 23 1 135 2 1 5 147 72 8 to n o n -b a n k se c to r 112 79 147 78 4 1 6 L ia b il i t ie s 3 7 1 150 2 3 3 3 4 3 1 0 9 7 o f which d e p o s its 3 7 0 150 22 9 3 3 9 1 0 8 8 to n o n -b a n k se c to r 140 41 131 144 4 5 6 C o n s o lid a te d c la im s 39 5 2 9 6 4 9 2 154 1 3 3 7 o f which s h o r t - te rm 128 8 0 1 1 2 6 2 3 8 2 o n p u b l ic se c to r 4 0 33 4 0 2 0 133 o n n o n -b a n k p r iv a te s e c to r 121 108 164 58 45 1 U n u s e d lin e s 5 4 50 3 2 4 4 1 8 0 A f f i l ia te s lo c a l c u r re n c y c la im s o n lo c a l re s id e n ts 141 104 247 3 4 5 2 6 Source : BIS (2002). th ese data are provided in th e low er part o f Table A 4.1. T he co llec tio n s also in clu d e separate reporting o f foreign banks local business in loca l currency, a grow ing item d ue to in tern ation a l banks’ purchase o f d om estic banks in em erging econ om ies. Im p ro v em en ts The BIS data co llection s are con tin u ou sly b ein g im proved in term s o f accuracy, coverage an d tim elin ess. Likely im p rovem en ts w ith in th e n ex t tw o years in clu d e ad d in g m ore d eve lop in g countries and offshore centres to th e in ter­ n ation a l bank ing statistics, a cou n try breakdow n for th e derivatives business o f banks and m ore detailed data o n an u ltim ate risk basis. T he im prove­ m en ts are overseen b y th e C om m ittee o n th e G lobal F inancial System and an expert group o f central bank statisticians (see Fender and Frankel, 2001). N o tes * A n y o p in io n s exp re ssed in th is c h a p te r a re th o s e o f th e a u th o r a n d are n o t ne ce s­ s a r ily sh a re d b y th e BIS. H e lp fu l c o m m e n ts h a v e b e e n re c e ive d f r o m P a lle A n d e rs e n , C h a rle s F re e la n d , S te p h a n y G r if f i th -J o n e s , M a rc K la u , E lm a r K o c h , C h r is t in a L u n a , M a r ia n M ic u , P h i l ip T u rn e r , A g u s t in V il la r , K a rs te n v o n K le is t, B e a tr ice W eder, R a in e r W id e ra a n d p a r t ic ip a n ts a t s e m in a rs in S a n tia g o a n d H e ls in k i . B ru n o A lle m a n n , M e lis s a F io re l l i, M a rc K la u a n d D e n is P etre ass is ted w i t h th e d a ta . 1. F o r fu r th e r d e ta ils see BIS, 2 0 0 0 ; BIS, 2 0 0 2 ; F io re l l i, 2 0 0 0 . 2 . I t has b e e n sugg es ted t h a t th e m o re re a d y g ra n t in g o f g u a ra n te e s a n d s u p p o r t b y e x p o r t ag en c ie s is e n c o u ra g in g in te r n a t io n a l le n d in g b y E u ro p e a n b a n k s . 3 . H e d g in g b e tw e e n d o m e s t ic a g e n ts is l ik e p la y in g pass th e p a rc e l a n d do es n o t re d u c e th e n a t io n a l e x p o s u re . 4 . F o r a m o re d e ta i le d a n a ly s is o f f lo w s t o A s ia , in c lu d in g a n a n a ly s is based o n in d iv id u a l b a n k d a ta , see C a il lo u x a n d G r if f i th -J o n e s (2 0 0 0 ). 5 . See W o o ld r id g e (2 0 0 1 ) a n d C o h e n a n d R e m o lo n a (2 0 0 1 ). 6. A c c o rd in g t o US b a la n c e o f p a y m e n ts d a ta , n e t in f lo w s t o th e U n ite d States f r o m e m e rg in g e c o n o m ie s a ve ra g e d a ro u n d U S $ 7 0 b i l l i o n d u r in g 1 9 9 9 a n d 2 0 0 0 c o m p a re d w i t h a n e t ave ra ge o u t f lo w o f a ro u n d U S $ 4 0 b i l l i o n d u r in g th e th re e p re c e d in g yea rs . W h i le m u c h o f th is w e n t in t o th e p u rc h a s e o f g o v e rn m e n t b o n d s o r p o r t fo l io in v e s tm e n t, s o m e w o u ld h a v e b e e n d e p o s ite d in b a n k s . P r iv a te p e n s io n fu n d s i n L a t in A m e r ic a are n o w e s t im a te d to h a v e a ro u n d U S $ 1 7 0 b i l l i o n in fu n d s u n d e r m a n a g e m e n t. 7. See fo r e x a m p le C laessens a n d K lin g e b ie l (1 9 9 9 ). C laessens et al. (2 0 0 1 ) s h o w th a t s ig n if ic a n t fo re ig n b a n k e n t r y is asso c ia te d w i t h a re d u c t io n in o p e ra t in g expenses a n d th e p r o f i t a b i l i t y o f d o m e s t ic b a n k s . 8 . V e ry h ig h ra tes o f fo re ig n b a n k p e n e t ra t io n o c c u r, f o r e x a m p le , in N e w Z e a la n d (91 p e r c e n t) , B o ts w a n a (9 4 p e r c e n t) , J o rd a n (95 p e r c e n t) a n d B a h ra in (9 7 p e r c e n t) . A ra re case o f th is issue b e in g ad d re ssed f r o m s c ra tc h w as in th e w o r ld s n e w e s t n a t io n - East T im o r . R e p o r te d ly th e e c o n o m ic s m in is te r p re fe r re d n o t to h a v e a n y d o m e s tic b a n k s , b u t a n o th e r s e n io r p o l i t ic ia n fo u n d i t h a rd t o im a g in e a n a t io n w i t h o u t a t le a s t o n e d o m e s tic b a n k (The Economist, 2 S e p te m b e r 2 0 0 0 ). F o r d a ta o n shares o f fo re ig n b a n k s in b a n k in g assets, see H a w k in s a n d M ih a l je k (2 0 0 1 , ta b le 9 ). 9 . T h e F in a n c ia l S ta b il i ty F o ru m ’s (2 0 0 0 ) re p o r t o n c a p ita l f lo w s suggests t h a t in e m e rg in g e c o n o m ie s w h e re s u p e rv is o ry resources are scarce, s im p le re s tr ic t io n s o n b a n k s fo re ig n e x c h a n g e e x p o su re s m ig h t b e u s e d u n t i l a m o re s o p h is t ic a te d r is k m a n a g e m e n t a p p ro a c h is fe a s ib le . T h ese re s tr ic t io n s c o u ld in c lu d e l im i t s o n lo n g o r s h o r t p o s it io n s re la t iv e to c a p ita l, m in im u m h o ld in g s o f l iq u id assets, a n d reserve re q u ire m e n ts . F o re ig n c u r re n c y lo a n s c o u ld b e re s tr ic te d to a f ix e d p e rc e n ta g e o f c a p ita l o r b a n k s c o u ld be re q u ire d t o h o ld m o re c a p ita l a g a in s t th e s e lo a n s . 10. S uch in d e p e n d e n c e b e co m e s less l ik e ly i f b a n k s use th e sam e c re d it r is k m o d e ls a n d re ly o n th e sam e d a tab ase t o q u a n t i f y c re d it losses. 11. W h i le i t is re a s o n a b le fo r b o r ro w e rs to p a y m o re fo r lo n g e r - te rm lo a n s , th e p re m iu m m a y b e d r iv e n to o h ig h i f th e c a p ita l re q u ire m e n ts are in a p p ro p r ia te . 12 . T h e e c o n o m ie s are A u s tra lia , A u s tr ia , B aham as, B a h ra in , B e lg iu m , C a n a d a , C a y m a n Is la n d s , D e n m a rk , F in la n d , F ran ce , G e rm a n y , G u e rn se y , H o n g K o n g , In d ia , Ire la n d , Is le o f M a n , I ta ly , Ja p a n , Jersey, L u x e m b o u rg , N e th e r la n d s , N e th e r la n d s A n t il le s , N o rw a y , P o rtu g a l, S in g a p o re , S p a in , S w eden , S w itz e r la n d , T a iw a n , T u rke y , th e U n ite d K in g d o m a n d th e U n ite d S tates. 13. S om e c o u n tr ie s in c lu d e th e b a n k in g o p e ra t io n s o f t h e i r c e n t ra l b a n k a n d s o m e o n ly p ro v id e d a ta o n b a n k s o p e ra t in g in t h e ir o f fs h o re b a n k in g c e n tre s . S om e c o u n tr ie s o n ly p ro v id e a re s tr ic te d fo re ig n c u r re n c y b re a k d o w n . D iffe re n c e s e x is t b e tw e e n c o u n tr ie s in th e d e f in i t io n o f a b a n k . A c c o u n t in g d iffe re n c e s m a y a ffe c t th e basis o n w h ic h th e v a lu e o f s e c u rit ie s are re p o r te d a n d th e t re a tm e n t o f in t e r ­ est arrears. 14 . T h e t r e a tm e n t o f tra d e c re d its is o n e s u c h area. See v o n K le is t (2 0 0 2 ) a n d F in a n c ia l S ta b il i ty F o ru m (2 0 0 0 ) fo r a fu r th e r d is c u s s io n o f th e d if fe re n c e s b e tw e e n c re d ito r a n d d e b to r d a ta . 78 International Bank Lending John Hawkins 79 B a n k fo r In te r n a t io n a l S e tt le m e n ts (B IS) (2 0 0 0 ) Guide to the International Banking Statistics, J u ly , w w w .b is .o rg . (2 0 0 2 ) I n t r o d u c t io n t o th e BIS lo c a t io n a l a n d c o n s o lid a te d in te r n a t io n a l b a n k in g s ta tis t ic s , BIS Quarterly Review, D e c e m b e r: A 4 -A 5 s ta t is t ic a l a n n e x . Basel C o m m it te e o n B a n k in g S u p e rv is io n (2 0 0 1 ) The New Basel Capital Accord, w w w .b is .o rg , J a n u a ry . B u c h , C . (2 0 0 0 ) I n fo r m a t io n o r R e g u la t io n : W h a t is D r iv in g th e In te r n a t io n a l A c t iv it ie s o f C o m m e rc ia l B an ks? , Kiel Institute o f World Economics Working Paper n o . 1 0 1 1 , K ie l: K ie l I n s t i tu te o f W o r ld E c o n o m ic s , N o v e m b e r. C a il lo u x , J. a n d S. G r if f i th -J o n e s (2 0 0 0 ) I n te r n a t io n a l B a n k L e n d in g a n d th e East A s ia n C r is is , B r ig h to n : ID S , U n iv e r s ity o f Sussex. C laessens, S., A . D e m ir g i i f - K u n t a n d H . H u iz in g a (2 0 0 1 ) H o w D o e s F o re ig n E n t ry A ffe c t th e D o m e s tic B a n k in g M a rk e t? , Journal o f Banking and Finance, 25 , 5 : 8 9 1 -9 1 3 . a n d D . K lin g e b ie l (1 9 9 9 ) A lte rn a t iv e F ra m e w o rk s fo r P ro v id in g F in a n c ia l S erv ices , World Bank Policy Research Working Paper n o . 2 1 8 9 , W a s h in g to n , D C : W o r ld B a n k , S ep tem be r. C o h e n , B. a n d E. R e m o lo n a (2 0 0 1 ) O v e rv ie w , BIS Quarterly Review, J u n e : 1 -1 1 . E ic h e n g re e n , B. a n d R. H a u s m a n n (1 9 9 9 ) E x c h a n g e Rates a n d F in a n c ia l F r a g i l i t y ’, i n New Challenges for Monetary Policy, F e de ra l R eserve B a n k o f Kansas C ity , w w w .k c . f rb .o rg , p p . 3 2 9 -6 8 . Fe nde r, I. a n d A . F ra n k e l (2 0 0 1 ) A N e w Focus fo r th e BIS C o n s o lid a te d B a n k in g S ta tis t ic s , BIS Quarterly Review, M a rc h : 23 . F in a n c ia l S ta b il i ty F o ru m (2 0 0 0 ) Report o f the Working Group on Capital Flows, w w w . fs fo ru m .o rg , A p r i l . F io re l l i , M . (2 0 0 0 ) A T a le o f T w o S ta tis tic s : T h e BIS L o c a t io n a l a n d C o n s o lid a te d In te r n a t io n a l B a n k in g S ta tis t ic s , BIS Quarterly Review, J u n e : 16 . G o ld b e rg , L . (2 0 0 1 ) ‘W h e n is US B a n k L e n d in g t o E m e rg in g M a rk e ts V o la t i le ? , NBER Working Paper n o . 8 2 0 9 , C a m b r id g e , M A : N BER , A p r i l . G re n v il le , S. (2 0 0 0 ) C a p ita l F lo w s a n d C rise s , in G . N o b le a n d J. R a v e n h il l (eds), The A sian Financial Crisis and the Architecture o f Global Finance, C a m b r id g e : C a m b r id g e U n iv e r s ity Press: 3 6 -5 6 . A ls o in Reserve Bank o f Australia Bulletin, D e c e m b e r 19 9 8 : 1 6 -3 1 . G r if f i th -J o n e s , S. a n d S. S p ra tt (2 0 0 1 ) W i l l th e P ro p o s e d N e w Basel C a p ita l A c c o rd H a v e a N e g a tiv e E ffe c t o n D e v e lo p in g C o u n tr ie s ? ’, B r ig h to n : ID S , U n iv e r s i ty o f Sussex. H a w k in s , J. (1 9 9 9 ) E c o n o m ic a n d F in a n c ia l M o n i t o r in g , Australian Economic Indicators n o . 1 3 5 0 .0 (Ja n u a ry ): 3 -1 2 , C a n b e rra : A u s tra lia n B u re a u o f S ta tis tic s . a n d M . K la u (2 0 0 0 ) M e a s u r in g P o te n t ia l V u ln e ra b i l i t ie s i n E m e rg in g M a rk e t E c o n o m ie s , BIS Working Paper 9 1 , Basel: BIS, O c to b e r. a n d D . M ih a l je k (2 0 0 1 ) T h e B a n k in g In d u s t r y i n th e E m e rg in g M a rk e t E c o n o m ie s : C o m p e t i t io n , C o n s o lid a t io n a n d S y s te m ic S ta b il i ty - a n O v e rv ie w , BIS Papers, n o . 4 , Basel: BIS, 1 -4 4 . In s t i tu te o f In te r n a t io n a l F in a n c e ( IIF ) (2 0 0 1 ) C a p ita l F lo w s t o E m e rg in g M a rk e t E c o n o m ie s , w w w . i i f . c o m , 2 4 J a n u a ry . (2 0 0 2 ) C a p ita l F lo w s to E m e rg in g M a rk e t E c o n o m ie s , w w w . i i f . c o m , 18 S ep tem ber. J e a n n e a u , S. a n d M . M ic u (2 0 0 2 ) D e te rm in a n ts o f In te r n a t io n a l B a n k L e n d in g , BIS Working Paper 11 2 , Basel: BIS, J u n e . L a m fa lu ss y , A . (2 0 0 0 ) Financial Crises in Emerging Markets, N e w H a v e n , C T : Yale U n iv e r s i ty Press. R e fe re n c e s 80 International Bank Lending P o w e ll, A . (2 0 0 1 ) A C a p ita l A c c o rd fo r E m e rg in g E c o n o m ie s ? , u n p u b lis h e d p a pe r, S ep tem be r. T u rn e r , P. a n d U . N e u m a n n (2 0 0 1 ) ‘M a rk e ts , R e g u la t io n a n d B a n k in g in E m e rg in g M a rk e ts , u n p u b lis h e d p a pe r. V a n R ijc k e g h e m , C . a n d B. W e d e r (2 0 0 0 ) S p il lo v e rs th r o u g h B a n k in g C e n tre s : A P a n e l D a ta A n a ly s is , IMF Working Paper 0 0 /8 8 , W a s h in g to n , D C : IM F , M a y . (2 0 0 1 ) S ou rces o f C o n ta g io n : Is i t F in a n c e o r T rad e? , Journal o f International Economics, 54 , 2 (A u g u s t) : 2 9 3 -3 0 8 . v o n K le is t, K . (2 0 0 2 ) C o m p a r is o n o f C re d ito r a n d D e b to r D a ta o n S h o rt-T e rm E x te rn a l D e b t , BIS Papers 13, Basel: BIS, D e c e m b e r. W o o ld r id g e , P. (2 0 0 1 ) T h e In te r n a t io n a l B a n k in g M a rk e t , BIS Quarterly Review, J u n e : 12-20. 5 B a n k L e n d i n g t o E m e r g i n g M a r k e t s : C r o s s i n g t h e B o r d e r David Lubin Reflections on the collapse of short-term lending W ith ou t q u estion th e w orlds banks have b een th e largest n e t taker o f funds from em erging m arkets since th e 1997 A sian crisis. From Table 5.1 it is clear th a t b etw een th e en d o f 1997 - w h en banks exposure peaked - to th e en d o f 2000 , banks n et c la im s o n d eve lop in g countries fe ll b y a m assive U S$292.8 billion . M oreover it is clear from th e sam e table th a t banks actually becam e n et debtors to th e d eve lop in g w orld during th e sam e period. W hereas in 1997 th e banks had a n e t credit p o sitio n o f U S$147 b illion , b y D ecem ber 2 0 0 0 th is had turned in to a n e t debtor p o sitio n o f U S$145 b illion . It is Table 5.1 B a n k s n e t c ro s s -b o rd e r e x p o s u re t o d e v e lo p in g c o u n tr ie s , 1 9 9 7 a n d 2 0 0 1 (U S$ b i l l i o n ) 1997 2001 (03) Change B a n ks in te r n a t io n a l assets 1 0 5 1 2 0 6 8 7 4 5 1 2 - 1 7 6 6 9 4 A fr ic a a n d M id d le East 141 0 2 6 141 151 125 A s ia a n d P a c ific 4 4 9 9 1 3 2 7 3 3 0 8 - 1 7 6 60 5 E u ro p e 1 5 6 2 3 7 165 9 8 5 9 748 L a t in A m e r ic a 3 0 4 0 3 0 2 9 4 0 6 8 - 9 9 6 2 B a n k s in te r n a t io n a l l ia b i l i t ie s 9 0 3 9 3 4 1 0 9 0 001 1 8 6 0 6 7 A fr ic a a n d M id d le East 2 6 7 0 8 8 3 2 9 9 3 2 6 2 8 4 4 A s ia a n d P a c ific 2 8 5 4 7 6 3 6 9 104 8 3 6 2 8 E u ro p e 1 0 6 0 5 3 131 551 25 4 9 8 L a t in A m e r ic a 2 4 5 3 1 7 2 5 9 4 1 4 14 0 9 7 B a n k s n e t e x p o s u re 14 7 2 7 2 - 2 1 5 4 8 9 - 3 6 2 761 A fr ic a a n d M id d le East - 1 2 6 0 6 2 - 1 8 8 781 - 6 2 719 A s ia a n d P a c ific 16 4 4 3 7 - 9 5 79 6 - 2 6 0 2 3 3 E u ro p e 5 0 1 8 4 3 4 4 3 4 - 1 5 750 L a t in A m e r ic a 5 8 713 3 4 6 5 4 - 2 4 0 5 9 Source: BIS. 81 82 Bank Lending to Emerging Markets co m m o n en o u g h for th e w orlds banks to be n e t debtors to th e M iddle East and African regions, prim arily due to th e assets o w n ed b y o il-exp ortin g countries. Yet for d ev e lo p in g countries overall it is qu ite unusual for th e w orlds banks to b e n e t debtors to th e d eve lop in g w orld . O n th e face o f it, th ese data m ake a m ockery o f th e idea th at banks o u g h t to be used as a w ay o f ch a n n e llin g foreign savings to d eve lop in g countries. Three p o in ts are w orth m aking in order to h elp us understand w h y th e banks n e t exposure to d eve lop in g countries co llap sed so th orou gh ly b etw een th ese years. First, th e fall in n e t c la im s o n d ev e lo p in g cou ntries is h a lf exp la in ed b y a rise in d eve lop in g countries foreign exch an ge reserves. Table 5.1 sh o w s th a t there w as a U S$147 b illio n increase in banks liab ilities to d eve lop in g coun tries b etw een 1997 and 2 000 , and th is accou n ts for rough ly h a lf o f th e U S$292 b illio n fall in n et cla im s. T he reason w h y th is is in terestin g is th at it casts a sligh tly d ifferent ligh t o n th e reason w h y n et exposure fell. If banks w ere reducing their gross exposure to em erging m arkets - w h ich o f course th ey w ere d o in g - th is suggests an increase in risk aversion o n th e part o f th e banks. Yet at th e sam e tim e, if d ev e lo p in g c o u n ­ tries th em selves w ere increasing their h o ld in gs o f foreign exch an ge reserves, th is suggests th a t there w as an increase in risk aversion in th e d eve lop in g w orld . In o ther w ords, it w as n o t just banks th a t w ere m ore risk-averse, bu t also countries. In m an y w ays th is is iron ic , g iven th e w idespread sw itch that h as taken place in em erging m arkets from fixed exch an ge rate regim es to floa tin g regim es. In princip le o n e w ou ld exp ect a cou n try th at adopts a floa tin g rate regim e to w an t to h o ld few er foreign exch an ge reserves, n o t m ore, sin ce shocks can be absorbed b y ch an ges in th e exch an ge rate rather th an ch anges in th e qu an tity o f reserves. T he fact th at reserve h o ld in g s have risen so sharply seem s o n th e face o f it to suggest th a t d ev e lo p in g countries are n o t entirely h app y w ith th e com fort o f h av in g flexib le exch an ge rates as a m eans o f absorbing in tern ation a l shocks. This cou ld m ean o n e o f tw o th ings: either coun tries have a fear o f floa tin g ,1 in o th er w ords, th ey w a n t to m in im ize exch an ge rate vo la tility in order, for exam ple, to im prove contro l over in fla ­ tionary expectations; or th e y are con cern ed about th e p o ten tia l reversibility o f capital flow s, w h ich requires th em to h o ld a greater cu sh io n o f reserves o n th e realistic assu m p tion th at th e exch an ge rate ca n n o t b e exp ected to absorb th e entire sh ock o f a sustained n e t capital outflow . Second, th e fall in exposure w as m assively con cen trated in Asia. Table 5.1 sh ow s th at th e fall in n e t claim s to d eve lop in g countries b etw een 1997 and O ctober 2001 w as som e U S$363 b illion , but th at over 70 per cen t o f th is fall w as exp la in ed b y a fall in n e t c la im s to Asia. Indeed gross c la im s to n o n - A sian d eve lop in g countries w ere rather stable during th e 1 9 9 7 -2 0 0 1 period, rem ain ing c lose to U S $600 b illio n throu gh ou t. Third, th e fall in banks exposure is largely exp la in ed b y a fall in short­ term exposure. Table 5 .2 sh ow s that gross cross-border bank exposure to David Lubin 83 Table 5.2 Accounting for the fall in banks gross cross-border exposure to developing countries, 1997-2001 (Q3) USS bn T o ta l c h a n g e in b a n k s e x p o s u re - 1 4 6 .4 A fr ic a a n d M id d le East 5 .0 A s ia a n d P a c ific - 1 6 7 .4 E u ro p e 6 .9 L a t in A m e r ic a 9.1 C h a n g e in s h o r t - te rm e x p o s u re - 1 2 7 .9 A fr ic a a n d M id d le East - 0 . 9 A s ia a n d P a c ific - 1 1 0 .1 E u ro p e - 1 . 6 L a t in A m e r ic a - 1 5 2 .5 Source: BIS. d ev e lo p in g countries fell b y U S$146 b illion b etw een 1997 an d th e third quarter o f 2001; y e t th e fall in short-term exposure w as U S$128 b illion . In other w ords th e co llapse in cross-border len d in g b y banks to d eve lop in g countries w as very largely a fall in short-term exposure. So in m a n y w ays th is is a story about a sharp fall in short-term loan s to A sian borrowers. Yet th is to o sh ou ld b e put in to co n tex t, sin ce th e u n w in d in g o f th ese p ositio n s in 1 9 9 7 -2 0 0 0 w as sim ply th e counterpart to th e very sharp increase in short-term len d in g to Asia th at took p lace during th e late 1980s and early 1990s. For exam p le short-term loans as a share o f to ta l len d in g to th e A sian region rose from 47 per cen t in th e late 1980s to 63 per cen t in 1997 . T he repaym ents th at banks have received sin ce th e A sian crisis is best described as a process o f ba lance sheet co n so lid a tio n th at has reduced th e banks short-term loan s to a m ore acceptable level. W hat has h ap p en ed sin ce th e A sian crisis, in effect, is th at banks have reduced their short-term claim s tow ards th e norm al level o f 47 per cen t o f total loans. In oth er w ords th e banks reduction o f their gross short-term ex p o s­ ure sin ce 1997 looks like th e revulsion that o ften characterizes creditor behaviour in th e afterm ath o f a debt crisis. R evulsion, o f course, is th e flip side o f exuberance - th e period o f excessive op tim ism that precedes a crisis. In th is co n tex t it is w orth bearing in m in d th at th e gross repaym ents th at w ere m ade to banks over th e four years in q u estion w ere in m a n y w ays sim p ly th e u n w in d in g o f an increase in exposure th at took p lace in th e run-up to th e crisis. Gross cross-border bank exposure to Asia reached U S$423 b illio n in D ecem ber 1997, bu t had fa llen to U S$270 b illio n by M arch 2001 . Yet even th is level o f exposure w as m assively h igher th an it had b een in th e early 1990s: in D ecem ber 1993 banks exposure to Asia had b een U S$190 b illion . 84 Bank Lending to Emerging Markets O ne o f th e m a in con seq u en ces o f th is revu lsion is th a t th e prob lem o f short-term debt - w h ich has b een a principal th em e in each o f th e em erging m arket crises in th e past decade - is largely n o lon ger a problem for d eve lop ­ in g countries as a w h o le . T here has b een such a h u ge repaym ent o f short­ term debt to th e w orlds banks th at th ese days short-term debt poses little threat to th e hea lth o f d evelop in g countries balance sheets. A useful indicator o f th is is th e ratio o f short-term debt to foreign exch an ge reserves, w h ich has collapsed during recent years as b o th debtors and creditors h ave m o v ed to con so lid ate their b alan ce sheets. A ccording to data from th e Institu te o f In ternational F inance, in 1996 there w ere 14 large d ev e lo p in g countries w h o se stocks o f short-term external debt w ere greater th a n their foreign exch an ge reserves: A rgentina, Brazil, Bulgaria, Ind onesia , Israel, Korea, M exico , Pakistan, P h ilip p ines, R om ania, Russia, South Africa, T hailand and Turkey. By th e en d o f 2 0 0 0 th at num ber had fa llen to just six: A rgentina, Brazil, M exico, Pakistan, South Africa and Turkey. Table 5 .3 sh ow s th e b ig im p rovem en t in d eve lop in g countries balan ce sheets o n a regional basis: th e ratio o f short-term debt to foreign exch an ge reserves co llapsed b etw een 1996 an d 20 0 0 b o th in Latin Am erica - w here it fe ll from 83 per cen t to 54 per cen t - and, m ore spectacularly, in Asia, w here it fell from 83 per cen t to 33 per cent. T he process o f u n w in d in g th e short-term debt overh ang o f th e m id 1990s has b een reinforced b y th e sw itch from fixed to floa tin g exch an ge rate regim es in m a n y countries over th e past few years. T he p o in t is th at th e accu m u lation o f short-term debt in th e 1990s was at least partly a b y ­ product o f th e pervasiveness o f fixed exch an ge rates. T his encou raged b o th borrow ers and lenders to im agin e that currency risk h ad disappeared. This in turn m ade room for th e accu m u lation o f large stocks o f short-term external debt in order to fin an ce loca l currency assets to take advantage o f w h at w as perceived to b e a risk-free in terest arbitrage. N o w th at m a n y large em erging eco n o m ies h ave ab an d on ed fixed exch an ge rates for floa tin g on es there are fewer in cen tiv es for in stitu tio n s to create short-term liab ilities in foreign exch an ge. In other w ords th e sw itch to floa tin g exch an ge rate regim es has g o n e h an d in h a n d w ith th e co llapse in overall levels o f short­ term debt. Table 5.3 Y es te rday s p ro b le m : r a t io o f s h o r t - te rm d e b t to fo re ig n e x c h a n g e reserves, 1 9 9 6 a n d 2 0 0 0 (p e r c e n t) 1996 2000e A s ia 83 33 L a t in A m e r ic a 83 54 Source: Derived from Institute of International Finance databases. David Lubin 85 In v iew o f all th is, o n e q u estion th at m ig h t b e w orth asking is w h eth er there are an y w ays in w h ich th e w orlds fin an cia l regulators m ig h t try to avoid th e excessive b u ild -up o f short-term len d in g in th e future. Should th ere b e a prudential lim it o n th e am ou n t o f b ank len d in g for less th an o n e year? Prudential lim its o n short-term debt are n orm ally expressed in relation to a countrys level o f foreign exch an ge reserves. T he best k n ow n exp ression o f th is is th e G uidotti rule, w h ich suggests th at a prud en tly m an aged e co n o m y w ill have a short-term external debt th at is n o greater th an its stock o f foreign exch an ge reserves. In other w ords th e G uidotti rule focuses o n th e m aturity structure o f a d eve lop in g countrys b a lance sheet. This is all very sensib le. Yet at th e sam e tim e it m ig h t also b e w orth w h ile focu sin g o n th e m aturity structure o f th e banks co llec tive b a lance sheet. T he reason for th is is th at it m akes sense to th in k th at th e in cen tiv e for herd-like b eh aviour o n th e part o f banks w ill b eco m e greater as th e ratio of short-term loan s to to ta l loan s b ecom es larger. T he in tu itio n here is sim ple. If creditor A is th e o n ly short-term lender to cou n try 1, w h ile th e rest are longer-term lenders, th en th e in cen tiv e for th at creditor to roll over its short-term loan w ill be relatively h ig h since there w ill n o t b e so m a n y banks scram bling for access to cou n try ls reserves in th e even t o f a deterioration in cou n try risk. T his w ill rem ain true regardless o f th e cou n try ’s G uid otti rule ratio. All o ther th in gs b e in g equal, it is better to h ave a lo w ratio o f short-term debt to to ta l debt th a n a h ig h on e . T his situ ation is sum m arized in Figure 5 .1 , w h ich sh ow s com b in a tion s o f tw o ratios: th e short-term debt to reserves ratio (w h ich is essen tia lly a m easure o f th e qu a lity o f a countrys liq u id ity in foreign currencies), and th e short-term debt to total debt ratio. T he im portan t aspect o f th e latter ratio is th at it h elp s us to see th in gs from th e p o in t o f v iew o f th e creditors balance sh eet as o p p osed to th e debtors Ratio of short-term debt to foreign exchange reserves of country X Low High Low Ratio of short-term loans to total loans to country X High Best Worst Figure 5.1 C o m b in a t io n s o f s h o r t - te rm d e b t to reserves r a t io a n d s h o r t - te rm d e b t to t o ta l d e b t ra t io 86 Bank Lending to Emerging Markets balance sheet. B ecause o f th e p ossib ility o f herd behaviour by com m ercial creditors, a cou n try sh ou ld n o t o n ly try to m in im ize its short-term debt to reserves ratio, bu t sh ou ld also try to m in im ize its short-term debt to total debt ratio for an y g iven level o f reserves. It m ay even m ake sense to set a prudentia l lim it o n short-term d eb t as a share o f to ta l debt. At w h at level sh ou ld it be set? O ne w ay o f th in k in g about th is is to look at th e experience o f A sian countries during th e 1990s. At th e start o f th e 1990s th e ratio o f short-term debt to to ta l external debt for th e reg ion w as 5 0 per cen t. T his grew during th e course o f th e early 1990s to peak at 65 per cen t in 1995. S ince th e crisis, lenders revu lsion has pu sh ed th e ratio d o w n to levels w ell b e lo w 50 per cen t (it is currently at 47 per cen t). Arguably, therefore, a co n v en ien t prudentia l m easure for th e ratio m igh t be set at 50 per cen t. This w o u ld be n o m ore th a n a rule o f th u m b to coex ist w ith th e G uidotti rule o n th e ratio o f short-term debt to foreign exch an ge reserves. If short-term debt is a central ind icator o f risk in em erging m arkets, it is w orth p o in tin g ou t th at it is far from b e in g an in fa llib le indicator, particu­ larly if a countrys stock o f short-term debt fulfils certain q ualitative criteria. Put flippantly, there is short-term debt and there is short-term debt. C onsider South Africa, w h ich has con sisten tly b een th e e co n o m y w ith th e h igh est ratio o f short-term debt to foreign exch an ge reserves. The im portant q u estion is h o w S outh Africa m anaged to survive th e 1990s w ith o u t a debt crisis w h en th e ex isten ce o f large stocks o f short-term debt appears to have b een such a reliable ind icator o f th e crises in M exico , Asia, Russia, Brazil and, m ore recently, Turkey. Two features o f th e South African experience h elp exp la in w h y th e co u n ­ try m anaged to avoid a crisis. The first is th e ex isten ce o f a floa tin g exch an ge rate regim e, w h ich h elp ed to m in im ize th e accum ulation o f a b ig stock o f short-term liabilities to finance a cross-border interest arbitrage, or carry trade. The secon d (related) feature is th at South Africas short-term debt stock is w id ely regarded to b e related to trade finance. T his type o f len d ing , o f course, bears n o currency risk (for lender or borrower), and is related to an u nderlying transaction o f real eco n o m ic resources. All in all, th en , South Africas experience suggests th at early w arning indicators o f crisis in em erg­ in g econ om ies are likely to be m ore useful if th ey capture qualitative aspects o f short-term debt stocks rather th an sim ply assessing th e size o f th ose stocks. Trade-related debt stocks are likely to be m ore stable th an stocks o f debt, w h ich are b e in g used to finance cross-border interest arbitrage. Arguably M exicos stock o f short-term external debt is o f a sim ilar nature th ese days. Banks crossing the border W h ile it is clear th at banks h ave b een n et takers o f cross-border fu n d s from em erging m arkets in recent years, it is n o t true to say th a t th is behaviour necessarily sh ow s th at banks have w ithdraw n from em erging markets. David Lubin 87 W h ile cross-border exposure has fallen , in -cou n try exposure has risen. In other w ords, w h at w e have seen is better described as a redistribution o f banks’ overall em erging-m arket portfolios, in w h ich banks h ave substitu ted on sh ore for offshore len d in g . T he q u estion th at arises from th is is w h eth er th is portfo lio sh ift has brought an y ben efits to d eve lop in g countries, and in particular w h eth er it w ill en d up red ucing th eir vu lnerab ility to crisis. W hat is b ey o n d doubt is th at foreign banks have m assively increased their ow n ersh ip o f d eve lop in g countries b ank ing sectors, an d th at th is h ap p en ed precisely during th e crisis period o f th e late 1990s. T he increase in foreign p en etration o f em erging markets finan cia l system s is clear from Table 5 .4 , w h ich sh ow s th e percentage o f ban k in g sector assets o w n ed by Table 5.4 F o re ig n o w n e rs h ip o f b a n k in g s e c to r assets in s e le c te d e m e rg in g m a rk e ts , 1 9 9 4 a n d 1 9 9 9 (p e r c e n t) 1994 1999 Total banking Share owned Total banking Share owned sector assets by foreign- sector assets by foreign- controlled controlled banks banks Central Europe C z e c h R e p u b lic 4 6 .6 8 .3 6 3 .4 4 9 .3 H u n g a ry 2 6 .8 2 3 .8 3 2 .6 5 6 .6 P o la n d 3 9 .4 2 .3 9 1 .1 5 2 .8 T o ta l C e n tra l E u ro p e 1 1 2 .8 9 .9 187 .1 5 2 .3 Latin America A rg e n t in a 7 3 .2 16 .5 1 5 7 .0 4 8 .6 B ra z il 4 8 6 .9 12 .2 7 3 2 .3 16 .8 C h ile 4 1 .4 17 .6 11 2 .3 5 3 .6 C o lo m b ia 2 8 .3 5 .4 4 5 .3 1 7 .8 M e x ic o 2 1 0 .2 0 .9 2 0 4 .5 18 .8 P e ru 12 .3 2 .9 2 6 .3 3 3 .4 V e n e z u e la 16 .4 10 .4 2 4 .7 4 1 .9 T o ta l L a t in A m e r ic a 8 6 8 .7 9 .7 1 3 0 2 .4 2 5 .0 T o ta l e x c lu d in g M e x ic o a n d B ra z il 17 1 .5 13 .3 3 6 5 .6 4 4 .8 Asia K o re a 6 0 1 .1 0 .8 6 4 2 .4 4 .3 M a la y s ia 148 .1 6 .8 2 2 0 .6 11 .5 T h a ila n d 1 9 2 .8 0 .5 1 9 8 .8 5 .6 T o ta l A s ia 9 4 2 .0 1.7 1 0 6 1 .8 6 .0 Source: Mathieson and Roídos (2001). 88 Bank Lending to Emerging Markets foreign -contro lled banks (defined here as banks th at are at least 50 per cen t foreign -ow n ed ). S ince 1999 there have b een further large increases in for­ e ign ow nersh ip , for exam ple in M exico. T he m ost dram atic increase in foreign p en etration has b een in C entral Europe, w here th e share o f ban k in g assets con tro lled by foreign -ow n ed in stitu tio n s rose from 9 .9 per cen t in 1994 to 52.3 per cen t in 1999. D uring th e sam e period th e foreign penetra­ tio n o f th e Latin A m erican b an k in g system rose from 9 per cen t to 25 per cen t. Foreign en try to Asia w as m ore lim ited , w ith external ow nersh ip rising from o n ly 1 per cen t o f assets in 1994 to 6 per cen t in 1999. T he relatively sm all increase in foreign ow nersh ip o f th e A sian b ank ing system suggests th a t it w o u ld b e dangerous to overem ph asize th e id ea th at banks have s im p ly substitu ted local exposure for cross-border exposure. Clearly, banks tak ing repaym ents o f short-term loan s to A sian borrowers have n o t sim p ly ch a n n e lled th o se p aym en ts in to th e purchase o f A sian banks, so th e idea th at banks have b een en gag in g in som e redistribution o f their p ortfo lios m u st b e u n d erstood in an aggregate sense. Foreign ow nersh ip o f d evelop in g countries banking system s is ev id en t n o t just from th e perspective o f th e share o f assets ow n ed b y foreign in stitu tion s b u t also from th e perspective o f th e lenders th em selves. Table 5.5 looks at th e ch ange in banks cross-border len d in g b etw een 1995 and Septem ber 2001 and com pares th is w ith th e ch ange in foreign banks on sh ore len d in g in loca l currency d uring th e sam e period. It sh ow s th at BIS-reporting banks on sh ore loca l currency len d in g rose from a tota l o f U S $123 .9 b illio n in 1995 to U S$490.7 b illio n in Septem ber 2001 . N o t o n ly d id banks local len d in g increase in absolute term s, bu t it also increased substantia lly as a share o f banks overall em erging-m arket portfo lios. In total, foreign banks loca l Table 5.5 B a n ks in - c o u n t r y le n d in g ve rsu s c ro s s -b o rd e r le n d in g , 1 9 9 5 a n d 2 0 0 1 (U S$ b i l l i o n ) Cross-border exposure Local exposure in local currencies Total exposure Local exposure as a share o f the total (%) Total emerging markets D e c e m b e r 1995 8 6 8 .7 1 2 3 .9 9 9 2 .6 12 S e p te m b e r 20 01 8 7 4 .5 4 9 0 .7 1 3 6 5 .2 3 6 Asia D e c e m b e r 1995 3 7 3 .3 5 6 .5 4 2 9 .8 13 S e p te m b e r 2 0 0 1 2 7 3 .3 1 1 8 .9 3 9 2 .2 3 0 Latin America D e c e m b e r 1995 2 4 7 .1 3 3 .9 2 8 1 .0 12 S e p te m b e r 20 01 2 9 4 .0 2 6 9 .0 5 6 3 .1 4 8 Source: BIS. David Lubin 89 len d in g in local currencies in d eve lop in g countries rose from 12 per cen t o f their to ta l exposure in 1995 to 36 per c en t in Septem ber 2001 . This p h en o m en o n confirm s a p o in t m ade by Peek and R osengreen (2000: 57): As foreign banks get estab lish ed w ith brick and mortar operations, an increasing share o f th e len d in g m oves from offshore to onshore. O f course o n e m ust bear in m in d th at w h e n an in tern ation a l bank takes ow nersh ip o f a stock o f on sh ore loan s in a d eve lop in g country, th is is n o t eq u iva len t to a flo w th rough th e balance o f paym en ts. In other w ords th e increase in a banks con so lid a ted balance sh eet th at results from an acq u isition o f a loan b o o k m ay or m ay n o t result in a capital in flow . This d ep en d s en tirely o n th e cost to th e bank o f acquiring th e eq u ity in th e loca l in stitu tion . This p o in t is crucial to any d iscussion o f th e benefits that a foreign bank brings to a d eve lop in g countrys financia l system , sin ce banks FDI flow s in to d eve lop in g countries clearly are n o t replacing their cross-border flow s o f len d in g . T he best w ay to th in k about th e idea o f replacem ent is as a stock o f on sh ore loan s replacing a stock o f cross-border loans. It is also w orth bearing in m in d th a t there is som e c o n n ec tio n b etw een banks w ithdraw al from short-term cross-border len d in g in th e late 1990s and their increasing p en etration o f d eve lop in g countries fin an cia l system s. T he co n n ec tio n arises, o f course, because th e crises associated w ith th e failure to roll over short-term cross-border loan s - th ose in M exico, Asia, Russia, Brazil an d Turkey - have h ad th e effect o f substantia lly reducing th e entry cost for foreign banks. T his reduction has b een ach ieved n o t o n ly th rou gh th e effects o f currency devaluation , b u t also because th e crises h ave led to an erosion o f th e n e t w orth o f d eve lop in g countries finan cia l system s. T he reduction in entry cost m ay partially exp la in th e reason for th e redistribution o f banks em erging-m arket p ortfo lios tow ards loca l currency len d in g and aw ay from cross-border short-term lend ing . A nother in cen tive for crossing th e border is th a t th e capital required to support a g iven stock o f on sh ore len d in g in a d eve lop in g cou n try m ay be sm aller th an th at required to support cross-border len d in g . T he reason for th is is th e p rov ision in g regim e th at banks face in their cross-border len d in g (or their in -cou n try len d in g in foreign currencies). If cross-border len d in g to a particular cou n try requires provisions to com p en sate for th e risk o f exch an ge controls, th is tax’ o n cross-border len d in g is avoidable if banks b ook assets in loca l currencies on shore. T he q u estion th at arises from all th is is w h eth er th e process o f ba lance sh eet redistribution th at seem s to h ave taken p lace over th e past few years has had an y iden tifiab le im pact o n (1) d eve lop in g countries vu ln erab ility to fin ancia l crisis, or (2) th e severity o f fin ancia l crises in d eve lop in g countries w h e n th ey do occur. This q u estion is im portan t since b o th th e probability o f a crisis and th e severity o f a crisis in a particular d eve lop in g cou n try are u n iversally th o u g h t to b e p ositive ly correlated w ith th e fragility o f th e d om estic ban k in g system in th a t country. Indeed w h ile an overhan g o f 90 Bank Lending to Emerging Markets short-term debt m ig h t h ave b een th e best sing le predictor o f currency crisis in d eve lop in g countries over th e past few years, fin an cia l system w eakness is u sually h ig h o n th e list o f ind icators o f vu lnerab ility to crisis. T his is true to th e ex ten t th at a p oorly regulated and p oorly m anaged fin an cia l system w ill have relatively few w ays o f exercising d isc ip lin e over th e structure o f banks b a lance sheets, w h ich can in turn leave th em burdened b y th e tw o balance sh eet m ism atch es th at h ave proved so p ain fu l in recent crises, n am ely a currency m ism atch (foreign currency liab ilities used to finan ce loca l currency assets) and a m aturity m ism atch (short-term liab ilities used to finan ce longer-term assets). T he latter m ism atch w as particularly ev id en t in th e recent Turkish crisis, and certain ly contributed to th e unsusta inab ility o f th e exch an ge rate regim e. In add ition to th is, fragile b an k in g system s are a lso th o u g h t to bear responsib ility for perpetuating crises sin ce (1) th e w eaker th e financial system th e greater th e pub lic sector resources n eed ed to recapitalize th e system in th e afterm ath o f th e crisis, and (2) th e weaker th e financia l system th e less able it w ill b e to h elp th e post-crisis recovery, sin ce capital fligh t w ill b e m axim ized an d in term ed ia tion m in im ized . So if it can be sh o w n th at foreign ow nersh ip h elp s to m ake finan cia l crises either less probable or less severe, th e process o f crossing th e border ou gh t to bring long-term b en efits to d evelop in g countries. How, th en , can w e sh ow th a t foreign ow n ersh ip can help? First consider th e case that foreign ow nersh ip m akes crises less severe.2 Foreign ow nersh ip can h e lp to diversify th e capital base o f a countrys b ank ing system , im prove th e pricing o f risk, an d im prove regulation , accounting , in form ation tech n o lo g y and th e level o f transparency. The value o f th ese b en efits in m aking a crisis less severe is that th ey can h elp to create a s itu a tion in w h ic h foreign -ow n ed banks co n tin u e to len d in an eco n o m ic d ow n turn , prim arily because foreign -ow n ed in stitu tio n s have a m ore diversified fu n d in g base. As G oldberg e ta l. (2000: 6) p u t it: If d om estica lly -ow n ed banks rely m ore h eav ily o n local d em an d d eposits and cyclica lly -sensitive sources o f funds, basic aggregate d em an d shocks sh ou ld generally lead to m ore v o la tile len d in g b y private d om estic banks th an from their foreign -ow n ed counterparts. Indeed G oldberg e ta l. sh o w th at in th e m id 1990s foreign -ow n ed banks in A rgentina and M exico had h igher rates o f loan grow th w ith low er v o la tility th an d om estica lly o w n ed banks, b o th private and state-ow ned . At th e least th is suggests th at th e presence o f foreign -ow n ed banks can m ake d eve lop in g countries fin ancia l crises less severe th an th ey w ou ld oth erw ise be. C ould foreign ow n ersh ip o f a d eve lop in g countrys ban k in g system m ake a crisis less probable? There are tw o w ays in w h ich th is m ig h t h ap pen . The first is that a better cap italized and better regarded b an k in g system cou ld lead to an increase in th e am ou n t o f a countrys savings h e ld in th e financial system , rather th a n under th e m attress. If foreign ow nersh ip o f a ban k in g David Lubin 91 system reduces th e proportion o f savings h eld as m attress cash, th en for­ e ign ow nersh ip cou ld b e th o u g h t o f as reducing th e probability o f crisis since th e econ om ys reliance o n foreign savings w ill h ave b een reduced. A secon d w ay in w h ich foreign ow nersh ip m ig h t reduce th e probability o f cri­ sis is b y provid ing a m ech an ism for depositors to engage in w h at m igh t be called internal capital flight. In a financia l system w here there is n o foreign ow nersh ip , depositors w h o fear b o th currency risk and cou n try risk have n o ch o ice b ut to liquidate their deposits and rem it dollars offshore: pure capital flight. By contrast in a finan cia l system w here foreign ow nersh ip exists, a foreign -ow ned bank is likely to support its depositors even during a country risk event. This is a version o f th e deep pocket argum ent, w h ich suggests th at subsidiaries are capable o f b e in g recapitalized even at a tim e o f serious deterioration in coun try risk, o n th e grounds th at a foreign -ow n ed in stitu tio n risks its reputation if it lets a foreign subsidiary fail. W hat th is m eans is that th e liab ilities o f a foreign -ow n ed bank in a d eve lop in g co u n ­ try can be th o u g h t to bear less cou n try risk th a n th e country itself. If th is is th e case, capital fligh t w ill b e m in im ized in an e co n o m y w ith foreign -ow ned banks. This in turn o u g h t to reduce th e probability o f crises in em erging markets. Yet all th is clearly fails to describe w h at h ap p en ed in A rgentina, w here a persistent fligh t o f depositors from th e substantia lly foreign -ow n ed ban k in g system u ltim ately forced th e g overn m en t to devalue th e exch an ge rate, defau lt o n its public debt and im p ose draconian restrictions o n th e publics access to deposits in an effort to preserve w h at rem ained o f th e central banks foreign exch an ge reserves. O n th e face o f it th e failure o f th e A rgentinean fin an cia l system to prevent th e crisis suggests th at d eve lop in g countries m ay gain little from en couragin g a foreign presence in their d om estic financia l system s. It m ay also m ean th at th e attractiveness o f crossing th e border w ill d im in ish for banks, since A rgentina has sh o w n th at there m ay be little to gain from su b stitu ting cross-border exposure for on sh ore exposure. It is still far to o early to draw co n clu sio n s from th e A rgentinean experience. T he tw o critical b u t unansw erable q u estion s are (1) w ou ld Argentinas fin an cia l crisis have h ap p en ed m ore qu ick ly if th e financial system had n o t b een substan­ tia lly foreign-ow ned , and (2) w ou ld th e crisis have b een m ore severe? Conclusion A lth ou gh banks h ave w ith o u t q u estion b een th e largest n e t taker o f cross- border fund s from d eve lop in g countries since 1997, th is has prim arily b een due to th e n et repaym ent o f short-term loans b y A sian borrowers, w h o have also substantia lly increased their asset p osition s in BIS-reporting banks. Yet th e fall in banks n e t cross-border exposure has to be exp la in ed a lon gsid e anoth er p h en o m en o n : th e very large increase in foreign p en etration o f em erging markets b an k in g system s. T his chapter has argued th at th ese tw o 92 Bank Lending to Emerging Markets p h en o m en a - cross-border revulsion an d th e large grow th in on sh ore exposure - are co n n ected to each other. In effect th e process o f crossing th e border con stitu tes a redistribution o f banks em erging-m arket portfolios. M oreover th e very process o f crossing th e border m ay b e th o u g h t o f as reducing th e risk o f financia l crises in d eve lop in g countries, a lth ou gh th e case o f A rgentina strongly suggests th at h av in g a foreign -ow n ed b ank ing system provides n o guarantees against crisis. N o te s 1. See C a lv o a n d R e in h a r t (2 0 0 0 ). 2 . P ro b a b ly th e b e s t s ta te m e n t o n th e p ro s a n d c o n s o f fo re ig n o w n e rs h ip i n a d e v e l­ o p in g c o u n t r y b a n k in g s y s te m is th a t i n th e p a p e r b y G o ld e rg et al. (2 0 0 0 ). R eferen ces C a lv o , G . A . a n d C . M . R e in h a r t (2 0 0 0 ) F ea r o f F lo a t in g , m im e o , C a m b r id g e , M A : N BER , M a y . G o ld b e rg , L ., B. G . D ages a n d D . K in n e y (2 0 0 0 ) F o re ig n a n d D o m e s tic B a n k P a r t i­ c ip a t io n in E m e rg in g M a rk e ts : Lessons f r o m M e x ic o a n d A rg e n t in a ’ , C a m b r id g e , M A : N BER , M a y . H a w k in s , J. a n d D . M ih a l je k (2 0 0 1 ) T h e B a n k in g In d u s t r y in th e E m e rg in g M a rk e t E c o n o m ie s : C o m p e t i t io n , C o n s o lid a t io n a n d S y s te m ic S ta b il i ty - A n O v e rv ie w , BIS Papers n o . 4 , Basel: BIS, 1 -4 4 . M a th ie s o n , D . J. a n d J. R o ld o s (2 0 0 1 ) T h e R o le o f F o re ig n B an ks in E m e rg in g M a rk e ts , IM F p re s e n ta t io n m a te r ia l, W a s h in g to n , D C : IM F , A p r i l . Peek, J. a n d E. S. R o s e n g re e n (2 0 0 0 ) Im p l ic a t io n s o f G lo b a l is a t io n o f th e B a n k in g S ec to r: T h e L a t in A m e r ic a n E x p e r ie n c e , New England Economic Review, S e p te m b e r/ O c to b e r. P o m e r le a n o , M . a n d G . V o jta (2 0 0 1 ) W h a t D o F o re ig n B a n ks D o in E m e rg in g M a rk e ts ? , p a p e r p re s e n te d a t th e W o r ld B a n k , IM F , a n d B ro o k in g s I n s t i t u t io n 3 rd A n n u a l F in a n c ia l M a rk e ts a n d D e v e lo p m e n t C o n fe re n c e , 1 9 -2 1 A p r i l , N e w Y o rk . 6 D e r i v a t i v e s , t h e S h a p e o f I n t e r n a t i o n a l C a p i t a l F l o w s a n d t h e V i r t u e s o f P r u d e n t i a l R e g u l a t i o n Randall Dodd Introduction As m atter o f policy, capital m arkets in m a n y parts o f th e d eve lop in g w orld w ere liberalized during th e 1990s in order to o p en up th e m arkets to greater flow s and a w ider array o f capital v eh ic le s .1 This p o licy succeeded, and pri­ vate capital flow s to d eve lop in g countries b o th increased and increasingly to o k th e form o f securities su ch as stocks and b o n d s (Tables 6.1 and 6.2). Even part o f th e grow th in direct foreign in v estm en t to o k th e form o f purchases o f eq u ity securities. This transform ation in d eve lop in g cou n try capital m arkets h ad th e effect o f broad en in g th e class o f global investors. W hereas in vestors in th e prior period w ere prim arily banks (through synd icated loans) and m u ltin ation a l corporations (direct in vestm en t), th e securitization b rought in ind iv idual investors and p rofession ally m anaged funds by in stitu tion a l investors, p en ­ sion funds, insurance com p an ies, u n iversity en d ow m en ts and fou n d ation s. T his contributed to th e increase in th e overall flow o f capital to d eve lop in g countries. T he increased flow s o f securitized capital b rough t forth th e n ew threat o f their rapid reversal; th ey also in trodu ced or increased th e exposure o f d evel­ o p in g countries financial m arkets to greater vo la tility o f securities prices in oth er d eve lop in g countries as w ell as th ose in advanced capital m arket countries. A lon g w ith th is transform ation o f capital flow s to d eve lop in g countries and th e associated n ew m arket risks cam e a n ew set o f parallel fin ancia l transactions. T hese financia l transactions, th o u g h less w ell understood , are integral to m od ern financia l m arkets and are just as im portant in their p oten tia l to contribute to fin an cia l sector instability . T hese shadow trans­ actions in clu d e derivatives,2 repurchase agreem ents and securities lend ing . T he term shadow sh ou ld n o t necessarily b e interpreted as nefarious or 93 94 Derivatives, Capital Flows and Prudential Regulation devious. Rather it reflects th e fact that th ese transactions are o ften built u p on , or are cast like a shadow , b y capital flow s. M oreover su ch transactions are far less transparent. Shadow transactions o ften fu n ctio n to h ed ge or m anage th e risks associ­ ated w ith capital flow s. H ow ever in som e cases th ey a lso serve to facilitate unprodu ctive activ ities, in c lu d in g tax avoidance, th e m an ip u la tion o f accountin g and reporting rules and th e outflanking o f p m d en tia l regulations. W h en used to d od ge financia l m arket regulations d esign ed to add safety and sou n d n ess to th e m arkets an d assure their transparency, th e n th ese un produ ctive activ ities are a source o f m arket in stab ility and reduce th e effic ien cy o f m arket pricing. In ad d ition th e use o f derivatives, even w h en th ey are used by foreign and d om estic enterprises for h edging , can c o n ­ tribute to dow nw ard pressure o n em erging m arket currencies as in vestors rush to hedge their currency exposure in an tic ip ation o f a finan cia l crisis or to m eet collateral requirem ents o n ce currency and asset prices b eg in to fall. A lth ou gh there are n o precise figures o n th e m agn itu d e o f th ese trans­ actions, th is d oes n o t m ean th at th e subject is n o t im portant, and it sh ou ld be exp lored in order to understand h o w su ch transactions can contribute to a fin ancia l crisis. T he n ew d eve lop m en ts in financia l transactions in d eve lop in g countries require n ew regulatory and supervisory efforts to ensure th at th e y w ill contribute to th e im p rovem en t o f liv in g standards and w ill n o t result in less stable financial system s and greater eco n o m ic vulnerability . T his chapter focuses o n derivatives and leaves repurchase agreem ents and securities len d in g transactions for an oth er tim e .3 It analyzes h o w derivatives are related to capital flow s and h o w th ey in troduce add ition a l concern s for m arket stability. This inclu d es an analysis o f p o lic ies d esign ed to stabilize develop in g countries financial markets, and o f financial regulations in in d u s­ trialized countries and h o w th ey m igh t be adapted to th e circum stances in d eve lop in g countries an d applied to reduce v o la tility and m itigate th e im p act o f financia l sector d isruptions o n th e overall econ om y. Transforming capital flows T he traditional status o f ban k in g as th e fo u n t for n ew capital w as som ew h at d im in ish ed b y capital m arket liberalization, w h ich resulted in th e em ergence o f m odern capital m arkets in d eve lop in g cou n tries.4 W hereas n ew capital w as o n ce raised w ith in th e firm or from th e banking sector, th e n ew arrange­ m en t a llow ed capital to be raised th rou gh th e issue o f stocks an d b o n d s.5 This securitization o f n ew capital proved to be m ore effic ien t in several im portant w ays and so o n surpassed bank len d in g as th e p red om in an t source for n ew capital form ation and sovereign b orrow ing .6 In th e trad itional m o d e l o f raising n ew capital from len d in g , banks m ob ilized savings an d co llected p oo ls o f id le liq u id ity in th e p aym en ts and Randall Dodd 95 settlem en ts system and turned th em in to loan ab le funds for n ew in v est­ m en ts. Banks trad itionally h eld loan s o n their balance sh eet as assets, and th is form ed th e basis for o n g o in g relationsh ips that prom oted greater in form ation sharing and trust. A n other ben efic ia l feature o f b ank len d in g w as th at banks cou ld m ore easily restructure th e debt o f a borrower because th e bank - or a num ber o f banks in a syndicate - h eld all o f th e debt. Traditionally, bank profits w ere earned th rou gh m aturity con version . Banks accepted short-term deposits, o n w h ich th ey paid short-term interest rates, and th en transform ed th e funds in to longer-term loan s o n w h ich th ey earned h igher, long-term in terest rates. T hese earnings d ep en d ed o n th e steepness o f th e y ie ld curve and h o w far th e bank was w illin g and able to m o v e a lon g th e curve. Banks o ften avoided th is in terest rate risk b y issu in g loan s o f m ed iu m - to long-term m aturity w h o se interest rate w as frequently adjusted accord ing to a short-term interest rate over th e life o f th e loan . This enab led th em to m atch th e costs o f their deposits to th e earnings o n their loan s w h ile a v o id in g th e m arket risk o f in terest rate fluctu ations. Traditional b an k in g h ad som e sign ifican t sh ortcom ings. T he loan s o n th e portfo lio w ere illiqu id , and all b u t th e very largest banks fou n d it d ifficu lt to in trodu ce geographic and sectoral d iversification in to th eir loan portfo lio . O n a m acroecon om ic level, capital form ation in th e form o f bank len d in g m ean t th at in v estm en t d ecision s w ere con tro lled b y a sm all num ber o f bank execu tives and m anagers and n o t th rough th e in teraction o f a large num ber o f an o n y m o u s m arket participants, as in securities m arkets. A nother short­ co m in g o n th e m acroecon om ic leve l w as that b ank loan s d id n o t generate m arket prices for th e in vestm en t assets - th at is, there was n o price d iscovery process, as fou n d in stock and b o n d markets. In n ovation and tech n o lo g ica l d eve lop m en ts in advan ced capital m arkets estab lished a precedent and h elp ed to p rom ote capital m arket liberalization in d eve lop in g countries. T he m od ern iza tion o f th e advanced financial m arkets had a p rofou nd effect o n th e shape o f capital flow s to th e d eve lop ­ in g w orld during th e 1990s. D uring th e 1970s an d 1980s th ese flow s were prim arily in th e form o f syndicated , variable rate, foreign bank loan s. Large m on ey-cen tre banks recycled petrodollars b y underw riting synd icated bank loan s to d eve lop in g countries th at w ere stm gg lin g to pay for o il im ports and w ere eager for n ew n et capital in flow s. T he loan s were m o stly adjustable rate and d en om in ated in US dollars or som e o ther m ajor currency.7 T his created a d istribution o f risk th at w as n o t b alanced b etw een borrower and lender. The borrower carried b o th th e exchange rate risk and th e interest rate risk. T he lender faced credit risk, b u t th is w as m in im ized b y restricting credit to sovereign en tities and th rough th e use o f cross-default clauses.8 T he lender also reduced credit risk th rou gh d iversification and th e loan syn ­ d ication process. W h en in terest rate and exch an ge rate m o v em en ts w en t against th e borrow er its debt p o sitio n deteriorated so b ad ly th at it was u nab le properly to service its foreign currency bank loan s. T his failure was transform ed in to increased credit exposure to th e lender. Painful debt n eg o ­ tia tion s fo llow ed and led to debt resch ed u ling co m b in ed w ith n ew len d in g . This approach w as ack now ledged to be a failure at th e en d o f th e 1980s and a n ew round o f d eb t reschedu ling com m en ced . This co m b in ed som e debt forgiveness w ith n ew collateralized len d in g k n ow n as Brady b on d s. In th e end , b o th th e in tern ation a l lenders and th e d eve lop in g cou n try borrow ers suffered; th e 10 years o f debt overhan g in Latin America, b eg in n in g in 1982, has co m e to be called the lo st decade. C apital flow s began to ch an ge in th e late 1980s and early 1990s. Table 6.1 sh ow s th e great transform ation th at occurred in capital flow s to d eve lop in g countries. As a percentage o f to ta l capital flow s, bank len d in g fell from n early 64 per cen t in 1 9 7 3 -8 1 to a lm ost 12 per cen t in 1 9 9 0 -9 7 , w h ile capital flow s in th e form o f stocks rose from 0 .3 per cen t to 16 .4 percent. The use o f b on d s as a d ev e lo p m en t fin an ce veh ic le rose from 3.5 percent to 15.2 per cen t over th e sam e period . This n o t o n ly elevated th e status o f th e East A sian b o n d m arket bu t a lso estab lished East A sian eq u ity m arkets as p lat­ form s o n w h ich to raise capital and d estin ation s in w h ich to locate th e port­ fo lio in vestm en ts o f h igh n e t w ealth ind iv idu als as w ell as in stitu tion a l in vestm en ts (D alla and Khatkate, 1996). Two o f th e key indicators o f financial m arket d eep en in g and sop h istica tion is th e num ber o f firm s listed o n th e stock m arkets and th e size o f m arket cap italization . As can b e seen in Table 6.2, th ese key indicators grew rapidly b etw een 1990 and 1999. In Table 6.1 th e percentages m easure th e proportion o f total capital flow s, and th e sum o f th e percentages equals th e share o f private flow s. Private capital flow s accou n ted for 84 .5 per cen t o f flow s in th e earlier period, w h ile th e capital m arket liberalization p o lic ies o f th e 1990s resulted in 9 3 .6 per cen t o f capital flow s b e in g from private sources in th e later period. Table 6.3 sh ow s th e flow s to d eve lop in g countries during th e 1990s. T he result o f th e transform ation was n o t just greater flow s an d greater vo la tility of flow s and asset prices; it was also a redistribution o f risk b etw een 96 Derivatives, Capital Flows and Prudential Regulation Table 6.1 P r iv a te c a p ita l f lo w s to d e v e lo p in g c o u n tr ie s , 1 9 7 3 -8 1 a n d 1 9 9 0 -9 7 (p e rc e n ta g e o f to ta l o f f ic ia l a n d p r iv a te f lo w s ) * Type o f flow 1973-81 1990-97 B o n d s 3 .5 15 .2 B a n k le n d in g 6 3 .9 11 .7 F o re ig n d ire c t in v e s tm e n t 16 .8 50 .3 P o r t fo l io e q u i ty 0 .3 16 .4 * Figures are calcu la ted as percen tage o f to ta l flow s a n d therefo re p riva te flows d o n o t add u p to 100 p e r cen t. Source: W orld B ank (2000: 126). Randall Dodd 97 Table 6.2 M aturation of East Asian stock markets, 1990-99 Num ber o f listed companies Capitalization (US$ million) 1990 1999 1990 1999 In d o n e s ia 125 2 7 7 8 08 1 6 4 0 6 7 K o re a 6 6 9 725 1 1 0 5 9 4 3 0 8 5 3 4 M a la y s ia 2 8 2 757 4 8 611 14 5 4 4 5 P h i lip p in e s 153 2 2 6 5 9 2 7 4 8 105 S in g a p o re 15 0 3 5 5 3 4 3 0 8 19 8 4 0 7 T h a ila n d 2 1 4 3 9 2 2 3 8 9 6 5 8 3 6 5 T o ta l 1 5 9 3 2 732 2 3 1 4 1 7 8 2 2 9 2 3 (+ 7 2 % ) (+ 2 5 6 % ) Source: W orld Bank (2001). investors in advanced capital m arkets and capital recip ients in d eve lop in g countries. This m ore d iversified flow o f foreign capital (diversified in th e sense th at various capital veh ic le s were used to ch a n n e l th e capital flow s) generated a d ifferent d istribution o f m arket an d credit risks. C om pared w ith th e bank loans o f th e 1970s and early 1980s, th is m ore d iversified flow o f capital ten d ed to distribute risk tow ards investors in th e advanced capital m arket econ om ies. Stocks or eq u ity shares sh ifted price risk, exch an ge rate risk and credit risk to foreign investors. Local currency b o n d s sh ifted price, in terest rate risk, exch an ge rate risk and credit risk to foreign investors. Even m ajor-currency-denom inated b on d s issued b y d evelop in g-cou n try borrowers sh ifted interest rate risk, as w ell as credit risk, to foreign investors. D irect foreign in v estm en t in p hysica l capital - w h eth er eq u ip m en t, p lan t or real estate - sim ilarly sh ifted price and exch an ge rate risks and credit risk to foreign investors. T he co m b in ed effect w as p o ten tia lly to reduce th e d evel­ o p in g econ om ies exposure to th e m arket risk.9 Growth of shadow transactions O v erv iew D erivative trading grew up a longside th ese n ew form s o f capital flow as part o f an effort to im prove th e m an agem en t o f th e risks o f global in vestin g . D erivatives a llow ed risk to be sh ifted aw ay from investors w h o did n o t w an t it and tow ards th o se w h o w ere m ore w illin g and able to bear it. At th e sam e tim e, how ever, derivatives created n ew risks th at were p o ten tia lly destabiliz­ in g for d evelop in g econ om ies. T he fo llow in g is an analysis o f h o w derivatives played a constructive role in ch a n n e llin g capital from advanced capital m arkets to d eve lop in g econ om ies, and h o w at th e sam e tim e th ey p layed a p o ten tia lly destructive role in lay ing th e fou n d ation s o f th e subsequent \o00 Table 6,3 N e t lo n g - te rm f lo w s to d e v e lo p in g c o u n tr ie s , 1 9 9 0 -9 8 (US$ b i l l i o n ) 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 O ff ic ia l 5 5 .9 6 2 .3 54 .0 5 3 .4 4 5 .9 5 3 .9 3 1 .0 3 9 .9 5 0 .6 5 2 .0 P r iv a te ( to ta l) 4 2 .6 6 1 .6 99 .8 1 6 5 .8 1 7 4 .5 2 0 3 .3 2 8 2 .1 3 0 4 .0 2 6 7 .7 2 3 8 .7 B a n k lo a n s 3 .2 5 .0 16.4 3 .5 8 .8 3 0 .4 37 .5 5 1 .6 4 4 .6 - 1 1 . 4 B o n d 1 .2 10 .9 11.1 3 6 .6 3 8 .2 3 0 .8 6 2 .4 4 8 .9 3 9 .7 2 5 .0 O th e r d e b t 1 1 .3 2 .8 10.7 8 .7 3 .5 1.0 2 .2 3 .0 - 3 . 1 5 .5 E q u ity - p o r t fo l io 2 .8 7 .6 14.1 5 1 .0 3 5 .2 36 .1 4 9 .2 3 0 .2 15 .6 2 7 .6 D F I 24 .1 3 5 .3 47 .5 6 6 .0 8 8 .8 1 0 5 .0 1 3 0 .8 1 7 0 .3 1 7 0 .9 1 9 2 .0 T o ta l 9 8 .5 1 2 3 .9 153 .8 2 1 9 .2 2 2 0 .4 2 5 7 .2 3 1 3 .1 3 4 3 .9 3 1 8 .3 2 9 0 .7 P riv a te (% ) B a n k lo a n s 7.5 8.1 16.4 2 .1 5 .0 15 .0 13 .3 1 7 .0 16 .7 - 4 . 8 B o n d 2 .8 17 .7 11.1 22 .1 2 1 .9 1 5 .2 22 .1 16 .1 1 4 .8 10 .5 O th e r d e b t 2 6 .5 4 .5 10.7 5 .2 2 .0 0 .5 0 .8 1 .0 - 1 . 2 2 .3 E q u ity - p o r t fo l io 6 .6 12 .3 14.1 3 0 .8 2 0 .2 17 .8 17 .4 9 .9 5 .8 1 1 .6 D F I 5 6 .6 5 7 .3 4 7 .6 3 9 .8 5 0 .9 5 1 .6 4 6 .4 5 6 .0 6 3 .8 8 0 .4 Source: W orld B ank (2001). Randall Dodd 99 crisis. T hese capital instrum ents, their associated risks and th e associated derivatives used to m anage th e risks are listed in Table 6.4. D erivatives facilitate capital flow s b y u n b u n d lin g risk in to its co m p o n en t parts and th en m ore effic ien tly redistributing th e various sources o f risk associated w ith each capital instrum ent, in clu d in g bank loans, equities, bond s and direct foreign in vestm en t. Foreign currency loan s exp ose th e foreign in vestor to credit risk and th e d om estic borrow er to exch an ge rate risk; a fixed interest rate loan exp oses th e foreign lender to in terest rate risk and Table 6.4 C a p ita l in s tru m e n ts , t h e i r a s so c ia te d r is ks a n d th e d e r iv a t iv e s u s e d to m a n a g e th e r isks Capital instrument Risk exposure Derivative, or risk management Bank loans1 In v e s to r C re d itw o r th in e s s C re d it d e r iv a tiv e s , c ro s s -d e fa u lt D e v e lo p in g c o u n t r y In te re s t ra te c la u se o r d iv e r s if ic a t io n In te re s t ra te sw ap F o re ig n e x c h a n g e F o re ig n e x c h a n g e fo rw a rd , sw a p L iq u id i t y o r o p t io n L in e o f c re d it (e m b e d d e d o p t io n ) C a r ry tra d e F o re ig n e x c h a n g e TRS ( to ta l r e tu r n sw a p ) Bonds2 M a jo r c u r re n c y b o n d In v e s to r In te re s t ra te In te re s t ra te sw a p o r fu tu re C re d itw o r th in e s s D iv e rs i f ic a t io n P rice TRS D e v e lo p in g c o u n t r y F o re ig n e x c h a n g e F o re ig n e x c h a n g e fo rw a rd , sw a p L o c a l c u r re n c y b o n d In v e s to r F o re ig n e x c h a n g e o r o p t io n F o re ig n e x c h a n g e fo rw a rd o r sw a p In te re s t ra te In te re s t ra te sw ap D e v e lo p in g c o u n t r y n .a . Equity P o r t fo l io /D F I In v e s to r F o re ig n e x c h a n g e F o re ig n e x c h a n g e fo rw a rd , sw a p P rice o r o p t io n TRS, e q u i ty fu tu re s a n d o p t io n s D e v e lo p in g c o u n t r y n .a . F D I (n o n -s e c u r it iz e d ) In v e s to r F o re ig n e x c h a n g e F o re ig n e x c h a n g e fo rw a rd , sw a p D e v e lo p in g c o u n t r y n .a . o r o p t io n Notes: 1 Bank loans are p resum ed to be den o m in a ted in a m ajor currency (for exam ple US dollars), a t variab le (floating) in te res t ra tes a n d u n d e rw ritte n by a synd ica te o f banks. 2 B ond refers to co n v en tio n a l n o tes a n d bo n d s, floa ting ra te n o te s a n d s tru c tu red notes. Source: A u tho rs o w n analysis. 100 Derivatives, Capital Flows and Prudential Regulation a variable rate lo a n exp oses th e d om estic borrow er to in terest rate risk; and a long-term lo a n exposes th e foreign lender to greater credit risk and a short­ term loan exp oses th e d om estic borrower to refunding risk (som etim es called liq u id ity risk). Equities exp ose th e foreign investor to credit risk a lon g w ith th e m arket risk from chan ges in th e exch an ge rate, m arket price o f th e stock and th e uncertain d iv id en d paym ents. N otes and b on d s exp ose th e foreign investor to credit risk and m arket interest rate risk, and hard currency bon d s exp ose th e d om estic borrower to exch an ge rate risk. T he finan cia l in n o v ­ a tion o f in trod u cin g derivatives to capital m arkets a llow s th ese traditional arrangem ents o f risk to b e redesigned in order better to m eet th e desired risk profiles o f th e issuers and holders o f th ese capital instru m ents. W h ile th e risk-sh ifting fu n ctio n o f derivatives serves th e usefu l role o f h ed g in g and thereby facilita ting capital flow s, th e increased use o f deriva­ tives raises con cern about th e stab ility o f th e e co n o m y as a w h o le . T he use o f derivatives can lead to less transparency b etw een counterparties and b etw een regulators and m arket participants. T hey can be used for u n pro­ ductive activ ities such as avo id in g prudentia l regulations, m an ip u la tin g accou n tin g rules and credit ratings, and evad ing tax. T hey can also b e used to raise th e level o f m arket risk exposure relative to capital in th e pursuit o f higher y ie ld in g - an d h igher risk - in v estm en t strategies. The greater th e m arket exposure - p ossib ly created b y o p en p osition s in derivative contracts - th e greater th e im pact o f a ch an ge in th e exch an ge rate or o ther m arket price o n th e finan cia l sector and e co n o m y as a w h o le . In th is con tex t th e use o f derivatives to reduce th e am ou n t o f capital relative to th e am ou n t o f risk-taking activ ities reduces th e ab ility o f capital to serve as a buffer against m arket turbulence and to serve as a governor o n total risk taking. T his increases th e lik e lih ood o f system ic failure an d h e ig h ten s doubts about th e stability o f th e financial sector and th e eco n o m y as a w hole. A n a ly sis o f tra n sa c tio n s T he rem ainder o f th is section is organized as fo llow s. T he risk characteristics o f each type o f capital in stru m en t is analyzed , together w ith th e types o f derivative th at are lik ely to be used in co n ju n ctio n w ith th at in strum ent. N ext, each o f th e relevant derivatives is briefly described before jo in in g th e tw o d iscu ssions to sh o w h o w th e capital in stru m ents an d derivatives are used together or as substitutes. Foreign exchange forw ard A foreign exch an ge forward is a contract in w h ich counterparties agree to exch an ge specified am ou n ts o f foreign currencies at a specified exch an ge rate o n a specified future date (Figure 6.1). T he forward exch an ge rate is th e price at w h ich th e counterparties w ill exch an ge currency o n th e future exp iration date. The forward rate is n egotia ted so th at th e p resent va lu e o f th e forward contract is zero at th e tim e it is traded; th is is referred to as trading at par or Randall Dodd 101 Figure 6.1 F o re ig n e x c h a n g e fo rw a rd at th e m arket. As a result n o m o n ey n eed be paid at th e co m m en cem en t o f th e contract, a lth ou gh th e counterparties m ay agree to p ost collateral in order to ensure each others adherence to th e contract. Foreign exchange swap A foreign exch an ge sw ap is sim p ly th e co m b in in g o f a sp ot and a forward transaction (or p ossib ly tw o forwards). T he starting leg o f th e sw ap usually con sists o f a sp ot foreign exch an ge transaction at th e current sp ot exch an ge rate, and th e c lo s in g leg con sists o f a secon d foreign exch an ge transaction at th e contracted forward rate. For exam ple, a loca l investor enters a foreign exch an ge swap o f p esos against dollars in w h ich th e investor buys U S$100 0 0 0 tod ay at an exch an ge rate o f U S$0.05 per p eso (thus p aying 2 0 0 0 0 0 0 pesos), an d contracts to sell U S$100 0 0 0 (that is, b u y pesos) at U S$0.0475 in 180 days. T he loca l in vestor receives U S$100 0 0 0 in th e starting leg, and th en u p o n th e sw ap exp iration date pays U S$100 0 0 0 in exch an ge for receiv ing 2 105 263 pesos in th e c lo s in g leg. T his 10 .8 per cen t an n u al rate o f return in pesos is due to th e depreciation o f th e peso against th e dollar (or appreciation o f th e dollar against th e peso), an d it reflects th e presum ed fact th at th e p eso rate o f return from in vestin g in peso- d en om in ated assets is h igher th a n th e US dollar rate o f return. Foreign exch an ge forwards and sw aps are used by b o th foreign and d om estic in vestors to h ed ge foreign exch an ge risk. Foreign investors from advanced capital m arkets w h o purchase securities d en o m in a ted in loca l currencies use foreign exch an ge forwards and sw aps to h ed ge their lo n g loca l currency exposure. Sim ilarly foreign direct in vestm en ts in p hysica l real estate, p lant or eq u ip m en t are exp osed to th e risk o f loca l currency depreci­ a tion . Local d evelop in g-cou n try in vestors w h o borrow in m ajor currencies 102 Derivatives, Capital Flows and Prudential Regulation in order to in vest in local currency assets are also exposed to foreign exchange risk, and th ey to o u se foreign exch an ge forwards and sw aps - as w ell as futures and o p tio n s w h en available - to m an age their risks. O f course foreign exch an ge forwards and sw aps are also used for specu la­ tio n in th ese loca l currencies. D erivatives enab le speculators to leverage their capital in order to take larger p osition s in th e va lue o f loca l currencies. T his in turn m ean s th at d evelop in g -cou n try central banks m ust w atch th e exch an ge rate in tw o m arkets, th e spot and forward, in order to m ain ta in their fixed exch an ge rates. Forwards and foreign exch an ge swaps are n o t alw ays h ig h ly collateralized (m arket exposure m easured as a percentage o f th e principal). C ollateral is less likely to b e used for trading b etw een th e m ajor m arket dealers, and collateral is usually low er for less vo la tile financial in stru m en ts such as foreign currency.10 This enab les foreign -exch ange derivative users to obta in greater am ou n ts o f currency exposure relative to capital, and therefore it can leave foreign -exchan ge derivative counterparties exp osed to greater credit risk. T he largest credit losses in th e derivatives m arkets in recent years w ere due to defaults o n foreign currency forwards in East Asia and R ussia.11 Foreign exchange forwards and swaps - capital outflow problems In add ition to th e above dangers o f u sing foreign exch an ge derivatives, there is an additional prob lem w ith reverse capital flow s. This arises from th e n eed o f derivative dealers to create b o th lo n g and short p o sitio n s in develop in g- coun try currencies in order to m ake a m arket in derivatives. Every derivative contract in v o lv es a short and a lo n g p o sition . T he party b u yin g pesos in exch an ge for US dollars in th e forward m arket is lo n g in p esos (and sh ort in dollars), w h ile th e counterparty is short in pesos. In th e m arket for p eso forwards and sw aps there is likely to be o n e or m ore dealers. A dealer m akes a m arket b y q u otin g b id and offer (ask)12 prices and th en stan d in g b eh in d th em . Ideally th e dealer faces a m arket th at is fu ll o f participants w h o are w illin g to b u y and sell in equal am ou n ts. In th is case th e dealer reacts to investors h ittin g h is b id (selling p esos for dollars forward to th e dealer) b y trying to lay o ff th e lo n g peso exposure b y se llin g p esos to oth er participants in th e m arket (th ose w h o are liftin g th e dealers offer). H ow ever it is lik ely that a dealer in d evelop in g-cou n try foreign -exch an ge derivatives w ill o ften face a on e-sid ed or im balanced m arket in w h ich m ost participants w an t to b e short in th e loca l currency.13 T his m ean s th at it is o ften d ifficu lt or exp en sive for dealers to lay o ff their lo n g p osition s by sellin g short to others in th e forward or other derivatives m arkets. As a result, either th e forward rate m u st rise (or fall) su ffic ien tly to com p en sate th e dealer and o th er risk takers for h o ld in g greater am ou n ts o f risk, or th e dealer m ust fin d other, cheaper m eans to lay o ff th e risk. O n e alternative m eth o d used b y dealers in th e face o f an im balanced m arket is to create a sy n th etic forward or sw ap contract th rou gh th e u se o f th e local credit m arkets. In order to create a syn th etic short forward peso Randall Dodd 103 p o sitio n against th e dollar, th e dealer borrows in th e local peso credit market (thus creating a p eso liability), uses th e lo a n proceeds to b u y dollars spot and th en in vests th e dollars (thus o b ta in in g a dollar asset). Ideally th e m aturity o f th e forward, p eso lo a n and dollar in v estm en t w ill m atch . T he product o f th ese three transactions g ives th e dealer a sp ecified am ou n t o f dollars in futures (the lo a n repaym ent) th at can b e so ld for p esos at a specified exch an ge rate in settlin g th e forward contract, th e proceeds from w h ich w ill repay th e p eso loan and leave th e dealer w ith a profit. In th is m anner th e dealer can co n tin u e to q u ote b id and offer prices w ith o u t h o ld in g m ar­ ket risk. N o te th at in th e process o f creating a syn th etic short forward p o sitio n to m ake a m arket in foreign exch an ge derivatives, th e dealer has generated a capital ou tflow b y borrow ing at h o m e and len d in g abroad in th e dollar market. Thus in th e con tex t o f im balanced markets, w here m ore participants are w illin g to h o ld short rather th a n lo n g p osition s, h ed g in g can generate capital ou tflow s. If a foreign in vestor trades a foreign exch an ge forward or sw ap in order to h ed ge an in v estm en t in a local-currency security or direct in vestm en t, th en th e derivatives m arket w ill p o ten tia lly generate a capital ou tflow equal to th e size o f th e hedge. If th e foreign in vestor w ish es to h ed ge th e fu ll va lue o f th e in vested princip le, th en th e h ed g in g process can p oten tia lly neutralize or n et-ou t th e capital in flow . O f course th e flow is again reversed and returns to th e d eve lop in g cou n try w h en th e dealers loan m atures and h e or she uses th e dollar proceeds to u n w in d h is or her syn th etic forward p o s itio n .14 There is an ad d ition a l con cern w ith foreign exch an ge sw aps and their effect o n capital flow s. N ote th at th e cash flow s from su ch a sw ap resem ble th e cash flow from a short-term foreign currency loan (see exam p le above). D ollars are received tod ay and are repaid in th e future, and th e loan cost is paid in p esos based o n th e dollar and p eso in terest rates. In recogn ition o f th is, M alaysia p roh ib ited foreign exch an ge sw aps as part o f its effort to im p ed e capital in flow s prior to th e 1997 finan cia l crisis. Interest rate swap T he basic in terest rate swap, called th e van illa in terest rate swap, is an agree­ m en t b etw een tw o parties to exch an ge th e n e t o f tw o series o f paym en ts. O ne series o f p aym en ts is based o n a fixed in terest rate applied to a n o tio n a l principal, such as 6 per cen t o n US$1 m illio n , and th e o th er series o f paym en ts is based o n a floa tin g rate, such as a 3 -m o n th LIBOR (L ondon in terbank offered rate), app lied to th e sam e n o tio n a l principal. In order to sim plify p aym en ts an d other clearing issues, m ost swap contracts a llow th e tw o parties to pay (or receive) o n ly th e n e t or th e d ifference b etw een th ese tw o series o n each p aym en t or drop date. Borrowers w ith variable interest rate loan s can h ed ge their in terest rate risk w ith a sw ap in w h ich th ey receive th e floa tin g rate and pay th e fixed rate (that is, b u y a swap), and th ereby sw ap their floa tin g rate p aym ents for fixed rate paym ents. 104 Derivatives, Capital Flows and Prudential Regulation Total return swap A total return swap (TRS) is a contract in w h ich at least o n e series o f paym ents is based o n th e to ta l rate o f return (the ch an ge in m arket price p lus in terest or d iv id en d p aym ents) o n som e un d erly in g asset, security or security index . The other leg o f th e sw ap is typ ica lly based o n a variable in terest rate such as th e LIBOR, b ut m ay be a fixed rate or th e total rate o f return o n som e other financial in strum ent. Based o n w h at is k n ow n abou t th e precrisis situation s in M exico and East Asia, TRSs in th ose situations usually con sisted o f sw apping th e LIBOR against th e to ta l rate o f return o n a govern m en t security. A TRS replicates th e p ositio n o f borrow ing at th e LIBOR in order to fin ance th e h o ld in g o f a security. T he returns are th e sam e, b u t u n lik e an actual cash m arket transaction , it d oes n o t in v o lv e ow nersh ip or debt. Instead th e o n ly capital in v o lv ed in a TRS is th e p ostin g o f collateral. In add ition to th e reduction in th e n eed to co m m it capital to th e transaction, a TRS also has n o im pact on a firms balance sh eet and is n o t likely to b e subject to regulatory restrictions o n foreign exch an ge exp osu re.15 In short, TRSs a llow finan cia l in stitu tion s and investors to raise their risks and p o ten tia l returns, relative to capital. O ne o f th e troub lesom e uses o f TRSs is to capture th e gains from th e carry trade or carry business. A profitable carry trade exists w h en exch an ge rates are fixed and in terest rate differentials persist b etw een tw o econ om ies. T hen it is possib le to borrow in th e lo w in terest rate currency and len d in th e h igh in terest rate currency w ith n o risk other th a n th at o f a failure in th e fixed exch an ge rate regim e. T he use o f a TRS alters th e form , but n o t necessarily th e quantity, o f cap­ ital flow s to d ev e lo p in g countries. A lternatively, w h en d evelop in g-cou n try financial in stitu tion s engage in th e carry business, th e capital flow s are in th e form o f m ajor-currency (usually short-term ) bank loans. W h en th ey pursue th e sam e profit op p ortu n ities b y u sin g a TRS, th is generates indirect capital flow s as th e TRS counterparties, usually dealers from advanced capital m arkets, b u y th e u n d erly in g asset as a h ed ge against their side o f th e TRS. C onsider th e dealers side o f th e transaction . T he dealer contracts to receive th e LIBOR p lus a spread in exch an ge for p ay in g th e total return o n a local currency security. T he dealer does n o t in ten d to profit b y in vestin g in th e exp ecta tion th at th e LIBOR w ill rise or that th e to ta l return o n th e security w ill fall. Instead th e dealer lays o ff th e risk by borrow ing at th e LIBOR and u sin g th e proceeds to buy th e local currency security. T he dealer th en passes-through in th e regular swap p aym en t th e proceeds from h o ld in g th e loca l security, w h ile th e dealers cost o f borrow ing to b u y th e security is covered by th e receipt o f LIBOR paym ents. T he spread above th e LIBOR paid to th e dealer is th e dealers profit, and th e dealer en d s up h o ld in g n o m arket risk.16 Randall Dodd 105 N o te th at in th e process o f h ed g in g th e dealers p o sitio n in th e TRS there is a capital in flo w to th e d eve lop in g country because th e advanced capital m arket dealer has purchased local currency security. N orm ally a flow o f capital in th e form o f loca l currency securities w ill sh ift th e exch an ge rate risk to th e advanced capital m arkets, bu t n o t in th is case. Instead it fu n ction s in con ju n ctio n w ith th e TRS to leave th e loca l d evelop in g-cou n try investor h o ld in g th e foreign exch an ge risk (the short dollar p osition ), m u ch like a m ajor currency bank loan . O n th e o n e h a n d th e u se o f a TRS results in a sim ilar foreign exch an ge exposure to th at described before. H ow ever in som e w ays it is far w orse. In com parison w ith usin g foreign b ank loan s to capture profit from th e carry trade, th e use o f a TRS causes an even greater surge in cross-border flow s th a n d o short-term bank loans. T he surge orig inates from th e collateral requirem ents for th e swap. If th e present value o f th e sw ap sud d en ly drops as a result o f a rise in loca l in terest rates or a drop in th e va lue o f th e currency, or b o th , th en th e loca l sw ap holder is required to p ost add itional collateral w ith th e sw ap counterparty. G enerally th is m ean s se llin g other assets, o ften other d evelop in g -cou n try assets, in order to ob ta in dollars to m eet th e requirem ent to post ad d itional collateral b y th e n ex t day - if n o t later th e sam e day. Thus TRSs can result in large and im m ed iate m ajor currency ou tflow s. If short-term bank loan s are considered h o t m oney, th en p aym en ts to m eet m argin and collateral requirem ents are m icrow ave m o n e y - th ey b ecom e h o t m ore quickly. As an in d ica tion o f th e p o ten tia l m agn itu d e o f th ese collateral outflow s, Garber and Lall (1996) cite th e IMF and industry sources, w h ich reported that M exican banks h e ld U S$16 b illio n in tesob on os to ta l return swaps at th e tim e o f th e d eva luation o f th e M exican peso . T he authors calcu lated th at th e in itia l peso d eva luation depressed th e va lu e o f tesob on os b y 15 per cent, and th at th is w ou ld h ave required th e delivery o f U S$2.4 b illio n in collateral th e n ex t day. This w o u ld exp la in about h a lf o f th e US$5 b illio n o f foreign reserves lo st b y th e M exican central bank th e day after d evalu ation . In th is way, collateral or m argin calls o n derivatives can accelerate th e pace o f a financia l crisis, and th e greater leverage that derivatives provide can also m u ltip ly th e size o f th e losses and thereby d eep en th e crisis. T he u se o f TRSs also increases th e lik e lih o o d o f con tag ion . T h ey o ften in v o lv e cross-currency assets and p aym en ts an d are therefore m ore likely to transfer d isruptions from o n e m arket to another. N eftc i (1998) c la im s that o n e reason w h y Korean banks en gaged in so m a n y In d on esian TRSs w as that th ey were seeking h igh er rates o f return in response to a rise in their fu n d in g costs. But, n o te th at at th e en d o f th is process, Korean banks are b e in g exp osed to In d on esian credit. This, how ever, is n o t v isib le o n their balance sheets. This situ ation n o t o n ly creates th e p ossib ility for con tag ion , b u t m ay also m ake th e co n ta g io n unpred ictab le and severe (ibid.). 106 Derivatives, Capital Flows and Prudential Regulation Structured notes Structured n o tes , a lso k n ow n as hybrid instru m ents, are a co m b in a tio n o f a credit m arket in strum ent, such as a b o n d or n o te , w ith a derivative, such as an o p tio n or futures-like contract. Hybrid in strum en ts in clu d e such c o n ­ ven tio n a l securities as convertib le stocks, convertib le b on d s and callable b on d s. T hese have lo n g b een am on g th e set o f traditional securities regularly issued and traded in US finan cia l markets. Structured n o tes w ere part o f th e n ew w ave o f in n o v a tio n in capital flow s to d eve lop in g coun tries in th e 1990s. T hey offered issuers and investors either better y ie ld s th an sim ilarly rated securities, or better com b in a tion s or bu n d les o f risk characteristics. In som e cases structured n o tes w ere designed to c ircum vent accou n tin g rules or govern m en t regu lations and th u s a llow low er capital charges, greater foreign exch an ge exposure or greater overall risk to capital. The n otes u sed in d eve lop in g countries w ere u su ally structured so th at their y ie ld w as linked to th e va lue o f o n e or m ore o f th e currencies or stock in d ices in th e d ev e lo p in g eco n o m ies in qu estion . T he issuers o f th ese structured n o tes w ere fin an cia l in stitu tion s from ad van ced capital m arket econ om ies, and th e investors w ere o ften d evelop in g-cou n try finan cia l in s ti­ tu tion s and investors w h o w ere m ore w illin g to h o ld th eir o w n exch an ge rate risk or th at o f their n e igh b ou rin g d eve lop in g countries. Putable debt T he largest threat to fin ancia l m arket stab ility th at d id n o t d irectly in v o lv e foreign exch an ge exposu re w as th e use o f em b ed d ed derivatives, called put op tion s, in lo a n and b o n d debt contracts. T hese put o p tio n s o n th e debt principal en ab led lenders to recall their principal in th e ev en t o f eco n o m ic trouble. T he effect was to drain th e d eve lop in g cou n try fin an cia l m arkets o f liq u id ity at just th e tim e it w as m ost urgently needed . It is n o t un u su a l for credit instrum en ts to h ave attached o p tion s. Callable bon d s are fam iliar fin an cia l instrum ents in advanced capital m arkets. T hey are a co m b in a tio n o f a co n v en tio n a l b o n d and a call o p tio n th at allow s th e issuer (that is, th e borrower) to recall th e principal o n th e b o n d at a specified va lue (usually par) after som e future date. C allable b o n d s are used b y borrowers to reduce th e risk o f b e in g locked in to h igh er th an m arket rates o f interest o n their ou tstan d in g debt. In th e case o f d ev e lo p in g cou n try debt, th e attached o p tio n s w ere usually puts rather th an calls. This granted th e lenders, n o t th e borrowers, th e right to reclaim their principal. Lenders in advanced capital m arkets a ttached put provisions to loan s and b on d s in order to reduce th e risk th a t adverse m acro- eco n o m ic co n d itio n s or other circum stances w ou ld reduce th e ability o f their borrowers to repay their debts. It also reduced their exposure to increases in dollar or o th er hard currency in terest rates. Yet an oth er m o tiv a tio n Randall Dodd 107 in vo lved ou tflan k in g tax and regulatory requirem ents because th e putable loans cou ld be treated like long-term debts ev en th o u g h th ey fu n ctio n ed like short-term on es. T hese put o p tio n s w ere in th e form o f hard and soft puts. Hard puts, u sually attached to a n o te or b on d , gave th e lender th e right to d em an d principal repaym ent after a certain date, for exam p le a five-year n o te m igh t b e putab le after o n e year. Soft puts, u sually attached to loans, gave lenders th e right to reschedule th e term s o f their credit if certain adverse even ts occurred. Table 6.5 sh ow s th e breakdow n b etw een loans and b on d s in East Asia. M ost o f th e hard pu t o p tio n s w ere closer to th e European- th an to th e A m erican-style o p tion . In th ese cases op tio n holders had th e right to exercise th e o p tio n o n ly o n specific days, or perhaps sem iannually; in very few cases were th e op tion s exercisable o n a con tin u ou s basis, as w ith Am erican op tions. A ttached put op tion s facilitated len d in g by low ering th e costs to borrowers and ensuring th at lenders w ou ld have len d in g alternatives in th e even t o f adverse m arket d isruptions. This putab le debt in stru m en t w as used w id ely in th e rapidly grow ing d evelop in g-cou n try b o n d m arket. T he IMF estim ated in 1999, u sin g p ublic databases, th at there w ere U S$32 b illio n in debts putab le th rou gh th e en d o f 2 0 0 0 for all em erging countries. O f th e total, U S$23 b illio n w as from East A sian issuers and US$8 b illio n w as from Brazil. T he presence o f putable debt in len d in g to d eve lop in g eco n o m ies raises several policy concerns. First, th e attached put lowers th e borrow ing costs and th is in turn encourages m ore borrow ing and len d in g . Second, th e tax and regulatory treatm ent o f putable debt o ften incorrectly treats it as long-term debt even th o u g h it fu n ction s like short-term debt. Third, it creates liq u id ity shortages in the: even t o f a fin ancia l d isruption , and it does so just at th e tim e w h en liqu id ity is crucial for th e successfu l fu n ctio n in g o f th e financia l sector. In sum , putab le debt ten d s to increase in d eb ted n ess and does so in a m anner that exacerbates finan cia l disruptions. Table 6 .5 P u ta b le d e b t is su e d f r o m East A s ia (U S$ m i l l io n , d u e in 19 99 o r 2 0 0 0 ) Loans Bonds H o n g K o n g 1 5 4 9 2 6 4 2 In d o n e s ia 2 8 7 6 9 6 3 K o re a 3 2 6 3 3 9 8 6 M a la y s ia 547 1 7 3 0 P h i lip p in e s 75 - S in g a p o re 53 2 - T h a ila n d 1 6 8 0 1 3 1 3 T o ta l 10 5 2 2 10 6 3 4 Source-. IMF (1999). 108 Derivatives, Capital Flows and Prudential Regulation Threats to currency stability: derivatives a n d fixed exchange rate regimes T he presence o f derivatives m arkets poses a special set o f ch allen ges for govern m en ts w ith a fixed exch an ge rate regim e. This is true w h eth er it is a soft peg, a craw ling peg or a hard peg. D evelop in g-cou n try govern m en ts pursue a fixed exch an ge rate p o licy in order to encourage trade and in v est­ m en t by low erin g exch an ge rate risk. A fixed exch an ge rate can p rom ote grow th th rou gh th e exp an sion o f trade and foreign in v estm en t b y m aking th ose eco n o m ic d ecis ion s less uncertain and m ore dependab le. T his reduces th e costs o f th e foreign exch an ge risk in v o lv ed in im p ortin g capital and raw m aterial, exp ortin g good s an d repaying foreign debts. A nother w ay is to stop th e acceleration o f in fla tio n b y an ch orin g to external price levels. A gainst th is backdrop, th e presence o f exchange-rate-related derivatives raises several im p ortan t problem s th at are expressed in th e fo llow in g questions: • O f w h at use are foreign exch an ge forwards or sw aps w h en th e fixed exch an ge rate regim e elim in ates norm al m arket price vo latility? In other w ords, h o w and w h y can th ey be used if there is n o m arket vo la tility to hedge? • W hat purpose is served b y th e price discovery o f th e forward rate (d iscount or prem ium ) an d w h at signals does it send? • H ow does it affect th e ab ility o f th e central bank to m ain ta in th e fixed exch an ge rate? The first problem is th at in th e absence o f norm al m arket price fluctuations, exch an ge rate derivatives fu n ctio n as a specu lative or h ed g in g in strum en t against th e success o f th e governm ents policy . In a fixed exch an ge rate c o n ­ text, th e o n ly exch an ge rate m o v em en t th at investors n eed to h ed ge against is a failure o f th e fixed rate regim e th at results in either a d eva luation o f th e pegged exch an ge rate or com p lete ab an d on m en t o f th e regim e. T here is a m u ch sm aller risk th at a d eve lop in g countrys currency w ill appreciate, and so th e m ore relevant risk is a d eclin e in its value. U sin g a forward, swap or o p tio n to take a p o ten tia lly profitable p o sitio n o n a p ossib le fall in th e currencys va lue is practically a on e-w ay bet. T he future exch an ge rate deter­ m in ed in a forward or sw ap derivative m arket is n o t an expression of eco n o m ic va lue b ut reflects th e lik e lih ood o f g overn m en t failure, or is a m easure o f th e lack o f co n fid en ce in th e governm en ts ab ility to m ain ta in a fixed exch an ge rate. In short it is a p o litica l price or th e price o f a p o licy e v e n t.17 D erivative m arkets also provide leverage to speculators and players w h o m ig h t m o u n t an attack o n th e fixed exch an ge rate. This leverage in tak ing a p osition o n th e currencys value, w heth er usin g foreign exch an ge forwards, R a n d a ll D o d d 1 0 9 s w a p s o r o p t i o n s , l o w e r s t h e c o s t o f a n d t h e r e f o r e r a i s e s t h e p o t e n t i a l g a i n f r o m s u c h a n u n d e r t a k i n g . D e r i v a t i v e s p r o v i d e l o w e r c o s t p r i c e e x p o s u r e b e c a u s e o f t h e i r h i g h e r l e v e r a g e ( w h i c h s a v e s o n t h e c o s t o f c a p i t a l ) , h i g h e r l e v e l s o f l i q u i d i t y ( s o m e t i m e s ) a n d l o w e r t r a n s a c t i o n c o s t s . T h u s t h e p r e s e n c e o f d e r i v a t i v e m a r k e t s e m p o w e r s t h o s e w h o a r e b e t t i n g o r p l o t t i n g a g a i n s t t h e s u c c e s s o f t h e g o v e r n m e n t s m a c r o e c o n o m i c p o l i c y . M o r e o v e r , b e c a u s e i t i s a p o l i t i c a l p r i c e a n d p r a c t i c a l l y a o n e - w a y b e t , t h e r e a r e l i k e l y t o b e f a r m o r e i n v e s t o r s w h o w a n t t o b e s h o r t - r a t h e r t h a n l o n g - i n t h e l o c a l c u r r e n c y . I n o r d e r t o c o m p l e t e t h e m a r k e t , f o r e i g n e x c h a n g e d e r i v a t i v e s d e a l e r s w i l l h a v e t o c r e a t e s y n t h e t i c s h o r t p o s i t i o n s ( d e s c r i b e d a b o v e ) i n o r d e r t o l a y o f f t h e i r l o n g - s i d e r i s k . T h e r e s u l t o f t h i s i s a c a p i t a l o u t f l o w , a n d a s t h e s h o r t i n t e r e s t g r o w s i n t h e d e r i v a t i v e s m a r k e t t h e c a p i t a l o u t f l o w w i l l i n c r e a s e a n d t h u s c o n t r i b u t e t o s e l f - f u l f i l l i n g s p e c u l a t i o n a g a i n s t t h e c u r r e n c y . T h e s e c o n d p r o b l e m i s t h a t i n t h e p r e s e n c e o f a f i x e d - r a t e s y s t e m , t h e f o r ­ w a r d a n d s w a p m a r k e t w i l l c r e a t e a m a r k e t p r i c e ( a p r o c e s s k n o w n a s p r i c e d i s c o v e r y ) t h a t w i l l r e f l e c t t h e l a c k o f c o n f i d e n c e i n t h e g o v e r n m e n t s e x c h a n g e r a t e p o l i c y . T h a t p r i c e w i l l a l m o s t c e r t a i n l y i n d i c a t e t h a t t h e f u t u r e v a l u e o f t h e c u r r e n c y w i l l b e b e l o w t h e p r e s e n t p e g g e d s p o t r a t e . I f t h a t p r i c e i s m i s u n d e r s t o o d , t h e n i t w i l l r e g u l a r l y s e n d s i g n a l s t h a t t h e c u r r e n c y i s g o i n g t o m o v e o f f o f t h e p e g . T h e t h i r d p r o b l e m c o n c e r n s h o w t h e p r e s e n c e o f f o r w a r d a n d s w a p m a r k e t s a f f e c t s t h e c e n t r a l b a n k s a b i l i t y t o m a i n t a i n a f i x e d e x c h a n g e r a t e r e g i m e a g a i n s t d o w n w a r d p r e s s u r e c a u s e d b y a s h o r t - t e r m i m b a l a n c e o r a l a r g e s p e c u l a t i v e a t t a c k . I f t h e r e i s o n l y a s p o t m a r k e t f o r f o r e i g n c u r r e n c y , t h e n t h e c e n t r a l b a n k c a n d e f e n d i t s e x c h a n g e r a t e p e g b y i n t e r v e n i n g d i r e c t l y i n t h e s p o t m a r k e t t o b u y i t s c u r r e n c y w i t h f o r e i g n r e s e r v e s , a n d b y t i g h t e n i n g t h e d o m e s t i c c r e d i t c o n d i t i o n s . D i r e c t i n t e r v e n t i o n c a n b e e f f e c t i v e , e v e n t h o u g h t h e f o r e i g n c u r r e n c y m a r k e t i s l a r g e , b e c a u s e t h e c e n t r a l b a n k s i n t e r v e n t i o n i s b o t h a l a r g e n e t p u r c h a s e w i t h i n t h a t m a r k e t a n d b e c a u s e i t s e n d s a s i g n a l . T i g h t e n i n g c r e d i t c o n s i s t s o f e i t h e r r a i s i n g i n t e r e s t r a t e s - w h i c h w i l l a t t r a c t f o r e i g n c a p i t a l i n f l o w s , d i s c o u r a g e o u t f l o w s a n d i n c r e a s e t h e c o s t o f c a r r y i n g s y n t h e t i c s h o r t p o s i t i o n s - o r r e s t r i c t i n g t h e s u p p l y o f c r e d i t ( t h a t i s , i m p o s i n g c a p i t a l c o n t r o l s ) t o c e r t a i n b o r r o w e r s , s u c h a s f o r e i g n e r s o r n o n - c o m m e r c i a l f i r m s . T h e p r e s e n c e o f o n e o r m o r e f o r e i g n - e x c h a n g e d e r i v a t i v e m a r k e t s a d d s p o l i c y t a r g e t s f o r t h e c e n t r a l b a n k . M o r e o v e r t h e d e r i v a t i v e m a r k e t s a r e i n s o m e w a y s m o r e p r o b l e m a t i c a s t a r g e t s t h a n t h e s p o t m a r k e t . W h i l e t h e s p o t m a r k e t i s l a r g e , t h e p o t e n t i a l s i z e o f t h e f o r w a r d a n d s w a p m a r k e t i s i n f i n i t e . I f t h e c e n t r a l b a n k r a i s e s l o c a l i n t e r e s t r a t e s , t h e n t h e i n t e r e s t r a t e d i f f e r e n ­ t i a l i n c r e a s e s a n d s e r v e s a s a l a r g e r b a s i s f o r d i s c o u n t i n g t h e f o r w a r d a n d s w a p r a t e s . I f t h e c e n t r a l b a n k i n t e r v e n e s d i r e c t l y , p e r h a p s i n a n e f f o r t t o a v o i d t h e f o r w a r d m a r k e t s i g n a l l i n g a l a c k o f c o n f i d e n c e i n t h e r e g i m e , t h e n t h e r e i s p o t e n t i a l l y n o e n d t o t h e e f f o r t . I f t h e c e n t r a l b a n k s i n t e r v e n t i o n 1 1 0 D eriva tives , C a p ita l F low s a n d P ru d e n tia l R egu la tion s u c c e e d s i n s u p p o r t i n g t h e f o r w a r d o r s w a p r a t e , t h i s o f f e r s a t t a c k e r s a b e t t e r p r i c e a t w h i c h t o s e l l t h e l o c a l c u r r e n c y i n t h e f u t u r e . I f t h e c e n t r a l b a n k d o e s n o t i n t e r v e n e , t h e n t h e f o r w a r d c a n c o n t i n u e t o s i g n a l a d e v a l u a t i o n a n d f u r t h e r g r o w t h i n i n t e r e s t i n t h e f o r w a r d o r s w a p m a r k e t w i l l s p u r c a p i t a l o u t f l o w s a s d e r i v a t i v e d e a l e r s c o n s t m c t s y n t h e t i c s h o r t p o s i t i o n s . T h i s i s n o t t o s a y t h a t t h e s i t u a t i o n b e c o m e s h o p e l e s s . I n t h e f a c e o f a c u r r e n c y a t t a c k , t h e c e n t r a l b a n k c a n t a k e t h e e x t r a s t e p o f i m p o s i n g c a p i t a l c o n t r o l s t h a t p r o h i b i t b a n k s f r o m d e l i v e r i n g t h e l o c a l c u r r e n c y t o f o r e i g n e n t i t i e s . T h i s p r e v e n t s f o r e i g n s p e c u l a t o r s f r o m d e l i v e r i n g o n t h e i r f o r w a r d c o n t r a c t s . T h i s m e a s u r e , t a k e n t o g e t h e r w i t h a n i n c r e a s e i n i n t e r e s t r a t e s , a m o u n t s t o a b e a r s q u e e z e . T h i s s t r a t e g y , a s u s e d i n t h e c a s e o f T h a i l a n d i n t h e s p r i n g o f 1 9 9 7 , i s d e s c r i b e d i n L a l l ( 1 9 9 7 ) a n d G a r b e r a n d L a l l ( 1 9 9 6 ) . P o lic y so lu tio n s T h e f o l l o w i n g p o l i c y p r o p o s a l s c o n s i s t o f a s e t o f f i n a n c i a l m a r k e t r e g u l a t i o n s t h a t a r e d e s i g n e d t o m a k e f i n a n c i a l m a r k e t s m o r e e f f i c i e n t a n d l e s s s u s ­ c e p t i b l e t o d i s r u p t i o n s a n d d i s t o r t i o n s . 18 T h e y s h o u l d e n c o u r a g e t h e u s e o f d e r i v a t i v e s f o r r i s k m a n a g e m e n t p u r p o s e s w h i l e d i s c o u r a g i n g t h e i r u s e i n u n p r o d u c t i v e p u r s u i t s t h a t m i g h t c r e a t e d a n g e r o u s l e v e l s o f e x p o s u r e t o m a r k e t r i s k , a s w e l l a s c r e d i t r i s k , o r l e a d t o r e v e r s e c a p i t a l f l o w s . T h e s e p r u d e n t i a l r e g u l a t o r y p r o p o s a l s a r e f u n d a m e n t a l l y o f t w o t y p e s . T h e f i r s t r e l a t e s t o r e p o r t i n g a n d r e g i s t r a t i o n r e q u i r e m e n t s a n d i s d e s i g n e d t o i m p r o v e t h e t r a n s p a r e n c y - a n d t h u s t h e p r i c i n g e f f i c i e n c y - o f t h e m a r k e t s . R e p o r t i n g r e q u i r e m e n t s a l s o m a k e s t h e g o v e r n m e n t , a n d o t h e r m a r k e t s u r v e i l l a n c e a u t h o r i t i e s , b e t t e r a b l e t o d e t e c t a n d d e t e r f r a u d a n d m a n i p u l a t i o n . R e g i s t r a t i o n r e q u i r e m e n t s a r e e s p e c i a l l y u s e f u l i n p r e v e n t i n g f r a u d . T h e s e c o n d t y p e o f p r u d e n t i a l r e g u l a t o r y m e a s u r e s c o n s i s t s o f c a p i t a l a n d c o l l a t e r a l ( a l s o k n o w n a s m a r g i n ) r e q u i r e m e n t s . C a p i t a l r e q u i r e m e n t s f u n c t i o n t o p r o v i d e b o t h a b u f f e r a g a i n s t t h e v i c i s s i t u d e s o f t h e m a r k e t a n d a g o v e r n o r o n t h e t e n d e n c y o f m a r k e t c o m p e t i t i o n t o d r i v e p a r t i c i p a n t s t o s e e k h i g h r e t u r n s a n d t h u s h i g h e r r i s k s . 19 C o l l a t e r a l r e q u i r e m e n t s h a v e b a s i c a l l y t h e s a m e e f f e c t , a l t h o u g h t h e y a p p l y t o t r a n s a c t i o n s a n d n o t i n s t i t u t i o n s . H e n c e n o n - f i n a n c i a l i n s t i t u t i o n s t h a t w o u l d n o t o t h e r w i s e b e s u b j e c t t o c a p i t a l r e q u i r e m e n t s w o u l d b e s u b j e c t t o c o l l a t e r a l r e q u i r e m e n t s o n t h e i r d e r i v a t i v e t r a n s a c t i o n s . M o r e o v e r t h e c u r r e n t m a r k e t p r a c t i c e f o r m a n a g i n g c o l l a t e r a l , i n s o f a r a s t h e r e i s o n e , i s d a n g e r o u s . I t r e q u i r e s a f i r m t o b e c o m e s u p e r - m a r g i n e d i f i t s c r e d i t r a t i n g d r o p s s u b s t a n t i a l l y ( e s p e c i a l l y i f i t d r o p s b e l o w i n v e s t m e n t g r a d e ) . T h i s r e q u i r e s a d e r i v a t i v e c o u n t e r p a r t y t o p o s t a s u b s t a n t i a l a m o u n t o f a d d i t i o n a l c o l l a t e r a l , a n d a m o u n t s t o a l a r g e d e m a n d f o r f r e s h c a p i t a l a t j u s t t h e t i m e w h e n t h e f i r m i s e x p e r i e n c i n g p r o b l e m s w i t h i n a d e q u a t e c a p i t a l . T h i s m a r k e t p r a c t i c e c r e a t e s a c r i s i s a c c e l e r a t o r . R a n d a ll D o d d 1 1 1 T h e p r o p o s a l s o f f e r e d h e r e a r e d i v i d e d i n t o t w o g r o u p s . T h e f i r s t a p p l y t o f i n a n c i a l i n s t i t u t i o n s a n d m a r k e t s i n i n d u s t r i a l i z e d o r d e v e l o p e d c o u n t r i e s . D e v e l o p i n g c o u n t r i e s f i n a n c i a l m a r k e t s a r e n o t i s o l a t e d f r o m t h e i r c o u n t e r ­ p a r t s i n t h e a d v a n c e d c a p i t a l m a r k e t s o f d e v e l o p e d c o u n t r i e s , a n d t h i s i n t e r ­ c o n n e c t e d n e s s - e s p e c i a l l y t h r o u g h d e r i v a t i v e m a r k e t s - i s v e r y i m p o r t a n t . A s o n e s e n i o r I M F o f f i c i a l o n c e r e m a r k e d t o t h e a u t h o r i n p r i v a t e , I h a v e n e v e r s e e n o n e s i n i n d e v e l o p i n g - c o u n t r y f i n a n c i a l m a r k e t s t h a t d i d n o t h a v e a s i t s c o u n t e r p a r t y s o m e o n e f r o m N e w Y o r k o r F o n d o n . T h e s e c o n d s e t i n c l u d e s a l l t h e e l e m e n t s o f t h e f i r s t p l u s s o m e a d d i t i o n a l p r o v i s i o n s f o r f i n a n c i a l i n s t i t u t i o n s a n d m a r k e t s i n d e v e l o p e d c o u n t r i e s . O n e m e r i t o f i d e n t i f y i n g u s e f u l r e g u l a t o r y i m p r o v e m e n t s i s t h a t e a c h d e v e l ­ o p i n g c o u n t r y c a n a d o p t t h e s e p r u d e n t i a l r e g u l a t i o n s o n i t s o w n i n i t i a t i v e . A n o t h e r m e r i t i s t h a t m o s t o f t h e s e r e g u l a t i o n s a r e t h e s a m e o r s i m i l a r t o o n e s u s e d i n i n d u s t r i a l i z e d c o u n t r i e s a n d t h e r e f o r e s h o u l d n o t b e c o n s i d e r e d o b j e c t i o n a b l e b y t h e I M F o r o t h e r a c t o r s i n t h e i n t e r n a t i o n a l c a p i t a l m a r k e t s . Developed countries: registration, reporting, transparency and liquidity Reporting and registration requirements • R e q u i r e p a r t i c i p a n t s ( c o u n t e r p a r t i e s ) i n d e r i v a t i v e c o n t r a c t s t o r e p o r t t h e i r t r a n s a c t i o n s t o t h e d e s i g n a t e d r e g u l a t o r y a u t h o r i t y . A l l e x c h a n g e - t r a d e d d e r i v a t i v e s a r e c u r r e n t l y r e p o r t e d t o t h e e x c h a n g e a n d i t s c l e a r i n g h o u s e . T h e e x c h a n g e h o u s e c o l l e c t s t h i s i n f o r m a t i o n a n d e i t h e r r e p o r t s i t t o t h e r e g u l a t o r o r k e e p s t h e r e c o r d s s o t h a t t h e y c a n b e c a l l e d f o r i n t h e f u t u r e . M o s t o v e r - t h e - c o u n t e r ( O T C ) d e r i v a t i v e t r a n s a c t i o n s a r e t r a d e d t h r o u g h t h e I S D A M a s t e r T r a d i n g A g r e e m e n t ( M a s t e r A g r e e m e n t ) , w h i c h r e q u i r e s t h e c o u n t e r p a r t i e s t o d e r i v a t i v e s t r a d e t o e x c h a n g e c o n f i r m ­ a t i o n m e s s a g e s t o e n s u r e t h a t a l l t h e k e y t e r m s a r e u n d e r s t o o d . T h e r e p o r t i n g r e q u i r e m e n t w o u l d e n t a i l t h e m s e n d i n g a c o p y o f t h e e m a i l m e s s a g e o r f a x t o t h e r e g u l a t o r y a u t h o r i t y . • R e q u i r e d e r i v a t i v e d e a l e r s t o r e p o r t t h e i r d e r i v a t i v e t r a n s a c t i o n s t o t h e d e s i g n a t e d r e g u l a t o r y a u t h o r i t y . T h e d a t a s h o u l d i n c l u d e p r i c e , v o l u m e , o p e n i n t e r e s t , p u t - c a l l v o l u m e a n d r a t i o s , m a t u r i t y , i n s t r u m e n t , u n d e r ­ l y i n g i t e m , a m o u n t s t r a d e d b e t w e e n o t h e r d e a l e r s a n d w i t h e n d - u s e r s , a n d c o l l a t e r a l a r r a n g e m e n t s . T h i s i n f o r m a t i o n w o u l d b e c o m p i l e d , a n d t h e n o n - p r o p r i e t a r y d a t a w o u l d b e m a d e a v a i l a b l e t o t h e o v e r a l l m a r k e t i n o r d e r t o i m p r o v e t r a n s p a r e n c y . O n c e a g g r e g a t e d , t h i s d a t a w o u l d r e v e a l t h e c h a r a c t e r o f t h e m a r k e t w h i l e p r o t e c t i n g t h e d e t a i l s o f d e a l e r s m a r k e t p o s i t i o n s ( a s s u m i n g t h e r e a r e s e v e r a l d e a l e r s ) . D a t a o f a p r o p r i e t a r y n a t u r e w o u l d b e r e t a i n e d b y t h e r e g u l a t o r i n o r d e r t o d e t e c t a n d d e t e r f r a u d , m a n i p u l a t i o n a n d p o t e n t i a l s y s t e m i c b r e a k s i n t h e m a r k e t s . 1 1 2 D eriv a tiv e s , C a p ita l F low s a n d P ru d e n tia l R egu la tion • R e q u i r e p u b l i c l y t r a d e d c o r p o r a t i o n s t o m a k e a n e x p l i c i t s t a t e m e n t o f t h e i r d e r i v a t i v e a c t i v i t i e s . A m e n d t h e f i n a n c i a l r e p o r t i n g r u l e s t o r e q u i r e t h a t a l l r e g u l a r f i n a n c i a l r e p o r t i n g s t a t e m e n t s i n c l u d e t h e a c t u a l , u n d e r ­ l y i n g e c o n o m i c p r o p e r t i e s a n d b u s i n e s s p u r p o s e s o f m i n o r i t y i n t e r e s t s , s p e c i a l p u r p o s e e n t i t i e s a n d d e r i v a t i v e t r a n s a c t i o n s . I n o r d e r t o b r i n g o f f - b a l a n c e s h e e t a c t i v i t i e s i n t o t h e s a m e l i g h t a s b a l a n c e s h e e t s , d e r i v a t i v e s w o u l d b e r e p o r t e d b y n o t i o n a l v a l u e ( l o n g a n d s h o r t ) , m a t u r i t y , i n s t r u m e n t a n d c o l l a t e r a l a r r a n g e m e n t s . T h i s w o u l d e n a b l e i n v e s t o r s t o d e t e r m i n e w h e t h e r a f i r m w a s u n d e r - o r o v e r h e d g e d , a n d w h e t h e r i t w a s p r i m a r i l y a c t i n g a s a p r o d u c e r o r a w h o l e s a l e r . • R e g i s t e r a l l d e r i v a t i v e d e a l e r s a n d b r o k e r s . I n t h e U n i t e d S t a t e s , b a n k s , t h r i f t a n d o t h e r d e p o s i t o r y i n s t i t u t i o n s , s e c u r i t i e s b r o k e r s , s e c u r i t i e s d e a l e r s , f u t u r e s a n d o p t i o n s b r o k e r s a n d i n s u r a n c e s a l e s ­ p e r s o n s a r e r e q u i r e d t o r e g i s t e r w i t h t h e i r r e l e v a n t r e g u l a t o r y a u t h o r i t y . T h i s e s t a b l i s h e s a m i n i m u m c o m p e t e n c e l e v e l f o r t h e i n d i v i d u a l s , b a c k g r o u n d c h e c k s t o d e t e c t f r a u d a n d t h e f t c o n v i c t i o n s f o r s a l e s p e o p l e a n d p r o p e r b u s i n e s s o r g a n i z a t i o n f o r t h e i n s t i t u t i o n s . E v e n t h o u g h o v e r - t h e - c o u n t e r d e r i v a t i v e m a r k e t s a r e g e n e r a l l y d e a l e r m a r k e t s , t h e r e g u l a t i o n s s h o u l d a l s o a p p l y t o b r o k e r s . S o m e e l e c t r o n i c d e r i v a t i v e t r a d i n g p l a t f o r m s f u n c t i o n l i k e b r o k e r s , a n d u n f o r e s e e a b l e c h a n g e s i n t h e m a r k e t s m a y a g a i n e l e v a t e t h e r o l e o f b r o k e r s . • M o d e r n i z e a c c o u n t i n g r u l e s a n d o t h e r f i n a n c i a l m a r k e t r e g u l a t i o n s i n o r d e r p r o p e r l y t o a c c o u n t f o r e m b e d d e d d e r i v a t i v e s . A l a r g e a n d g r o w i n g a m o u n t o f s e c u r i t i e s a n d l o a n s h a v e d e r i v a t i v e s a t t a c h e d t o o r e m b e d d e d i n t h e m . T h i s h a s f u n d a m e n t a l l y a l t e r e d t h e e f f e c t i v e n e s s o f t h e e x i s t i n g m l e s f o r m a k i n g c a p i t a l c h a r g e s a g a i n s t t h e r i s k s a s s o c i a t e d w i t h h o l d i n g o r i s s u i n g t h e s e s e c u r i t i e s , f o r f i n a n c i a l r e p o r t s o n i n v e s t m e n t s i n t h e s e s e c u r i t i e s a n d e v e n f o r r e g u l a t i o n s t h a t m i g h t o t h e r w i s e p r o h i b i t c e r t a i n f i n a n c i a l i n s t i t u t i o n s , s u c h a s p e n s i o n f u n d s o r i n s u r a n c e c o m p a n i e s , f r o m i n v e s t i n g i n t h e s e s e c u r i t i e s . U p - d a t e d r u l e s s h o u l d r e f l e c t t h e m a r k e t r i s k a s s o c i a t e d w i t h t h e a t t a c h e d o r e m b e d d e d d e r i v a t i v e a n d n o t m e r e l y t h e c r e d i t r i s k o f t h e p r i n c i p a l o f t h e s e c u r i t y . Liquidity requirements • I n o r d e r t o a s s u r e m a r k e t l i q u i d i t y , r e q u i r e O T C d e r i v a t i v e d e a l e r s t o a c t a s m a r k e t m a k e r s a n d m a i n t a i n b i d / a s k q u o t e s t h r o u g h o u t t h e t r a d i n g d a y . D e a l e r s b e n e f i t f r o m t h e i r p r i v i l e g e d r o l e i n t h e m a r k e t . I n a d d i t i o n t o e a r n i n g t h e i r b i d / a s k s p r e a d , d e a l e r s a r e a l s o p r i v y t o t h e m o s t r e c e n t c h a n g e s i n t h e m a r k e t . A l o n g w i t h t h i s p r i v i l e g e s h o u l d c o m e t h e r e s p o n s i b i l i t y o f h e l p i n g t o m a i n t a i n l i q u i d i t y a n d a n o r d e r l y m a r k e t . U S s t o c k e x c h a n g e s , s u c h a s t h e N Y S E a n d N A S D A Q , a l r e a d y r e q u i r e s p e c i a l i s t s t o a c t a s d e a l e r s R a n d a ll D o d d 1 1 3 o r m a r k e t m a k e r s t h r o u g h o u t t h e t r a d i n g d a y . L i k e w i s e i n t h e O T C c a s h m a r k e t f o r U S T r e a s u r y s e c u r i t i e s , p r i m a r y d e a l e r s a r e r e q u i r e d t o a c t a s m a r k e t m a k e r s t h r o u g h o u t t h e t r a d i n g d a y . T h o s e m a r k e t s h a v e p r o v e n t o b e s o m e o f t h e m o s t e f f i c i e n t a n d m o s t l i q u i d i n t h e w o r l d , a n d s o t h i s s u p p o r t i n g m a r k e t r u l e h a s a l r e a d y p r o v e n i t s m e r i t . Antifraud and antimanipulation authority • S t r i c t l y p r o h i b i t f r a u d o n t h e m a r k e t a n d t h e m a n i p u l a t i o n o f m a r k e t p r i c e s a n d m a k e t r a n s g r e s s i o n s s u b j e c t t o c i v i l a n d c r i m i n a l p e n a l t i e s . I n o r d e r t o p r o t e c t t h e i n t e g r i t y o f m a r k e t p r i c e s s o t h a t t h e y w i l l e n c o u r a g e t h e w i d e s t p o s s i b l e m a r k e t p a r t i c i p a t i o n a n d w i l l n o t s e n d d i s t o r t i n g s i g n a l s t h r o u g h o u t t h e e c o n o m y , f r a u d a n d m a n i p u l a t i o n s h o u l d b e s t r i c t l y p r o ­ h i b i t e d a n d m a d e p u n i s h a b l e b y c i v i l a n d c r i m i n a l l a w . • R e q u i r e r e p o r t s o f l a r g e t r a d e r s p o s i t i o n s . D e r i v a t i v e d e a l e r s a n d e x c h a n g e s w o u l d h a v e t o r e p o r t e a c h e n t i t y t h a t r e a c h e s a c e r t a i n p o s i t i o n a l s i z e i n t h e m a r k e t . T h i s i n f o r m a t i o n w o u l d b e c o m p i l e d a c r o s s m a r k e t s i n o r d e r t o d e t e c t a n d d e t e r m a r k e t m a n i p u l a t i o n . S u c h l a r g e t r a d e r r e p o r t i n g d a t a h a s p r o v e n v e r y u s e f u l t o t h e U S C o m m o d i t y F u t u r e s T r a d i n g C o m m i s s i o n i n t e r m s o f m a r k e t s u r v e i l l a n c e . • E x t e n d t h e k n o w t h y c u s t o m e r r u l e t o a l l f i n a n c i a l i n s t i t u t i o n s t h a t e n g a g e i n l e n d i n g , u n d e r w r i t i n g , r e p u r c h a s e a g r e e m e n t t r a n s a c t i o n s a n d s e c u r i t i e s l e n d i n g t r a n s a c t i o n s , a n d t o a l l d e r i v a t i v e t r a n s a c t i o n s w i t h e n t i t i e s i n d e v e l o p i n g c o u n t r i e s . T h i s p r o v i s i o n w o u l d d i s c o u r a g e f i n a n c i a l s h a r p s t e r s f r o m b l o w i n g u p t h e i r c u s t o m e r s . F o r e x a m p l e , c e r t a i n s t r u c t u r e d s e c u r i t i e s ( f o r i n s t a n c e p r i n c i p a l e x c h a n g e - r a t e - l i n k e d n o t e s , o r P E R L s ) s e r v e d n o p o s i t i v e p u r p o s e f o r E a s t A s i a n i n v e s t o r s a n d w e r e p r i m a r i l y a s t e a l t h v e h i c l e f o r f i n a n c i a l i n s t i t u t i o n s i n d e v e l o p e d c o u n t r i e s t o a c q u i r e l o n g - d a t e d s h o r t p o s i t i o n s i n d e v e l o p i n g c o u n t r i e s c u r r e n c i e s . 20 T h i s p r o v i s i o n a l r e a d y e x i s t s i n U S s e c u r i t i e s m a r k e t s a n d a c o m p a r a b l e m e a s u r e e x i s t s f o r U S b a n k i n g m a r k e t s . I t s h o u l d b e e x t e n d e d t o d e r i v a t i v e m a r k e t s , w h e r e t h e r e i s e v e n g r e a t e r c o n c e r n w i t h t h e l a r g e d i f f e r e n c e s b e t w e e n m a r k e t p a r t i c i p a n t s i n r e s p e c t o f d e g r e e o f f i n a n c i a l s o p h i s t i c a t i o n . Developed countries: capital and collateral requirements Capital requirements • U p d a t e t h e c a p i t a l r e q u i r e m e n t s f o r a l l f i n a n c i a l i n s t i t u t i o n s , i n c l u d i n g d e r i v a t i v e d e a l e r s t h a t m i g h t n o t o t h e r w i s e b e r e g i s t e r e d a s f i n a n c i a l i n s t i ­ t u t i o n s , s o t h a t t h e c a p i t a l i s h e l d i n a n a m o u n t t h a t i s c o m m e n s u r a t e n o t o n l y w i t h t h e e x p o s u r e t o c r e d i t l o s s , b u t a l s o w i t h p o t e n t i a l f u t u r e e x p o s u r e a n d t h e v a l u e a t r i s k . 1 1 4 D e riva tives , C a p ita l F low s a n d P ru d e n tia l R egu la tion T h i s p r o v i s i o n i s b e g i n n i n g t o b e a p p l i e d i n s o m e f i n a n c i a l s p h e r e s i n d e v e l ­ o p e d c o u n t r i e s , f o r e x a m p l e t h e U S S e c u r i t i e s a n d E x c h a n g e C o m m i s s i o n h a s a d o p t e d i t f o r d e r i v a t i v e d e a l e r s r e g i s t e r e d u n d e r r u l e s k n o w n a s B r o k e r - D e a l e r L i t e . C a p i t a l s e r v e s t w o f u n c t i o n s : i t a c t s a s a b u f f e r w h e n a f i r m s u f f e r s f r o m a n a d v e r s e e v e n t ; a n d i t l i m i t s t h e e x t e n t o f a f i r m s r i s k - t a k i n g i n t h a t t h e c a p i t a l r e q u i r e m e n t i s s t r u c t u r e d t o b e p r o p o r t i o n a l t o r i s k e x p o s u r e . C a p i t a l r e q u i r e m e n t s a r e e s s e n t i a l i n p r e v e n t i n g p r o b l e m s a t o n e f i r m f r o m b e c o m i n g p r o b l e m s a t o t h e r f i r m s . T h i s i s e s p e c i a l l y i m p o r t a n t f o r d e a l e r s i n f i n a n c i a l m a r k e t s b e c a u s e t h e i r f a i l u r e c a n l e a d t o m a r k e t p r o b l e m s s u c h a s i l l i q u i d i t y ( m a r k e t f r e e z e - u p ) o r m e l t d o w n . Collateral requirements • R e q u i r e a d e q u a t e a n d a p p r o p r i a t e c o l l a t e r a l o r m a r g i n t o b e p o s t e d a n d m a i n t a i n e d o n a l l d e r i v a t i v e t r a n s a c t i o n s . 21 C o l l a t e r a l ( m a r g i n ) o n t r a n s a c t i o n s f u n c t i o n s i n t h e s a m e w a y a s c a p i t a l d o e s f o r f i n a n c i a l i n s t i t u t i o n s . I t h e l p s t o p r e v e n t p r o b l e m s a t o n e f i r m o r w i t h o n e t r a n s a c t i o n f r o m c a u s i n g p e r f o r m a n c e p r o b l e m s f o r o t h e r t r a n s ­ a c t i o n s a n d o t h e r f i r m s . I n d o i n g s o i t r e d u c e s t h e l i k e l i h o o d o f d e f a u l t o r o t h e r c r e d i t - r e l a t e d l o s s e s , a n d i t r e d u c e s t h e m a r k e t s v u l n e r a b i l i t y t o a f r e e z e - u p o r m e l t d o w n . T h e c u r r e n t m a r k e t p r a c t i c e s i n r e s p e c t o f c o l l a t e r a l a r e f a r f r o m a d e q u a t e . O n e p a r t i c u l a r l y d a n g e r o u s p r a c t i c e i s t o r e q u i r e a s m a l l i n i t i a l c o l l a t e r a l l e v e l , b u t t h e n t o r e q u i r e a f i r m t o b e c o m e s u p e r - m a r g i n e d i f i t s c r e d i t r a t i n g d r o p s . T h i s c a u s e s a l a r g e i n c r e a s e i n t h e n e e d f o r c o l l a t e r a l p r e c i s e l y w h e n t h e f i r m i s e x p e r i e n c i n g p r o b l e m s w i t h i n a d e q u a t e c a p i t a l . I n e f f e c t i t a c t s a s a c r i s i s a c c e l e r a t o r . Developing countries: registration, reporting, transparency and liquidity Additional registration and reporting requirements • R e p o r t i n g a n d r e g i s t r a t i o n r e q u i r e m e n t s f o r d e r i v a t i v e d e a l e r s a n d d e r i v a ­ t i v e p a r t i c i p a n t s i n d e v e l o p i n g c o u n t r i e s s h o u l d b e t h e s a m e a s t h o s e i n d e v e l o p e d c o u n t r i e s . P r e v e n t i n g f r a u d a n d m a i n t a i n i n g a t r a n s p a r e n t m a r k e t e n v i r o n m e n t a r e n o l e s s i m p o r t a n t i n d e v e l o p i n g e c o n o m i e s t h a n i n d e v e l o p e d o n e s . T h e n e e d t o m a i n t a i n r e p o r t i n g a n d r e g i s t r a t i o n r e q u i r e m e n t s i s t h e r e f o r e j u s t a s g r e a t . T h e c o s t o f a d m i n i s t e r i n g a n d e n f o r c i n g t h e s e r e q u i r e m e n t s i s n o t s u b s t a n t i a l . T h e a b i l i t y t o e n f o r c e r e p o r t i n g r e q u i r e m e n t s c o u l d b e e n h a n c e d b y s t i p u l a t i n g t h a t a n y d e r i v a t i v e t r a n s a c t i o n t h a t w a s n o t r e p o r t e d c o u l d n o t b e p u t b e f o r e t h e c o u r t f o r l e g a l e n f o r c e a b i l i t y o r a b a n k r u p t c y c l a i m . R a n d a ll D o d d 1 1 5 T h i s p r o v i s i o n w o u l d e n c o u r a g e d e r i v a t i v e c o u n t e r p a r t i e s t o c o m p l y w i t h r e p o r t i n g r e q u i r e m e n t s i n o r d e r t o p r o t e c t t h e i r c o n t r a c t u a l i n t e r e s t s . O t h e r ­ w i s e i t w o u l d a m o u n t t o g i v i n g a c o u n t e r p a r t y a n o p t i o n l e g a l l y t o a b r o g a t e t h e o b l i g a t i o n s o f t h e c o n t r a c t . Developing countries: capital and collateral requirements Capital requirements in addition to those for developed countries listed above • L i m i t e x p o s u r e t o f o r e i g n e x c h a n g e r a t e s , i n t e r e s t r a t e s a n d o t h e r m a r k e t p r i c e f l u c t u a t i o n s t o a p e r c e n t a g e o f c a p i t a l . T h e s e l i m i t a t i o n s c o u l d b e f i g u r e d a s p e r c e n t a g e o f c a p i t a l a n d b e a u g m e n t e d b y a n a b s o l u t e l i m i t . T h e l i m i t a t i o n s h o u l d a p p l y t o a c o n s o l i d a t e d b a l a n c e s h e e t a n d o f f - b a l a n c e s h e e t m e a s u r e o f e x p o s u r e . T h e l i m i t s c o u l d b e m a d e t i g h t e r f o r h i g h e r d e g r e e s o f e x c h a n g e r a t e m a n a g e m e n t . E x a m p l e s o f p o s i t i o n o r e x p o s u r e l i m i t s a l r e a d y e x i s t o n U S d e r i v a t i v e e x c h a n g e s . T h e s e r e s t r i c t i o n s a m o u n t t o e x p l i c i t l i m i t a t i o n s o n r i s k t a k i n g , b u t n o t h e d g i n g . T h i s m e a s u r e c a n b e v e r y e f f e c t i v e i n l i m i t i n g t h e a m o u n t o f c a r r y t r a d e o r h o t m o n e y r e l a t e d t r a n s a c t i o n s b e c a u s e t h e y r e s u l t i n e x c h a n g e r a t e e x p o s u r e a n d s o m e t i m e s i n t e r e s t r a t e e x p o s u r e . H e n c e t h e m e a s u r e d i s e n c o u r a g e s l e v e r a g e d e x p o s u r e t o d e v a l u a t i o n o r d e p r e c i a t i o n , a n d e n c o u r a g e s ; l o n g - t e r m o r m o r e d i v e r s i f i e d i n v e s t m e n t . • L i m i t t h e m i s m a t c h i n g o f m a t u r i t y o n a s s e t s a n d l i a b i l i t i e s . A n o t h e r s o u r c e o f f i n a n c i a l v u l n e r a b i l i t y t h a t c a n p l a g u e d e v e l o p i n g c o u n ­ t r i e s m o r e t h a n t h e i r w e a l t h i e r d e v e l o p e d n e i g h b o u r s i s t h e r i s k a s s o c i a t e d w i t h m i s m a t c h i n g t h e m a t u r i t y o f a s s e t s a n d l i a b i l i t i e s . N o t o n l y i s t h e r e a n i n t e r e s t r a t e r i s k f r o m c h a n g e s i n t h e l e v e l a n d s l o p e o f t h e y i e l d c u r v e , b u t t h e r e i s a l s o a l i q u i d i t y o r r e f u n d i n g r i s k i n h e r e n t i n n o t b e i n g a b l e t o r o l l - o v e r o r r e n e w l o a n s . Collateral requirements • T h e c o l l a t e r a l r e q u i r e m e n t s f o r d e r i v a t i v e d e a l e r s a n d o t h e r d e r i v a t i v e p a r t i c i p a n t s i n d e v e l o p i n g c o u n t r i e s s h o u l d b e t h e s a m e a s t h o s e i n d e v e l ­ o p e d c o u n t r i e s . C o l l a t e r a l r e q u i r e m e n t s a r e n o l e s s i m p o r t a n t f o r f i n a n c i a l m a r k e t s i n d e v e l ­ o p i n g e c o n o m i e s t h a n f o r t h o s e i n d e v e l o p e d e c o n o m i e s . T h e a p p r o p r i a t e l e v e l o f c o l l a t e r a l s h o u l d b e s u f f i c i e n t l y h i g h t o p r o v i d e a s a f e a n d s o u n d f o u n d a t i o n f o r m a r k e t t r a n s a c t i o n s , b u t n o t s o h i g h t h a t t h e u s e o f r i s k m a n a g e m e n t t o o l s w o u l d b e d i s c o u r a g e d b y t h e i r l a c k o f a f f o r d a b i l i t y . D e v e l o p i n g c o u n t r i e s h a v e a d d i t i o n a l r e a s o n s t o m a i n t a i n e v e n s t r o n g e r c o l l a t e r a l r e q u i r e m e n t s . T h e y n e e d t o e s t a b l i s h a r e p u t a t i o n f o r m a r k e t s a f e t y a n d s o u n d n e s s . B e c a u s e t h e y t e n d t o s u f f e r m o r e t h a n w e a l t h y c o u n t r i e s w h e n f i n a n c i a l s e c t o r d i s r u p t i o n s o c c u r , t h e y r e q u i r e a g r e a t e r b u f f e r a g a i n s t 1 1 6 D eriv a tiv e s , C a p ita l F low s a n d P ru d e n tia l R egu la tion s u c h d i s r u p t i o n s . I n a d d i t i o n , b y r a i s i n g t h e c o s t o f r i s k t a k i n g , r e l a t i v e l y h i g h e r c o l l a t e r a l r e q u i r e m e n t s w i l l s e r v e t o d i s c o u r a g e e x c e s s i v e r i s k t a k i n g . T h e a b o v e p r u d e n t i a l r e g u l a t i o n s s h o u l d a p p l y t o d e v e l o p e d a n d d e v e l o p i n g c o u n t r i e s a l i k e a n d t h e r e s p o n s i b i l i t y o f m a k i n g t h e c h a n g e s h o u l d b e s h a r e d . B u r d e n s h a r i n g w o u l d a p p l y n o t j u s t t o d e b t f o r g i v e n e s s o r d e b t w o r k - o u t s , b u t a l s o t o t h e s h a r i n g o f r i s k s . T h i s f o l l o w s f r o m t h e b a s i c i n s i g h t t h a t d e v e l o p e d c o u n t r i e s h a v e h a d m o r e y e a r s o f e x p e r i e n c e i n r e g u l a t i n g t h e i r f i n a n c i a l m a r k e t s , a n d t h e b e n e f i c i a l w i s d o m o f t h i s e x p e r i e n c e s h o u l d b e s h a r e d . I t w o u l d n o t b e a o n e - w a y p r o c e s s b e c a u s e a m i r r o r c o u l d b e h e l d u p t o d e v e l o p e d c o u n t r i e s i f t h e y p u s h e d f o r c h a n g e s i n d e v e l o p i n g c o u n t r i e s t h a t w e r e i n c o n s i s t e n t w i t h w h a t w a s a c t u a l l y p r a c t i s e d a t h o m e . A f t e r a l l t h e U S f i n a n c i a l m a r k e t s - w i t h t h e e x c e p t i o n o f O T C d e r i v a t i v e m a r k e t s - a r e c l o s e l y r e g u l a t e d a n d s o t h e W a s h i n g t o n C o n s e n s u s f o r a l i b e r a l i z e d , f r e e - m a r k e t a p p r o a c h t o d e v e l o p i n g c o u n t r i e s f i n a n c i a l m a r k e t s a m o u n t s t o a d v o c a t i n g d o a s w e s a y , n o t a s w e d o . T h e a d v o c a t e d r e g u l a t i o n s w o u l d h o l d b o t h s i d e s a c c o u n t a b l e i n t h e i r o w n w a y . Notes 1. The term vehicle refers to the form in which capital is raised and traded: bank loans, bonds (including local currency, major currency and structured notes), equities and foreign direct investment. 2. The term derivative is used in the most generic sense to mean a contract that is used to create price exposure by having its price derived from that of an under­ lying commodity, security, rate, index or event. It also creates leverage and does not generally require the transfer of title or principal. Examples of derivatives are futures, options, forwards, swaps and the derivative component of hybrid instruments such as structured notes. 3. A repurchase is similar to a foreign exchange swap in that it includes an obligation first to purchase (sell) and then to sell (purchase) a security at agreed-upon prices. A securities loan is comparable but is treated as a loan on which collateral is posted and rent is paid instead of a matching set of transactions. 4. An excellent discussion of the traditional role of the banking sector can be found in Ron Chernow (1997). 5. The term bond will be used here for the broad class of credit instmments that are also known as notes, debentures and paper. 6. A discussion of how securities markets surpassed the traditional banking business can be found in Lowell and Farrell (1996). 7. Major currency refers to the US dollar, the euro, the yen or the pound sterling, which are the currencies most likely to be used to denominate loans and securities issued by developing countries. 8. A cross-default clause in a loan contract means that a default by a borrower against any one lender is considered a default against all lenders. 9. The term market risk refers to a set of all investment risks except credit risk and settlement risk. Market risk includes price risk, interest rate risk and exchange rate risk. R a n d a ll D o d d 1 1 7 10. Volatility is less in comparison with local currency securities, whose risk is the product of both foreign exchange risk and security price risk. 11. Data from Swaps Monitor (Spraus, 1999) and the US Treasurys Controller of the Currency. 12. A bid is the price at which the dealer is willing to buy, and the ask or offer is the price at which the dealer is willing to sell. 13. If investors seek to acquire mostly long local currency positions, then the deriva­ tive dealer will do the opposite and this will create a capital inflow. 14. Similarly the purchase of dollars in the spot market by the dealer is u lti­ mately reversed when the dealer purchases pesos in settlement of the forward contract. 15. It would incur a capital charge only if it were to move into the money. 16. The dealers credit risk - the risk of the counterparty failing to act on the contract - is mitigated by the use of collateral. In addition there may be some basis risk between the TRS and the returns on the actual security. 17. This is not to say that there is no economic value to a political or policy event. 18. These proposals were prepared as part of a presentation by the author to the North-South Institute in Ottawa, October 2001. 19. John Eatwell has expressed serious concern about whether the capital held to meet capital requirements can successfully function as a buffer against such changes (Eatwell, 2001). 20. For descriptions of these structured securities and how they are transacted, see Partnoy (1999) and Dodd (2002). 21. For good background reading on collateral provision in OTC derivative markets in the United States, see Johnson (2002). References Chernow, R. (1997) The Death of the Banker - The Decline and Fall of the Great Financial Dynasties and the Triumph of the Small Investor, New York: Vintage Books. Dalla, I. and D. Khatkate (1996) The Emerging East Asian Bond Market, Finance Development, March, Washington, DC: IMF/World Bank. Dodd, R. (2002) The Role of Derivatives in the East Asian Financial Crisis, in L. Taylor and J. Eatwell (eds), International Capital Markets: Systems in Transition, Oxford: Oxford University Press. Eatwell, J. (2001) The Challenges Facing International Financial Regulation, paper presented to the Western Economic Association, July. Garber, P. (1998) Derivatives in International Capital Flow, NBER Working Paper no. 6623 (June), Cambridge, MA: NBER. and S. Lall (1996) ‘Derivative Products in Exchange Rate Crises, in R. Glick (ed.), Managing Capital Flows and Exchange Rates: Perspectives from the Pacific Basin, New York: Cambridge University Press for the Federal Reserve Bank of San Francisco. International Monetary Fund (IMF) (1999) Involving the Private Sector in Forestalling and Resolving Financial Crises, Washington, DC: IMF. Johnson, C. A. (2002) Over-The-Counter Derivatives: Documentation, New York: Bowne. Lall, S. (1997) Speculative Attacks, Forward Market Intervention and the Classic Bear Squeeze, IMF Working Paper, June, Washington, DC: IMF. Lowell, B. and D. Farrell (1996) Market Unbound - Unleashing Global Capitalism, New York: John Wiley and Sons. 1 1 8 D eriv a tiv e s , C a p ita l F low s a n d P ru d e n tia l R egu la tion Neftci, S. N. (1998) FX Short Positions, Balance Sheets and Financial Turbulence: An Interpretation of the Asian Financial Crisis, CEP A Working Paper no. 11, New York: CEPA, October. Partnoy, F. (1999) F.I.A.S.C.O.: The Inside Story of a Wall Street Trader, New York: Penguin. Spraus, Paul (ed.) (1999) Swaps Monitor, www.swapsmonitor.com. World Bank (2000) Global Development Finance, Washington, DC: World Bank. (2001) World Development Report 2000/2001, Oxford: Oxford University Press. 7Ratings since the Asian Crisis* H e lm u t Reisen In tro d u ctio n I n t e r m s o f f o r e i g n f i n a n c e , t h e s i n g l e m o s t i m p o r t a n t v i s i t o r t o a d e v e l o p i n g c o u n t r y i n t h e 1 9 6 0 s w a s a r e p r e s e n t a t i v e f r o m a W e s t e r n a i d a g e n c y ; i n t h e 1 9 7 0 s i t w a s a c o m m e r c i a l b a n k e r e a g e r t o r e c y c l e O P E C s u r p l u s e s ; a n d i n t h e 1 9 8 0 s i t w a s a n I M F o f f i c i a l . S i n c e t h e n i t h a s b e e n a s o v e r e i g n a n a l y s t f r o m o n e o f t h e l e a d i n g r a t i n g a g e n c i e s : M o o d y s I n v e s t o r S e r v i c e s , S t a n d a r d P o o r o r F i t c h . T h e r i s e i n p r i v a t e c a p i t a l f l o w s a n d t h e s t a g n a t i o n o f c o n c e s s i o n a l f i n a n ­ c i a l a s s i s t a n c e h a s s i g n i f i c a n t l y i n c r e a s e d t h e i n f l u e n c e o f c r e d i t r a t i n g s o n t h e t e r m s ( a n d m a g n i t u d e ) o n w h i c h d e v e l o p i n g c o u n t r i e s c a n t a p w o r l d b o n d m a r k e t s . S i n c e b o n d m a r k e t s a r e e f f e c t i v e l y u n r e g u l a t e d , c r e d i t r a t i n g a g e n c i e s h a v e b e c o m e t h e m a r k e t s de facto r e g u l a t o r s . I n d e e d , u n l i k e i n i n d u s t r i a l c o u n t r i e s , w h e r e c a p i t a l m a r k e t a c c e s s i s u s u a l l y t a k e n f o r g r a n t e d , s o v e r e i g n r a t i n g s a r e v i t a l t o d e v e l o p i n g c o u n t r i e s a s t h e i r a c c e s s t o c a p i t a l m a r k e t s i s p r e c a r i o u s a n d v a r i a b l e . T h e r e c e n t p r o p o s a l b y t h e C o m m i t t e e o n B a n k i n g S u p e r v i s i o n f o r a n e w B a s e l C a p i t a l A c c o r d m a y m e a n e v e n g r e a t e r i m p o r t a n c e f o r c r e d i t r a t i n g s i n t h e f u t u r e ( R e i s e n , 2 0 0 0 , 2 0 0 1 ) . T h e i n c r e a s e d i m p o r t a n c e o f r a t i n g a g e n c i e s f o r e m e r g i n g - m a r k e t f i n a n c e h a s b r o u g h t t h e i r w o r k t o t h e a t t e n t i o n o f a w i d e r g r o u p o f o b s e r v e r s - a n d s u b j e c t e d t h e m t o c r i t i c i s m . T h e M e x i c a n c r i s i s o f 1 9 9 4 - 9 5 r e v e a l e d t h a t c r e d i t r a t i n g a g e n c i e s , l i k e a l m o s t e v e r y b o d y e l s e , w e r e r e a c t i n g t o e v e n t s r a t h e r t h a n a n t i c i p a t i n g t h e m , a n o b s e r v a t i o n r e i n f o r c e d b y r a t i n g p e r f o r m a n c e s b e f o r e a n d d u r i n g t h e A s i a n c r i s i s ( R e i s e n a n d v o n M a l t z a n , 1 9 9 9 ) . R a t i n g a g e n c i e s w e r e a c c u s e d ( f o r e x a m p l e b y t h e I M F i n 1 9 9 9 ) o f b e i n g g u i d e d b y o u t d a t e d r a t i n g m o d e l s a n d o f i g n o r i n g l i q u i d i t y r i s k s a n d c u r r e n c y c r i s i s v u l n e r a b i l i t i e s . T h e y e v e n a c k n o w l e d g e d t h i s t h e m s e l v e s ( H u h n e , 1 9 9 8 ) . T h i s c h a p t e r a s s e s s e s w h e t h e r t h e i m p o r t a n c e o f r a t i n g s f o r d e v e l o p i n g - c o u n t r y f i n a n c e h a s c h a n g e d a n d w h e t h e r r a t i n g a g e n c i e s h a v e c h a n g e d t h e d e t e r m i n a n t s o f t h e i r r a t i n g d e c i s i o n s . I t a l s o p r o v i d e s a n a n a l y s i s o f r e c e n t s u g g e s t i o n s b y t h e B a s e l C o m m i t t e e o n B a n k i n g S u p e r v i s i o n , a s t h e s e a r e 1 1 9 1 2 0 R atings since the A s ia n C risis v e r y i m p o r t a n t f o r g a u g i n g t h e f u t u r e r o l e o f s o v e r e i g n r a t i n g s f o r f o r e i g n d e b t f i n a n c e i n d e v e l o p i n g c o u n t r i e s . I t t h e n l o o k s a t r a t i n g d e t e r m i n a n t s b e f o r e a n d a f t e r t h e A s i a n c r i s i s t o s e e w h a t h a s c h a n g e d a n d w h e t h e r r a t i n g m o d e l s h a v e m o v e d t o w a r d s i d e n t i f i c a t i o n o f t h e f a c t o r s s t r e s s e d i n t h e l i t e r a t u r e o n c r i s i s v u l n e r a b i l i t y , b e f o r e c o n s i d e r i n g t h e m a r k e t i m p a c t o f r a t i n g e v e n t s , l o o k i n g a g a i n a t c h a n g e s a f t e r t h e o u t b r e a k o f t h e A s i a n c r i s i s . I t t h e n e v a l u a t e s w h e t h e r r e c e n t r e g u l a t o r y e n d e a v o u r s t o s t r e n g t h e n t h e r o l e o f s o v e r e i g n r a t i n g s i n s e t t i n g b a n k s c a p i t a l r e q u i r e m e n t s c a n b e j u s t i f i e d i n l i g h t o f t h e i r r o l e i n b o o m - b u s t c y c l e s i n d e v e l o p i n g - c o u n t r y l e n d i n g . T h e c h a p t e r e n d s w i t h s o m e p o l i c y p r o p o s a l s . S o v ere ig n ra tin g d eterm in a n ts: w h a t h a s ch a n g ed ? O n e o f t h e s t r i k i n g f e a t u r e s o f t h e A s i a n c r i s i s w a s t h e s o - c a l l e d r a t i n g c r i s i s ( J i i t t n e r a n d M c C a r t h y , 2 0 0 0 ) , i n w h i c h t h e r a t i n g s o f t h e a f f e c t e d c o u n t r i e s w e r e s u b s t a n t i a l l y d o w n g r a d e d . K o r e a s r a t i n g , f o r e x a m p l e , f e l l o n a v e r a g e b y t h r e e l e t t e r g r a d e s a n d n i n e r a t i n g n o t c h e s ; s o v e r e i g n r a t i n g c h a n g e s o f t h a t m a g n i t u d e h a d n e v e r b e e n o b s e r v e d b e f o r e , a n d t h e y h a d r a r e l y b e e n o b s e r v e d i n t h e l o n g h i s t o r y o f r a t i n g t r a n s i t i o n s f o r U S c o r p o r a t e b o n d s ( B o n t e etal., 1 9 9 9 ) . T h e r a t i n g i n s t a b i l i t y r e f l e c t e d m o r e t h a n c h a n g e s i n a c o u n t r y s u n d e r l y i n g f u n d a m e n t a l s ; i t a l s o r e f l e c t e d i n s t a b i l i t y o f t h e d e t e r ­ m i n a n t s u n d e r l y i n g s o v e r e i g n r a t i n g s f o r e m e r g i n g m a r k e t s . S o v e r e i g n r i s k r e f l e c t s t h e a b i l i t y a n d w i l l i n g n e s s o f a g o v e r n m e n t i s s u e r t o m e e t i t s f u t u r e d e b t o b l i g a t i o n s . I n t h e a b s e n c e o f b i n d i n g i n t e r n a t i o n a l b a n k r u p t c y l e g i s l a t i o n , c r e d i t o r s h a v e o n l y l i m i t e d l e g a l r e d r e s s a g a i n s t s o v e r e i g n b o r r o w e r s , w h o m a y a l s o d e f a u l t f o r p o l i t i c a l r e a s o n s . B o t h q u a l i ­ t a t i v e a n d q u a n t i t a t i v e f a c t o r s a r e e x a m i n e d t o f o r m a v i e w o f o v e r a l l c r e d i t w o r t h i n e s s . M e a s u r e s o f e c o n o m i c a n d f i n a n c i a l p e r f o r m a n c e a r e u s e d i n t h e q u a n t i t a t i v e a s s e s s m e n t w h i l e p o l i t i c a l d e v e l o p m e n t s , e s p e c i a l l y t h o s e w h i c h b e a r o n f i s c a l f l e x i b i l i t y , f o r m t h e c o r e o f t h e q u a l i t a t i v e e v a l u a t i o n . W h i l e r a t i n g a g e n c i e s p e r i o d i c a l l y u p d a t e t h e l i s t o f t h e n u m e r o u s e c o n o m i c , s o c i a l a n d p o l i t i c a l f a c t o r s t h a t u n d e r l i e t h e i r s o v e r e i g n c r e d i t r a t i n g s , s o m e o f t h e m a r e n o t q u a n t i f i a b l e a n d t h e r e i s l i t t l e g u i d a n c e a b o u t t h e i r r e l a t i v e w e i g h t s . T h e locus classicus f o r q u a n t i t a t i v e e v i d e n c e o n s o v e r e i g n r a t i n g d e t e r m i n ­ a n t s i s C a n t o r a n d P a c k e r ( 1 9 9 6 ) . U s i n g c r o s s - s e c t i o n a l d a t a f o r 4 9 c o u n t r i e s ( S e p t e m b e r 1 9 9 5 ) , t h e a u t h o r s e s t i m a t e d w h i c h q u a n t i t a t i v e i n d i c a t o r s w e i g h e d m o s t h e a v i l y i n t h e d e t e r m i n a t i o n o f s o v e r e i g n r i s k r a t i n g s b y M o o d y s a n d S t a n d a r d P o o r s , a n d t h e i r a v e r a g e r a t i n g s . P e r c a p i t a i n c o m e ( + ) , G D P g r o w t h ( + ) , c o n s u m e r p r i c e i n f l a t i o n ( - ) , f o r e i g n d e b t a s a p e r c e n t a g e o f e x p o r t s ( - ) , a d u m m y f o r l e v e l o f e c o n o m i c d e v e l o p m e n t ( + ) a n d a d u m m y f o r d e f a u l t h i s t o r y ( - ) w e r e g e n e r a l l y s i g n i f i c a n t a n d h a d t h e e x p e c t e d s i g n , w h i l e f i s c a l b a l a n c e ( + ) a n d e x t e r n a l b a l a n c e ( + ) w e r e n o t s i g n i f i c a n t i n t h e a u t h o r s m u l t i p l e r e g r e s s i o n e s t i m a t e s . T h e a d j u s t e d R 2 w a s H e lm u t Reisen 1 2 1 a b o v e 0 . 9 0 f o r a v e r a g e r a t i n g s a s w e l l a s M o o d y s a n d S t a n d a r d P o o r s r a t i n g s . T h e r e s u l t s c o n f i r m t h a t t o a l a r g e e x t e n t s o v e r e i g n r a t i n g s w e r e e x p l a i n e d b y a l i m i t e d n u m b e r o f k e y m a c r o e c o n o m i c v a r i a b l e s b e f o r e t h e A s i a n c r i s i s . S o m e o f t h e r a t i n g d e t e r m i n a n t s i d e n t i f i e d a b o v e , s u c h a s G D P g r o w t h a n d f i s c a l b a l a n c e s , a r e t o a c e r t a i n d e g r e e e n d o g e n o u s t o c a p i t a l i n f l o w s . T o i g n o r e t h e e n d o g e n e i t y o f s u c h r a t i n g d e t e r m i n a n t s r i s k s i n t r o d u c i n g a p r o c y c l i c a l e l e m e n t i n t o t h e r a t i n g p r o c e s s a n d i n t e n s i f y i n g b o o m - b u s t c y c l e s i n e m e r g i n g - m a r k e t l e n d i n g b y u n d e r p i n n i n g t h e b u i l d - u p o f u n s u s ­ t a i n a b l e i n f l o w s w i t h i m p r o v e d s o v e r e i g n r a t i n g s . F u r t h e r m o r e t h e r e s e e m s l i t t l e c o n c e r n f o r t h e a l l o c a t i o n o f f l o w s : t h e d e b t c y c l e h y p o t h e s i s r e q u i r e s i n f l o w s t o b e i n v e s t e d i n t r a d e - r e l a t e d a r e a s a n d m a r g i n a l s a v i n g s r a t e s t o e x c e e d t h e a v e r a g e s a v i n g s r a t e u p o n r e c e i p t o f c a p i t a l i n f l o w s ( F f r e n c h - D a v i s a n d R e i s e n , 1 9 9 8 ) . D u r i n g t h e 1 9 9 0 s t h e p r e c r i s i s r a t i n g d e t e r m i n a n t s i d e n t i f i e d b y C a n t o r a n d P a c k e r h a d l i t t l e i n c o m m o n w i t h t h e d o m e s t i c r o o t s o f t h e f i n a n c i a l c r i s e s ( b a n k i n g , c u r r e n c y a n d d e b t ) i n d e v e l o p i n g c o u n t r i e s ( s e e f o r e x a m p l e R e i s e n , 1 9 9 8 ; G o l d s t e i n , 1 9 9 9 ) : w e a k n a t i o n a l b a n k i n g a n d f i n a n c i a l s y s t e m s , p r e m a t u r e a n d p o o r l y s u p e r v i s e d f i n a n c i a l l i b e r a l i z a t i o n , p o o r p u b l i c a n d p r i v a t e d e b t m a n a g e m e n t , w i t h i n a d e q u a t e l i q u i d i t y d e f e n c e s a g a i n s t s h o c k s , a n d v u l n e r a b l e e x c h a n g e r a t e r e g i m e s . I n o t h e r w o r d s i t s e e m s t h a t s o v e r e i g n r a t i n g s i n t h e p e r i o d l e a d i n g u p t o t h e A s i a n c r i s i s w e r e d r i v e n b y a n o u t ­ d a t e d r a t i n g m o d e l . T a b l e 7 . 1 s h o w s t h a t t h e e x p l a n a t o r y p o w e r o f t h e C a n t o r - P a c k e r m o d e l d e t e r i o r a t e d i n t h i s p e r i o d , p a r t i c u l a r l y i n 1 9 9 8 ( o n e y e a r a f t e r t h e A s i a n c r i s i s b r o k e o u t ) , w i t h t h e a d j u s t e d R 2 d r o p p i n g f r o m o v e r 0 . 9 0 t o 0 . 8 6 f o r M o o d y s a n d 0 . 8 3 f o r S t a n d a r d P o o r . T h e m o d e l d e t e r i o r a t e d d u r i n g 1 9 9 7 d u e t o a s t r u c t u r a l b r e a k ( J i i t t n e r a n d M c C a r t h y , 2 0 0 0 ) , b u t t h e a d d i t i o n o f n e w r a t i n g d e t e r m i n a n t s h a s h e l p e d t o i m p r o v e t h e e x p l a n a t o r y p o w e r . I n a d d i t i o n t o t h e e i g h t d e t e r m i n a n t s u s e d i n t h e C a n t o r - P a c k e r m o d e l , J i i t t n e r a n d M c C a r t h y h a v e a d d e d f i v e r a t i n g d e t e r m i n a n t s f r o m t h e l i t e r a t u r e o n c r i s i s v u l n e r a b i l i t y : Table 7.1 Explanatory power of the conventional determinants of sovereign ratings, 1995-98 (adjusted R2 of Cantor-Packer model) Average rating Moodys rating Standard Poors rating 1995 0.924 0.905 0.926 1996 0.902 0.884 0.902 1997 0.913 0.909 0.893 1998 0.856 0.863 0.834 Sources : C a n to r a n d P a ck er (1 9 9 6 ) ; J i it tn e r a n d M c C a r th y (2 0 0 0 ) . 1 2 2 R atings since the A s ia n C ris is • S h o r t - t e r m i n t e r e s t r a t e d i f f e r e n t i a l s vis-à-vis t h e U S a s a p r o x y o f c u r r e n c y r i s k . • A r a n g e ( 1 - 5 ) o f p r o b l e m a t i c a s s e t s a s a p e r c e n t a g e o f G D P ( S t a n d a r d P o o r s a s s e s s m e n t o f b a n k s ) . • T h e e s t i m a t e d c o n t i n g e n t l i a b i l i t y o f t h e f i n a n c i a l s e c t o r a s a p e r c e n t a g e o f G D P . • T h e r o l l i n g , f o u r - y e a r g r o w t h r a t e o f c r e d i t t o t h e p r i v a t e s e c t o r a s a p e r c e n t a g e o f G D P . • T h e p e r c e n t a g e d e v i a t i o n o f t h e r e a l e x c h a n g e r a t e f r o m t h e 1 9 9 0 s a v e r a g e s . F o r e m e r g i n g m a r k e t s , J i i t t n e r a n d M c C a r t h y u s e a v a r i a b l e - s e l e c t i o n p r o ­ c e s s t o i d e n t i f y w h i c h o f t h e t w e l v e v a r i a b l e s h a v e t h e h i g h e s t e x p l a n a t o r y p o w e r f o r s o v e r e i g n r a t i n g s . F o r m i d 1 9 9 8 , c o n s u m e r p r i c e i n f l a t i o n ( - ) , e x t e r n a l d e b t a s a p e r c e n t a g e o f e x p o r t s ( - ) , a d u m m y d e f a u l t h i s t o r y ( - ) , a n d t w o o f t h e n e w v a r i a b l e s - t h e i n t e r e s t r a t e d i f f e r e n t i a l a n d t h e r e a l e x c h a n g e r a t e - e n t e r s i g n i f i c a n t l y i n t o t h e r e g r e s s i o n a s r a t i n g d e t e r m i n a n t s , w i t h a n a d j u s t e d R 2 o f 9 1 . 2 p e r c e n t . N e i t h e r t h e i n t e r e s t r a t e d i f f e r e n t i a l n o r t h e e x c h a n g e r a t e v a r i a b l e w e r e s i g n i f i c a n t d e t e r m i n a n t s o f t h e r a t i n g s i n m i d 1 9 9 7 , i n d i c a t i n g t h a t t h e s e v a r i a b l e s w e r e o v e r l o o k e d b y t h e a g e n c i e s b e f o r e t h e c r i s i s . M o r e o v e r t h e f i n a n c i a l - s e c t o r v a r i a b l e s w e r e n o t r e f l e c t e d i n t h e r a t i n g d i f f e r e n t i a l s i n 1 9 9 7 o r 1 9 9 8 . T h i s i n d i c a t e s t h a t d i f f e r e n c e s b e t w e e n t h e s t r e n g t h / f r a g i l i t y o f t h e f i n a n c i a l s e c t o r s i n e m e r g i n g m a r k e t s w e r e s t i l l n o t e m p h a s i z e d i n r a t i n g d e c i s i o n s a y e a r a f t e r t h e T h a i b a h t p l u n g e d . J i i t t n e r a n d M c C a r t h y ( i b i d . : 2 2 ) c o n c l u d e t h a t t h e r e i s n o s e t m o d e l o r f r a m e w o r k f o r j u d g e m e n t w h i c h i s c a p a b l e o f e x p l a i n i n g t h e v a r i a t i o n s i n t h e a s s i g n m e n t o f s o v e r e i g n r a t i n g s o v e r t i m e . T h e i m p r e s s i o n t h a t - d e s p i t e t h e l e s s o n s f r o m t h e A s i a n c r i s i s - v a r i a b l e s r e l a t i n g t o f i n a n c i a l - s e c t o r s t r e n g t h d o n o t s e e m t o f i g u r e l a r g e l y i n t h e d e t e r m i n a n t s o f s o v e r e i g n r a t i n g s i s s u p p o r t e d b y m o r e r e c e n t r a t i n g d e v e l ­ o p m e n t s i n L a t i n A m e r i c a . W h i l e M e x i c o , w h i c h i s g e n e r a l l y c o n s i d e r e d t o s u f f e r f r o m a w e a k d o m e s t i c b a n k i n g s e c t o r , m o v e d u p t o t h e i n v e s t m e n t - g r a d e r a t i n g l e v e l ( M o o d y s ) , A r g e n t i n a , w h i c h i s o f t e n p r a i s e d f o r t h e s t r e n g t h o f i t s d o m e s t i c f i n a n c i a l s e c t o r , h a s s u f f e r e d s e v e r a l d o w n g r a d e s i n r e c e n t y e a r s . T h e a g e n c i e s j u s t i f i e d t h e s e d i v e r g e n t r a t i n g t r e n d s b y e m p h a s i z i n g r a t h e r c o n v e n t i o n a l i n d i c a t o r s s u c h a s f i s c a l f l e x i b i l i t y a n d e x t e r n a l s o l v e n c y ( G r a n d e s , 2 0 0 1 ) . T h e f i r s t e d i t i o n o f Moodys Country Credit Statistical Handbook ( 2 0 0 1 a ) l i s t s t h e q u a n t i t a t i v e m e a s u r e s i n c l u d e d i n i t s s o v e r e i g n r a t i n g d e c i s i o n s . T h e a g e n c y a c k n o w l e d g e s t h a t T h e r e l e v a n c e o f s p e c i f i c e c o n o m i c a n d f i n a n c i a l v a r i a b l e s c a n v a r y a c c o r d i n g t o t h e b r o a d l e v e l o f d e v e l o p m e n t o f c o u n t r i e s F o r e x a m p l e , m o r e d e t a i l o n f i s c a l p o l i c y i n d i c a t o r s i s p r o v i d e d f o r t h e m o r e a d v a n c e d c o u n t r i e s , w h i l e a l a r g e r r a n g e o f i n d i c a t o r s i n t h e e x t e r n a l d e b t a n d H e lm u t Reisen 1 2 3 b a l a n c e - o f - p a y m e n t s a r e a s i s p r o v i d e d f o r t h e d e v e l o p i n g [ e m e r g i n g - m a r k e t ] c o u n t r i e s ( i b i d . : 3 ) . T h e q u a n t i t a t i v e i n d i c a t o r s f a l l i n t o f o u r b r o a d c a t e g o r i e s : • E c o n o m i c s t r u c t u r e a n d p e r f o r m a n c e : i n c l u d e s v a r i o u s m e a s u r e s o f G D P ( g r o w t h ) , i n f l a t i o n , u n e m p l o y m e n t a n d t r a d e . M o o d y s e m p h a s i z e s a m o n g t h e s e G D P g r o w t h ( + ) a n d e x p o r t g r o w t h ( + ) i n t h e h a n d b o o k . • F i s c a l i n d i c a t o r s : g e n e r a l g o v e r n m e n t r e v e n u e , e x p e n d i t u r e , f i n a n c i a l b a l a n c e , p r i m a r y b a l a n c e a n d d e b t a s a p e r c e n t a g e o f G D P . A c c o r d i n g t o M o o d y s , T h e f i s c a l b a l a n c e s a n d d e b t s t o c k s o f t h e v a r i o u s l e v e l s o f g o v e r n m e n t a r e a m o n g t h e m o s t i m p o r t a n t i n d i c a t o r s e x a m i n e d b y s o v e r e i g n r i s k a n a l y s t s . T h e a b i l i t y o f g o v e r n m e n t t o e x t r a c t r e v e n u e s f r o m t h e p o p u l a t i o n o f t a x p a y e r s a n d u s e r s o f s e r v i c e s , t h e e l a s t i c i t y o f r e v e n u e w i t h r e s p e c t t o t h e g r o w t h o r d e c l i n e o f n a t i o n a l i n c o m e , a n d t h e r i g i d i t y o f t h e c o m p o s i t i o n o f g o v e r n m e n t e x p e n d i t u r e s a r e k e y f a c t o r s t h a t d e t e r m i n e w h e t h e r c e n t r a l a n d l o c a l g o v e r n m e n t s w i l l b e a b l e t o m a k e f u l l a n d t i m e l y p a y m e n t s o f i n t e r e s t a n d p r i n c i p a l o n o u t s t a n d i n g d e b t ( i b i d . : 6 ) . • E x t e r n a l p a y m e n t s a n d d e b t : m e a s u r e s f o r t h e r e a l e f f e c t i v e e x c h a n g e r a t e ( p e r c e n t a g e c h a n g e ) , r e l a t i v e u n i t l a b o u r c o s t s ( p e r c e n t a g e c h a n g e ) , c u r r e n t a c c o u n t b a l a n c e ( U S d o l l a r s a n d p e r c e n t a g e o f G D P ) , f o r e i g n c u r r e n c y d e b t ( U S d o l l a r s , p e r c e n t a g e o f G D P a n d p e r c e n t a g e o f e x p o r t s ) , a n d t h e d e b t s e r v i c e r a t i o ( p e r c e n t a g e o f e x p o r t s ) . N o t e w o r t h y h e r e i s M o o d y s s t a t e m e n t t h a t H i s t o r i c a l l y , f o r e i g n c u r r e n c y d e b t h a s b e e n t h e c e n t r a l i n d i c a t o r o f s o v e r e i g n r i s k a n a l y s i s . . . b u t t h a t . . . i s n o t a m e a n i n g f u l c a t e g o r y i n d e v e l o p e d c o u n t r i e s w i t h l o w i n f l a t i o n , h i g h m o n e t a r y c r e d i b i l i t y , a n d d e e p c a p i t a l m a r k e t s a n d / o r u n i v e r s a l b a n k s t h a t a l l o w g o v e r n m e n t s a n d c o r p o r a t i o n s t o b o r r o w l o n g t e r m a t f i x e d r a t e s i n d o m e s ­ t i c c u r r e n c i e s . . . a n a d d i t i o n a l f a c t o r i s d o l l a r i z a t i o n o r e u r o i z a t i o n . I n c o u n t r i e s t h a t a r e e f f e c t i v e l y o p e r a t i n g w i t h o u t a d o m e s t i c c u r r e n c y , t h e b o r d e r l i n e b e t w e e n d o m e s t i c a n d f o r e i g n d e b t b e c o m e s q u i t e f u z z y ( i b i d . : 8 ) . • M o n e t a r y a n d l i q u i d i t y i n d i c a t o r s : i n c l u d e s h o r t - t e r m i n t e r e s t r a t e s ( p e r c e n t ) , d o m e s t i c c r e d i t ( p e r c e n t a g e c h a n g e ) , d o m e s t i c c r e d i t / G D P , M 2 / f o r e i g n e x c h a n g e r e s e r v e s , f o r e i g n e x c h a n g e r e s e r v e s ( U S d o l l a r s ) , s h o r t - t e r m e x t e r n a l d e b t a n d c u r r e n t l y m a t u r i n g l o n g - t e r m e x t e r n a l d e b t / f o r e i g n e x c h a n g e r e s e r v e s , a n d a l i q u i d i t y r a t i o ( e x t e r n a l l i a b i l i t i e s o f b a n k s / e x t e r n a l a s s e t s o f b a n k s . M o o d y s s t i l l s e e m s t o b e r a t h e r l u k e ­ w a r m a b o u t t h e i m p o r t a n c e o f t h e s e i n d i c a t o r s a s i t p r e s e n t s t h e m a s o f u s e i n e v a l u a t i n g a c o u n t r y s v u l n e r a b i l i t y t o a c u r r e n c y o r b a n k i n g c r i s i s ( i b i d . : 9 ) . I t r e f e r s t o e c o n o m e t r i c m o d e l s a s o n l y p a r t i a l l y s u c c e s s f u l , w i t h t h e b e s t o f t h e m o d e l s b e i n g a b l e t o a c c o u n t f o r o n l y s o m e o f t h e a c t u a l c r i s e s t h a t o c c u r r e d a n d p r e d i c t i n g t o o m a n y t h a t d i d n o t ( i b i d . : 1 0 ) . 1 2 4 R atings since the A s ia n C risis I t i s f a i r t o a r g u e t h a t t h e s e t o f i n d i c a t o r s e m p h a s i z e d b y M o o d y s b e t t e r p r e p a r e s i t t o g i v e a d v a n c e w a r n i n g o f f i r s t - g e n e r a t i o n c u r r e n c y c r i s e s ( w h e r e d o m e s t i c m a c r o f u n d a m e n t a l s t r i g g e r a f i n a n c i a l c r i s i s ) t h a n o f s e c o n d - g e n e r a t i o n ( w h e r e i n c o n s i s t e n c i e s b e t w e e n e x t e r n a l a n d i n t e r n a l i m b a l a n c e s m a t t e r ) o r t h i r d - g e n e r a t i o n c r i s e s , i n w h i c h i l l i q u i d i t y a n d f i n a n c i a l - s e c t o r w e a k n e s s e s p l a y a c e n t r a l r o l e . S t a n d a r d P o o r ( f o r e x a m p l e S P , 2 0 0 1 ) s e e m s t o p u t m o r e w e i g h t o n l i q u i d i t y a n d f i n a n c i a l - s e c t o r v a r i a b l e s i n i t s a s s e s s m e n t s ; i t e x p l i c i t l y l i s t s t h e i m p o r t a n c e o f b a n k s a s c o n t i n g e n t l i a b i ­ l i t i e s i n s o v e r e i g n r a t i n g s i n i t s r a t i n g s - m e t h o d o l o g y p r o f i l e . T h e d i f f e r e n c e i n e m p h a s i s o b s e r v e d h e r e - w h i c h c a n o n l y b e c a s u a l - s u g g e s t s t h a t M o o d y s h a s a c o m p a r a t i v e a d v a n t a g e i n d e t e c t i n g c r i s i s v u l n e r a b i l i t y i n A r g e n t i n a , w h i l e S t a n d a r d P o o r i s b e t t e r p r e p a r e d t o w a r n a b o u t T u r k e y s p r o b l e m s . T h i s i s s u p p o r t e d b y t h e r e c e n t c r i s e s i n T u r k e y a n d A r g e n t i n a ( F i g u r e s 7 . 1 a n d 7 . 2 ) . I n F e b r u a r y 2 0 0 1 a n o t h e r e x c h a n g e - r a t e - b a s e d s t a b i l i z a t i o n s c h e m e f a i l e d i n T u r k e y w h e n t h e l i r a p l u n g e d b y m o r e t h a n 3 0 p e r c e n t . A w e a k b a n k i n g s y s t e m , i n a c u t e c r i s i s s i n c e l a t e N o v e m b e r 2 0 0 0 , a n d a n o v e r r e l i a n c e o n h o t m o n e y i n f l o w s h a d m a d e t h e c o u n t r y v u l n e r a b l e t o f i n a n c i a l c r i s i s ( O E C D , 2 0 0 1 ) . T h e c r i s i s w a s a v a r i e t y o f t h e n o w - c l a s s i c t a b l i t a f a i l u r e e x p e r i e n c e d i n t h e S o u t h e r n C o n e o f L a t i n A m e r i c a t w e n t y y e a r s e a r l i e r . Figure 7.1 Turkeys exchange rate and sovereign ratings, 1990-2001 H e lm u t Reisen 1 2 5 Figure 7.2 Argentinas sovereign spreads and ratings, 1990-2001 * E m e rg in g M a rk e ts B o n d I n d e x (A rg e n tin a ) A s s e e n i n F i g u r e 7 . 1 , M o o d y s d o w n g r a d e o n c e a g a i n c a m e o n l y a f t e r t h e c r a s h w h i l e S t a n d a r d P o o r s c a m e s l i g h t l y e a r l i e r . W i t h r e g a r d t o A r g e n t i n a , f r o m a t l e a s t e a r l y 2 0 0 0 A r g e n t i n a s c u r r e n c y b o a r d f a i l e d t o d e l i v e r a s u s t a i n e d r e d u c t i o n i n d e v a l u a t i o n a n d s o v e r e i g n r i s k . T h e r e w e r e t h r e e m a j o r c a u s e s o f t h i s ( B r a g a etal., 2 0 0 1 ) . F i r s t , t h e c u r r e n c y b o a r d h a d c e a s e d t o c o n f e r s u f f i c i e n t f i s c a l d i s c i p l i n e f r o m 1 9 9 5 o n w a r d s . T h i s h a d s e t i n m o t i o n a v i c i o u s c i r c l e o f r i s i n g c o u n t r y r i s k a n d d e p r e s s e d g r o w t h , w h i c h i n t u r n h a d w o r s e n e d t h e p u b l i c d e f i c i t t h r o u g h l o w e r t a x r e c e i p t s a n d h i g h e r d e b t s e r v i c e c o s t s . S e c o n d , i n i t i a l i n f l a t i o n i n e r t i a , w a g e r i g i d i t y a n d a n i n a p p r o p r i a t e a n c h o r c u r r e n c y i m p l i e d e f f e c t i v e o v e r v a l u a t i o n o f t h e p e s o . B u s i n e s s c y c l e s i n t h e U n i t e d S t a t e s ( t o w h i c h j u s t 8 p e r c e n t o f A r g e n t i n a ’s e x p o r t s w e r e d i r e c t e d ) a n d A r g e n t i n a h a d b e e n a s y n c h r o n o u s f o r m u c h o f t h e 1 9 9 0 s , w h i l e B r a z i l s d e v a l u a t i o n i n e a r l y 1 9 9 9 h a d s t r o n g l y w e a k e n e d A r g e n t i n a s c o m p e t i t i v e n e s s . T h i r d , h i g h l i q u i d i t y r e q u i r e m e n t s h a d b e e n i m p o s e d o n t h e c o u n t r y s f i n a n c i a l s y s t e m ( t o m a k e u p f o r t h e l a c k o f t h e l e n d e r - o f - l a s t r e s o r t f u n c t i o n i n a c u r r e n c y b o a r d ) . J u s t l i k e a n y r e s e r v e r e q u i r e m e n t , h i g h l i q u i d i t y n e e d s h a d d r i v e n a s i g n i f i c a n t w e d g e b e t w e e n l e n d i n g r a t e s a n d s a v i n g r a t e s , d i s c o u r a g i n g b o t h s a v i n g s a n d i n v e s t m e n t . T h i s a g a i n , b y c o n s t r a i n i n g g r o w t h a n d f u e l l i n g t h e n e e d f o r f o r e i g n s a v i n g s , h a d l e d t o a g r a d u a l d e t e r i o r a t i o n o f A r g e n t i n a s d e b t d y n a m i c s . A g a i n , r a t i n g a g e n c i e s w e r e f a i r l y l a t e t o g i v e w a r n i n g o f d e t e r i ­ o r a t i n g f u n d a m e n t a l s , b u t t h e y a r g u a b l y p e r f o r m e d b e t t e r t h a n t h e y d i d i n 1 2 6 R atings since the A s ia n C risis t h e c a s e o f T u r k e y a s t h e y d o w n g r a d e d A r g e n t i n a b e f o r e t h e b o n d c r a s h ( t h e p e s o r e m a i n e d f i x e d ) i n 2 0 0 1 ( F i g u r e 7 . 2 ) . T h e m ark et im p a c t o f so v ere ig n ratin gs I n t h e c o n t e x t o f t h e g l o b a l f i n a n c i a l a r c h i t e c t u r e , i t i s i m p o r t a n t t o e x p l o r e t h e m a r k e t i m p a c t o f s o v e r e i g n r a t i n g e v e n t s b e c a u s e r a t i n g s m a y h a v e a n i m p a c t o n b o o m - b u s t c y c l e s i n l e n d i n g t o d e v e l o p i n g c o u n t r i e s . I n p r i n c i p l e , s o v e r e i g n r a t i n g s c o u l d h e l p t o a t t e n u a t e b o o m - b u s t c y c l e s i n e m e r g i n g - m a r k e t l e n d i n g . D u r i n g t h e b o o m , e a r l y r a t i n g d o w n g r a d e s w o u l d h e l p d a m p e n e u p h o r i c e x p e c t a t i o n s a n d r e d u c e p r i v a t e s h o r t - t e r m c a p i t a l f l o w s , w h i c h h a v e r e p e a t e d l y f u e l l e d c r e d i t b o o m s a n d f i n a n c i a l v u l n e r a b i l i t y i n c a p i t a l - i m p o r t i n g c o u n t r i e s . I f s o v e r e i g n r a t i n g s h a d n o m a r k e t i m p a c t t h e y w o u l d b e u n a b l e t o s m o o t h b o o m - b u s t c y c l e s . W o r s e , i f t h e y l a g g e d b e h i n d r a t h e r t h a n l e d f i n a n c i a l m a r k e t s a n d h a d a m a r k e t i m p a c t , i m p r o v e d r a t i n g s w o u l d r e i n f o r c e e u p h o r i c e x p e c t a t i o n s a n d s t i m u l a t e e x c e s s i v e c a p i t a l i n f l o w s d u r i n g t h e b o o m . D u r i n g t h e b u s t , d o w n g r a d i n g m i g h t a d d t o p a n i c a m o n g i n v e s t o r s , d r i v i n g m o n e y o u t o f t h e c o u n t r y a n d f o r c i n g u p s o v e r e i g n y i e l d s p r e a d s . F o r e x a m p l e t h e d o w n g r a d i n g o f A s i a n s o v e r e i g n r a t i n g s t o j u n k s t a t u s r e i n f o r c e d t h e r e g i o n s c r i s i s i n m a n y w a y s : c o m m e r c i a l b a n k s c o u l d n o l o n g e r i s s u e i n t e r n a t i o n a l l e t t e r s o f c r e d i t f o r l o c a l e x p o r t e r s a n d i m p o r t e r s ; i n s t i t u t i o n a l i n v e s t o r s h a d t o o f f l o a d A s i a n a s s e t s a s t h e y w e r e r e q u i r e d t o m a i n t a i n p o r t f o l i o s o n l y i n i n v e s t m e n t - g r a d e s e c u r i t i e s ; a n d f o r e i g n c r e d i t o r s w e r e e n t i t l e d t o c a l l i n l o a n s u p o n t h e d o w n g r a d e s . I f g u i d e d b y o u t d a t e d c r i s i s m o d e l s , s o v e r e i g n r a t i n g s w o u l d f a i l t o p r o v i d e e a r l y w a r n i n g s i g n a l s o f a l i k e l y c u r r e n c y c r i s i s , w h i c h a g a i n m i g h t c a u s e h e r d b e h a v i o u r b y i n v e s t o r s . H o w e v e r , a s f a r a s s o v e r e i g n r a t i n g s a r e c o n c e r n e d t h e r e a r e s e v e r a l r e a s o n s w h y a s i g n i f i c a n t m a r k e t i m p a c t c a n n o t b e e a s i l y e s t a b l i s h e d . F i r s t , s o v e r e i g n r i s k r a t i n g s a r e p r i m a r i l y b a s e d o n p u b l i c l y a v a i l a b l e i n f o r m a t i o n ( L a r r a i n et al., 1 9 9 7 ) , s u c h a s l e v e l s o f f o r e i g n d e b t a n d f o r e i g n e x c h a n g e r e s e r v e s , o r p o l i t i c a l a n d f i s c a l c o n s t r a i n t s . C o n s e q u e n t l y a n y s o v e r e i g n r a t i n g a n n o u n c e m e n t w i l l b e c o n t a m i n a t e d w i t h o t h e r p u b ­ l i c l y a v a i l a b l e n e w s . R a t i n g a n n o u n c e m e n t s m a y b e l a r g e l y a n t i c i p a t e d b y t h e m a r k e t . T h i s d o e s n o t e x c l u d e , h o w e v e r , t h e f a c t t h a t t h e i n t e r p r e t a t i o n o f s u c h n e w s b y t h e r a t i n g a g e n c i e s m a y b e c o n s i d e r e d a n i m p o r t a n t s i g n a l o f c r e d i t w o r t h i n e s s . S e c o n d , i n t h e a b s e n c e o f a c r e d i b l e s u p r a n a t i o n a l m e c h a n i s m t o s a n c t i o n s o v e r e i g n d e f a u l t , t h e d e f a u l t r i s k p r e m i u m - u n l i k e i n n a t i o n a l l e n d i n g r e l a t i o n s h i p s - i s d e t e r m i n e d b y t h e b o r r o w e r s w i l l i n g ­ n e s s r a t h e r t h a n a b i l i t y t o p a y ( E a t o n et ah, 1 9 8 6 ) . A g a i n , i t i s n o t e a s y f o r r a t i n g a g e n c i e s t o a c q u i r e p r i v i l e g e d i n f o r m a t i o n i n t h i s a r e a t h a t c o u l d b e c o n v e y e d t o t h e m a r k e t t h r o u g h r a t i n g s . B y e x a m i n i n g t h e l i n k s b e t w e e n s o v e r e i g n c r e d i t r a t i n g s a n d d o l l a r b o n d y i e l d s p r e a d s , R e i s e n a n d v o n M a l t z a n ( 1 9 9 9 ) a i m e d t o d e t e r m i n e w h e t h e r t h e t h r e e l e a d i n g r a t i n g a g e n c i e s - M o o d y s , S t a n d a r d P o o r a n d F i t c h H e lm u t R eisen 1 2 7 I B C A - c o u l d i n t e n s i f y o r a t t e n u a t e b o o m - b u s t c y c l e s i n e m e r g i n g - m a r k e t l e n d i n g . T h e o b s e r v a t i o n p e r i o d w a s f r o m 1 9 8 9 - w h e n e m e r g i n g - m a r k e t r a t i n g s s t a r t e d t o g a i n m o m e n t u m - t o 1 9 9 7 , t h e y e a r w h e n t h e A s i a n c r i s i s e r u p t e d . T h e a u t h o r s p r o d u c e d a n e v e n t s t u d y e x p l o r i n g t h e m a r k e t r e s p o n s e ( c h a n g e s i n d o l l a r b o n d y i e l d s p r e a d s ) f o r 3 0 t r a d i n g d a y s b e f o r e a n d a f t e r t h e r a t i n g a n n o u n c e m e n t s . T h r e e o f t h e r e s u l t s t h a t e m e r g e d f r o m t h e e v e n t s t u d y d e s e r v e s p e c i a l e m p h a s i s : • W h i l e i n g e n e r a l t h e r a t i n g e v e n t s b y e a c h o f t h e t h r e e l e a d i n g a g e n c i e s d i d n o t p r o d u c e a s t a t i s t i c a l l y s i g n i f i c a n t r e s p o n s e i n s o v e r e i g n y i e l d s p r e a d s , t h e i r a g g r e g a t e d r a t i n g a n n o u n c e m e n t s p r o d u c e d s i g n i f i c a n t e f f e c t s o n y i e l d s p r e a d s i n t h e e x p e c t e d d i r e c t i o n , n o t a b l y o n e m e r g i n g - m a r k e t b o n d s . • R a t i n g d o w n g r a d e s w i d e n e n e d t h e y i e l d s p r e a d s o n e m e r g i n g - m a r k e t b o n d s . W h i l e t h e r i s e i n y i e l d s p r e a d s p r e c e d e d t h e d o w n g r a d e s , i t w a s s u s t a i n e d f o r a n o t h e r 2 0 t r a d i n g d a y s a f t e r t h e r a t i n g e v e n t . • I m m i n e n t r a t i n g u p g r a d e s o f e m e r g i n g - m a r k e t b o n d s w e r e p r e c e d e d b y s i g n i f i c a n t y i e l d c o n v e r g e n c e . S u b s e q u e n t t o t h e r a t i n g e v e n t , h o w e v e r , t h e r e w a s n o s i g n i f i c a n t m a r k e t r e s p o n s e . H o w e v e r , b o t h t h e r a t i n g e v e n t s a n d t h e y i e l d s p r e a d s m a y h a v e b e e n d e t e r m i n e d b y e x o g e n o u s s h o c k s ; t h i s c a l l e d f o r a n a n a l y s i s t h a t w o u l d c o r r e c t t h e y i e l d d e t e r m i n a n t s f o r f u n d a m e n t a l f a c t o r s . R e i s e n a n d v o n M a l t z a n ( 1 9 9 9 ) t h e r e f o r e r a n a G r a n g e r c a u s a l i t y t e s t - c o r r e c t i n g f o r t h e j o i n t d e t e r m i n a n t s o f r a t i n g s a n d y i e l d s p r e a d s - a n d f o u n d t h a t c h a n g e s i n s o v e r e i g n r a t i n g s w e r e i n t e r d e p e n d e n t w i t h c h a n g e s i n b o n d y i e l d s . T h e G r a n g e r t e s t s u g g e s t e d t h a t t h e s o v e r e i g n r a t i n g s b y t h e t h r e e l e a d i n g a g e n c i e s d i d n o t i n d e p e n d e n t l y l e a d t h e m a r k e t , b u t t h a t t h e y w e r e i n t e r d e p e n d e n t w i t h b o n d y i e l d s p r e a d s o n c e t h e r a t i n g s a n d t h e s p r e a d s w e r e c o r r e c t e d f o r f u n d a m e n t a l d e t e r m i n a n t s . W h i l e t h e r e s u l t s s u g g e s t t h a t r a t i n g a n n o u n c e m e n t s a r e s e e n a s a s i g n i f i c a n t s i g n a l o f c r e d i t ­ w o r t h i n e s s , t h e i r i m p a c t m a y b e d u e t o t h e p r u d e n t i a l r e g u l a t i o n a n d i n t e r n a l g u i d e l i n e s t o w h i c h i n s t i t u t i o n a l i n v e s t o r s a r e s u b j e c t a n d w h i c h d e b a r t h e m f r o m h o l d i n g s e c u r i t i e s b e l o w c e r t a i n r a t i n g c a t e g o r i e s . 1 T h e t w o - w a y c a u s a l i t y b e t w e e n r a t i n g s a n d s p r e a d s o b s e r v e d o v e r t h e p a s t d e c a d e m a y a l s o s u g g e s t t h a t t h e c r i t i c i s m a d v a n c e d a g a i n s t t h e a g e n c i e s i n t h e w a k e o f t h e M e x i c a n a n d A s i a n c u r r e n c y c r i s e s s t i l l h o l d s t r u e w h e n i t i s b a s e d o n m o r e o b s e r v a t i o n s t h a n j u s t t h o s e s u r r o u n d i n g t h e s e p r o m i n e n t c r i s i s e p i s o d e s . W h i l e t h e e v e n t s t u d y s u g g e s t s t h a t r a t i n g a g e n c i e s d o s e e m t o h a v e t h e p o t e n t i a l t o m o d e r a t e t h e b o o m s t h a t p r e c e d e c u r r e n c y c r i s e s , t h e G r a n g e r t e s t s m a y j u s t i f y t h e c o n c e r n t h a t t h i s p o t e n t i a l h a s n o t y e t b e e n p r o d u c t i v e l y e x p l o i t e d b y t h e a g e n c i e s b y i n d e p e n d e n t l y l e a d i n g t h e m a r k e t s w i t h t i m e l y r a t i n g c h a n g e s . A s s e e n i n t h e l a t e s t c r i s e s i n A r g e n t i n a a n d T u r k e y , a n d a s c o n f i r m e d b y m o r e r e c e n t s t u d i e s t h a t s t r e t c h t h e o b s e r v a t i o n 1 2 8 R atings since the A s ia n C risis p e r i o d b e y o n d 1 9 9 7 t o 2 0 0 0 ( K a m i n s k y a n d S c h m u k l e r , 2 0 0 1 ) , r a t i n g a g e n ­ c i e s c a n s t i l l b e s e e n a s l a t e r a t h e r t h a n e a r l y w a r n i n g s y s t e m s . B u t a r e t h e y g u i l t y b e y o n d r e a s o n a b l e d o u b t ? A c c o r d i n g t o M o r a ( 2 0 0 1 ) , t h e a n s w e r i s n o . H e r f i n d i n g s c o n f i r m t h a t r a t i n g s m o v e i n a p r o c y c l i c a l w a y , b u t t h a t t h e c a u s a l e f f e c t o f s o v e r e i g n r a t i n g s o n b o t h t h e h i g h e r c o s t o f b o r r o w i n g a n d c a p i t a l - f l o w r e v e r s a l s r e m a i n a m b i g u o u s a f t e r c o n t r o l l i n g f o r m a c r o e c o n o m i c v a r i a b l e s a n d l a g g e d s p r e a d s ( a v a r i a b l e t h a t s t a n d s f o r t h e p a s s i v e r e s p o n s e o f s o v e r e i g n r a t i n g s t o c h a n g e s i n m a r k e t s e n t i m e n t ) . M o r a ( 2 0 0 1 ) h a s a n o t h e r p u z z l i n g f i n d i n g : h i g h e r r a t i n g l e v e l s m e a n a h i g h e r p r o b a b i l i t y o f c u r r e n c y c r a s h e s o n c e o t h e r f a c t o r s a r e c o n t r o l l e d f o r . T h i s f i n d i n g i s e x p l a i n e d b y t h e a m o u n t o f c a p i t a l f l o w s t h a t c o u n t r i e s w i t h b e t t e r r a t i n g s c a n o b t a i n a n d t h a t m a k e t h e m m o r e v u l n e r a b l e t o c a p i t a l f l o w r e v e r s a l s . W h a t a b o u t t h e f u t u r e m a r k e t i m p a c t o f s o v e r e i g n r a t i n g s ? I n a r e c e n t r e v i s i o n t o i t s c o u n t r y c e i l i n g p o l i c y , M o o d y s ( 2 0 0 1 b ) a n n o u n c e d t h a t i t w o u l d a l l o w c e r t a i n b o r r o w e r s t o p i e r c e t h e c o u n t r y c e i l i n g , t h a t i s , t o o b t a i n b e t t e r r a t i n g s t h a n t h e f o r e i g n c u r r e n c y b o n d s o f t h e g o v e r n m e n t i n t h e i r r e s p e c t i v e d o m i c i l e s . T h e t r a d i t i o n a l r a t i o n a l e f o r c o u n t r y c e i l i n g s h a s b e e n t h a t g o v e r n m e n t s c o n f r o n t e d b y a n e x t e r n a l p a y m e n t s c r i s i s h a v e t h e p o w e r a n d m o t i v a t i o n t o l i m i t f o r e i g n c u r r e n c y o u t f l o w s , i n c l u d i n g d e b t p a y m e n t s . A s s o v e r e i g n r a t i n g s s e r v e a s a c e i l i n g f o r t h e p r i v a t e s e c t o r r a t i n g s o f a n y g i v e n c o u n t r y , t h e i r i n f l u e n c e s t r e t c h e s f a r b e y o n d g o v e r n m e n t s e c u r ­ i t i e s . S e v e r a l m o n t h s e a r l i e r S P ( 2 0 0 0 ) h a d a n n o u n c e d e n h a n c e d r a t i n g s f o r p r i v a t e s e c t o r i s s u e r s f r o m s u b i n v e s t m e n t g r a d e c o u n t r i e s i f t r a n s f e r a n d c o n v e r t i b i l i t y i n s u r a n c e w a s u t i l i z e d . P o i n t i n g t o r e c e n t e x a m p l e s o f d e f a u l t o n g o v e r n m e n t d e b t - n o t a b l y E c u a d o r , P a k i s t a n , R u s s i a a n d U k r a i n e - M o o d y s ( 2 0 0 1 b : 1 ) c o n s i d e r e d t h a t T a r g e , i n t e r n a t i o n a l l y r e c o g n i z e d e n t i t i e s t h a t h a v e r e l i e d s i g n i f i c a n t l y o n a c c e s s t o i n t e r n a t i o n a l c a p i t a l m a r k e t s a n d w h o s e d e f a u l t w o u l d i n f l i c t s u b s t a n t i a l d a m a g e o n t h e e c o n o m y w e r e b e i n g a l l o w e d t o s e r v i c e f o r e i g n c u r r e n c y d e b t . C o n s e q u e n t l y i n J u n e 2 0 0 1 t h e a g e n c y p l a c e d 3 8 e n e r g y c o m p a n i e s , f i n a n c i a l i n s t i t u t i o n s a n d t e l e c o m m u n i c a t i o n s c o m p a n i e s i n e m e r g i n g m a r k e t s , m a n y i n B r a z i l a n d M e x i c o , o n r e v i e w f o r u p g r a d e . T h e c h a n g e i n t h e c o u n t r y c e i l i n g a p p r o a c h s h o u l d n o t o n l y a l l o w t h e r a t i n g s o f p r i v a t e s e c t o r d e b t o r s t o e x c e e d t h e i r c o u n t r y c e i l i n g s , b u t s h o u l d a l s o d i m i n i s h t h e m a r k e t i m p a c t o f s o v e r e i g n r a t i n g e v e n t s a s f e w e r b o r r o w e r s w i l l b e i m m e d i a t e l y c o n c e r n e d b y t h e m . I n d i c a t o r s o f c r e d i t r a t i n g p r e s s u r e a s i n s t r u m e n t s f o r t r a d i n g e m e r g i n g - m a r k e t b o n d s , s u c h a s t h o s e d e v e l o p e d b y D e u t s c h e B a n k ( 2 0 0 0 ) , m a y i n c r e a s e a n t i c i p a t i o n a n d h e n c e r e d u c e t h e m e a s u r e d m a r k e t i m p a c t o f r a t i n g e v e n t s . R a t i n g a c t i o n s a r e d e l i v e r e d i n a d i s c r e t e a n d , a s d o c u m e n t e d a b o v e , l a t e f a s h i o n w h i l e c r e d i t f u n d a m e n t a l s m o v e c o n t i n u o u s l y . Y e t r a t i n g e v e n t s h a v e a n i m p a c t o n s p r e a d s a n d t h i s c a n b e e x p l o i t e d b y b o n d t r a d e r s . R e f e r r i n g t o L a r r a i n et al. ( 1 9 9 7 ) a n d R e i s e n a n d v o n M a l t z a n ( 1 9 9 9 ) , H e lm u t Reisen 1 2 9 D e u t s c h e B a n k h a s b u i l t a r e g r e s s i o n m o d e l t o e x p l a i n c r e d i t r a t i n g s a n d c a l i b r a t e d t w e l v e - m o n t h f o r e c a s t s t o a r r i v e a t a c u r r e n t f i t t e d r a t i n g . R a t i n g p r e s s u r e i s d e f i n e d a s t h e d i f f e r e n c e b e t w e e n t h e f i t t e d a n d t h e a c t u a l r a t i n g f o r a g i v e n c o u n t r y . L o n g a n d s h o r t p o s i t i o n s c a n t h e n b e e n g a g e d a c c o r d i n g t o w h e t h e r t h e r a t i n g p r e s s u r e i n d i c a t o r i s p o s i t i v e o r n e g a t i v e . W h e n t h e r a t i n g a c t i o n f i n a l l y h i t s t h e m a r k e t , t h e s e i n v e s t m e n t b e t s c a n b e d i s s o l v e d ( s e l l t h e n e w s ) , w h i c h c a n t r i g g e r p e r v e r s e , m e a s u r e d m a r k e t r e s p o n s e s t o r a t i n g c h a n g e s . A s D e u t s c h e B a n k ( 2 0 0 0 ) c l a i m s t o h a v e p r o f i t a b l y u s e d i n d i c a t o r s o f r a t i n g p r e s s u r e f o r i t s t r a d i n g s t r a t e g i e s , o t h e r i n v e s t o r s m a y h a v e s t a r t e d t o p l a y r a t i n g e v e n t s i n t h e s a m e w a y . R ev ision s to th e B asel A ccord a n d so v e r e ig n ra tin gs T h e B a s e l C o m m i t t e e o n B a n k i n g S u p e r v i s i o n h a s r e l e a s e d t w o c o n s u l t a t i v e p a p e r s o n a N e w B a s e l C a p i t a l A c c o r d ( B a s e l C o m m i t t e e , 1 9 9 9 , 2 0 0 1 ) , w h i c h a i m s t o s e t a s t a n d a r d f o r r e g u l a t o r y b a n k c a p i t a l p r o v i s i o n . I t i s i n t e n d e d t o g r a n t r a t i n g a g e n c i e s a n e x p l i c i t r o l e i n t h e d e t e r m i n a t i o n o f t h e r i s k w e i g h t s a p p l i e d t o m i n i m u m c a p i t a l c h a r g e s a g a i n s t d i f f e r e n t c a t e g o r i e s o f b o r r o w e r . R i s k w e i g h t s d e t e r m i n e b a n k s l o a n s u p p l y a n d f u n d i n g c o s t s , a s t h e y h a v e t o a c q u i r e a c o r r e s p o n d i n g a m o u n t o f c a p i t a l r e l a t i v e t o t h e i r r i s k - w e i g h t e d a s s e t s . I t i s w i d e l y a g r e e d t h a t c r o s s - b o r d e r l e n d i n g h a s f a c e d r e g u l a t o r y d i s t o r t i o n s u n d e r t h e 1 9 8 8 B a s e l A c c o r d . M o s t i m p o r t a n t l y , s h o r t - t e r m b a n k l e n d i n g t o e m e r g i n g m a r k e t s h a s b e e n e n c o u r a g e d b y a r e l a t i v e l y l o w 2 0 p e r c e n t r i s k w e i g h t , w h i l e b a n k c r e d i t t o n o n - O E C D b a n k s w i t h a r e s i d u a l m a t u r i t y o f o v e r o n e y e a r h a s b e e n d i s c o u r a g e d b y a 1 0 0 p e r c e n t r i s k w e i g h t . T h i s h a s s t i m u l a t e d c r o s s - b o r d e r i n t e r b a n k l e n d i n g , w h i c h h a s b e e n d e s c r i b e d a s t h e A c h i l l e s h e e l o f t h e i n t e r n a t i o n a l f i n a n c i a l s y s t e m . O E C D - b a s e d b a n k s a n d g o v e r n m e n t s h a v e r e c e i v e d m o r e l e n i e n t t r e a t m e n t , e v e n i f t h e i r s o v e r e i g n r i s k s a r e e q u i v a l e n t t o o r w o r s e t h a n t h o s e o f n o n - O E C D e m e r g i n g m a r k e t s . H e n c e a r e f o r m o f t h e B a s e l A c c o r d s h o u l d b e w e l c o m e . W h i l e t h e p r o p o s e d r e v i s i o n s o f t h e B a s e l A c c o r d o n c a p i t a l a d e q u a c y w i l l m a i n t a i n t h e 8 p e r c e n t r i s k - w e i g h t e d c a p i t a l r e q u i r e m e n t , t h e B a s e l C o m m i t t e e i n i t i a l l y p r o p o s e d a r e v i s i o n o f t h e c a l c u l a t i o n o f r i s k w e i g h t ­ i n g s t h a t w o u l d s u b s t i t u t e c r e d i t r a t i n g s f o r a s p l i t b e t w e e n t h e O E C D a n d n o n - O E C D a s t h e m a i n d e t e r m i n a n t ( R e i s e n , 2 0 0 0 ) . T h e c o m m i t t e e i s n o w p r o p o s i n g t w o m a i n a p p r o a c h e s t o t h e c a l c u l a t i o n o f r i s k w e i g h t s : a s t a n d a r d i z e d a n d a n i n t e r n a l r a t i n g s - b a s e d ( I R B ) a p p r o a c h ( G r i f f i t h - J o n e s a n d S p r a t t , 2 0 0 1 ; R e i s e n , 2 0 0 1 ) . O n e o f t h e m a i n c h a n g e s f r o m t h e c o m m i t t e e s 1 9 9 9 c o n s u l t a t i v e p a p e r ( B a s e l C o m m i t t e e , 1 9 9 9 ) i s t h e c l e a r i n d i c a t i o n t h a t l e a d i n g b a n k s w i l l b e a b l e t o u s e t h e I R B a p p r o a c h t o s e t r i s k w e i g h t s . T h e m a j o r c h a n g e c o m p a r e d w i t h t h e 1 9 8 8 B a s e l A c c o r d i s t h a t i n t h e c a s e o f s o v e r e i g n e x p o s u r e , m e m b e r s h i p o f t h e O E C D w i l l n o l o n g e r p r o v i d e t h e b e n c h m a r k f o r r i s k w e i g h t s . 1 3 0 R atings since the A s ia n C risis T a b l e 7 . 2 s u m m a r i z e s t h e p r o p o s a l s f o r r i s k w e i g h t s u n d e r t h e s t a n d a r d i z e d a p p r o a c h . T h e p r o p o s e d r i s k w e i g h t s w i l l s u b s t i t u t e c r e d i t r a t i n g s b y e l i g i b l e e x t e r n a l c r e d i t a s s e s s m e n t i n s t i t u t i o n s ( n o t j u s t r a t i n g a g e n c i e s , a s u n d e r t h e 1 9 9 9 p r o p o s a l , b u t a l s o e x p o r t c r e d i t a g e n c i e s , E C A s ) 2 f o r a s p l i t b e t w e e n t h e O E C D a n d n o n - O E C D a s t h e m a i n d e t e r m i n a n t . R i s k w e i g h t s w i l l c o n t i n u e t o b e d e t e r m i n e d b y c a t e g o r y o f b o r r o w e r - s o v e r e i g n , b a n k o r c o r p o r a t e - b u t c h a n g e s h a v e b e e n m a d e w i t h i n e a c h o f t h e s e c a t e g o r i e s . U n d e r t h e p r o p o s a l a s o v e r e i g n w i t h a n A A A r a t i n g ( o r 1 E C A r i s k s c o r e u n d e r t h e O E C D 1 9 9 9 m e t h o d o l o g y ) w i l l r e c e i v e a 0 p e r c e n t r i s k w e i g h t ; l o w e r r a t i n g s t r a n s l a t e i n t o a j u m p i n r i s k w e i g h t s v i a 2 0 , 5 0 , 1 0 0 a n d 1 5 0 p e r c e n t f o r s o v e r e i g n s w e i g h t e d b e l o w B m i n u s ( o r E C A r i s k s c o r e 7 ) . T h e r e a r e t w o o p t i o n s f o r t h e t r e a t m e n t o f c l a i m s o n b a n k s . T h e f i r s t i s f o r b a n k s t o b e a s s i g n e d a r i s k w e i g h t t h a t i s o n e c a t e g o r y l e s s f a v o u r a b l e t h a n t h a t a s s i g n e d t o t h e s o v e r e i g n o f i n c o r p o r a t i o n . N a t i o n a l s u p e r v i s o r s i n l o w - r a t e d d e v e l ­ o p i n g c o u n t r i e s m a y o p t f o r t h e s e c o n d o p t i o n , w h i c h b a s e s t h e r i s k w e i g h t o n a n e x t e r n a l a s s e s s m e n t o f t h e b a n k . F o r c l a i m s o n c o r p o r a t e s , a m o r e r i s k - s e n s i t i v e f r a m e w o r k i s p r o p o s e d t h a t m o v e s a w a y f r o m t h e u n i f o r m 1 0 0 p e r c e n t r i s k w e i g h t f o r a l l c o r p o r a t e c r e d i t s u n d e r t h e 1 9 8 8 A c c o r d . B o t h t h e o r y a n d e v i d e n c e s u g g e s t t h a t t h e B a s e l I I A c c o r d w i l l d e s t a b i l i z e p r i v a t e c a p i t a l f l o w s t o t h e d e v e l o p i n g c o u n t r i e s i f t h e c u r r e n t p r o p o s a l t o l i n k r e g u l a t o r y b a n k c a p i t a l t o s o v e r e i g n r a t i n g s i s a d a p t e d . T h i s h y p o t h e s i s c o n t a i n s t w o e l e m e n t s . F i r s t , t h e o r y s u g g e s t s t h a t l i n k i n g b a n k l e n d i n g t o r e g u l a t o r y c a p i t a l t h r o u g h a r i g i d m i n i m u m c a p i t a l r a t i o s e r v e s t o a m p l i f y m a c r o e c o n o m i c f l u c t u a t i o n s . S e c o n d , t h e e v i d e n c e s u m m a r i z e d i n t h e Table 7.2 The new Basel Capital Accord (risk weight under the standardized approach, per cent) Agency rating AAA to AA- A+ to A- BBB+ to BBB- BB+ to BB— B+ to B- Below B- Sovereign ECA risk score 1 2 3 4-6 4-6 7 Sovereigns 0 20 50 100 100 150 Banks - option l 1 20 50 100 100 100 150 Banks - option 22 20 503 503 1003 100 150 Corporates 20 50 100 100 150 150 Notes: 1 R isk w e ig h t in g b a s e d o n r isk w e ig h t in g o f s o v e re ig n in w h ic h th e b a n k is in c o rp o ra te d . T h e r a t in g s h o w n th u s re fe rs t o th e so v e re ig n ra t in g . 2 R isk w e ig h t in g b a s e d o n th e r a t in g o f t h e in d iv id u a l b a n k . 3 C la im s o n b a n k s w i th a n o r ig in a l m a tu r i t y o f le ss t h a n th r e e m o n t h s w o u ld re c e iv e a w e ig h t in g o n e c a te g o ry m o re fa v o u ra b le th a n th e r isk w e ig h t in g s h o w n a b o v e , s u b je c t t o a f lo o r o f 2 0 p e r c e n t . Source: B asel c o m m it te e o n b a n k in g s u p e rv is io n , T h e N ew B asel C a p i ta l A cco rd : a n e x p la n a to ry n o te ’, s e c o n d c o n s u lta t iv e p a p e r, Basel, J a n u a r y 2 0 0 1 (w w w .b is .o rg ). H e lm u t Reisen 1 3 1 p r e c e d i n g s e c t i o n s u g g e s t s t h a t s o v e r e i g n r a t i n g s l a g b e h i n d r a t h e r t h a n l e a d t h e m a r k e t s , a n d i t s e e m s t h a t t h e r e i s l i t t l e s c o p e f o r i m p r o v i n g t h a t p e r f o r m a n c e . T h u s a s s i g n i n g f i x e d m i n i m u m c a p i t a l t o b a n k a s s e t s w h o s e r i s k w e i g h t s a r e i n t u r n d e t e r m i n e d b y m a r k e t - l a g g i n g r a t i n g s w i l l r e i n f o r c e t h e t e n d e n c y o f t h e c a p i t a l r a t i o t o w o r k i n a p r o c y c l i c a l w a y . T h e B a s e l I I p r o p o s a l s w i l l r e i n f o r c e t h a t t e n d e n c y a s a s t r o n g d i s c o n t i n u i t y i n t r e a t i n g A a n d b e l o w - r a t e d a s s e t s w i l l m a k e b a n k s l o a n p o r t f o l i o s m o r e l i q u i d i t y - h u n g r y , t h u s i n c r e a s i n g t h e v u l n e r a b i l i t y o f t h e f i n a n c i a l s y s t e m t o l i q u i d i t y r i s k . W i t h r e g a r d t o t h e t h e o r y , a s s u m i n g a n o n - M o d i g l i a n i - M i l l e r w o r l d w h e r e i n v e s t m e n t d e m a n d d e p e n d s o n t h e a b i l i t y o f f i r m s t o r e t a i n e a r n i n g s o r o b t a i n b a n k l o a n s , B l u m a n d H e l l w i g ( 1 9 9 5 ) s h o w h o w c a p i t a l a d e q u a c y r e g u l a t i o n f o r b a n k s m a y r e i n f o r c e m a c r o e c o n o m i c f l u c t u a t i o n s . I f n e g a t i v e s h o c k s t o a g g r e g a t e d e m a n d r e d u c e t h e a b i l i t y o f d e b t o r s t o s e r v i c e t h e i r d e b t s t o b a n k s , t h e r e d u c t i o n i n d e b t s e r v i c e w i l l l o w e r b a n k e q u i t y , w h i c h w i l l i n t u r n r e d u c e b a n k l e n d i n g a n d i n v e s t m e n t b e c a u s e o f c a p i t a l a d e q u a c y r e q u i r e m e n t s . L i n k i n g b a n k l e n d i n g t o b a n k e q u i t y t h u s a c t s a s a n a u t o m a t i c a m p l i f i e r f o r m a c r o e c o n o m i c f l u c t u a t i o n s : b a n k s l e n d m o r e w h e n t i m e s a r e g o o d a n d l e s s w h e n t i m e s a r e b a d . M o r e o v e r t h e m i n i m u m c a p i t a l r a t i o c a n a l s o b e s h o w n t o r a i s e t h e s e n s i t i v i t y o f i n v e s t m e n t d e m a n d t o c h a n g e s i n o u t p u t a n d p r i c e s . A n i m p o r t a n t a s s u m p t i o n u n d e r l y i n g t h e B l u m - H e l l w i g m o d e l i s t h a t t h e c a p i t a l a d e q u a c y r e q u i r e m e n t i s b i n d i n g . W i t h a b i n d i n g r e q u i r e m e n t , c , a n a d d i t i o n a l d o l l a r o f b a n k p r o f i t s i n d u c e s 1 / c a d d i t i o n a l u n i t s o f b a n k l e n d i n g . A s b a n k s m i n i m u m r a t i o s h a v e c o n t i n u e d t o h o v e r a r o u n d t h e r e q u i r e d 8 p e r c e n t i n t h e m a j o r a d v a n c e d c o u n t r i e s , t h e y c a n g e n e r a l l y b e c o n s i d e r e d a s b i n d i n g ; h e n c e t h e l o g i c o f t h e B l u m - H e l l w i g m o d e l i s o f m o r e t h a n p u r e l y a c a d e m i c i n t e r e s t . I t m a y b e a r g u e d t h a t a s p e c i f i c p r o p o s a l i n t h e B a s e l I I A c c o r d r i s k s r e i n f o r c i n g t h e p r o c y c l i c a l i m p a c t o f m i n i m u m c a p i t a l r e q u i r e m e n t s . A l a r g e d i s c o n t i n u i t y i s s u g g e s t e d i n B a s e l I I b e t w e e n t h e r i s k w e i g h t s o n b o r r o w e r s r a t e d A a n d b e l o w . T o t h e e x t e n t t h a t a h i g h s h a r e o f b a n k s l o a n p o r t f o l i o s i s i n v e s t e d i n A - r a t e d b o r r o w e r s , t h e f i n a n c i a l s y s t e m m a y b e c o m e v u l n e r ­ a b l e t o a l i q u i d i t y c r i s i s i n a d o w n t u r n i n w h i c h b o r r o w e r s a r e d o w n g r a d e d . B a n k s w o u l d c o n f r o n t h i g h e r c a p i t a l r e q u i r e m e n t s f o r t h i s c l a s s o f b o r r o w e r s . O n e r e s p o n s e w o u l d b e t o c u t b a c k o n l e n d i n g t o l o w e r r a t e d c r e d i t o r s . L i n k i n g r e g u l a t o r y b a n k c a p i t a l t o a g e n c y r a t i n g s m i g h t m o v e b a n k s l o a n - p o r t f o l i o b e h a v i o u r c l o s e r t o t h e i r s h o r t - t e r m t r a d i n g b e h a v i o u r . G o v e r n e d b y t h e m a r k - t o - m a r k e t r u l e s o f t h e v a l u e a t r i s k ( V a R ) a p p r o a c h , i t h a s b e e n s h o w n t h a t b a n k s f i r s t e n c o u r a g e d e x c e s s i v e b a n k l e n d i n g a n d t h e n i n t e n s i f i e d t h e g l o b a l c o n t a g i o n o f t h e 1 9 9 8 f i n a n c i a l c r i s i s ( R e i s e n , 1 9 9 9 ) . U n d e r V a R c r i s i s c o n t a g i o n i s i n t e n s i f i e d a s a v o l a t i l e e v e n t i n o n e c o u n t r y a u t o m a t i c a l l y g e n e r a t e s a n u p w a r d r e - e s t i m a t e o f c r e d i t a n d m a r k e t r i s k i n a c o r r e l a t e d c o u n t r y . T h e B a s e l I I p r o p o s a l s w i l l r e i n f o r c e t h e p r o c y c l i c a l 1 3 2 R atings since the A s ia n C ris is t e n d e n c y a s a s t r o n g d i s c o n t i n u i t y b e t w e e n r i s k w e i g h t s o n d i f f e r e n t l y r a t e d a s s e t s w i l l m a k e b a n k s l o a n p o r t f o l i o s m o r e l i q u i d i t y - h u n g r y , t h u s i n c r e a s i n g t h e v u l n e r a b i l i t y o f t h e f i n a n c i a l s y s t e m t o l i q u i d i t y r i s k . T o t h e e x t e n t t h a t a l a r g e p r o p o r t i o n o f b a n k s l o a n p o r t f o l i o s i s i n v e s t e d i n t r i p l e - B - r a t e d s o v e r e i g n s a n d c o r p o r a t e s ( w i t h a 5 0 p e r c e n t r i s k w e i g h t , T a b l e 7 . 2 ) , t h e d o w n g r a d i n g o f s u c h a s s e t s ( i m p l y i n g a 1 0 0 p e r c e n t r i s k w e i g h t a c c o r d i n g t o t h e s t a n d a r d i z e d a p p r o a c h ) w i l l f o r c e b a n k s t o r e s e r v e m o r e l i q u i d i t y o r t o c u t b a c k l e n d i n g t o t h e d o w n g r a d e d b o r r o w e r s . H e n c e t h e f i n a n c i a l s y s t e m w o u l d b e c o m e m o r e v u l n e r a b l e t o a l i q u i d i t y c r i s i s . W i t h r e g a r d t o t h e e v i d e n c e , t h e d e t e r m i n a n t s a n d n a t u r e o f s o v e r e i g n r a t i n g s r i s k i n t e n s i f y i n g t h e p r o c y c l i c a l i m p a c t o f t h e c a p i t a l a d e q u a c y r e q u i r e m e n t s u n d e r t h e B a s e l I I p r o p o s a l s . F i r s t , t h e r e a l r a t e o f ( a n n u a l ) G D P g r o w t h h a s r e p e a t e d l y b e e n f o u n d t o b e a n i m p o r t a n t d e t e r m i n a n t o f r a t i n g s , w i t h a p o s i t i v e s i g n . T h i s i m p l i e s t h a t s o v e r e i g n r a t i n g s w i l l i m p r o v e d u r i n g b o o m p e r i o d s a n d d e c l i n e d u r i n g b u s t p e r i o d s , t h u s r e i n f o r c i n g b o o m - b u s t c y c l e s . S e c o n d , a s i t i s h a r d f o r r a t i n g a g e n c i e s t o a c q u i r e a n e d g e o n i n f o r m a t i o n o n s o v e r e i g n r i s k , t h e y t e n d t o l a g b e h i n d r a t h e r t h a n l e a d f i n a n c i a l m a r k e t s ( R e i s e n a n d v o n M a l t z a n , 1 9 9 9 ) . M o r e o v e r t h e i r r a t i n g s o n l o w - r a t e d b o r r o w e r s a r e a t t i m e s c h a r a c t e r i z e d b y a l o w d e g r e e o f d u r a b i l i t y ( I M F , 1 9 9 9 ) , i n d i c a t i n g a w e a k p r e d i c t i o n v a l u e . T h e B a s e l I I A c c o r d w o u l d s t r e n g t h e n t h e m a r k e t i m p a c t o f s o v e r e i g n r a t i n g s , b u t a s l o n g a s s o v e r e i g n r a t i n g s f a i l t o c o n v e y p r i v i l e g e d i n f o r m a t i o n t o t h e m a r k e t s , i m p r o v i n g r a t i n g s w i l l r e i n f o r c e e u p h o r i c e x p e c t a t i o n s a n d s t i m u l a t e e x c e s s i v e c a p i t a l i n f l o w s t o e m e r g i n g m a r k e t s ; d u r i n g a b u s t , d o w n g r a d i n g m i g h t c a u s e c r e d ­ i t o r s a n d i n v e s t o r s t o p a n i c , d r i v i n g m o n e y o u t o f t h e a f f e c t e d c o u n t r i e s a n d f o r c i n g u p s o v e r e i g n y i e l d s p r e a d s . M o r e o v e r t h e N e w B a s e l A c c o r d d i s c o u r a g e s l o n g - t e r m i n t e r b a n k l e n d i n g t o e m e r g i n g a n d d e v e l o p i n g c o u n t r i e s . F o r s p e c u l a t i v e - g r a d e d e v e l o p i n g c o u n t r i e s t h e r e g u l a t o r y i n c e n t i v e s f o r s h o r t - t e r m i n t e r b a n k l e n d i n g w i l l t h e r e f o r e t i l t t h e s t r u c t u r e o f t h e i r c a p i t a l i m p o r t s t o w a r d s s h o r t - t e r m d e b t . S h o r t - t e r m f o r e i g n d e b t , i n r e l a t i o n t o o f f i c i a l f o r e i g n e x c h a n g e r e s e r v e s , h a s b e e n i d e n t i f i e d a s t h e s i n g l e m o s t i m p o r t a n t p r e c u r s o r o f f i n a n c i a l c r i s e s t r i g g e r e d b y c a p i t a l f l o w r e v e r s a l s . T a b l e 7 . 3 s h o w s t h e p o t e n t i a l i m p a c t o f r i s k w e i g h t s f o r s h o r t - t e r m ( l e s s t h a n t h r e e m o n t h s ) b a n k - t o - b a n k l e n d i n g . L e t u s f i r s t l o o k a t h o w t h e ( 1 9 8 8 ) B a s e l A c c o r d h a s d i s c o u r a g e d l o n g - t e r m i n t e r b a n k l e n d i n g t o b a n k s f r o m d e v e l o p i n g c o u n t r i e s , a s o p p o s e d t o t h e n e u t r a l i n c e n t i v e s p r o v i d e d f o r l e n d i n g t o O E C D - b a s e d b a n k s . T h e r i s k - a d j u s t e d r e t u r n f o r l e n d i n g t o t r i p l e - B - r a t e d n o n - O E C D b a n k s i s c a l c u l a t e d a s 1 2 . 5 p e r c e n t f o r l o n g m a t u r i t i e s a n d 6 2 . 5 p e r c e n t f o r s h o r t m a t u r i t i e s ; t h e r e s p e c t i v e n u m b e r s a r e 5 0 p e r c e n t a n d 2 5 0 p e r c e n t f o r d o u b l e - B - r a t e d b a n k s , a n d 8 7 . 5 p e r c e n t a n d 4 3 7 p e r c e n t f o r s i n g l e - B - r a t e d b a n k s . T h e s t a n d a r d i z e d a p p r o a c h s u g g e s t e d i n B a s e l I I w o u l d a t t e n u a t e t h e b i a s t o w a r d s s h o r t - t e r m l e n d i n g t o t r i p l e - B - r a t e d a n d d o u b l e - B - r a t e d b o r r o w e r s , b u t w o u l d n o t e n t i r e l y T a b le 7 .3 R e g u l a t o r y i n c e n t i v e s f o r s h o r t - t e r m i n t e r b a n k l e n d i n g Long-term, option 2 Short-term, option 2 Assumed Risk1 Capital Risk-adj. Break-even LIBOR weight required return, spread spread per $100 (%)2 change (bp)3 Assumed Risk Capital Risk-adj. Break-even LIBOR weight1 required return spread spread per $100 (%)2 change (bp)3 Double-A (OECD-based) Current 10 20 1.6 6.3 - 10 20 1.6 6.3 - Standardized - 20 1.6 6.3 - - 20 1.6 6.3 - IRB approach - 7 0.6 16.7 - 6 - 0 0.0 n.a. n.a. Triple-B (non-OECD) Current 100 100 8.0 12.5 - 100 20 1.6 62.5 - Standardized - 50 4.0 25.0 -5 0 - 20 1.6 62.5 - IRB approach - 40 3.2 31.3 -6 0 - 10 0.8 125.0 -5 0 Double-B (non-OECD) Current 400 100 8.0 50.0 - 400 20 1.6 250.0 Standardized - 100 8.0 50.0 - - 50 4.0 100.0 + 600 IRB approach - 379 30.3 13.2 + 1 115 - 60 4.8 83.3 +800 Table 7 .3 (C o n tin u e d ) Long-term, option 2 Short-term, option 2 Assumed LIBOR spread Risk1 Capital Risk-adj. weight required return, per $100 (%)2 Break-even spread change (bp)2 Assumed LIBOR spread Risk Capital Risk-adj. Break-even weight required return spread per $100 (%)2 change (bp)1 Single-B (non-OECD) Current 700 100 8.0 87.5 700 20 1.6 437.5 Standardized - 100 8.0 87.5 - - 100 8.0 87.5 +2 800 IRB approach - 630 50.4 13.9 +3 709 - 400 32.0 21.9 + 13 300 Notes: 1 F or th e IRB a p p ro a c h , lo n g - te rm ( th re e -y e a r) r isk w e ig h ts a re o b ta in e d fro m th e c u b ic r e g re s s io n e s t im a te in F igu re 7 .1 . T h e u n d e r ly in g d e fa u l t ra te s fo r s h o r t- te rm e x p o s u re s h a v e b e e n o b ta in e d f ro m M o o d y s - th e y a re 0 p e r c e n t fo r d o u b le -A b o rro w e rs , 0 .1 p e r c e n t fo r trip le -B , 0 .6 p e r c e n t fo r do u b le -B a n d 6 .8 p e r c e n t fo r sing le -B (M o o d y s , 2 0 0 1 : e x h ib i t 16). F o r th e s ta n d a rd iz e d a p p ro a c h , c la im s o n b a n k s ra te d b e tw e e n A + a n d B B - w ith a n o r ig in a l m a tu r i t y o f less t h a n th r e e m o n th s w o u ld rece iv e a r a t in g t h a t w as o n e c a te g o ry m o re fa v o u ra b le t h a n th e risk w e ig h t o n lo n g e r m a tu r it ie s . 2 A ssu m e s LIBOR f la t f u n d in g . T h e r is k -a d ju s te d r e tu rn o n c a p ita l is 1 00 d iv id e d b y th e r e g u la to ry c a p ita l re q u ire d p e r $ 1 0 0 m u l t ip l ie d b y th e sp read o v e r LIBOR; q u o te d as r e tu r n in excess o v e r LIBOR. 3 In d ic a te s t h e a m o u n t o f s p re a d m o v e m e n t n e e d e d ( in b a s is p o in t s ) to p ro d u c e th e r is k -a d ju s te d r e tu r n a c h ie v e d u n d e r t h e c u r r e n t B asel I e n v i r o n m e n t . B rea k -e v en s p re a d c h a n g e is th e d iffe re n c e i n r is k -a d ju s te d r e tu r n b e tw e e n c u r r e n t a n d s t a n d a rd iz e d ; IRB a p p r o a c h m u l t ip l ie d b y c a p ita l r e q u ire d p e r $ 1 0 0 in s t a n d a rd iz e d r e s p e c t iv e IRB a p p ro a c h . Source: A u th o r s c a lc u la t io n b a s e d o n th e p ro c e d u re d e v e lo p e d b y D e u ts c h e B an k (2 0 0 1 ). H e lm u t R eisen 1 3 5 r e m o v e i t . B y c o n t r a s t , b a n k - t o - b a n k l e n d i n g t o s i n g l e - B - r a t e d b o r r o w e r s w o u l d n o l o n g e r b e d i s t o r t e d b y h i g h e r r i s k - a d j u s t e d r e t u r n s o n s h o r t - t e r m l e n d i n g u n d e r t h e s t a n d a r d i z e d a p p r o a c h . S t r o n g i n c e n t i v e s w o u l d c o n t i n u e t o b e p r o v i d e d u n d e r t h e i n t e r n a l - r a t i n g s - b a s e d a p p r o a c h f o r s h o r t - t e r m b a n k l e n d i n g , p a r t i c u l a r l y t o t r i p l e - B b a n k s . T h e r e q u i r e d b r e a k - e v e n s p r e a d c h a n g e w o u l d b e m i n u s 5 0 b a s i s p o i n t s o n s h o r t - t e r m l e n d i n g u n d e r t h e IR B a p p r o a c h c o m p a r e d w i t h t h e c u r r e n t B a s e l r e q u i r e m e n t s , a s t h e c o r r e s p o n d i n g r i s k w e i g h t w o u l d d r o p t o 1 0 p e r c e n t ( a s s u m i n g a 0 . 1 p e r c e n t p r o b a b i l i t y o f d e f a u l t o n s h o r t - t e r m e x p o s u r e ) , a c c o r d i n g t o e v i d e n c e p r o v i d e d b y M o o d y s ( 2 0 0 1 a ) . T h e r e f o r e , w h i l e f o r e x p o s u r e s w i t h a r e s i d u a l m a t u r i t y o f t h r e e y e a r s t h e c o r r e s p o n d i n g p r o b a b i l i t y o f d e f a u l t ( 0 . 4 1 p e r c e n t ) w o u l d t r a n s l a t e i n t o a r i s k w e i g h t o f 4 0 p e r c e n t a n d a r i s k - a d j u s t e d r e t u r n o f 3 1 . 3 p e r c e n t ( f o r a n a s s u m e d s p r e a d o v e r L I B O R o f 1 0 0 b a s i s p o i n t s ) , t h e e q u i v a l e n t r i s k - a d j u s t e d r e t u r n w o u l d b e m u c h h i g h e r - 1 2 5 p e r c e n t - f o r s h o r t - t e r m e x p o s u r e s t o t r i p l e - B - r a t e d b a n k s . S o m e p o lic y c o n c lu s io n s U n l i k e i n i n d u s t r i a l i z e d c o u n t r i e s , w h e r e c a p i t a l m a r k e t a c c e s s i s u s u a l l y t a k e n f o r g r a n t e d , s o v e r e i g n r a t i n g s p l a y a v i t a l r o l e i n d e v e l o p i n g c o u n t r i e s a s t h e i r a c c e s s t o c a p i t a l m a r k e t s i s p r e c a r i o u s a n d v a r i a b l e . T h e r e c e n t p r o p o s a l b y t h e C o m m i t t e e o n B a n k i n g S u p e r v i s i o n f o r a n e w B a s e l C a p i t a l A c c o r d i m p l i e s t h a t c r e d i t r a t i n g s w i l l b e o f e v e n g r e a t e r r e g u l a t o r y i m p o r t a n c e i n f u t u r e d e c a d e s . R a t i n g b e h a v i o u r i n t h e r e c e n t e m e r g i n g - m a r k e t c r i s e s i n A r g e n t i n a a n d T u r k e y s u g g e s t s t h a t r a t i n g d e t e r m i n a n t s h a v e n o t b e e n s u f f i c i e n t l y m o d i f i e d t o p u t t h e a g e n c i e s a h e a d o f m a r k e t e v e n t s , a n d t h a t c o n v e n t i o n a l r a t i n g d e t e r m i n a n t s h a v e l o s t s o m e o f t h e i r e x p l a n a t o r y p o w e r . F i n a n c i a l - s e c t o r w e a k n e s s e s a n d i l l i q u i d i t y h a v e n o t y e t b e e n g i v e n t h e w e i g h t i n g t h e y d e s e r v e . P r o c y c l i c a l r a t i n g d e t e r m i n a n t s r e m a i n a n i m p o r t a n t i n g r e d i e n t i n a g e n c i e s n o t e s , a n d i t h a s b e e n s u g g e s t e d t h a t a g e n c i e s s h o u l d c o r r e c t t h e m f o r t h e e n d o g e n o u s e f f e c t s o f ( s h o r t - t e r m ) c a p i t a l i n f l o w s . B u t e v e n w i t h s u c h i m p r o v e m e n t s , s o v e r e i g n r a t i n g s a r e b o u n d t o l a g b e h i n d t h e m a r k e t s . F i r s t , c r e d i t r a t i n g s a n d r a t i n g a c t i o n s a r e d e l i v e r e d i n a d i s c r e t e f a s h i o n , w i t h a c t i o n b e i n g t a k e n w h e n s u f f i c i e n t u p w a r d o r d o w n ­ w a r d p r e s s u r e h a s b e e n p u t o n t h e c r e d i t f u n d a m e n t a l s , w h i c h t h e m s e l v e s m o v e i n a c o n t i n u o u s f a s h i o n . S e c o n d , s o v e r e i g n r i s k r a t i n g s a r e p r i m a r i l y b a s e d o n p u b l i c l y a v a i l a b l e i n f o r m a t i o n . C o n s e q u e n t l y a n y s o v e r e i g n r a t i n g a n n o u n c e m e n t w i l l b e c o n t a m i n a t e d b y o t h e r p u b l i c l y a v a i l a b l e n e w s . T h i r d , r a t i n g a n n o u n c e m e n t s m a y b e l a r g e l y a n t i c i p a t e d b y t h e m a r k e t ( a l t h o u g h t h e i n t e r p r e t a t i o n o f s u c h n e w s b y t h e r a t i n g a g e n c i e s m a y b e s e e n a s a n i m p o r t a n t s i g n a l o f c r e d i t w o r t h i n e s s ) . W h i l e s o v e r e i g n r a t i n g s o f t e n l a g b e h i n d t h e m a r k e t s , j o i n t d o w n g r a d e s o f e m e r g i n g - m a r k e t d e b t b y t h e l e a d i n g a g e n c i e s c a n h a v e a l a s t i n g m a r k e t 1 3 6 R atings since the A s ia n C risis i m p a c t ; u p g r a d e s , i n c o n t r a s t , a r e l a r g e l y a n t i c i p a t e d . T h e i m p a c t o f d o w n ­ g r a d e s m a y b e d u e t o t h e p r u d e n t i a l r e g u l a t i o n a n d i n t e r n a l i n d u s t r y g u i d e ­ l i n e s t o w h i c h i n s t i t u t i o n a l i n v e s t o r s a r e s u b j e c t a n d w h i c h d e b a r t h e m f r o m h o l d i n g s e c u r i t i e s b e l o w c e r t a i n r a t i n g c a t e g o r i e s , a n d t o d e b t c o n t r a c t s t h a t a l l o w c r e d i t o r s t o w i t h d r a w l o a n s w h e n b o r r o w e r r a t i n g s d r o p b e l o w a c e r t a i n t h r e s h o l d . B u t u n l e s s p r u d e n t i a l r e g u l a t i o n , t h a t i s , t h e B a s e l A c c o r d , r e i n f o r c e s t h e m a r k e t i m p a c t o f s o v e r e i g n r a t i n g s , t h e i r i m p a c t m i g h t d i m i n i s h s o m e w h a t i n t h e f u t u r e . T h e r a t i n g a g e n c i e s h a v e s t a r t e d t o l o o s e n t h e i r c o u n t r y c e i l i n g p o l i c y , a l l o w i n g c e r t a i n p r i v a t e s e c t o r b o r r o w e r s b e t t e r r a t i n g s t h a n t h e i r s o v e r e i g n s . A n d e m e r g i n g - m a r k e t b o n d t r a d i n g s t r a t e g i e s s e e m t o h a v e i n c r e a s i n g l y e x p l o i t e d t h e l a t e n a t u r e o f r a t i n g a c t i o n s b y a n t i c i p a t i n g t h e m . F i n a l l y , t h i s c h a p t e r h a s a d d r e s s e d t h e c o n c e r n t h a t t h e B a s e l I I A c c o r d w i l l d e s t a b i l i z e p r i v a t e c a p i t a l f l o w s t o d e v e l o p i n g c o u n t r i e s i f t h e c u r r e n t p r o p o s a l t o l i n k r e g u l a t o r y b a n k c a p i t a l t o s o v e r e i g n r a t i n g s i s a d o p t e d . A s s i g n i n g f i x e d m i n i m u m c a p i t a l t o b a n k a s s e t s w h o s e r i s k w e i g h t s a r e d e t e r m i n e d b y m a r k e t - l a g g i n g r a t i n g s w i l l r e i n f o r c e t h e t e n d e n c y o f t h e c a p i t a l r a t i o t o w o r k i n a p r o c y c l i c a l w a y . C r e d i t s p r e a d s w i l l m o r e c l o s e l y r e f l e c t c r e d i t r a t i n g s a s a p r o x y o f d e f a u l t p r o b a b i l i t y . W h i l e t h i s i s e x a c t l y w h a t s u p e r v i s o r s a r e a i m i n g a t , t h e c a l c u l a t i o n s p r o v i d e d h e r e i n d i c a t e t h a t t h e c h a s m b e t w e e n i n v e s t m e n t - g r a d e b o r r o w e r s - b a s e d m o s t l y i n t h e O E C D c o u n t r i e s a n d i n s o m e o f t h e m o r e s u c c e s s f u l e m e r g i n g m a r k e t s - a n d s p e c u l a t i v e - g r a d e b o r r o w e r s , m o s t l y f r o m t h e d e v e l o p i n g w o r l d , w i l l d e e p e n . T h i s w o u l d c l e a r l y r u n a g a i n s t t h e e n d e a v o u r o f t h e g l o b a l d e v e l o p m e n t c o m m u n i t y t o b r o a d e n t h e r a n g e o f d e v e l o p i n g c o u n t r i e s t h a t b e n e f i t f r o m p r i v a t e c a p i t a l i n f l o w s . T h e B a s e l I I p r o p o s a l s n o t o n l y r i s k r a i s i n g t h e c a p i t a l c o s t s f o r s p e c u l a t i v e - g r a d e d e v e l o p i n g c o u n t r i e s , t h e y m a y a l s o s e r v e t o i n c r e a s e t h e v o l a t i l i t y o f b a n k c r e d i t s u p p l y t o t h i s g r o u p o f c o u n t r i e s . N o t e s * The author alone is responsible for the content of this chapter, which should not be attributed to the OECD or the OECD Development Centre. 1. In particular, upgrades to investment grade open up a much wider investor base to emerging and developing countries. As they become eligible for inclusion in benchmark investment-grade indices, portfolio managers will have consciously to justify a countrys exclusion rather than start from the presumption that the country will not be included in investment-grade portfolios. Such portfolios are particularly held by long-term contractual institutions, such as pension funds and insurance companies. An upgrade to investment grade will therefore result in a higher and more stable demand for a developing countrys bonds, as the demand for the countrys bonds will not be limited to unconstrained investors, such as high-yield managers and hedge funds, that are able to trade opportunistically in and out of speculative-grade bonds. 2. See Griffith-Jones and Spratt (2001) for a discussion of the use of export credit agencies in regulating bank capital and the potential impact of this on developing countries. H e lm u t Reisen 1 3 7 Basel Committee on Banking Supervision (1999) A New Capital Adequacy Framework, Basel: BIS (www.bis.org). (2001) ‘The New Basel Capital Accord, Basel: BIS (www.bis.org). Blum, J. and M. Hellwig (1995) The Macroeconomic Implications of Capital Adequacy Requirements for Banks, European Economic Review, 39, 3. Bonte, R. etal. (1999) Supervisory Lessons to be Drawn from the Asian Crisis, Basel Committee on Banking Supervision Working Papers, no. 2, Basel: BIS. Braga de Macedo, J., D. Cohen and H. Reisen (2001) Monetary Integration for Sustained Convergence: Earning Rather than Importing Credibility, in Dont Fix, Dont Float, Paris: OECD Development Centre Studies. Cantor, R. and F. Packer (1996) Determinants and Impact of Sovereign Credit Ratings, Federal Reserve Bank of New York, Economic Policy Review, 20, 2. Deutsche Bank (2000) Emerging Markets Weekly, 3 November (DB Global Markets Research - research.gm.db.com). (2001) New Basel Capital Accord, Deutsche Bank Global Markets Research (research.gm.db.com). Eaton, J. M. Gersowitz, and J. Stiglitz (1986) The Pure Theory of Country Risk, European Economic Review, 30, 3: 481-513. Ffrench-Davis, R. and H. Reisen (1998) Capital Flows and Investment Performance: An Overview, in Capital Flows and Investment Performance: Lessons from Latin America, Santiago: ECLAC/OECD. Goldstein, M. (1999) Safeguarding Prosperity in a Global Financial System: The Future International Financial Architecture Report, New York: Council on Foreign Relations (www.cfr.org). Grandes, M. (2001) ‘External Solvency, Dollarisation and Investment Grade: Towards a Vicious Circle?, OECD Development Centre Technical Papers, no. 177, Paris: OECD. Griffith-Jones, S. and S. Spratt (2001) Selected Issues Arising from the New Basel Capital Accord and their Potential Impact on Developing Countries, mimeo, Brighton: IDS, University of Sussex. Huhne, C. (1998) How the Rating Agencies Blew it on Korea’, The International Economy, May/June. International Monetary Fund (IMF) (1999) Capital Markets Report, Washington, DC: IMF, September. Jiittner, D. J. and J. McCarthy (2000) Modelling a Rating Crisis, mimeo, Sydney: Macquarie University. Kaminsky, G. and S. Schmukler (2001) Emerging Markets Instability: Do Sovereign Ratings Affect Country Risk and Stock Returns?, paper presented at the conference on The Role of Credit Reporting Systems in the International Economy, World Bank, wwwl .worldbank.org/finance. Larrain, G., H. Reisen and J. von Maltzan (1997) Emerging Market Risk and Sovereign Credit Ratings, OECD Development Centre Technical Paper, no. 124, Paris: OECD, April. Moodys Investor Services (2001a) Moodys Country Credit Statistical Handbook, 1st edn, New York: Moodys, January, www.moodys.com. (2001b) Revised Country Ceiling Policy, June, www.moodys.com. Mora, N. (2001) Sovereign Credit Ratings: Guilty Beyond Reasonable Doubt?, mimeo, Cambridge, MA: Massachusetts Institute of Technology. OECD (2001) Economic Survey of Turkey, Paris: OECD, February. Reisen, H. (1998) ‘Domestic Causes of Currency Crises: Policy Lessons for Crisis Avoidance, OECD Development Centre Technical Papers, no. 136, Paris: OECD. References 138 R atings since the A s ia n C ris is (1999) After the Great Asian Slump: Towards a Coherent Approach to Global Capital Flows, OECD Development Centre Policy Brief, no. 16, Paris: OECD. (2000) Revisions to the Basel Accord and Sovereign Ratings, in R. Hausmann and U. Hiemenz (eds), Global Finance from a Latin American Viewpoint, Paris: Inter- American Development Bank and OECD Development Centre. (2001) Will Basel II Contribute to Convergence in International Capital Flows?, Bankarchiv, Jg. 49, Vienna: Oesterreichische Bankwissenschaftliche Gesellschaft, August. and J. von Maltzan (1999), Boom and Bust and Sovereign Ratings, International Finance, 2, 2 (July). Standard Poor (SP) (2000) ‘New Rating Approach Gives Private-Sector Issuers Credit for Partial Coverage of Transfer and Convertibility Risk, October, www.standardandpoors.com. (2001) Rating the Transition Economies - 2001, April, www.standardandpoors.com. 8 Proposals for Curbing the Boom-Bust Cycle in the Supply of Capital to Emerging Markets* John W illia m s o n In tro d u ctio n T h e p r o b l e m o f b o o m - b u s t c y c l e s i n c a p i t a l f l o w s t o e m e r g i n g m a r k e t s i s w e l l r e c o g n i z e d . T h i s c h a p t e r e x a m i n e s w h i c h f o r m s o f c a p i t a l f l o w a r e p a r t i c u l a r l y p r o b l e m a t i c i n t h i s r e s p e c t a n d w h i c h a r e m o r e s t a b l e , a n d t h e n c o n s i d e r s w h a t m i g h t b e d o n e t o s t a b i l i z e t h e o v e r a l l f l o w o f p r i v a t e c a p i t a l . T h e p o s s i b i l i t i e s h e r e i n v o l v e a l t e r i n g e i t h e r t h e v o l u m e o r t h e b e h a v i o u r o f t h e v a r i o u s t y p e s o f f l o w . T h e r e i s n o t m u c h t h a t c a n b e d o n e f r o m t h e s u p p l y s i d e t o a l t e r t h e r e l a t i v e v o l u m e o f d i f f e r e n t f o r m s o f c a p i t a l f l o w ; s u c h p o l i c i e s a s a r e a v a i l a b l e i n t h i s r e s p e c t c o n c e r n t h e c a p i t a l c o n t r o l s t h a t c a n b e e x e r c i s e d b y c a p i t a l - i m p o r t i n g c o u n t r i e s , a s u b j e c t t h a t i s d e a l t w i t h i n C h a p t e r 1 2 . H e n c e t h i s c h a p t e r f o c u s e s o n t h e w a y s i n w h i c h s u p p l y - s i d e r e f o r m s m i g h t b e a b l e t o a l t e r t h e b e h a v i o u r o f c e r t a i n t y p e s o f c a p i t a l f l o w . D ia g n o s is o f w h ere th e p ro b lem s lie C o n v e n t i o n a l w i s d o m h a s l o n g h e l d t h a t s o m e f o r m s o f c a p i t a l f l o w a r e m u c h m o r e p r o n e t o r a p i d r e v e r s a l t h a n o t h e r s . T h i s v i e w w a s c h a l l e n g e d b y C l a e s s e n s et al. ( 1 9 9 4 ) , w h o f a i l e d t o f i n d s t a t i s t i c a l l y s i g n i f i c a n t d i f f e r e n c e s i n t h e t i m e s e r i e s p r o p e r t i e s o f d i f f e r e n t f o r m s o f c a p i t a l f l o w ( F D I , p o r t f o l i o e q u i t y , l o n g - t e r m , s h o r t - t e r m , b a n k s , g o v e r n m e n t a n d p r i v a t e ) . B u t i n h i s d i s c u s s i o n o f t h i s p a p e r , C a l v o ( 1 9 9 8 ) p r e s c i e n t l y p o i n t s o u t t h a t t h e a u t h o r s e s t i m a t e s o f v o l a t i l i t y ( w h i c h e s s e n t i a l l y f o c u s o n t h e s e c o n d m o m e n t o f t h e t i m e s e r i e s ) m i g h t f a i l t o g i v e d u e w e i g h t t o w h a t i s o f m o s t i m p o r t a n c e : t h e p o s s i b i l i t y o f o c c a s i o n a l m a j o r d i s r u p t i o n s ( w h i c h a r e m e a s u r e d b y h i g h e r m o m e n t s i n t h e t i m e s e r i e s ) . 1 T o j u d g e b y w h a t h a p p e n e d i n E a s t A s i a d u r i n g i t s r e c e n t c r i s i s , w h e n F D I w a s l a r g e l y m a i n t a i n e d w h i l e b a n k c a p i t a l r e v e r s e d o n a g r a n d s c a l e , i t i s i n d e e d p r o p e r t o w o r r y m u c h m o r e a b o u t t h e v o l a t i l i t y o f s o m e f o r m s o f c a p i t a l f l o w t h a n o f o t h e r s . A m o r e r e c e n t s t u d y 1 3 9 1 4 0 C u rb in g the B o o m -B u s t C ycle b y L i p s e y ( 2 0 0 1 ) c o n f i r m e d t h e c o n v e n t i o n a l w i s d o m a b o u t t h e r e l a t i v e s t a b i l i t y o f F D I f l o w s . T h i s i s n o t t o s a y t h a t m u l t i n a t i o n a l s w i l l r e f r a i n f r o m s h i f t i n g w o r k i n g b a l a n c e s a m o n g c u r r e n c i e s d e p e n d i n g o n t h e i r v i e w o f t h e m a c r o e c o n o m i c p r o s p e c t s , b u t j u s t t h a t s u c h s h i f t s a r e u n l i k e l y t o b e l a r g e r e l a t i v e t o t h e t o t a l s u m s u n k i n c a p i t a l i n v e s t m e n t . L a r g e - s c a l e r e v e r s a l i s i n m o s t c a s e s p h y s i c a l l y i m p o s s i b l e . B a n k l e n d i n g , w h i c h w a s t h e p r i n c i p a l c o m p o n e n t o f t h e c a p i t a l f l o w r e v e r s a l i n E a s t A s i a , w a s a t t h e o t h e r e x t r e m e t o F D I . T h e s a m e w a s t r u e i n t h e d e b t c r i s i s . C o m m o n s e n s e ( a n d r e c e i v e d w i s d o m ) s u g g e s t s t h a t s h o r t ­ t e r m b a n k l o a n s a r e m o r e p r o n e t o i n s t a b i l i t y t h a n l o n g - t e r m l o a n s , a n e x p e c t a t i o n t h a t a g a i n s e e m s t o h a v e b e e n v e r i f i e d b y t h e e v a p o r a t i o n o f i n t e r b a n k c r e d i t l i n e s e x p e r i e n c e d b y K o r e a i n l a t e 1 9 9 7 . O n e r e a s o n w h y C l a e s s e n s etal. ( 1 9 9 4 ) f a i l e d t o f i n d a n y d i s t i n c t i o n i n v o l a t i l i t y b a s e d o n m a t u r i t y m a y b e t h a t t h e y l u m p e d t r a d e c r e d i t s w i t h o t h e r s h o r t - t e r m c r e d i t s e x t e n d e d b y b a n k s . T h e u s u a l b e l i e f i s t h a t t r a d e c r e d i t s a r e o n e o f t h e l e s s v o l a t i l e s o u r c e s o f f i n a n c e - d e s p i t e t h e f a c t t h a t e a c h i n d i v i d u a l c r e d i t i s s h o r t t e r m - b e c a u s e t h e y a r e c o n s t a n t l y r e n e w e d a s n e w t r a d e t r a n s a c t i o n s n e e d t o b e f i n a n c e d . I t i s t h e r e s i d u a l i t e m - b a n k c l a i m s t h a t h a v e a s h o r t t e r m t o m a t u r i t y a n d a r e n o t t r a d e - r e l a t e d - t h a t c o n v e n t i o n a l w i s d o m h o l d s t o b e p a r t i c u l a r l y v o l a t i l e . I t h a s b e e n a r g u e d b y P e r s a u d ( 2 0 0 0 ) t h a t t h e r e c e n t m o v e s t o s t r e n g t h e n b a n k r i s k m a n a g e m e n t , s t r e n g t h e n p r u d e n t i a l s t a n d a r d s a n d i n c r e a s e t r a n s ­ p a r e n c y m a y e v e n i n t e n s i f y t h e p r o b l e m o f p r o c y c l i c a l b e h a v i o u r b y b a n k s . H e p o i n t s t o t h e i n c r e a s i n g u s e o f D E A R ( d a i l y e a r n i n g s a t r i s k ) l i m i t s a s a t o o l o f r i s k m a n a g e m e n t t h a t s e e m s p e r f e c t l y r a t i o n a l w h e n v i e w e d f r o m t h e s t a n d p o i n t o f t h e i n d i v i d u a l b a n k , b u t w h i c h c a n s e r v e t o i n c r e a s e v o l a t i l i t y . T h e D E A R s e t s a l i m i t o n h o w m u c h t h e b a n k i s p r e p a r e d t o r i s k l o s i n g d u r i n g t h e f o l l o w i n g d a y w i t h , s a y , 1 p e r c e n t p r o b a b i l i t y : I t i s c a l c u l a t e d b y t a k i n g t h e b a n k s p o r t f o l i o . . . a n d e s t i m a t i n g t h e f u t u r e d i s t r i b u t i o n o f d a i l y r e t u r n s b a s e d o n p a s t m e a s u r e s o f m a r k e t c o r r e l a t i o n a n d v o l a t i l i t y . B o t h r i s i n g v o l a t i l i t y a n d r i s i n g c o r r e l a t i o n w i l l i n c r e a s e t h e p o t e n t i a l l o s s o f t h e p o r t f o l i o , i n c r e a s i n g D E A R W h e n D E A R e x c e e d s t h e l i m i t , t h e b a n k r e d u c e s e x p o s u r e , o f t e n b y s w i t c h i n g i n t o l e s s v o l a t i l e a n d l e s s c o r r e l a t e d a s s e t s . T h e d a i l y p u b l i c a t i o n o f s t a t i s t i c s c a n a c c e l e r a t e a n d i n t e n s i f y t h e s p r e a d o f a n y b a d n e w s t h a t m a y b r e a k , w i t h d e c l i n i n g a s s e t v a l u e s a n d i n c r e a s i n g v o l a t i l i t y s e r v i n g a s s o p h i s t i c a t e d p o s i t i v e f e e d b a c k m e c h a n i s m s . S o m u c h f o r t h e e a s y c a s e s . T h e i n t e r e s t i n g q u e s t i o n c o n c e r n s t h e v o l a t i l ­ i t y o f o t h e r c l a i m s t h a t c a n b e s o l d q u i c k l y , n o t a b l y p o r t f o l i o e q u i t y a n d l o n g - t e r m b o n d s . T h e r e w a s i n d e e d a r e d u c t i o n i n t h e f l o w o f p o r t f o l i o i n v e s t m e n t t o E a s t A s i a i n 1 9 9 7 - 9 8 , a l t h o u g h n o t h i n g l i k e t h e r e v e r s a l s e e n i n t h e c a s e o f b a n k l e n d i n g . T h e r e i s a n i m p o r t a n t r e a s o n w h y o n e s h o u l d John W ill ia m s o n 1 4 1 e x p e c t l e s s v o l a t i l i t y i n t h e c a s e o f p o r t f o l i o e q u i t y t h a n i n t h e c a s e o f s h o r t ­ t e r m l o a n s : t h e p r i c e o f t h e r e l e v a n t a s s e t ( s h a r e s ) c a n a d j u s t , r a t h e r t h a n a l l t h e a d j u s t m e n t t a k i n g p l a c e i n t h e v o l u m e . I n d e e d i f a s h o c k h a s t h e s a m e i m p a c t o n t h e f u t u r e e x p e c t a t i o n s o f d o m e s t i c a n d f o r e i g n i n v e s t o r s i n s h a r e s , t h e n o n e w o u l d e x p e c t t h a t a l l t h e r e s u l t i n g a d j u s t m e n t w o u l d s h o w u p i n a c h a n g e i n s h a r e p r i c e s , w i t h n o c o n s e q u e n c e s f o r c a p i t a l f l o w s o r e x c h a n g e r a t e s . ( L a r g e a n d a b r u p t d e c l i n e s i n s h a r e p r i c e s c a n a l s o c r e a t e p r o b l e m s , e s p e c i a l l y w h e n e x p e c t a t i o n s a r e e n d o g e n o u s a n d e x t r a p o l a t i v e r a t h e r t h a n e x o g e n o u s a n d r e g r e s s i v e . I w o u l d n o n e t h e l e s s a r g u e t h a t t h e s t o c k m a r k e t i s a r a t h e r g o o d p l a c e t o a b s o r b t h e i m p a c t o f c h a n g e s i n e x p e c t ­ a t i o n s , b e c a u s e t h e l i n k s f r o m t h e s t o c k m a r k e t t o t h e r e a l e c o n o m y t e n d t o b e w e a k i n t h e s h o r t t e r m . ) I t i s o n l y w h e n f o r e i g n i n v e s t o r s l o s e t h e i r n e r v e a b o u t t h e p r o s p e c t s f o r a c o u n t r y o r r e g i o n i n a w a y t h a t d o m e s t i c i n v e s t o r s d o n o t , a s i n E a s t A s i a i n 1 9 9 7 , t h a t o n e s h o u l d e x p e c t a n i m p a c t o n c a p i t a l f l o w s . T h e e m p i r i c a l e v i d e n c e i s n o t a s r e a s s u r i n g a s t h e o r e t i c a l c o n s i d e r a t i o n s m i g h t h a v e l e d o n e t o e x p e c t . F r o o t etal. ( 1 9 9 8 ) h a v e f o u n d e v i d e n c e t h a t e q u i t y f l o w s a r e p e r s i s t e n t o v e r t i m e a n d t h a t i n v e s t o r s o f t e n b u y ( s e l l ) i n r e s p o n s e t o a p r i c e r i s e ( d e c l i n e ) . K a m i n s k y etal. ( 1 9 9 9 ) c o n c l u d e t h a t m u t u a l f u n d s h a v e a d e s t a b i l i z i n g i m p a c t a n d h a v e h e l p e d s p r e a d c o n t a g i o n i n L a t i n A m e r i c a . I t a l s o s e e m s t h a t C h i l e a n p e n s i o n f u n d s m a d e a l m o s t n o u s e o f t h e i r n e w r i g h t s t o i n v e s t a b r o a d d u r i n g C h i l e s c a p i t a l i n f l o w s u r g e , b u t t h e n b e g a n p l a c i n g f u n d s a b r o a d o n a l a r g e s c a l e w h e n c a p i t a l f l o w r e v e r s a l o c c u r r e d a f t e r t h e E a s t A s i a n c r i s i s ( F f r e n c h - D a v i s a n d T a p i a , 2 0 0 1 ) . B e k a e r t etal. ( 1 9 9 9 ) h a v e f o u n d t h a t w h e n e q u i t y c a p i t a l l e a v e s i t d o e s s o f a s t e r t h a n t h e s p e e d a t w h i c h i t e n t e r e d , s u g g e s t i n g t h a t i t i s n o t s o d i f f i c u l t t o f i n d d o m e s t i c p u r c h a s e r s . O n l y B a r t h a n d Z h a n g ( 1 9 9 9 ) c a n f i n d n o e v i d e n c e t h a t f o r e i g n i n v e s t o r s h a v e p l a y e d a d e s t a b i l i z i n g r o l e : i n d e e d t h e y c l a i m t h a t i t w a s o n l y i n o n e m o n t h ( D e c e m b e r 1 9 9 7 ) t h a t m u t u a l f u n d s w e r e n e t s e l l e r s i n t h e f o u r m a i n c r i s i s c o u n t r i e s o f E a s t A s i a ( i b i d . : 2 0 1 ) . A n d w h i l e t h e y r e f e r t o s o m e i n v e s t o r s a s h a v i n g b e e n a t t r a c t e d i n t o t h e A s i a n m a r k e t s w i t h a s h o r t - t e r m h o r i z o n s e e k i n g h i g h r e t u r n s ( i b i d . : 1 9 9 ) , t h e y a l s o a r g u e t h a t t h e f i g u r e s s h o w t h a t f o r e i g n i n s t i t u t i o n a l i n v e s t o r s w e r e s l o w t o e x i t a f t e r t h e c r i s i s s t a r t e d , a s a r e s u l t o f w h i c h t h e y l o s t a l o t o f m o n e y ( i b i d . : 2 0 2 - 5 ) . K o r e a h a s a p a r t i c u l a r l y r i c h d a t a s e t ( a l t h o u g h t h e r e a r e d o u b t s a b o u t i t s r e l i a b i l i t y ) , a n d t h i s h a s e n a b l e d r e s e a r c h e r s t o t r a c e t h e s t r a t e g y o f i n d i ­ v i d u a l i n v e s t o r s i n a w a y t h a t i s n o t p o s s i b l e e l s e w h e r e . T h e f i r s t s t u d y t o e x p l o i t t h i s s o u r c e , t h a t b y C h o e etal. ( 1 9 9 9 ) , s u g g e s t s t h a t w h i l e t h e t r a d e b y f o r e i g n i n v e s t o r s w a s d e s t a b i l i z i n g b e f o r e t h e c r i s i s , f o r e i g n i n v e s t o r s a c t e d a s a s t a b i l i z i n g f o r c e d u r i n g t h e c r i s i s . H o w e v e r t h e i r d a t a e x t e n d e d o n l y b r i e f l y i n t o t h e c r i s i s p e r i o d , a n d t h e s u b s e q u e n t s t u d y b y K i m a n d W e i ( 1 9 9 9 a ) c o n c l u d e s t h a t f o r e i g n i n s t i t u t i o n a l a n d ( e v e n m o r e ) i n d i v i d u a l i n v e s t o r s w e r e p o s i t i v e - f e e d b a c k t r a d e r s ( t h a t i s , b o u g h t i n r e s p o n s e t o 1 4 2 C u rb in g the B o o m -B u s t C ycle a p r i c e r i s e a n d s o l d i n r e s p o n s e t o a p r i c e f a l l ) b o t h b e f o r e a n d d u r i n g t h e c r i s i s . T h e o n l y e x c e p t i o n t o t h i s p r o c y c l i c a l b e h a v i o u r w a s p r i o r t o t h e c r i s i s b y f o r e i g n i n s t i t u t i o n s w i t h a K o r e a n o f f i c e : t h e s e w e r e c o n t r a r i a n t r a d e r s ( t h a t i s , t e n d e d t o b u y r e c e n t l o s e r s a n d s e l l r e c e n t w i n n e r s ) . K i m a n d W e i a l s o c a l c u l a t e t h a t a c o n t r a r i a n s t r a t e g y w o u l d h a v e b e e n m o r e p r o f i t a b l e t h a n a p o s i t i v e - f e e d b a c k s t r a t e g y , w h i c h s u g g e s t s t h a t K o r e a n s w h o h a d b e e n f o l l o w i n g s u c h a s t r a t e g y ( a s t h e c o u n t e r p a r t o f t h e f o r e i g n p o s i t i v e - f e e d b a c k s t r a t e g i e s ) m u s t h a v e m a d e m o n e y , o r a t l e a s t l o s t l e s s m o n e y t h a n f o r e i g n e r s . K i m a n d W e i ( 1 9 9 9 b ) a l s o f o u n d e v i d e n c e t h a t m u t u a l f u n d s b a s e d i n t h e U n i t e d S t a t e s a n d U n i t e d K i n g d o m e n g a g e d i n p o s i t i v e - f e e d b a c k t r a d i n g , a n d t o s o m e e x t e n t i n h e r d i n g b e h a v i o u r , i n K o r e a i n 1 9 9 7 - 9 8 . 2 N o t e t h a t a l l t h e s e s t u d i e s f o c u s o n p o r t f o l i o e q u i t y i n v e s t m e n t i n t h e s t o c k m a r k e t s o f e m e r g i n g c o u n t r i e s . A s B a r t h a n d Z h a n g ( 1 9 9 9 ) p o i n t o u t , p o r t f o l i o e q u i t y i s i n v e s t e d i n e m e r g i n g m a r k e t s t h r o u g h t w o a d d i t i o n a l c h a n n e l s , o n e o f w h i c h i s p r i v a t e ( t h a t i s , n o n - t r a d e d ) e q u i t y . B a r t h a n d Z h a n g s f i g u r e 6 . 2 s u g g e s t s t h a t i n E a s t A s i a t h i s i s a s m a l l b u t r a t h e r s t a b l e f l o w . I n t h e o t h e r c h a n n e l , e m e r g i n g - m a r k e t c o m p a n i e s l i s t t h e i r s h a r e s o n i n t e r n a t i o n a l m a r k e t s s u c h a s N e w Y o r k ( o f d o m i n a n t i m p o r t a n c e f o r L a t i n A m e r i c a n c o m p a n i e s ) o r L o n d o n ( d i t t o f o r S o u t h A f r i c a n c o m p a n i e s ) . B a r t h a n d Z h a n g s t a b l e s 6 - 1 2 s h o w t h a t i n t e r n a t i o n a l p l a c e m e n t s r o s e t o m a j o r i m p o r t a n c e i n t h e m i d 1 9 9 0 s a n d p e a k e d i n 1 9 9 7 , b e f o r e f a l l i n g s u b s t a n t i a l l y i n 1 9 9 8 . T h e d e c l i n e i n i n t e r n a t i o n a l p l a c e m e n t s w a s n e v e r t h e l e s s m o d e s t c o m p a r e d w i t h t h a t i n f o r e i g n i n v e s t m e n t i n l o c a l s t o c k m a r k e t s : i t m o v e d f r o m U S $ 6 b i l l i o n i n 1 9 9 6 t o U S $ 1 1 b i l l i o n i n 1 9 9 7 a n d U S $ 4 b i l l i o n i n 1 9 9 8 , w h i l e i n v e s t m e n t i n l o c a l m a r k e t s f e l l f r o m U S $ 9 b i l l i o n i n 1 9 9 6 t o m i n u s U S $ 3 b i l l i o n i n 1 9 9 7 a n d p l u s U S $ 1 b i l l i o n i n 1 9 9 8 . A u t h o r i t a t i v e s o u r c e s a s s e r t t h a t t h e s h a r p r e d u c t i o n i n t h e i n f l o w o f p o r t f o l i o e q u i t y t o E a s t A s i a d u r i n g t h e 1 9 9 7 c r i s i s r e f l e c t e d q u i t e d i f f e r e n t b e h a v i o u r o n t h e p a r t o f t w o d i f f e r e n t g r o u p s o f i n v e s t o r s ( a n a c c o u n t t h a t i s c o n s i s t e n t w i t h t h e r e p o r t b y B a r t h a n d Z h a n g , 1 9 9 9 : 1 9 7 ) . T h e w i t h d r a w a l s w e r e m a d e b y g l o b a l f u n d s t h a t h a d b e e n s e a r c h i n g f o r h i g h - y i e l d i n g i n v e s t m e n t s a n d h a d b e e n a t t r a c t e d b y t h e h i g h y i e l d s i n E a s t A s i a n s h a r e m a r k e t s p r i o r t o t h e c r i s i s , b u t w h i c h h a d n o t a d v e r t i s e d t h e i r i n v e s t m e n t s i n e m e r g i n g m a r k e t s . T h e y w e r e e m b a r r a s s e d t o b e h o l d i n g a s s e t s w h o s e v a l u e h a d c o l l a p s e d , a n d g o t o u t a s f a s t a s t h e y c o u l d b e f o r e t h e i r h o l d i n g s b e c a m e w i d e l y k n o w n a n d c r i t i c i z e d . B u t a c c o r d i n g t o t h i s a c c o u n t t h e h o l d i n g s b y f u n d s t h a t h a d a d v e r t i s e d t h e y w e r e i n v e s t i n g i n e m e r g i n g m a r k e t s r e m a i n e d s t e a d y , a n d t h e y m a y e v e n h a v e p i c k e d u p s o m e o f t h e s h a r e s b e i n g s o l d b y t h e f o r m e r g r o u p , p e r h a p s t o s u s t a i n t h e i r t a r g e t a s s e t a l l o c a t i o n s . T h e s e i n v e s t o r s w e r e i n e m e r g i n g m a r k e t s f o r t h e l o n g h a u l , w e r e a w a r e t h a t t h e s e w e r e i n h e r e n t l y r i s k y m a r k e t s t h a t w o u l d h a v e d o w n s a s w e l l a s u p s , a n d n e i t h e r t h e m a n a g e r s o f t h e f u n d s n o r t h e i r i n v e s t o r s p a n i c k e d . W o r r y i n g l y , G r i f f i t h - J o n e s ( 2 0 0 1 ) s u g g e s t s t h a t i n r e c e n t y e a r s John W illia m s o n 1 4 3 t h e i m p o r t a n c e o f g l o b a l f u n d s h a s i n c r e a s e d r e l a t i v e t o t h a t o f d e d i c a t e d e m e r g i n g m a r k e t f u n d s . D o e s M i l t o n F r i e d m a n s f a m o u s 1 9 5 3 t h e o r e m - w h i c h s a y s t h a t d e s t a ­ b i l i z i n g s p e c u l a t o r s m u s t l o s e m o n e y ( b e c a u s e t o d e s t a b i l i z e a m a r k e t o n e m u s t b u y n e a r t h e p e a k a n d s e l l n e a r t h e t r o u g h , w h e r e a s m a k i n g m o n e y r e q u i r e s t h e o p p o s i t e ) - p r o v i d e r e a s s u r a n c e t h a t f u n d s t h a t a m p l i f y t h e b o o m - b u s t c y c l e w i l l l o s e m o n e y a n d s o a t l e a s t e n r i c h d o m e s t i c i n v e s t o r s ? N o t n e c e s s a r i l y . O n e p o s s i b i l i t y , a l l u d e d t o e a r l i e r , i s t h a t t h a t t h e c o u n t e r ­ p a r t t o s a l e s b y f o r e i g n e r s w i l l b e p u r c h a s e s b y o t h e r f o r e i g n e r s . B u t e v e n i f f o r e i g n p o r t f o l i o i n v e s t o r s d o i n d e e d t e n d t o f o l l o w t h e h e r d , b u y i n g w h e n t h e m a r k e t i s r i s i n g a n d s e l l i n g w h e n i t i s f a l l i n g , s o t h a t , i n t o t a l , d o m e s t i c i n v e s t o r s a r e s e l l i n g w h e n t h e m a r k e t i s r i s i n g a n d b u y i n g w h e n i t i s f a l l i n g , i t d o e s n o t n e c e s s a r i l y f o l l o w t h a t t h e f o r e i g n e r s w i l l l o s e m o n e y . B u y i n g o n a r i s i n g m a r k e t a n d b u y i n g n e a r t h e p e a k a r e n o t t h e s a m e t h i n g ; s p e c u l a t o r s w h o a r e a l e r t t o c h a n g e s i n t r e n d m a y b e a b l e t o q u i t b u y i n g , a n d s e l l o u t s o o n a f t e r t h e p e a k i s p a s t a n d m a k e m o n e y . T h e e m p i r i c a l s t u d i e s r e p o r t e d a b o v e o f f e r c o n t r a d i c t o r y v e r d i c t s o n w h e t h e r m a n y f o r e i g n i n v e s t o r s i n f a c t g o t o u t o f E a s t A s i a s u f f i c i e n t l y q u i c k l y t o s a v e t h e i r s k i n s . W h a t i s q u i t e c l e a r i s t h a t f o r e i g n i n v e s t o r s a s a w h o l e l o s t a n e n o r m o u s s u m o f m o n e y i n E a s t A s i a , o r a t l e a s t o n p a p e r : s o m e U S $ 1 6 6 b i l l i o n d u r i n g 1 9 9 7 , a c c o r d i n g t o t h e c a l c u l a t i o n s b y B a r t h a n d Z h a n g ( 1 9 9 9 : 2 0 4 ) . M u c h t h e s a m e a n a l y s i s a p p l i e s t o l o n g - t e r m b o n d s , w h o s e p r i c e s a l s o f l u c ­ t u a t e i n r e s p o n s e t o c h a n g e s i n e x p e c t a t i o n s i n s u c h a w a y a s t o e n s u r e t h a t t h e t o t a l s t o c k o f b o n d s c o n t i n u e s t o b e w i l l i n g l y h e l d . F l o w e v e r , n o m i n a l l y l o n g - t e r m b o n d s s o m e t i m e s i n c l u d e p u t o p t i o n s , g i v i n g t h e h o l d e r t h e r i g h t t o d e m a n d e a r l y r e p a y m e n t a t h i s o r h e r d i s c r e t i o n o n c e r t a i n d a t e s . I f s u c h d a t e s c o i n c i d e w i t h a c r i s i s , t h e n t h e l o a n t e n d s t o d i s a p p e a r j u s t w h e n i t i s m o s t n e e d e d , a s h a p p e n e d i n K o r e a i n l a t e 1 9 9 7 . W h i l e t h e h o l d i n g s o f t h o s e w h o b u y e m e r g i n g - m a r k e t a s s e t s w i t h t h e i n t e n t i o n o f h o l d i n g o n t o t h e m m a y n o t b e a s s t a b l e a s o n e m i g h t w i s h , a l a r g e l y s e p a r a t e a n d p e r h a p s m o r e a c u t e p r o b l e m i s p o s e d b y o v e r t l y s p e c u l a t i v e a c t i v i t i e s . H e d g e f u n d s - i n s t i t u t i o n s w h o s e m a n a g e r s q u i t e c o n ­ s c i o u s l y r a n g e t h e w o r l d l o o k i n g f o r m a r k e t a n o m a l i e s o r g o o d s p e c u l a t i v e b e t s t h a t a r e e x p e c t e d t o y i e l d h i g h r e t u r n s a n d a r e t o t a l l y u n r e g u l a t e d o n t h e g r o u n d s t h a t o n l y r i c h p e o p l e w h o d o n o t n e e d p r o t e c t i o n i n v e s t i n t h e m - a r e t h e a r c h e t y p e . T h e p r o p r i e t a r y t r a d i n g d e s k s o f i n v e s t m e n t b a n k s a n d o t h e r f i n a n c i a l c o m p a n i e s ( c o m m e r c i a l b a n k s , s e c u r i t i e s f i r m s a n d e v e n a f e w i n s u r a n c e c o m p a n i e s ) b e h a v e s i m i l a r l y . H e d g e f u n d s w e r e t h e b u t t o f P r i m e M i n i s t e r M a h a t h i r s c r i t i c i s m s i n 1 9 9 7 , b u t K a u f m a n ( 2 0 0 0 ) a s s e r t s t h a t v i r t u a l l y a l l i n v e s t m e n t i n s t i t u t i o n s h a v e n o w a d o p t e d t h i s i n v e s t m e n t s t y l e f o r a t l e a s t a n i m p o r t a n t p a r t o f t h e i r a c t i v i t i e s . T h e a c t i o n s o f t h e s e i n v e s t o r s i n 1 9 9 8 c o m e u n d e r o f f i c i a l s c r u t i n y i n t h e r e p o r t b y t h e M a r k e t D y n a m i c s S t u d y G r o u p o f t h e F i n a n c i a l S t a b i l i t y F o r u m s W o r k i n g G r o u p o n H i g h l y L e v e r a g e d I n s t i t u t i o n s ( H L I s ) 1 4 4 C u rb in g the B o o m -B u s t C ycle ( F i n a n c i a l S t a b i l i t y F o r u m , 2 0 0 0 ) . T h e g r o u p e x a m i n e d t h e p o s s i b l e d e s t a ­ b i l i z i n g i m p a c t o f l a r g e a n d c o n c e n t r a t e d H L I p o s i t i o n s [ i n 1 9 9 8 ] a n d t h e i m p l i c a t i o n s f o r m a r k e t i n t e g r i t y o f v a r i o u s a g g r e s s i v e p r a c t i c e s ( i b i d . : 9 7 ) . T h e e c o n o m i e s w i t h w h i c h t h e y w e r e c o n c e r n e d w e r e A u s t r a l i a , F l o n g K o n g , M a l a y s i a , N e w Z e a l a n d , S i n g a p o r e a n d S o u t h A f r i c a , a l t h o u g h N e w Z e a l a n d a n d S i n g a p o r e e x p r e s s e d l e s s c o n c e r n t h a n t h e o t h e r f o u r . T h e s e c o u n t r i e s e x p e r i e n c e d s t r o n g p r e s s u r e o n t h e i r f o r e i g n e x c h a n g e a n d d o m e s t i c f i n a n ­ c i a l m a r k e t s i n t h e m i d d l e o f 1 9 9 8 . B y t h e n i t w a s p r e t t y c l e a r t h a t a l l t h e c u r r e n c i e s ( e x c e p t t h e F l o n g K o n g d o l l a r , w h i c h w a s f i x e d b y a c u r r e n c y b o a r d ) w e r e u n d e r v a l u e d , y e t t h e s p e c u l a t i v e p r e s s u r e s w e r e a l l f o r f u r t h e r d e p r e c i a t i o n . T h i s w a s t h e t i m e w h e n t h e H o n g K o n g m o n e t a r y a u t h o r i t y u p s e t t h e f r e e m a r k e t f u n d a m e n t a l i s t s b y b u y i n g a b i g c h u n k o f t h e e q u i t y m a r k e t t o d e f e n d i t s e l f a g a i n s t t h e d o u b l e p l a y . T h e p r e s s u r e s w e r e r e l i e v e d i n S e p t e m b e r a n d g a v e w a y t o a s h a r p r e b o u n d i n e a r l y O c t o b e r w h e n t h e H L I s w e r e f o r c e d t o d e l i v e r f o l l o w i n g t h e c o l l a p s e o f L T C M . T h e r e p o r t d o c u m e n t s t h e f a c t t h a t a h a n d f u l o f H L I s e s t a b l i s h e d s u c h l a r g e s h o r t p o s i t i o n s i n t h e s e c u r r e n c i e s t h a t t h e y s t r e t c h e d t h e c a p a c i t y o f n a t u r a l c o u n t e r p a r t i e s ( s u c h a s e x p o r t e r s ) t o o f f s e t t h e i r p o s i t i o n s . T h e q u e s t i o n t h a t a n e c o n o m i s t i n s t i n c t i v e l y a s k s i s h o w t h e y e x p e c t e d t o m a k e m o n e y o u t o f s u c h o p e r a t i o n s . I t i s o n e t h i n g t o h a v e t h e m a r k e t p o w e r t o f o r c e a p r i c e b e l o w i t s f u n d a m e n t a l v a l u e , b u t i t i s q u i t e a n o t h e r t o m a k e m o n e y o u t o f f o r c i n g i t t h e r e . T o d o t h a t , o n e n e e d s t o b e a b l e t o g e t o t h e r s t o s e l l t h e c u r r e n c y a t e v e n m o r e u n d e r v a l u e d l e v e l s i n o r d e r t o c l o s e o u t o n e s s h o r t s a l e s a t a p r o f i t . I n t h e c a s e o f H o n g K o n g , t h e H L I s s o u g h t t o p r o f i t b y d o u b l e p l a y , w h i c h i n v o l v e d s e l l i n g e q u i t i e s s h o r t a n d t h e n s e l l i n g t h e H o n g K o n g d o l l a r s h o r t , r e l y i n g o n t h e a u t o m a t i c i n t e r e s t r a t e r i s e g e n e r a t e d b y t h e c u r r e n c y b o a r d r u l e s i n o r d e r t o f o r c e d o w n e q u i t y p r i c e s . T h i s w o u l d h a v e y i e l d e d t h e m a p r o f i t e v e n i f t h e H o n g K o n g d o l l a r w a s n o t d e v a l u e d a s l o n g a s t h e H o n g K o n g m o n e t a r y a u t h o r i t y p l a y e d b y t h e r u l e s o f t h e g a m e ( w h i c h i t d i d n o t , b e c a u s e i t i n t e r v e n e d t o b u y t h e e q u i t y i n d e x ) . B u t i n o t h e r c a s e s t h e H L I s c o u l d h a v e e x p e c t e d t o p r o f i t o n l y i f t h e y p a n i c k e d t h e m a r k e t . T h e e v i d e n c e i s t h a t t h i s i s e x a c t l y w h a t t h e y t r i e d t o d o . T h e r e p o r t d i s c u s s e s a g g r e s s i v e p r a c t i c e s i n t h e f o r m o f t a l k i n g t h e b o o k , w h i c h m e a n s d i s s e m ­ i n a t i n g r u m o u r s d e s i g n e d t o i n f l u e n c e p r i c e s s o a s t o b e n e f i t t h e p o s i t i o n s a l r e a d y t a k e n . A m a n a g e r o f a n H L I l a r g e e n o u g h t o h a v e s i g n i f i c a n t m a r k e t p o w e r m i g h t m a k e n e g a t i v e c o m m e n t s o n a c u r r e n c y t h a t w o u l d d i s c o u r a g e o t h e r m a r k e t p a r t i c i p a n t s f r o m t a k i n g c o n t r a r y p o s i t i o n s . S o m e f i n a n c i a l i n s t i t u t i o n s a r e r e p o r t e d t o h a v e p u b l i s h e d r e s e a r c h c o n c l u s i o n s t h a t w e r e d e s i g n e d t o i n f l u e n c e t h e m a r k e t ( p o s i t i o n s l e d r e s e a r c h r a t h e r t h a n v i c e v e r s a , i b i d . : 1 0 6 ) . T h e y e x p l o i t e d m o m e n t u m t r a d i n g b y o t h e r p a r t i c i p a n t s b y t r a d i n g h e a v i l y a t i l l i q u i d h o u r s , a p p a r e n t l y a t t e m p t i n g t o m o v e r a t e s r a t h e r t h a n t o g e t t r a n s a c t i o n s e x e c u t e d a t t h e b e s t p o s s i b l e p r i c e . H L I s a t t i m e s t o o k c o r r e l a t e d p o s i t i o n s w i t h i n a n d a c r o s s m a r k e t s , p r e s u m a b l y b y John W illia m s o n 1 4 5 d e s i g n t h o u g h n o o n e c o u l d p r o v e t h a t i t w a s n o t b y c o i n c i d e n c e . T h e s e t a c t i c s a t t i m e s s u c c e e d e d i n d r i v i n g m a n y r e g u l a r t r a d e r s o u t o f t h e m a r k e t f o r f e a r t h a t t h e y w o u l d b e o v e r w h e l m e d b y H L I s t h a t w e r e n o t p l a y i n g b y t h e n o r m a l r u l e s o f a c o m p e t i t i v e m a r k e t . A t o t h e r t i m e s o t h e r m a r k e t p a r t i c i p a n t s w e r e e m b o l d e n e d t o a d d t o m o m e n t u m ( i b i d . : 1 0 7 ) , o r a t l e a s t n o t t o s t a n d i n t h e w a y o f p o s i t i o n i n g b y l a r g e H L I s . A n d s o m e H L I s w e r e a b l e t o t a k e a d v a n t a g e o f t h e i r k n o w l e d g e o f t h e i m p a c t o f p r i c e c h a n g e s , f o r e x a m p l e p r o p r i e t a r y t r a d i n g d e s k s w e r e a b l e t o t a k e a d v a n t a g e o f t h e i r k n o w l e d g e a b o u t w h e n d e c l i n i n g b o n d p r i c e s w o u l d r e q u i r e b o n d s a l e s b y s w a p d e s k s , o r t h e y m i g h t h a v e p u s h e d r a t e s t o l e v e l s t h a t t h e y k n e w w o u l d t r i g g e r s t o p - l o s s o r d e r s o r k n o c k - o u t o p t i o n s . T h e s t u d y g r o u p d i d n o t r e a c h a c o n s e n s u s o n t h e r o l e a n d i m p o r t a n c e o f t h e a g g r e s s i v e t r a d i n g p r a c t i c e s t h a t i t d o c u m e n t e d , b u t i t i s p r e t t y c l e a r t h a t m o s t m e m b e r s o f t h e g r o u p c o n c l u d e d t h a t s u c h p r a c t i c e s t h r e a t e n e d m a r k e t i n t e g r i t y . A f t e r m a k i n g a h o s t o f c a r e f u l q u a l i f i c a t i o n s , t h e r e p o r t c o n c l u d e d : T h e g r o u p i s c o n c e r n e d a b o u t t h e p o s s i b l e i m p a c t o n m a r k e t d y n a m i c s o f s o m e o f t h e a g g r e s s i v e p r a c t i c e s c i t e d i n t h e c a s e - s t u d y e c o n o m i e s d u r i n g 1 9 9 8 ; i t i s n o t , h o w e v e r , a b l e t o r e a c h a c o n c l u s i o n o n t h e s c a l e o f t h e s e p r a c t i c e s , w h e t h e r m a n i p u l a t i o n w a s i n v o l v e d a n d t h e i r i m p a c t o n m a r k e t i n t e g r i t y . S o m e g r o u p m e m b e r s b e l i e v e t h a t t h e t h r e s h o l d f o r a s s e s s i n g m a n i p u l a t i o n c a n b e s e t t o o h i g h a n d t h a t s o m e o f t h e a g g r e s s i v e p r a c t i c e s r a i s e i m p o r t a n t i s s u e s f o r m a r k e t i n t e g r i t y . T h e y a r e o f t h e v i e w t h a t t h e r e i s s u f f i c i e n t e v i d e n c e t o s u g g e s t t h a t a t t e m p t e d m a n i p u l a t i o n c a n a n d d o e s o c c u r i n f o r e i g n e x c h a n g e m a r k e t s a n d s h o u l d b e a s e r i o u s c o n c e r n f o r p o l i c y m a k e r s ( i b i d . ) I t i s d i f f i c u l t t o i m a g i n e a m u c h m o r e d a m n i n g i n d i c t m e n t c o m i n g f r o m a g r o u p o f o f f i c i a l s . Strateg ic issu es T h e f o c u s h e r e w i l l b e o n h o w t o m a k e i n d i v i d u a l t y p e s o f c a p i t a l f l o w l e s s u n s t a b l e , r a t h e r t h a n o n t r y i n g t o i n f l u e n c e t h e m i x o f d i f f e r e n t f o r m s o f c a p i t a l f l o w s . A g o o d p l a c e t o s t a r t c o n s i d e r i n g w h a t m i g h t b e d o n e i n t h i s c o n n e c t i o n i s t o c o n s i d e r w h y p o r t f o l i o e q u i t y s e e m s t o h a v e d i s a p p o i n t e d t h e e x p e c t a t i o n s o f t h o s e w h o a r g u e d t h a t i t w a s u n l i k e l y t o p o s e p r o b l e m s o f i n s t a b i l i t y . I t c a n b e c o n j e c t u r e d t h a t t h e r e a s o n l i e s i n t h e w a y t h a t f i n a n c i a l m a r k e t s o p e r a t e . C o n s i d e r t h e w o r d s o f K a u f m a n ( 2 0 0 0 : 6 1 ) : A s m a r k e t s a n d a s s e t s h a v e c h a n g e d d r a m a t i c a l l y w i t h t h e e m e r g e n c e o f a n e w g l o b a l f i n a n c i a l s y s t e m , s o h a s t h e c o m p o s i t i o n o f f i n a n c i a l i n s t i ­ t u t i o n s t h e m s e l v e s . T h e p o w e r a n d i n f l u e n c e o f t r a d i t i o n a l c o m m e r c i a l 1 4 6 C u rb in g the B o o m -B u s t C ycle b a n k s , s a v i n g s a n d l o a n s , a n d i n s u r a n c e c o m p a n i e s h a v e d i m i n i s h e d , w h i l e a n e w b r e e d o f i n s t i t u t i o n a l p a r t i c i p a n t s h a s c o m e t o t h e f o r e . T h e s e i n s t i t u t i o n s a r e d i s t i n g u i s h e d b y t h e i r e m p h a s i s o n s h o r t - t e r m i n v e s t m e n t p e r f o r m a n c e , t h e i r h e a v y u s e o f l e v e r a g e , a n d t h e i r w i l l i n g n e s s t o m o v e i n a n d o u t o f m a r k e t s - w h e t h e r e q u i t i e s , b o n d s , c u r r e n c i e s , o r c o m m o d i t i e s - i n a r e l e n t l e s s q u e s t t o m a x i m i z e r e t u r n s . T h e n e w b r e e d i n c l u d e s t h e o f t e n - r e v i l e d h e d g e f u n d s , a l t h o u g h t h e y a r e n e i t h e r t h e s o l e n o r t h e l e a d i n g c o n t e s t a n t s . I n f a c t , m o s t p r o m i n e n t b a n k s , s e c u r i t i e s f i r m s , a n d e v e n a f e w i n s u r a n c e c o m p a n i e s p o s s e s s d e p a r t m e n t s t h a t e m u l a t e t h e t r a d i n g a n d i n v e s t m e n t a p p r o a c h o f t h e h e d g e f u n d s . E v e n t h e c o r p o r a t e t r e a s u r i e s o f a n u m b e r o f n o n - f i n a n c i a l c o r p o r a t i o n s a r e e n g a g e d i n t h i s a c t i v i t y . O n c e a r c a n e a n d e x o t i c , t h e h e d g e f u n d a p p r o a c h t o i n v e s t m e n t h a s b e e n m a i n s t r e a m e d . I n o t h e r w o r d s t h e f i n a n c i a l m a r k e t s a r e c u r r e n t l y d o m i n a t e d b y i n v e s t ­ m e n t m a n a g e r s w i t h a s h o r t - t e r m i s t p h i l o s o p h y , b a s e d o n t h e t r u i s m t h a t t o m a x i m i z e r e t u r n s i n e a c h a n d e v e r y s h o r t r u n n e c e s s a r i l y m a x i m i z e s r e t u r n s o v e r t h e l o n g r u n a s w e l l . W h a t i t c l e a r l y d o e s n o t m a x i m i z e i s t h e u s e f u l n e s s o f f i n a n c i a l m a r k e t s t o t h o s e w h o r a i s e f u n d s f r o m t h e m . A k e y q u e s t i o n i s w h e t h e r s h o r t - t e r m i s t m a n a g e m e n t i s r e a l l y i n t h e i n t e r e s t o f t h e u l t i m a t e i n v e s t o r s : t h e i n d i v i d u a l s w h o b u y m u t u a l f u n d s a n d t h e i n s t i t u t i o n s w h o s e e n d o w m e n t s a n d w o r k i n g a s s e t s a r e u n d e r m a n a g e ­ m e n t . T h e c o n t r a r y a r g u m e n t h a s b e e n d e v e l o p e d b y S w e n s e n ( 2 0 0 0 ) , w h o i s t h e c h i e f i n v e s t m e n t o f f i c e r o f Y a le U n i v e r s i t y a n d inter alia m a n a g e s i t s e n d o w m e n t . T h e b a s i c a r g u m e n t i s t h a t s h o r t - t e r m i s t m a n a g e m e n t r i s k s w h i p l a s h ( s e l l i n g a n a s s e t j u s t b e f o r e i t r i s e s o r b u y i n g i t j u s t b e f o r e i t s p e a k ) a n d u n d e r m i n e s t h e l i k e l i h o o d o f s y s t e m a t i c c o n t r a r i a n i n v e s t m e n t ( b u y i n g w h a t i s c u r r e n t l y o u t o f f a s h i o n a n d s e l l i n g w h a t i s c u r r e n t l y i n f a s h i o n ) . S u c h a c t i o n s o f t e n s e e m u n t h i n k a b l e i n t h e s h o r t t e r m , b u t t h e e v i d e n c e i s t h a t o n a v e r a g e t h e y a r e m o r e o f t e n r i g h t t h a n w r o n g . T h e b a s i c c h a r a c t e r i s t i c s o f a l o n g - t e r m i n v e s t m e n t s t r a t e g y , a s l a i d o u t b y S w e n s e n , i n v o l v e a s t r a t e g i c d e c i s i o n t o d i v i d e t h e p o r t f o l i o a m o n g a s s e t c l a s s e s i n t a r g e t p r o p o r t i o n s b a s e d o n l o n g - t e r m r i s k - r e t u r n c h a r a c t e r i s t i c s . W i t h i n e a c h a s s e t c l a s s , a s s e t s a r e m a n a g e d b y i n d i v i d u a l m a n a g e r s w h o a r e s e l e c t e d a c c o r d i n g t o t h e i r p e r f o r m a n c e r e l a t i v e t o t h e r e s t o f t h e a s s e t c l a s s , a s i n t h e c o n v e n t i o n a l s h o r t - t e r m i s t a p p r o a c h . B u t t h e s t r a t e g i c e l e m e n t i n t h i s s t r a t e g y l e a d s t o r e s u l t s t h a t a r e e x a c t l y c o n t r a r y t o t h o s e y i e l d e d b y t h e D E A R a p p r o a c h d e s c r i b e d a b o v e . F o r e x a m p l e a m a r k e t r u n o n e m e r g i n g m a r k e t a s s e t s l e a d s t o t h e p u r c h a s e o f m o r e o f s u c h a s s e t s , i n o r d e r t o r e s t o r e t h e p r o p o r t i o n o f t h e p o r t f o l i o i n t h a t a s s e t c l a s s t o i t s t a r g e t s h a r e , r a t h e r t h a n t o t h e s a l e o f s i m i l a r a s s e t s , a s u n d e r D E A R . T h i s t e n d s t o s t a b i l i z e m a r k e t s r a t h e r t h a n d e s t a b i l i z e t h e m . W h i c h s t r a t e g y p r o d u c e s b e t t e r r e s u l t s f o r t h e u l t i m a t e i n v e s t o r ? T h e Y a le e n d o w m e n t m a n a g e d b y S w e n s e n h a s i n d e e d a c h i e v e d s u p e r i o r r e t u r n s . B u t John W illia m s o n 1 4 7 s o h a v e m o s t o f t h e h e d g e f u n d s , t h e e x a m p l e par excellence o f t h e s h o r t - t e r m i s t a p p r o a c h . W h a t b o t h h a v e i n c o m m o n i s s u p e r i o r m a n a g e m e n t . O n e w o u l d n e e d a m u c h m o r e s y s t e m a t i c c o m p a r i s o n t o b e a b l e t o d r a w a n y s t r o n g c o n c l u s i o n a b o u t t h e s u p e r i o r i t y o f o n e a p p r o a c h o v e r t h e o t h e r f r o m t h e s t a n d p o i n t o f i t s a b i l i t y t o g e n e r a t e r e s u l t s t o t h e u l t i m a t e i n v e s t o r . W h a t o n e c a n s u r e l y s a y i s t h a t t h e r e i s n o r e a s o n t o a c c e p t a s a x i o m a t i c t h e s e l f - s e r v i n g c l a i m o f t h e s h o r t - t e r m i s t s t h a t a n y a p p r o a c h o t h e r t h a n t h e i r s i s s e l f - e v i d e n t l y a t t h e c o s t o f t h e i n v e s t o r . P e r h a p s t h e b i g g e s t d i f f i c u l t y w i t h t h e l o n g - t e r m a p p r o a c h i s t h e d i f f i c u l t y o f m o n i t o r i n g t h e p e r f o r m a n c e o f i n v e s t m e n t m a n a g e r s i n r e a l t i m e . I f o n e a b a n d o n s t h e d i s c i p l i n e o f r e g u l a r c o m p a r i s o n s w i t h t h e b e h a v i o u r o f a p e e r g r o u p , p o o r l y p e r f o r m i n g m a n a g e r s h a v e t o o m u c h o p p o r t u n i t y t o p l e a d t h a t t h e y a r e c u r r e n t l y i n v e s t i n g i n w h a t i s u n f a s h i o n a b l e a n d t h a t p a t i e n c e i s n e e d e d t o g i v e t h e m a r k e t t i m e t o r e a l i z e t h e e r r o r o f i t s w a y s . B u t t h e b e s t a n t i d o t e t o t h e l a c k o f t h a t d i s c i p l i n e i s t o d e m a n d a n a l t e r n a t i v e t y p e o f d i s c i p l i n e i n t h e f o r m o f a c o h e r e n t l o n g - t e r m s t r a t e g y s u c h a s t h a t d e s c r i b e d a b o v e . I t i s t r u s t e e s w h o s h o u l d e n s u r e t h a t t h i s a l t e r n a t i v e d i s c i p ­ l i n e i s i n p l a c e , a l t h o u g h t h e y c a n b e a s p r o n e t o p a n i c ( t h e g r e a t e n e m y o f c o n t r a r i a n i n v e s t i n g ) a s a n y o n e e l s e . E v e n t h o u g h i t c a n n o t b e p r o v e d a t t h i s s t a g e , t h e p r e s u m p t i o n i s t h a t u l t i m a t e i n v e s t o r s a n d b o r r o w e r s s h a r e a c o m m o n i n t e r e s t i n s e c u r i n g a s h i f t f r o m t h e c u r r e n t l y d o m i n a n t m o d e o f s h o r t - t e r m i s t i n v e s t m e n t m a n a g e m e n t t o t h e l o n g - t e r m s t r a t e g y d e s c r i b e d a b o v e . T h e y s h a r e a c o m m o n e n e m y i n t h e f o r m o f t h e p o r t f o l i o m a n a g e m e n t i n d u s t r y , a s i t i s c u r r e n t l y o r g a n i z e d . T h i s h a s a n i n t e r e s t i n m a i n t a i n i n g r e m u n e r a t i o n b a s e d l a r g e l y o n f r e q u e n t s h o r t - t e r m c o m p a r i s o n s w i t h t h e p e r f o r m a n c e o f p e e r s , w h i c h g e n e r a t e s h i g h r e m u n e r a t i o n a n d l o t s o f p o r t f o l i o c h u r n i n g t o g e n e r a t e c o m m i s s i o n i n c o m e t o p a y t h e h i g h s a l a r i e s . T h e q u e s t i o n i s w h e t h e r a n y t h i n g c a n b e d o n e b y m e a n s o f p u b l i c p o l i c y t o t i l t t h e b a l a n c e o f a d v a n t a g e t o w a r d s t h o s e i n v e s t m e n t m a n a g e r s w h o e m p l o y a l o n g - t e r m s t r a t e g y . T h e r e m a i n d e r o f t h i s c h a p t e r c o n s i s t s o f b r i e f e x p l o r a t i o n s o f s e v e r a l i d e a s t h a t m i g h t h e l p p u s h t h i n g s t h a t w a y . A n a m e n d e d UDROP P e r h a p s t h e m o s t p r o m i s i n g p o s s i b i l i t y i n t h i s c o n n e c t i o n i s a n i d e a t h a t h a s s u r f a c e d a s a r e s u l t o f t h e r e p e a t e d f i n a n c i a l c r i s e s a n d t h e c o s t s t h e y h a v e i m p o s e d o n t h e i r v i c t i m s : t h a t i t s h o u l d b e p o s s i b l e t o d e c l a r e a m o r a ­ t o r i u m o n d e b t s e r v i c e p a y m e n t s . M a n y o b s e r v e r s h a v e c o m e t o f e e l t h a t , w i t h p r i v a t e c a p i t a l f l o w s a s l a r g e a n d v o l a t i l e a s t h e y a r e n o w , t h e o n l y r e s p o n s e t o t h e o u t b r e a k o f a c u r r e n c y c r i s i s i s t o i n t e r r u p t a r u n b y force majeure. T h i s c o n c l u s i o n i s r e i n f o r c e d b y t h e f a c t t h a t t h e c o u n t r i e s t h a t c a m e o u t o f r e c e n t f i n a n c i a l c r i s e s r e l a t i v e l y q u i c k l y a n d l e a s t b a d l y s c a r r e d 1 4 8 C u rb in g the B o o m -B u s t C ycle w e r e t h o s e ( n o t a b l y K o r e a a n d B r a z i l i n 1 9 9 9 ) i n w h i c h t h e a u t h o r i t i e s q u i c k l y n e g o t i a t e d a l e n g t h e n i n g o f d e b t m a t u r i t i e s w i t h a n i m p o r t a n t c l a s s o f c r e d i t o r s . T h e t h i n k i n g i s t h a t i n m a n y s u c h c r i s e s t h e p r o b l e m i s o n e o f i l l i q u i d i t y r a t h e r t h a n i n s o l v e n c y ; t h e c o u n t r y w o u l d b e c a p a b l e o f h o n o u r i n g i t s o b l i g a t i o n s w i t h o u t a c u t i n t h e i r p r e s e n t v a l u e ( d e b t r e l i e f ) i f o n l y t h e r e p a y m e n t o b l i g a t i o n s w e r e s p r e a d o v e r a l o n g e r t i m e p e r i o d , b u t t h e i n c e n t i v e o f a n y i n d i v i d u a l c r e d i t o r i s t o c u t a n d r u n . I n t h i s s i t u a t i o n o n e n e e d s t o s o l v e t h e c r e d i t o r s c o o r d i n a t i o n p r o b l e m b y g i v i n g t h e m a n i n c e n t i v e t o c o m e t o t h e t a b l e a n d q u i c k l y n e g o t i a t e a d e b t r e s t r u c t u r i n g . A m o r a t o r i u m o r s t a n d s t i l l c o u l d p r o v i d e t h a t i n c e n t i v e b y e l i m i n a t i n g t h e n e e d t o c u t a n d r u n . T h e p r o b l e m i s h o w t o o f f e r t h a t p o s s i b i l i t y w i t h o u t d e s t r o y i n g t h e s a n c t i t y o f t h e d e b t c o n t r a c t s p r i n c i p l e t h a t u n d e r l i e s a n y c a p i t a l m a r k e t . N o t e a l s o t h a t a s u c c e s s f u l l y d e s i g n e d s t a n d s t i l l m e c h a n i s m m i g h t h a v e t h e a t t r a c t i v e f e a t u r e o f s a b o t a g i n g t h e i n v e s t m e n t s t r a t e g y o f s h o r t - t e r m i s t s w h i l e l e a v i n g l o n g - t e r m s t r a t e g i e s r e l a t i v e l y u n s c a t h e d . T o c o n s i d e r t h e p o s s i b i l i t i e s w e s h a l l s t a r t w i t h t h e m o s t c o n c r e t e p r o p o s a l f o r a s t a n d s t i l l t h a t h a s y e t b e e n t a b l e d , t h e U D R O P p r o p o s a l b y B u i t e r a n d S i b e r t ( 1 9 9 9 ) . U D R O P i s t h e a c r o n y m f o r u n i v e r s a l d e b t r o l l o v e r o p t i o n w i t h a p e n a l t y . I n B u i t e r a n d S i b e r t s w o r d s : A l l f o r e i g n - c u r r e n c y I O U s m u s t h a v e a r o l l o v e r o p t i o n a t t a c h e d t o t h e m . T h i s i n c l u d e s p r i v a t e a n d s o v e r e i g n , l o n g - t e r m a n d s h o r t - t e r m , m a r k e t a b l e a n d n o n - m a r k e t a b l e , n e g o t i a b l e a n d n o n - n e g o t i a b l e d e b t , i n c l u d i n g o v e r ­ d r a f t s , c r e d i t l i n e s , a n d c o n t i n g e n t c l a i m s A l l b o r r o w e r s , p u b l i c a n d p r i v a t e , m u s t b e g i v e n [ a n ] o p t i o n . . . [ t h a t ] w o u l d e n t i t l e t h e b o r r o w e r , a t h i s s o l e d i s c r e t i o n , t o e x t e n d m a t u r i n g d e b t f o r a s p e c i f i e d p e r i o d ( s a y t h r e e o r s i x m o n t h s ) at a penalty rate. T h e b o r r o w e r w o u l d b e e n t i t l e d t o t h e r o l l o v e r o n l y i f t h e d e b t i n q u e s t i o n h a d b e e n s e r v i c e d i n f u l l , b a r r i n g t h e f i n a l r e p a y m e n t . . . W e e x p e c t t h e p e n a l t y s p r e a d a n d o t h e r f e a t u r e s o f t h e r o l l o v e r c o n t r a c t t o b e n e g o t i a t e d b e t w e e n d e b t o r s a n d c r e d i t o r s , r a t h e r t h a n d e c r e e d b y a g o v e r n m e n t o r i n t e r n a t i o n a l b o d y ( i b i d . : 2 3 1 - 2 ) . B u i t e r a n d S i b e r t e m p h a s i z e t h a t t h e i r s c h e m e i s i n t e n d e d o n l y t o h e l p o t h e r w i s e s o l v e n t b o r r o w e r s w h o a r e u n a b l e t o r o l l o v e r t h e i r f o r e i g n c u r r e n c y d e b t b e c a u s e o f a l i q u i d i t y c r i s i s . H o w e v e r m o s t c r i s e s a r e n o t p u r e p a n i c s t h a t a r e r e s o l v e d s i m p l y b y t h e p a s s a g e o f t i m e . T h e y a r i s e w h e n c r e d i t o r s d e v e l o p d o u b t s a b o u t t h e a b i l i t y o f d e b t o r s t o s e r v i c e t h e i r d e b t s o n t h e c o n t r a c t u a l l y a g r e e d t e r m s , a n d t h e y e n d w h e n t h o s e d o u b t s a r e r e s o l v e d . O n e h a s t o a s k w h y a s i x - m o n t h d e l a y w i t h o u t a n y r e s t r u c t u r i n g o f d e b t b e y o n d t h a t p o i n t s h o u l d a l l a y s u c h f e a r s : s u r e l y t h e p r e s u m p t i o n i s John W ill ia m s o n 1 4 9 t h a t t h e d e b t o r s c o n d i t i o n w i l l b e e s s e n t i a l l y t h e s a m e a s i t w a s w h e n t h e U D R O P w a s e x e r c i s e d , w h i c h s u g g e s t s a d a n g e r t h a t a l l i t w o u l d a c c o m p l i s h w o u l d b e t o d e l a y t h e c r i s i s . N e v e r t h e l e s s a n a m e n d e d v e r s i o n o f t h e U D R O P p r o p o s a l w o u l d b e a n a t u r a l c o m p l e m e n t t o t h e i d e a s f o r a n i n t e r n a t i o n a l b a n k r u p t c y m e c h a n i s m t h a t w e r e r e c e n t l y f l o a t e d b y A n n e K r u e g e r ( 2 0 0 1 ) . E n f o r c i n g t h e s t a n d s t i l l s h e e n v i s a g e s w o u l d b e m u c h e a s i e r i f a l l i n t e r n a t i o n a l l o a n s i n c l u d e d a c l a u s e t h a t c o u l d b e i n v o k e d t o e x t e n d t h e m a t u r i t y o f t h e l o a n i n t h e e v e n t o f t h e b o r r o w i n g c o u n t r y f a c i n g a c r i s i s . T o t r a n s f o r m t h i s i n t o a p r o p o s a l t h a t c o u l d s e r v e t h e f u n c t i o n o f a s t a n d s t i l l , h o w e v e r , o n e w o u l d n e e d t o a l t e r t h e t e r m f o r w h i c h t h e r o l l o v e r w o u l d a p p l y . T h e a b o v e d i a g n o s i s o f w h a t i s n e e d e d t o e n d a d e b t c r i s i s s u g g e s t s t h a t a n e x t e n s i o n o f m u c h m o r e t h a n s i x m o n t h s i s l i k e l y t o b e n e e d e d . T h e t h r e e - y e a r e x t e n s i o n o f m a t u r i t i e s t h a t w a s n e g o t i a t e d b e t w e e n K o r e a a n d i t s b a n k c r e d i t o r s a t t h e e n d o f 1 9 9 7 s e e m s m u c h m o r e l i k e l y t o b e t y p i c a l . I n f a c t t h i s i s a d i m e n s i o n t h a t p r o b a b l y s h o u l d n o t b e p r e s p e c i f i e d , b u t i n s t e a d n e g o t i a t e d b e t w e e n t h e d e b t o r a n d a c r e d i t o r c o m m i t t e e ad hoc a s a n d w h e n t h e r o l l o v e r o p t i o n i s i n v o k e d . T h e c r e d i t o r s w i l l p r e s u m a b l y s e e k t h e s h o r t e s t r o l l o v e r p e r i o d t h a t w i l l a l l o w t h e d e b t o r t o r e s t o r e i t s l i q u i d i t y a n d e s c a p e f r o m t h e c r i s i s . B u t i f t h e y a r e r e c a l c i t r a n t a b o u t a g r e e i n g t o a r e a l i s t i c t i m e f r a m e , t h e d e b t o r w o u l d b e r e l i e v e d o f t h e o b l i g a t i o n o f p a y i n g a m o r t i z a t i o n pro tern. T h e i n c e n t i v e f o r t h e d e b t o r t o a g r e e t o t h e s h o r t e s t r e a l i s t i c p e r i o d f o r t h e r o l l o v e r i s t o p r e s e r v e i t s s t a n d i n g i n t h e c a p i t a l m a r k e t s . C r e d i t o r s h a v e r e a c t e d a d v e r s e l y t o t h e U D R O P i d e a . I f i t t u r n s o u t t h e y a r e s o s t r o n g l y a v e r s e t o i t a s t o b r i n g l e n d i n g t o a h a l t , o n e s o l u t i o n m i g h t b e t o e x e m p t l o n g - t e r m l o a n s a b o v e a c e r t a i n m a t u r i t y . T r a d e c r e d i t s m i g h t b e a l l o w e d t o s a t i s f y t h e r e q u i r e m e n t b y m e a n s o f a p r o v i s i o n f o r a g i v e n v o l u m e o f c r e d i t s t o r e v o l v e o v e r t i m e , o n t h e m o d e l o f t h e b a n k s 1 9 9 8 a g r e e m e n t w i t h B r a z i l . B u t l o a n s t h a t s h o u l d n o t b e e x e m p t e d , n o m a t t e r h o w s e v e r e t h e i m p a c t o n v o l u m e , a r e s h o r t - t e r m l o a n s . I t i s t r u e t h a t U D R O P w o u l d a d d t o t h e r i s k o f s h o r t - t e r m l e n d i n g t o a d e b t o r w h o s e m e d i u m - t e r m p o s i t i o n l o o k e d d o u b t f u l , b u t t h a t i s t h e p o i n t . S h o r t - t e r m i s t l e n d e r s f i n d i t m o r e d i f f i c u l t t o p e r s u a d e t h e m s e l v e s t h a t t h e y c a n b u y s h o r t - t e r m a s s e t s a n d t h e n w i n t h e r a c e t o e x i t i f t h i n g s g o w r o n g . T h e g a m e w h e r e i n v e s t m e n t b a n k e r s a d v i s e t h e i r c l i e n t s t h a t i t i s s a f e t o b u y s h o r t ­ t e r m a s s e t s f r o m c o u n t r y X b e c a u s e i t l o o k s s a f e e n o u g h f o r t h e n e x t n m o n t h s w o u l d b e u n d e r c u t . O n l y i n v e s t o r s w h o w e r e w i l l i n g t o m a k e a r e l a t i v e l y l o n g - t e r m c o m m i t m e n t w o u l d i n v e s t i n e m e r g i n g m a r k e t l o a n s , a n d t h o s e a r e t h e o n l y i n v e s t o r s w o r t h h a v i n g . U D R O P w o u l d n o t , o f c o u r s e , r e s o l v e t h e p r o b l e m p o s e d b y s h o r t - t e r m i s t i n v e s t o r s i n t h e e q u i t y m a r k e t s . P e r h a p s t h a t i s a p r o b l e m w e a r e g o i n g t o h a v e t o l i v e w i t h . 1 5 0 C u rb in g the B o o m -B u s t C ycle T rading g u id e lin e s fo r fo r e ig n e x c h a n g e m ark ets I n r e a c t i o n t o t h e c r i t i c i s m s b y t h e S u b - G r o u p o n M a r k e t D y n a m i c s o f t h e S t u d y G r o u p o n H i g h l y L e v e r a g e d I n s t i t u t i o n s o f t h e F i n a n c i a l S t a b i l i t y F o r u m r e f e r r e d t o a b o v e , i n F e b r u a r y 2 0 0 1 a g r o u p o f 1 6 l e a d i n g b a n k s a n n o u n c e d a v o l u n t a r y c o d e o f c o n d u c t . T h e i d e a w a s t h a t i f a l l t h e l e a d i n g b a n k s w e r e t o s u b s c r i b e t o t h e s e p r i n c i p l e s , a n d d e n y l i q u i d i t y t o p a r t i e s w h o m t h e y b e l i e v e d t o b e v i o l a t i n g t h e m , t h e n t h e r e w o u l d b e n o f u r t h e r i n c i d e n t s l i k e t h o s e o f A u g u s t - S e p t e m b e r 1 9 9 8 . T h e p r i n c i p l e s t h e y a n n o u n c e d w e r e a s f o l l o w s : • B a n k s s h o u l d b e s e n s i t i v e t o m a r k e t r i s k a n d c r e d i t m a n a g e m e n t a n d p a y s p e c i a l a t t e n t i o n t o t h e f i n a n c i n g o f t r a d e s i n a c u r r e n c y e x p e r i e n c i n g h i g h v o l a t i l i t y . • F o r e i g n e x c h a n g e m a n a g e r s s h o u l d p a y p a r t i c u l a r c a r e w h e n e x e c u t i n g o r d e r s i n t i m e s o f v o l a t i l i t y a n d m a r k e t m a k e r s s h o u l d h a v e t h e r i g h t t o r e f u s e c u s t o m e r t r a n s a c t i o n s t h a t t h e y f e l t m i g h t f u r t h e r d i s r u p t o r i n t e n d t o d i s r u p t m a r k e t s . • S t o p / l o s s o r d e r s : f o r e i g n e x c h a n g e m a n a g e r s s h o u l d c o m m u n i c a t e f r e ­ q u e n t l y w i t h c u s t o m e r s o n m a r k e t d e v e l o p m e n t s , e s p e c i a l l y w i t h r e g a r d t o i n d i v i d u a l t r i g g e r l e v e l s . • C a r e s h o u l d b e t a k e n t h a t c u s t o m e r s i n t e r e s t s w e r e n o t e x p l o i t e d w h e n f i n a n c i a l i n t e r m e d i a r i e s t r a d e d f o r t h e i r o w n a c c o u n t . • I n s t i t u t i o n s s h o u l d b e a t t e n t i v e a t a l l t i m e s t o e n s u r e t h e i n d e p e n d e n c e a n d i n t e g r i t y o f a n y m a r k e t - r e l a t e d r e s e a r c h t h e y p u b l i s h e d . • F i n a n c i a l i n t e r m e d i a r i e s s h o u l d i m p l e m e n t r i g o r o u s g u i d e l i n e s o n t h e h a n d l i n g o f r u m o u r s . D e a l e r s s h o u l d n o t r e l a y i n f o r m a t i o n t h a t t h e y k n e w t o b e f a l s e o r s u s p e c t e d m i g h t b e i n a c c u r a t e . • M a n i p u l a t i v e p r a c t i c e s b y b a n k s w i t h e a c h o t h e r o r w i t h c l i e n t s c o n s t i ­ t u t e d u n a c c e p t a b l e t r a d i n g b e h a v i o u r . • F o r e i g n e x c h a n g e t r a d i n g m a n a g e m e n t s h o u l d p r o h i b i t t h e d e l i b e r a t e e x p l o i t a t i o n o f e l e c t r o n i c d e a l i n g s y s t e m s t o g e n e r a t e a r t i f i c i a l p r i c e b e h a v i o u r . I t i s r a t h e r s a d t h a t i t w a s n e c e s s a r y f o r l e a d i n g f i n a n c i a l i n s t i t u t i o n s t o a n n o u n c e t h a t i n f u t u r e t h e y w o u l d c o n s i d e r i t b a d f o r m t o m a n i p u l a t e t h e i r c l i e n t s o r t o p u b l i s h r e s e a r c h t h a t l a c k e d i n t e g r i t y , b u t p e r h a p s w e s h o u l d b e t h a n k f u l f o r s m a l l m e r c i e s . A t p r e s e n t t h e r e a p p e a r s t o b e n o i n t e n t i o n t o i n v e s t i g a t e w h e t h e r b a n k s a r e l i v i n g u p t o t h e i r v o l u n t a r y c o d e . I t w o u l d b e w o r t h a d d i n g t h i s t o t h e t a s k s i m p o s e d o n s u p e r v i s o r s . L im ita tio n s o n in v estm en t-g ra d e b o n d s I n v e s t o r s w i t h f i d u c i a r y r e s p o n s i b i l i t i e s , s u c h a s i n s u r a n c e c o m p a n i e s , a r e f o r b i d d e n ( a t l e a s t i n t h e U n i t e d S t a t e s ) t o h o l d b o n d s t h a t a r e l e s s t h a n John W illia m s o n 1 5 1 i n v e s t m e n t g r a d e . A t f i r s t g l a n c e i s m a y s e e m s e n s i b l e , s i n c e i t p r e c l u d e s t h e s e i n s t i t u t i o n s a b u s i n g t h e i r p o s i t i o n o f t r u s t b y u s i n g i n v e s t o r s m o n e y t o b u y r i s k y a s s e t s . W h a t d o e s n o t m a k e s e n s e , h o w e v e r , i s t h a t t h i s r e q u i r e ­ m e n t i s s p e c i f i e d i n t e r m s o f w h a t t h e y m a y h o l d r a t h e r t h a n w h a t t h e y m a y a c q u i r e . T h e d i f f e r e n c e c a n b e c r u c i a l . I n l a t e 1 9 9 7 i n s u r a n c e c o m p a n i e s h o l d i n g K o r e a n b o n d s w e r e f o r c e d b y t h i s r e q u i r e m e n t t o s e l l t h e m i n t h e m i d s t o f t h e m a r k e t i m p l o s i o n , w h e n t h e c r e d i t r a t i n g a g e n c i e s h a d p a n i c k e d a n d s u d d e n l y c u t K o r e a s r a t i n g t o b e l o w i n v e s t m e n t g r a d e . T h e h o l d e r s w e r e n o t a l l o w e d t o e x e r c i s e t h e i r j u d g e m e n t o f w h e t h e r K o r e a n b o n d s r e m a i n e d a g o o d i n v e s t m e n t ( w h i c h t h e y c e r t a i n l y w e r e a f t e r t h e i r p r i c e h a d c o l l a p s e d ) b u t w e r e f o r c e d t o s e l l a n d t h e r e b y a d d t o t h e p r e s s u r e s o n K o r e a , a t t h e c o s t o f t h e i r c l i e n t s . A n y s u c h r e q u i r e m e n t s h o u l d b e r e d r a f t e d t o l i m i t w h a t f i d u c i a r y i n v e s t o r s c a n b u y r a t h e r t h a n w h a t t h e y c a n h o l d . T h a t w o u l d p r e v e n t t h e i r b e i n g f o r c e d t o s e l l i n r e s p o n s e t o a c r e d i t d o w n g r a d i n g , a s h a p p e n e d i n K o r e a i n l a t e 1 9 9 7 . A s w e l l a s m a k i n g b o n d l e n d i n g s o m e ­ w h a t m o r e s t a b l e , t h i s c h a n g e w o u l d r e d u c e t h e p r e m i u m o n s h o r t - t e r m i s t a s s e s s m e n t o f w h e t h e r a n d w h e n c r e d i t r a t i n g s m a y c h a n g e . P u t o p t io n s in b o n d co n tra cts A f i v e - y e a r l o a n w i t h a p u t o p t i o n e x e r c i s a b l e i n s i x - m o n t h s t i m e i s n o t r e a l l y a f i v e - y e a r b o n d ; f r o m a n e c o n o m i c s t a n d p o i n t i t i s a s h o r t - t e r m , s i x - m o n t h l o a n w i t h a r o l l o v e r p r o v i s i o n i f t h e l e n d e r c o n s e n t s a n d i t s h o u l d b e c o u n t e d a s s u c h i n t h e s t a t i s t i c s . C o r r e c t r e p o r t i n g w o u l d f o r c e b o t h b o r r o w e r s a n d t h e i r n a t i o n a l a u t h o r i t i e s t o r e c o g n i z e t h e r i s k s b e i n g t a k e n . O n e w o u l d e x p e c t t h a t t h i s w o u l d d i m i n i s h t h e a t t r a c t i v e n e s s o f a g r e e i n g t o t h e i n c l u s i o n o f p u t o p t i o n s i n b o n d c o n t r a c t s , a n d h e n c e l e n g t h e n t h e e f f e c t i v e m a t u r i t y o f b o n d s . C o lle c tiv e a c t io n c lau ses O n e o f t h e r e a s o n s f o r t h e s w i t c h f r o m b a n k l e n d i n g i n t h e 1 9 7 0 s t o b o n d l e n d i n g i n t h e 1 9 9 0 s w a s w i t h o u t m u c h d o u b t t h e l e s s e r v u l n e r a b i l i t y o f b o n d s t o r e s t r u c t u r i n g w h e n a c o u n t r y r a n i n t o d e b t s e r v i c i n g p r o b l e m s . T h i s w a s b a s e d i n p a r t i c u l a r o n p r o v i s i o n s t h a t w e r e i n t r o d u c e d i n t o N e w Y o r k l a w i n 1 9 3 9 t o r e s t r a i n a b u s i v e d e b t b u y b a c k s t h a t h a d t h e e f f e c t o f a r b i t r a r i l y e x p r o p r i a t i n g s o m e c r e d i t o r s ( B u c h h e i t a n d G u l a t i , 2 0 0 0 : 6 6 - 7 ) . T h e p r o v i s i o n s i n q u e s t i o n r e q u i r e d u n a n i m o u s c o n s e n t b y b o n d h o l d e r s t o a n y c h a n g e i n t h e t e r m s o f t h e p a y m e n t c l a u s e s , w h i c h w e r e t h o s e c l a u s e s t h a t s p e c i f i e d t h e s u m s t o b e p a i d i n d e b t s e r v i c e a n d t h e d a t e s w h e n p a y m e n t s w e r e d u e . T h i s g a v e a s i n g l e r e c a l c i t r a n t b o n d h o l d e r - o r a v u l t u r e f u n d t h a t b o u g h t u p d i s t r e s s e d d e b t - t h e a b i l i t y e i t h e r t o p r e v e n t a d e b t r e c o n s t r u c t i o n w h e n t h a t w a s n e c e s s a r y o r t o i n s i s t o n f u l l r e p a y m e n t e v e n w h e n o t h e r h o l d e r s h a d a g r e e d t o a c c e p t l e s s . I n d e e d s u c h a b o n d h o l d e r c o u l d n o r m a l l y e x p e c t t o d e m a n d , a n d w i n f r o m t h e c o u r t s , a c c e l e r a t e d 1 5 2 C u rb in g the B o o m -B u s t C ycle r e p a y m e n t w h e n n o r m a l d e b t s e r v i c e w a s i n t e r r u p t e d b e f o r e t h e d e b t r e c o n ­ s t r u c t i o n . N a t u r a l l y t h e p r o s p e c t t h a t s o m e c r e d i t o r s w o u l d n o t m a k e s a c r i f i c e s w h e n o t h e r s d i d , a n d t h a t t h e d e b t o r w o u l d i n d e e d b e a b l e t o s e r v i c e t h e c l a i m s o f t h e h o l d o u t s p r e c i s e l y b e c a u s e t h e o t h e r s h a d a g r e e d t o a c c e p t a w r i t e - d o w n o f t h e i r c l a i m s , m e a n t t h a t t h e m a j o r i t y w e r e r e l u c t a n t t o e n d o r s e b o n d r e s t r u c t u r i n g s . I t c o u l d e v e n b e t h a t t h e d e b t o r w o u l d b e u n a b l e t o h o n o u r t h e r e v i s e d d e b t t e r m s b e c a u s e o f t h e p a y m e n t i t w a s f o r c e d t o m a k e t o t h e h o l d o u t b o n d h o l d e r s . A s l o n g a s b o n d s w e r e a s m a l l p a r t o f t h e t o t a l c l a i m s o u t s t a n d i n g , i t w a s s i m p l e r t o a l l o w t h e m t o r e m a i n i n t a c t w h e n b a n k c l a i m s w e r e r e s t r u c t u r e d . I t w a s c l e a r t h a t t h i s c o u l d n o t c o n t i n u e i f d e b t o r s r a n i n t o t r o u b l e w h e n b o n d s h a d b e c o m e a l a r g e p a r t o f t h e t o t a l d e b t , a n d i n d e e d i n l a t e r y e a r s t h e o f f i c i a l s e c t o r s t a r t e d t o c a l l f o r p r i v a t e s e c t o r i n v o l v e m e n t i n d e b t w o r k o u t s ( t h e G 1 0 i n 1 9 9 6 ) . L e d b y E i c h e n g r e e n a n d P o r t e s ( 1 9 9 5 ) , a n u m b e r o f e c o n o m i s t s h a d a l r e a d y s t a r t e d t o a d v o c a t e t h e i n c l u s i o n o f c o l l e c t i v e a c t i o n c l a u s e s i n a l l b o n d c o n t r a c t s i n o r d e r t o f a c i l i t a t e t h e r e s t r u c t u r i n g o f b o n d s w h e n n e c e s s a r y . 3 W h e n t h i s p r o p o s a l w a s f i r s t m o o t e d t h e r e w e r e d i r e p r e ­ d i c t i o n s b y s o m e N e w Y o r k - b a s e d l e n d e r s , e c h o e d b y s o m e o f t h e i r c l i e n t s , t h a t a n y a t t e m p t t o i n c l u d e s u c h c l a u s e s w o u l d b r i n g l e n d i n g t o a h a l t , o r a t t h e l e a s t l e a d t o d r a s t i c i n c r e a s e s i n i n t e r e s t r a t e s . T h e n i t w a s r e a l i z e d t h a t a b o u t o n e t h i r d o f s u c h b o n d s , n a m e l y m o s t o f t h o s e s i g n e d i n L o n d o n , a l r e a d y i n c l u d e d s u c h c l a u s e s . E i c h e n g r e e n a n d M o d y ( 2 0 0 0 a , 2 0 0 0 b ) t h e r e ­ f o r e e x a m i n e d w h e t h e r t h e c l a u s e s h a d r e s u l t e d i n h i g h e r i n t e r e s t r a t e s f o r b o r r o w e r s , a s p e r t h e p r e d i c t i o n . I t t u r n e d o u t t h a t t h e i m p a c t w a s m o d e s t a n d , i n t e r e s t i n g l y , t h a t t h e d i r e c t i o n o f t h e i m p a c t d e p e n d e d o n t h e b o r r o w e r s c r e d i t w o r t h i n e s s . C o u n t r i e s w i t h p o o r c r e d i t r a t i n g s d i d i n d e e d h a v e t o p a y s o m e w h a t m o r e t o b o r r o w w h e n t h e y h a d t h e a d d e d s e c u r i t y o f c o l l e c t i v e a c t i o n c l a u s e s , p r e s u m a b l y r e f l e c t i n g l e n d e r s c o n c e r n t h a t u n w i l l ­ i n g n e s s t o p a y m i g h t c a u s e b o r r o w e r s t o a b u s e t h e c l a u s e s , e v e n i f t h e y w e r e a b l e t o p a y . B u t c o u n t r i e s w i t h g o o d c r e d i t r a t i n g s a c t u a l l y p a i d s o m e w h a t l e s s , p r e s u m a b l y r e f l e c t i n g l e n d e r s r e c o g n i t i o n t h a t t h e c l a u s e s w o u l d r e d u c e t h e c o s t o f r e s t r u c t u r i n g d e b t ( a n d t h e p o s s i b l e i n t e r r u p t i o n i n d e b t s e r v i c e p a y m e n t s w h i l e t h i s h a p p e n e d ) i n t h e r e m o t e p o s s i b i l i t y t h a t t h e c o u n t r i e s f o u n d t h e m s e l v e s u n a b l e t o p a y . L a w y e r s h a v e n o w f o u n d a w a y o f r e c o n s t r u c t i n g b o n d s i s s u e d u n d e r N e w Y o r k l a w , e v e n w i t h o u t c o l l e c t i v e a c t i o n c l a u s e s ( B u c h h e i t a n d G u l a t i , 2 0 0 0 ) . T h e k e y i s t o a c c o m p a n y t h e o f f e r t o s w a p o l d b o n d s f o r n e w o n e s t h a t c o n t a i n t h e r e v i s e d p a y m e n t t e r m s b y a m e n d i n g t h e n o n - p a y m e n t c l a u s e s o f t h e o l d b o n d s i n s u c h a w a y a s t o m a k e t h e s e b o n d s m u c h l e s s a t t r a c t i v e a n d i m p e d e h o l d o u t b o n d h o l d e r s f r o m s u c c e s s f u l l y l i t i g a t i n g f o r c o n t i n u e d o r a c c e l e r a t e d p a y m e n t . F o r e x a m p l e t h e o l d b o n d s m a y b e d e l i s t e d , t h e w a i v e r o f s o v e r e i g n i m m u n i t y m a y b e w i t h d r a w n a n d n e g a t i v e p l e d g e p r o t e c t i o n m a y b e r e m o v e d , a l l w i t h o u t t h e n e e d f o r t h e u n a n i m i t y t h a t p r e ­ v e n t s r e v i s i o n o f t h e p a y m e n t s c l a u s e s . S i n c e t h e s e d i s f i g u r i n g a m e n d m e n t s John W illia m s o n 1 5 3 t o t h e t e r m s o f t h e o l d b o n d s a r e a d o p t e d s i m u l t a n e o u s l y w i t h b o n d h o l d e r s e x c h a n g i n g t h e i r o l d b o n d s f o r t h e n e w d e b t i n s t r u m e n t s , t h e y a r e k n o w n a s e x i t c o n s e n t s . E x i t c o n s e n t s w e r e u s e d w h e n r e s t r u c t u r i n g j u n k b o n d s i n t h e 1 9 8 0 s , a n d i n 1 9 9 9 E c u a d o r w a s t h e f i r s t c o u n t r y t o u s e t h e t e c h n i q u e t o r e s t r u c t u r e s o v e r e i g n b o n d s . E x i t c o n s e n t s h a v e o n e g r e a t a d v a n t a g e o v e r c o l l e c t i v e a c t i o n c l a u s e s : t h e y c a n b e u s e d t o d e a l w i t h t h e s t o c k o f o l d b o n d s , r a t h e r t h a n s i m p l y a l l o w i n g t o d a y s n e w i s s u e s t o b e r e s t r u c t u r e d i n t h e f u t u r e . T h e y a l s o h a v e o n e g r e a t d i s a d v a n t a g e : t h e y d o n o t g i v e t o t a l p r o t e c t i o n a g a i n s t t h e t h r e a t o f l i t i ­ g a t i o n b y h o l d o u t s . A n o p t i m a l s t r a t e g y f o r a n e m e r g i n g m a r k e t ( o r a t l e a s t f o r o n e w i t h a r e p u t a t i o n a s a g o o d c r e d i t o r ) w o u l d b e t o e n s u r e t h a t a l l n e w b o n d s c o n t a i n e d c o l l e c t i v e a c t i o n c l a u s e s , w h i l e b e i n g r e a d y t o u s e e x i t c o n s e n t s o n o l d b o n d s s h o u l d t h e n e e d a r i s e . I t w o u l d b e v e r y e a s y t o e n s u r e t h a t i t s n e w b o n d s c o n t a i n e d s u c h c l a u s e s : a l l i t w o u l d n e e d t o d o w o u l d b e t o s h i f t i t s b o r r o w i n g t o L o n d o n u n t i l N e w Y o r k l a w w a s a m e n d e d s o t h a t t h e t e r m s o f i t s s t a n d a r d b o n d c o n t r a c t i n c l u d e d c o l l e c t i v e a c t i o n c l a u s e s . M i g h t t h e i n c l u s i o n o f c o l l e c t i v e a c t i o n c l a u s e s i n b o n d c o n t r a c t s a c t u a l l y m a k e b o n d s m o r e a t t r a c t i v e f o r c r e d i t o r s t o h o l d a s w e l l a s m a k i n g l i f e e a s i e r f o r d e b t o r s i f t h e w o r s t h a p p e n s ? T h a t w o u l d d e p e n d o n t h e n e t o u t c o m e o f t w o o p p o s i n g c o n s i d e r a t i o n s . O n t h e o n e h a n d , c o l l e c t i v e a c t i o n c l a u s e s w o u l d r e d u c e t h e c o s t a n d d i s r u p t i o n o f d e b t r e s t r u c t u r i n g s h o u l d t h e d e b t o r b e c o m e u n a b l e t o p a y o n t h e o r i g i n a l l y c o n t r a c t e d t e r m s . O n t h e o t h e r h a n d , t h e g r e a t e r e a s e o f r e n e g o t i a t i n g t e r m s m i g h t e n c o u r a g e a d e b t o r t o s u c c u m b t o t h e t e m p t a t i o n t o a v o i d p a y i n g w h e n i t c o u l d d o s o . E i c h e n g r e e n a n d M o d y s e v i d e n c e o n b o n d p r i c i n g i m p l i e s t h a t i n v e s t o r s a r e a b l e t o d i s c r i m i n a t e b e t w e e n t h e c o u n t r i e s i n w h i c h e a c h e f f e c t d o m i n a t e s , w h i c h s u g g e s t s t h a t t h e y a r e u n l i k e l y t o s u f f e r i f c o l l e c t i v e a c t i o n c l a u s e s b e c o m e r o u t i n e . B y m a k i n g m o r e e x p l i c i t t h e p o s s i b i l i t y t h a t b o n d s w i l l h a v e t o b e r e s t r u c t u r e d , o n e w o u l d e x p e c t c o l l e c t i v e a c t i o n c l a u s e s t o m a k e p o t e n t i a l b u y e r s w e i g h u p t h e c h a n c e s o f t h e i r b e i n g i n v o k e d , w h i c h w i l l h e l p t o c u r b s h o r t - t e r m i s m . T h o s e w h o s t i l l b u y t h e m a r e t h e r e f o r e m o r e l i k e l y t o p r o v e p a t i e n t h o l d e r s . C u rren cy o f d e n o m in a t io n O n e r e a s o n w h y c u r r e n c y c r i s e s t e n d t o b e s o d i s r u p t i v e i s t h a t f o r e i g n l e n d i n g t o a n e m e r g i n g m a r k e t c o u n t r y i s a l m o s t a l w a y s d e n o m i n a t e d i n e i t h e r d o l l a r s o r ( i f d i f f e r e n t ) t h e c u r r e n c y o f t h e l e n d e r . T h i s m e a n s t h a t a n y d e v a l u a t i o n i n c r e a s e s t h e b o r r o w i n g c o u n t r y s f o r e i g n l i a b i l i t i e s i n t e r m s o f i t s d o m e s t i c c u r r e n c y , w h i c h , i n e x t r e m e c a s e s c a n t h r e a t e n w i d e s p r e a d b a n k r u p t c y i n t h e f i n a n c i a l a n d / o r c o r p o r a t e s e c t o r s ( a s h a p p e n e d i n E a s t A s i a i n 1 9 9 7 ) . I n c o n t r a s t m a n y i n d u s t r i a l c o u n t r i e s b o r r o w p r e d o m i n ­ a n t l y i n t h e i r o w n c u r r e n c i e s , w h i c h m a k e s a n e x c h a n g e - r a t e c h a n g e f a r l e s s t h r e a t e n i n g . 1 5 4 C u rb in g the B o o m -B u s t C ycle T h e r e f o r e o n e c h a n g e t h a t s e e m s h i g h l y d e s i r a b l e w o u l d b e t o u s e t h e b o r r o w e r s c u r r e n c y t o d e n o m i n a t e i n t e r n a t i o n a l l o a n s . E i c h e n g r e e n a n d H a u s m a n n ( 1 9 9 9 ) i m p l y t h a t t h i s i s i n c o n c e i v a b l e b y d e s c r i b i n g e m e r g i n g - m a r k e t c o u n t r i e s a s s u f f e r i n g f r o m o r i g i n a l s i n . N o e v i d e n c e i s p r e s e n t e d t o j u s t i f y t h e i n n u e n d o t h a t t h e p r a c t i c e o f d e n o m i n a t i n g l o a n s i n f o r e i g n c u r r e n c i e s i s u n a l t e r a b l e . I n f a c t t h e r e a r e o c c a s i o n a l i n s t a n c e s o f e m e r g i n g c o u n t r i e s b o r r o w i n g i n t h e i r o w n c u r r e n c i e s , o f w h i c h t h e m a j o r e x a m p l e i s S o u t h A f r i c a . I n s t e a d o f d i s m i s s i n g t h e p o s s i b i l i t y o f a c h i e v i n g s u c h a d e s i r ­ a b l e r e f o r m , i t m a k e s m o r e s e n s e t o t r y t o u n d e r s t a n d w h y i t h a p p e n s s o r a r e l y , a n d t h e r e f o r e w h a t c o n d i t i o n s m i g h t b e n e c e s s a r y t o m a k e i t t h e n o r m . W h y m i g h t l e n d e r s s e e k t o a v o i d c u r r e n c y e x p o s u r e ? T h e s t r o n g e s t r e a s o n i s a d e s i r e t o a v o i d h o l d i n g a s s e t s i n a c u r r e n c y w h o s e a u t h o r i t i e s h a v e a r e c o r d o f i r r e s p o n s i b l e m a c r o e c o n o m i c m a n a g e m e n t t h a t c o u l d l e a d t o u n p r e d i c t a b l e l o s s e s t h r o u g h d e v a l u a t i o n . B u t m o s t e m e r g i n g m a r k e t s h a v e g o t b e y o n d t h e s t a g e o f t h i n k i n g t h a t c h e a t i n g t h e i r c r e d i t o r s i s a c l e v e r s t r a t e g y . S i n c e m o s t e m e r g i n g m a r k e t s d o m e s t i c i n t e r e s t r a t e s a r e h i g h e r t h a n d o l l a r i n t e r e s t r a t e s a t m o s t t i m e s , i t c a n b e e x p e c t e d t h a t a l e n d e r w i l l e a r n m o r e f r o m l o a n s d e n o m i n a t e d i n t h e b o r r o w e r s ’ c u r r e n c y i n n o r m a l t i m e s . I n d e e d t h e r e i s a p r e s u m p t i o n t h a t i n t h e l o n g r u n t h e c u r r e n c y r i s k p r e m i u m w i l l t e n d t o m a k e d o m e s t i c c u r r e n c y b o r r o w i n g m o r e e x p e n s i v e t o t h e b o r r o w e r a n d m o r e r e m u n e r a t i v e t o t h e l e n d e r . W h a t i t w i l l a c c o m p l i s h i s t o m o v e t h e o b l i g a t i o n t o p a y a w a y f r o m a t i m e w h e n p a y m e n t i s p a r t i c u ­ l a r l y o n e r o u s t o a t i m e w h e n i t i s l e s s p r o b l e m a t i c . A g r e e m e n t t o d e n o m i n a t e l o a n s i n t h e l o c a l c u r r e n c y w o u l d e s s e n t i a l l y r e d i s t r i b u t e e a r n i n g s o v e r t i m e i n s u c h a w a y a s t o r e d u c e t h e p r e s s u r e o n b o r r o w e r s a t p a r t i c u l a r l y d i f f i c u l t t i m e s , w i t h o u t r e d u c i n g - i n d e e d , p r o b a b l y i n c r e a s i n g - t h e p r e s e n t v a l u e o f e x p e c t e d e a r n i n g s . A l e n d e r t h a t w a s p a r t i c u l a r l y c o n c e r n e d t o a v o i d s h o w i n g a b a l a n c e - s h e e t l o s s c o u l d c o v e r i t s p o s i t i o n i n t h e f o r w a r d m a r k e t ( w h e t h e r t h e b o r r o w i n g c o u n t r y w o u l d s t i l l r e d u c e i t s r i s k s i n t h e e v e n t o f a d e v a l u a t i o n w o u l d d e p e n d o n w h e t h e r t h e c o v e r w a s p r o v i d e d b y a d o m e s t i c o r a f o r e i g n p a r t y ) . T h i s s u g g e s t s t h a t i t i s p r e t t y d i f f i c u l t t o j u s t i f y l e n d e r s o b s e s s i o n w i t h a v o i d i n g f o r e i g n c u r r e n c y e x p o s u r e . T h e g r e a t e r s e c u r i t y o f o w n - c u r r e n c y b o r r o w i n g w a s r e c o g n i z e d i n t h e 1 9 8 8 B a s e l A c c o r d , w h i c h a l l o w e d t h e p r e f e r e n t i a l 2 0 p e r c e n t r i s k w e i g h t t o a p p l y t o l o n g - t e r m b a n k l e n d i n g i n n o n - O E C D c o u n t r i e s w h e n i t w a s d e n o m i n ­ a t e d i n , a n d f i n a n c e d i n , t h e l o c a l c u r r e n c y . T h e p o l i c y q u e s t i o n i s w h e t h e r t h e i n d u s t r i a l c o u n t r i e s s h o u l d n o t g o f u r t h e r a n d d r o p t h e r e q u i r e m e n t t h a t l e n d i n g b e f i n a n c e d b y l o c a l c u r r e n c y d e p o s i t s o r b o r r o w i n g , a n d t h u s g i v e a n i n c e n t i v e f o r f o r e i g n l e n d i n g t o b e d e n o m i n a t e d i n t h e l o c a l c u r r e n c y . R em u n era tio n p ra ctices M o s t m a n a g e r s i n t h e a s s e t m a n a g e m e n t b u s i n e s s f a c e a r e m u n e r a t i o n s t r u c t u r e t h a t i s i n t e n d e d t o a l i g n t h e i r p e r s o n a l i n c e n t i v e s w i t h t h e w e l f a r e o f t h e i r p r i n c i p a l s . T h i s t a k e s t h e f o r m o f a b a s e s a l a r y a u g m e n t e d John W illia m s o n 1 5 5 b y a s u b s t a n t i a l b o n u s i f a s u p e r i o r p e r f o r m a n c e i s a c h i e v e d . T h e b a s e s a l a r y i s i n t e n d e d t o s e c u r e a r e a s o n a b l e s t a n d a r d o f l i v i n g f o r m a n a g e r s e v e n i f t h e i r p e r f o r m a n c e i s a v e r a g e , w h i l e t h e b o n u s p a y s t h e m p a r t o f t h e b e n e f i t t h a t w o u l d a c c r u e t o t h e i r p r i n c i p a l s i f t h e i r r e t u r n s a r e e x c e p t i o n a l , t h u s p r o v i d i n g t h e m w i t h a n i n c e n t i v e t o s t r i v e t o a c h i e v e e x c e p t i o n a l r e t u r n s . T h e b o n u s i s n o r m a l l y b a s e d o n t h e e x t e n t t o w h i c h t h e p o r t f o l i o s t h e y m a n a g e a c h i e v e a h i g h e r r e t u r n t h a n t h e n o r m f o r t h e a s s e t c l a s s i n w h i c h t h e y a r e i n v e s t i n g , a s m e a s u r e d b y t h e i n d e x f o r t h a t a s s e t c l a s s . T h e p r o b l e m w i t h t h i s p r a c t i c e i s t h a t t h e t i m e f r a m e o v e r w h i c h b o n u s e s a r e d e f i n e d m a y n o t b e l o n g e n o u g h f o r a c o n t r a r i a n i n v e s t m e n t p o l i c y t o b e a r f r u i t . I f b o n u s e s a r e p a i d a n n u a l l y a n d a f a d l a s t s o n l y a f e w m o n t h s , t h e n t h e b o n u s s y s t e m w i l l g i v e m a n a g e r s t h e r i g h t i n c e n t i v e . B u t i f b o n u s e s a r e p a i d o n a n a n n u a l b a s i s ( o r w o r s e , a s i s n o r m a l i n m u t u a l f u n d s , q u a r ­ t e r l y ) , a n d a f a d l a s t s f o r y e a r s , t h e n r e s p o n s i b l e i n v e s t m e n t m a n a g e r s w h o m a k e l o n g - t e r m c o n t r a r i a n i n v e s t m e n t s c a n f i n d t h e m s e l v e s f o r e g o i n g b o n u s e s f o r l o n g p e r i o d s . W o r s e , t h e y m a y r i s k b e i n g f i r e d f o r f a l l i n g b e h i n d t h e i n d e x f o r a p e r i o d s h o r t e r t h a n a f a d c a n l a s t . T h e b o n u s s y s t e m i s a n a t t e m p t t o r e s p o n d t o t h e r e a l p r o b l e m o f m a k i n g s u r e t h a t m a n a g e r s a c t i n t h e i n t e r e s t o f t h e i r p r i n c i p a l s , b u t i t c a n p r o v i d e a n i n c e n t i v e f o r m a n a g e r s t o c o m p e t e t o b e a t t h e i n d e x i n t h e s h o r t t e r m a n d m a k e s u r e t h e y d o n o t d e p a r t t o o f a r f r o m i t i n t h e l o n g e r t e r m , a p r a c t i c e t h a t c a n a m p l i f y a n d p r o l o n g f a d s . T h e i m p o r t a n c e a t t a c h e d t o m a n a g e r s p e r f o r m a n c e r e l a t i v e t o t h e i r c h o s e n b e n c h m a r k h a s t h e u n f o r t u n a t e e f f e c t o f i n d u c i n g h e r d b e h a v i o u r o n t h e p a r t o f m a n a g e r s . N o m a t t e r h o w s t r o n g l y t h e y b e l i e v e a s e c u r i t y t o b e m i s v a l u e d b y t h e m a r k e t , t h e y s i m p l y c a n n o t a f f o r d t o f o l l o w t h e i r c o n v i c t i o n s i f t h e y b e l i e v e t h a t t h e c r o w d i s g o i n g t o p e r p e t u a t e i t s e r r o r f o r a n y l e n g t h o f t i m e . T h a t w a y t h e y r i s k n o t m e r e l y t h e i r b o n u s e s , b u t p e r h a p s e v e n t h e i r j o b s . P r o f e s s i o n a l p r u d e n c e d i c t a t e s n o t s t r a y i n g t o o f a r f r o m t h e b e n c h m a r k , t h a t i s , n o t d e f y i n g t h e h e r d . S i n c e t h e p r o b l e m i s t h a t t h e b o n u s d e s i g n p r o v i d e s a n i n c e n t i v e t o f o l l o w t h e h e r d i n t h e s h o r t t e r m w i t h o u t p a y i n g p r o p e r a t t e n t i o n t o t h e l i k e l y l o n g - t e r m c o n s e q u e n c e s o f w h e r e t h e h e r d i s h e a d i n g , i t s e e m s n a t u r a l t o e x p l o r e t h e p o s s i b i l i t y o f i n t r o d u c i n g l o n g e r - t e r m p e r f o r m a n c e i n t o t h e d e s i g n . S u p p o s e , f o r e x a m p l e , t h a t m a n a g e r s w e r e p a i d t h e i r b o n u s o n l y a f t e r a d e l a y , a n d t h e n o n l y i f s u b s e q u e n t e v e n t s h a d n o t e s t a b l i s h e d t h a t t h e i r i n v e s t m e n t s t r a t e g i e s w e r e f l a w e d . T h i s w o u l d p r o v i d e a v e r y c o n c r e t e i n c e n t i v e t o a s s e s s t h e l o n g e r - t e r m s u s t a i n a b i l i t y o f t h e s t r a t e g i e s t h e y w e r e c h o o s i n g t o p u r s u e . A n d i t w o u l d n o t b e d i f f i c u l t t o u s e t a x p o l i c y t o e n c o u r a g e a l l a s s e t m a n a g e m e n t o r g a n i z a t i o n s t o r e v i s e t h e i r r e m u n e r a t i o n p r a c t i c e s i n t h i s w a y : a p r o v i s i o n c o u l d b e i n t r o d u c e d t h a t b o n u s e s p a i d p r o m p t l y o r w i t h o u t a p p r o p r i a t e c o n d i t i o n a l i t y w o u l d n o t c o u n t a s a n e x p e n s e t h a t e m p l o y e r s w e r e e n t i t l e d t o d e d u c t f r o m r e v e n u e w h e n c a l c u ­ l a t i n g t a x a b l e p r o f i t . 1 5 6 C u rb in g the B o o m -B u s t C ycle S u c h a n a p p r o a c h w o u l d b e r e l a t i v e l y e a s y i f a s s e t m a n a g e r s s t a y e d i n t h e s a m e j o b t h r o u g h o u t t h e i r c a r e e r , b u t d i f f i c u l t i e s w o u l d a r i s e w h e n a m a n a g e r q u i t t e d . O n e w o u l d n o t w a n t t o g i v e a n a r t i f i c i a l i n c e n t i v e t o a c c e l e r a t e t u r n o v e r b y p a y i n g o u t t h e b o n u s u n c o n d i t i o n a l l y t o a n y m a n a g e r w h o q u i t h i s o r h e r j o b . C o u l d o n e n o t i o n a l l y f r e e z e t h e p o r t f o l i o a s i t w a s o n t h e l e a v i n g d a t e a n d a p p l y t h e a g r e e d t e s t t o t h a t h y p o t h e t i c a l p o r t f o l i o ? S i n c e m a n a g e r s c h a n g e t h e i r p o r t f o l i o s q u i t e f r e q u e n t l y , t h a t w o u l d h a r d l y s e e m j u s t . W o u l d o n e l o o k a t t h e p e r f o r m a n c e a c h i e v e d b y h i s o r h e r s u c c e s s o r a n d a s s u m e t h a t t h e d e p a r t i n g m a n a g e r s p o l i c y w o u l d h a v e b e e n t h e s a m e ? I f t h a t w e r e a g o o d a s s u m p t i o n , o n e w o u l d h a v e t o d o u b t w h e t h e r i t w a s w o r t h c h a n g i n g t h e m a n a g e r . W o u l d o n e r e q u i r e t h e d e p a r t i n g m a n a g e r t o c o n t i n u e m a n a g i n g a h y p o t h e t i c a l p o r t f o l i o f o r t h e n e x t f i v e y e a r s t o e s t a b l i s h w h e t h e r s h e o r h e c o u l d h a v e a c h i e v e d t h e h u r d l e l e v e l o f p e r f o r m a n c e ? T h i s i s a p r o b l e m f o r w h i c h m o r e r e s e a r c h i s n e e d e d . A n a l t e r n a t i v e a p p r o a c h w o u l d i n v o l v e a m o r e r a d i c a l c h a n g e i n t h e w a y t h e i n d u s t r y f u n c t i o n s , w i t h t r u s t e e s t a k i n g o n a b i g g e r p a r t o f t h e b u r d e n . I n s t e a d o f h i r i n g m a n a g e r s t o m a k e t h e c r i t i c a l d e c i s i o n s a n d s e e k i n g t o b l a m e t h o s e m a n a g e r s w h e n t h i n g s w e n t w r o n g , t r u s t e e s c o u l d t h e m s e l v e s d e c i d e t o b u y a n d h o l d f o r t h e l o n g t e r m . O r t h e y c o u l d d e c i d e t o i n v e s t a c e r t a i n p r o p o r t i o n o f t h e i r p o r t f o l i o i n , s a y , e m e r g i n g - m a r k e t b o n d s a n d t h e n h i r e a m a n a g e r t o l o o k a f t e r i t f o r f i v e o r t e n y e a r s , w i t h t h e b o n u s t o b e d e t e r m i n e d o n l y a t t h e e n d o f t h a t p e r i o d o n t h e b a s i s o f c u m u l a t i v e p e r f o r m a n c e o v e r t h e w h o l e p e r i o d . T h e y m i g h t e v e n e x p e r i m e n t w i t h a s s i g n i n g a p o r t f o l i o t o a m a n a g e r f o r a t e n - y e a r p e r i o d a n d r e l y i n g o n h i s o r h e r s e n s e o f p r o f e s s i o n a l r e s p o n s i b i l i t y t o m o t i v a t e h i m o r h e r t o a c t i n t h e b e s t l o n g - t e r m i n t e r e s t o f t h e p r i n c i p a l s . T h i s a s s u m e s t h a t t h e r e a r e c o m p e t e n t p e o p l e w h o f i n d a p r o f e s s i o n a l c h a l l e n g e s u f f i c i e n t m o t i v a t i o n f o r e x c e p t i o n a l e f f o r t , w i t h o u t t h e n e e d f o r m o n e t a r y i n c e n t i v e s , w h i c h i s t a k e n f o r g r a n t e d i n m a n y o t h e r p r o f e s s i o n a l a r e a s . C o n c lu d in g rem arks T h e b o o m - b u s t c y c l e i n l e n d i n g t o e m e r g i n g m a r k e t s i s e x a g g e r a t e d b y t h e s h o r t - t e r m i s t n a t u r e o f m o d e r n f i n a n c i a l m a r k e t s a n d t h e i n c e n t i v e s t o w h i c h i n d i v i d u a l p a r t i c i p a n t s i n t h o s e m a r k e t s a r e s u b j e c t . W h i l e s o m e m e a s u r e s , s u c h a s p e r s u a d i n g b a n k s t o a b i d e b y t h e i r v o l u n t a r y c o d e o f c o n d u c t , m a y b e r e l a t i v e l y e a s y t o a c h i e v e , m o s t o f t h e o t h e r e a s y o n e s ( s u c h a s r e q u i r i n g p r o p e r a c c o u n t i n g o f b o n d s w i t h p u t o p t i o n s ) s e e m u n l i k e l y t o a c h i e v e a g r e a t d e a l . C h a n g i n g r e m u n e r a t i o n p r a c t i c e s m i g h t b e i m p o r t a n t , a l t h o u g h i t w i l l b e d i f f i c u l t t o f i n d a f o r m u l a t h a t w i l l w o r k s a t i s f a c t o r i l y f o r p e o p l e w h o c h a n g e j o b s . P e r h a p s t h e m o s t p r o m i s i n g m e a s u r e w o u l d b e t o a l l o w s t a n d s t i l l s t o b e i n v o k e d i n a c r i s i s , i n w h i c h c o n t e x t a n a m e n d e d U D R O P c l a u s e i n l o a n c o n t r a c t s m i g h t p r o v e h e l p f u l . John W illia m s o n 1 5 7 * The author acknowledges the helpful discussion of other participants at the UNU/ WIDER workshop in Santiago in March 2001. 1. Calvo described this more clearly in his oral version than in his written version. 2. They set out to test the hypothesis that mutual funds based offshore are more prone to heavy trading, positive (procyclical) feedback trading, and herding behaviour than are onshore funds. To their surprise they found that funds based in the United States and United Kingdom were more prone to positive feedback trad­ ing and herding behaviour, although the offshore funds did tend to trade more heavily. 3. Collective action clauses would allow a bondholders meeting to be convened to consider a debt reconstruction, rules allowing interest and amortization terms to be modified by a qualified majority of bondholders, sharing clauses, and so on. R e f e r e n c e s Barth, M. and X. Zhang (1999) Foreign Equity Flows and the Asian Financial Crisis, in A. Harwood, R. E. Litan and M. Pormerleano (eds), Financial Markets and Devel­ opment: The Crisis in Emerging Markets, Washington, DC: Brookings Institution. Bekaert, G., C. R. Harvey and R. L. Lumsdaine (1999) The Dynamics of Emerging Market Equity Flows, NBER Working Paper no. 7219, Cambridge, MA: NBER. Buchheit, L. C. and G. M. Gulati (2000) Exit Consents in Sovereign Bond Exchanges’, UCLA Law Review 48, 1 (October): 59-84. Buiter, W. H. and A. C. Sibert (1999) UDROP: A Contribution to the New Inter­ national Financial Architecture’, International Finance, 2, 2 (July): 227-48. Calvo, G.A. (1998) Capital Flows and Capital Market Crises: The Simple Economics of Sudden Stops, Journal of Applied Economics, 1 (1): 35-54. Choe, H., B. -C. Kho and R. M. Stulz (1998) Do Foreign Investors Destabilize Stock Markets? The Korean Experience in 1997, NBER Working Paper no. 6661, Cambridge, MA: NBER. Claessens, S., M. Dooley and A. Warner (1994) Portfolio Capital Flows: Hot or Cool?, in M. J. Howell (ed.), Investing in Emerging Markets, London: Euromoney Publications in association with the World Bank. Eichengreen, B. and R. Hausmann (1999) Exchange Rates and Financial Fragility, NBER Working Paper no. 7418, Cambridge, MA: NBER. Available at http:// papers.nber.org/papers/W7 418.pdf. and A. Mody (2000a) ‘Would Collective Action Clauses Raise Borrowing Costs?’, NBER Working Paper no. 7458, Cambridge, MA: NBER. (2000b) Would Collective Action Clauses Raise Borrowing Costs? An Update and Extension, World Bank Working Paper no. 2363, Washington, DC: World Bank. and R. Portes (1995) Crisis? What Crisis? Orderly Workouts for Sovereign Debtors, London: CEPR. Ffrench-Davis, R. and H. Tapia (2001) Three Policy Varieties to Face Capital Surges in Chile, in R. Ffrench-Davis (ed.), Financial Crises in Successful Emerging Economies, Santiago: McGraw-Hill, and Washington, DC: Brookings Institution. Financial Stability Forum (2000) ‘Part V: Report of the Market Dynamics Study Group, pp. 115-62, http:/ /www.fsforum.org/Reports/Rephli.html. Froot, K., P. OConnell and M. Seasholes (1998) The Portfolio Flows of International Investors, I, NBER Working Paper no. 6687, Cambridge, MA: NBER. Griffith-Jones, S. (2001) Capital Flows to Developing Countries: Does the Emperor Have Clothes?, UNU/WIDER, mimeo. Notes 1 5 8 C u rb in g the B o o m -B u s t C ycle Kaminsky, G., R. Lyons and S. Schmukler (1999) Managers, Investors, and Crises: Mutual Fund Strategy in Emerging Markets, mimeo, Washington, DC: World Bank. Kaufman, H. (2000) On Money and Markets: A Wall Street Memoir, New York: McGraw-Hill. Kim, W. and S.-J. Wei (1999a) Foreign Portfolio Investors Before and During a Crisis, NBER Working Paper no. 6968, Cambridge, MA: NBER. a n d (1999b) Offshore Investment Funds: Monsters in Emerging Markets?, NBER Working Paper no. 7133, Cambridge, MA: NBER. Krueger, A. (2001) International Financial Architecture for 2002: A New Approach to Sovereign Debt Restructuring, address given to the National Economists Club, 26 November. Lipsey, R. E. (2001) ‘Foreign Direct Investors in Three Financial Crises, NBER Working Paper no. 8084, Cambridge, MA: NBER. Persaud, A. (2000) Sending the Herd Off the Cliff Edge: The Disturbing Interaction Between Herding and Market-Sensitive Risk Management Practices, winning essay in the Jacques de Larosiere essay competition, sponsored by the IIF. Swensen, D. (2000) Pioneering Portfolio Management: An Unconventional Approach to Institutional Investment, New York: The Free Press: xvi, 366. Corporate Risk Management and Exchange Rate Volatility in Latin America* G rac ie la M o g u illa n s k y In tro d u ctio n A f t e r t h e T e q u i l a a n d A s i a n c r i s e s t h e r e w a s a n i m p o r t a n t d e b a t e o n t h e i m p a c t o f c a p i t a l - f l o w v o l a t i l i t y o n i n v e s t m e n t a n d g r o w t h i n d e v e l o p i n g c o u n t r i e s . I n p o l i c y c i r c l e s - i n c l u d i n g a m o n g p o l i c y - o r i e n t e d a c a d e m i c s - t h e d i s c u s s i o n c e n t r e d o n t h e n e e d f o r f u n d a m e n t a l r e f o r m o f t h e i n t e r ­ n a t i o n a l f i n a n c i a l a r c h i t e c t u r e . 1 T h e a c a d e m i c s t u d i e s o f t h e t i m e f o c u s e d o n t h e i m p a c t o f t h e v a r i o u s c o m p o n e n t s o f c a p i t a l f l o w s . T h i s c h a p t e r d e a l s w i t h t h e l a t t e r t y p e o f a n a l y s i s , i n p a r t i c u l a r t h e f i n a n c i a l m a n a g e m e n t o f m u l t i n a t i o n a l c o m p a n i e s w i t h i n v e s t m e n t s i n L a t i n A m e r i c a . A d i s t i n c t i o n i s m a d e b e t w e e n t h e d e g r e e o f r e v e r s i b i l i t y o f t h e p h y s i c a l i n v e s t m e n t f r o m f o r e i g n d i r e c t i n v e s t m e n t a n d t h e f l o w o f f u n d s l i n k e d t o i t . T h e a n a l y s i s c e n t r e s o n e p i s o d e s o f c u r r e n c y o r f i n a n c i a l s h o c k s a n d t h e f i n a n c i a l m a n a g e m e n t o f f i r m s t h a t e x p e c t a s i g n i f i c a n t d e v a l u a t i o n . T h i s a l l o w s u s t o e x p l o r e t h e i n t e r a c t i o n b e t w e e n t h e m i c r o e c o n o m i c b e h a v i o u r o f a n d t h e m a c r o e c o n o m i c i m p a c t o n t h e f o r e i g n e x c h a n g e m a r k e t , b a s e d o n t h e f o l l o w i n g q u e s t i o n s : • I s c u r r e n c y r i s k m a n a g e m e n t b y n o n - f i n a n c i a l c o r p o r a t i o n s a f f e c t e d b y f o r e i g n e x c h a n g e v o l a t i l i t y a n d f i n a n c i a l c o n t a g i o n ? • D o t h e d i v e r s e e x c h a n g e r a t e p o l i c i e s h a v e d i f f e r e n t e f f e c t s o n m u l t i n a ­ t i o n a l c o m p a n i e s c a s h f l o w m a n a g e m e n t ? • C a n w e i d e n t i f y m i c r o - m a c r o t r a n s m i s s i o n m e c h a n i s m s b e t w e e n c u r r e n c y r i s k m a n a g e m e n t a n d t h e f o r e i g n e x c h a n g e m a r k e t ? T h e s t u d y o n w h i c h t h i s c h a p t e r i s b a s e d u s e d t h e f o l l o w i n g m e t h o d o l o g y : i n t e r v i e w s w i t h t h e f i n a n c e m a n a g e r s o f m u l t i n a t i o n a l c o m p a n i e s i n v a r i o u s s e c t o r s b u t a l l w i t h i n v e s t m e n t s i n L a t i n A m e r i c a a n d h e a d q u a r t e r s i n t h e U n i t e d K i n g d o m o r S p a i n ; a r e v i e w o f t h e l i t e r a t u r e o n b u s i n e s s a n d c u r r e n c y 1 5 9 1 6 0 C orporate R isk M a n a g e m e n t a n d Exchange R a te V o la tility r i s k m a n a g e m e n t ; a n d a n a n a l y s i s o f s u r v e y s o n f i n a n c i a l r i s k m a n a g e m e n t i n d e v e l o p e d c o u n t r i e s . 2 S i x t e e n f i n a n c e m a n a g e r s w e r e i n t e r v i e w e d i n 1 2 m u l t i n a t i o n a l c o m p a n i e s . T h e i n d u s t r i e s r e p r e s e n t e d w e r e m i n i n g , o i l a n d g a s , e n e r g y , t e l e c o m m u n i ­ c a t i o n s , f o o d a n d f i n a n c e . F o u r o f t h e c o m p a n i e s r a n k e d a m o n g t h e t o p t e n f i r m s i n t e r m s o f s a l e s i n t h e r e g i o n a n d a l l o f t h e m h a d i n v e s t e d h e a v i l y i n L a t i n A m e r i c a d u r i n g t h e p r e v i o u s f i v e y e a r s . A s a c o m p l e m e n t t o t h e r e s e a r c h t h e f i n a n c e m a n a g e r s o f t h e m u l t i n a t i o n a l s s u b s i d i a r i e s w e r e i n t e r ­ v i e w e d i n C h i l e . T h e r e w e r e f o u r r e a s o n s f o r c h o o s i n g C h i l e f o r t h e s t u d y : ( 1 ) t h e C h i l e a n e x p e r i e n c e w a s c o n s i d e r e d p a r a d i g m a t i c a f t e r t h e e c o n o m i c r e f o r m s , ( 2 ) i t h a d a v e r y s t a b l e e c o n o m i c r e g i m e , ( 3 ) i t h a d g o o d c o u n t r y - r i s k q u a l i f i c a t i o n s a n d ( 4 ) t h e f i n a n c i a l s y s t e m w a s r e l a t i v e l y w e l l d e v e l o p e d . A s t h e a n a l y s i s a n d t h e c o n c l u s i o n s a r e n o t b a s e d o n s t a t i s t i c a l s a m p l e s a n d t h e r e a r e n o f i n d i n g s t h a t c a n b e s c i e n t i f i c a l l y t e s t e d , t h i s s t u d y c a n o n l y b e c o n s i d e r e d a s a n e s s a y o n t h e s u b j e c t , a n d p e r h a p s a s a n i n c e n t i v e f o r f u r t h e r r e s e a r c h . Foreign d irec t in v e s tm e n t a n d ca p ita l f lo w v o la t il ity D u r i n g t h e 1 9 9 0 s f o r e i g n d i r e c t i n v e s t m e n t ( F D I ) i n L a t i n A m e r i c a a n d t h e C a r i b b e a n r o s e f r o m a n a n n u a l a v e r a g e o f $ 6 b i l l i o n a t t h e b e g i n n i n g o f t h e d e c a d e t o $ 8 5 b i l l i o n i n 1 9 9 9 . E i g h t y p e r c e n t o f t h a t a m o u n t w a s c o n c e n ­ t r a t e d i n f o u r c o u n t r i e s : A r g e n t i n a , B r a z i l , C h i l e a n d M e x i c o . F D I a n d c a p i t a l f o r m a t i o n m a i n t a i n e d a s t r o n g r e l a t i o n s h i p d u r i n g t h e 1 9 8 0 s a n d 1 9 9 0 s ( F f r e n c h - D a v i s a n d R e i s e n , 1 9 9 8 ) , b u t a n i m p o r t a n t p e r ­ c e n t a g e o f F D I d u r i n g 1 9 9 9 a n d 2 0 0 0 c a m e f r o m m e r g e r s , a c q u i s i t i o n s a n d p r i v a t i z a t i o n s . E C L A C ( 2 0 0 1 ) e s t i m a t e s a n a c c u m u l a t e d f i g u r e o f $ 9 0 b i l l i o n i n t w o y e a r s , o r h a l f o f t h e t o t a l F D I i n t h a t p e r i o d . M o s t o f t h a t i n v e s t m e n t w a s i n i n f r a s t r u c t u r e , p a r t i c u l a r l y i n t h e t e l e c o m m u n i c a t i o n a n d e n e r g y s e c t o r s . A c o m p a r i s o n o f t h e f i g u r e s f o r t h e 1 9 8 0 s a n d t h e 1 9 9 0 s s h o w s t h a t F D I i n L a t i n A m e r i c a w a s c o n s i s t e n t l y l e s s v o l a t i l e t h a n n e t c a p i t a l t r a n s f e r s 3 ( s e e t h e s t a n d a r d d e v i a t i o n / a v e r a g e o f t h e s e r i e s i n T a b l e 9 . 1 ) . T h i s i s c o n s i s t e n t w i t h t h e f i n d i n g b y S a r n o a n d T a y l o r ( 1 9 9 9 ) t h a t F D I h a s a v e r y s i g n i f i c a n t p e r m a n e n t c o m p o n e n t , s u g g e s t i n g t h a t i t i s m o r e s e n s i t i v e t o t h e l o n g - t e r m s t r u c t u r a l f o r c e s b e h i n d a c o u n t r y s e c o n o m i c p e r f o r m a n c e t h a n o t h e r f o r m s o f f i n a n c i n g . H a u s m a n n a n d F e r n á n d e z A r i a s ( 2 0 0 0 a , 2 0 0 0 b ) a n d L i p s e y ( 2 0 0 1 ) a l s o c o n c l u d e t h a t F D I l i a b i l i t i e s s e e m t o b e s a f e r ( i n t h e s e n s e o f b e i n g l e s s c r i s i s p r o n e ) t h a n d e b t o r o t h e r f o r m s o f n o n - F D I o b l i g a t i o n . 4 H o w e v e r m u l t i n a t i o n a l c o m p a n i e s h a v e a l w a y s b e e n a w a r e o f c u r r e n c y v o l a t i l i t y . D u r i n g t h e 1 9 6 0 s , 1 9 7 0 s a n d 1 9 8 0 s t h e p r o b l e m w a s c a u s e d b y c o m m o d i t y p r i c e s h o c k s , i n c o n s i s t e n t m a c r o e c o n o m i c p o l i c i e s a n d h i g h i n f l a t i o n r a t e s - i n s o m e c a s e s h y p e r i n f l a t i o n . M u l t i n a t i o n a l s a d d r e s s e d t h i s p r o b l e m b y a c c e l e r a t i n g t h e r e m i t t a n c e o f d i v i d e n d s a n d d e p r e c i a t i o n G ra c ie la M o g u illa n s k y 1 6 1 r e s e r v e s . W i t h t h e o p e n i n g o f t h e c a p i t a l m a r k e t a n d f i n a n c i a l g l o b a l i z a t i o n , m u l t i n a t i o n a l c o m p a n i e s i n c r e a s e d t h e i r d e b t f i n a n c i n g . T h i s w a s s t i m u l a t e d b y t h e r e v a l u a t i o n o f L a t i n A m e r i c a n c u r r e n c i e s d u r i n g 1 9 9 0 - 9 7 ( F f r e n c h - D a v i s , 2 0 0 1 ) . F o r e i g n d e b t e x p o s u r e d e p e n d s o n t h e f i n a n c i a l s t r a t e g y o f t h e m u l t i n a t i o n a l c o m p a n y , t h e m a c r o e c o n o m i c d o m e s t i c a n d i n t e r n a t i o n a l e n v i r o n m e n t a n d t h e b u s i n e s s s e c t o r i n w h i c h i t i s l o c a t e d , a m o n g o t h e r f a c t o r s . I n t h e c a s e o f C h i l e , s t a t i s t i c s f r o m t h e F o r e i g n I n v e s t m e n t C o m m i t t e e s h o w t h a t i n t h e m i n i n g s e c t o r 7 0 p e r c e n t o f t o t a l F D I c o m e s f r o m l o a n s f r o m h e a d q u a r t e r s o r t h e i n t e r n a t i o n a l f i n a n c i a l s y s t e m , w h i l e i n m a n u f a c t u r i n g t h e f i g u r e i s o n l y 2 2 p e r c e n t . I n t h e c a s e o f t h e p u b l i c s e r v i c e s e c t o r , a t t h e b e g i n n i n g o f t h e 1 9 9 0 s f i r m s h a d a v e r y l o w l e v e l o f d e b t i n f o r e i g n c u r r e n c y b u t t h e s h a r e i n c r e a s e d r a p i d l y d u r i n g t h e r e s t o f t h e d e c a d e . I n s o m e c o u n t r i e s , i n c l u d i n g C h i l e , f i n a n c i n g w i t h f o r e i g n l o a n s w a s e n c o u r a g e d b y t a x b e n e f i t s . F oreign e x c h a n g e risk m a n a g e m e n t b y m u lt in a t io n a l firm s F i n a n c i a l a n d c u r r e n c y r i s k m a n a g e m e n t h a s b e c o m e a f u n d a m e n t a l p a r t o f b u s i n e s s a d m i n i s t r a t i o n d u r i n g t h e p a s t 1 0 - 1 5 y e a r s , b u t m u l t i n a t i o n a l f i r m s i n d e v e l o p i n g c o u n t r i e s w e r e m a n a g i n g t h e i r r i s k e x p o s u r e l o n g b e f o r e t h a t . I t m u s t b e r e m e m b e r e d t h a t t h e L a t i n A m e r i c a n c o u n t r i e s w e r e v e r y u n s t a b l e a n d h a d e x t r e m e l y h i g h i n f l a t i o n r a t e s , a n d c u r r e n c y c r i s e s w e r e f r e q u e n t . M a t c h i n g a s s e t s a n d l i a b i l i t i e s i n t h e s a m e c u r r e n c y s o t h a t p a y ­ m e n t s a n d r e c e i p t s i n a p a r t i c u l a r c u r r e n c y c o u l d b e o f f s e t , w a s t h e m o s t c o m m o n m e c h a n i s m f o r d e a l i n g w i t h f o r e i g n e x c h a n g e r i s k . A n o t h e r m e c h a n i s m s t i l l i n u s e i s t h e p o r t f o l i o a p p r o a c h . T h i s m e c h - a n i s m , i n w h i c h t h e f i r m m a n a g e s a g r e a t d i v e r s i t y o f c u r r e n t f l o w s , p r o v i d e s p r o t e c t i o n a g a i n s t c u r r e n c y r i s k . I t i m p l i e s g e o g r a p h i c a l d i v e r s i f i c a t i o n o f b u s i n e s s , d i v e r s i f i c a t i o n o f t y p e s o f b u s i n e s s a n d g e o g r a p h i c a l d i v e r s i f i c a t i o n i n o p e r a t i o n s a n d s o u r c e s . T h i s i s t h e c a s e f o r m u l t i n a t i o n a l c o m p a n i e s w i t h a l a r g e v a r i e t y o f g o o d s a n d b u s i n e s s e s i n d i f f e r e n t r e g i o n s a n d d i f f e r e n t c o u n t r i e s , s u c h a s t h e c h e m i c a l a n d p h a r m a c e u t i c a l i n d u s t r i e s a n d m a n u f a c ­ t u r e r s o f f o o d , b e v e r a g e s a n d o t h e r g o o d s . T h a n k s t o t h e d e v e l o p m e n t o f t h e i n t e r n a t i o n a l f i n a n c i a l s y s t e m , d u r i n g t h e 1 9 8 0 s a n d e s p e c i a l l y d u r i n g t h e 1 9 9 0 s m o s t m u l t i n a t i o n a l c o m p a n i e s a d o p t e d n e w r i s k m a n a g e m e n t i n s t r u m e n t s - s w a p s , f o r w a r d c o n t r a c t s a n d o p t i o n s , t h e s o - c a l l e d d e r i v a t i v e s - t o d e a l w i t h c u r r e n c y r i s k e x p o s u r e . 5 B u t i s t h e r e a n o p t i m a l m e a n s o f c u r r e n c y r i s k m a n a g e m e n t ? A typology o f financial strategies in currency risk m anagem ent T h e r e i s n o s i n g l e a c c e p t e d f r a m e w o r k t h a t c a n b e u s e d t o g u i d e h e d g i n g s t r a t e g i e s . A s F r o o t etal. ( 1 9 9 3 ) s t a t e d i n t h e e a r l y 1 9 9 0 s , t h e r e a r e m u l t i p l e s o l u t i o n s t o o p t i m a l h e d g i n g b y m u l t i n a t i o n a l f i r m s . A f i r m s o p t i m a l h e d g i n g s t r a t e g y - i n t e r m s o f t h e a m o u n t o f h e d g i n g a n d t h e i n s t r u m e n t s 1 6 2 C orporate R isk M a n a g e m e n t a n d E xchange R a te V o la tility u s e d - d e p e n d s o n t h e n a t u r e o f t h e i n v e s t m e n t , t h e f i n a n c i n g o p p o r t u n ­ i t i e s , t h e n a t u r e o f t h e p r o d u c t , t h e d e g r e e o f m a r k e t c o m p e t i t i o n a n d t h e h e d g i n g s t r a t e g i e s a d o p t e d b y i t s c o m p e t i t o r s . T h e r e f o r e d e t e r m i n i n g w h e t h e r a h e d g i n g s t r a t e g y i s a p p r o p r i a t e i s a v e r y c o m p l e x m a t t e r . I n t h e r e a l w o r l d e n t e r p r i s e s h a v e n e u t r a l , a v e r s e o r a c t i v e m a n a g e m e n t p o l i c i e s . E v e n i f t h e y a r e r i s k r e l u c t a n t t h e r e m a y b e c i r c u m s t a n c e s i n w h i c h m a t c h i n g c u r r e n c i e s b e t w e e n i n c o m e s a n d l i a b i l i t i e s i s i m p o s s i b l e o r t h e i n s t r u m e n t s f o r h e d g i n g a r e s o e x p e n s i v e t h a t t h e f i r m p r e f e r s t o h a v e s o m e e x p o s u r e t o r i s k . W e s h a l l t h e r e f o r e a s s u m e t h a t e n t e r p r i s e s a l w a y s h a v e s o m e p e r c e n t a g e o f r i s k e x p o s u r e . B u t h e d g i n g s t r a t e g i e s d i f f e r a m o n g f i r m s . F o r t h e p u r p o s e o f o u r a n a l y s i s , t h i s c h a p t e r d e v e l o p s a t y p o l o g y o f f i n a n c i a l s t r a t e g i e s , c l a s s i f y i n g f i r m s b y d e g r e e o f r i s k e x p o s u r e , w h i c h d e p e n d s o n m a r k e t o r i e n t a t i o n a n d d i v e r s i f i c a t i o n . Multinational companies in the export sector I n a s c e n d i n g o r d e r o f r i s k e x p o s u r e a r e m u l t i n a t i o n a l c o m p a n i e s t h a t d e a l w i t h c o m m o d i t i e s , m i n e r a l o i l a n d g a s , w o o d p u l p , f i s h m e a l , a n d s u b s i d i a r i e s i n e x p o r t p r o c e s s i n g z o n e s ( a s s e m b l y p l a n t s ) . I n g e n e r a l t h e i r i n v e s t m e n t s a r e f i n a n c e d w i t h e q u i t y ( F D I ) a n d l o a n s i n f o r e i g n c u r r e n c y , a n d t h e y m a t c h i n t e r e s t s e r v i c e s a n d r e m i t t a n c e s o f d i v i d e n d s w i t h i n c o m e i n t h e s a m e c u r r e n c y , s o t h e y a r e n a t u r a l l y h e d g e d 6 ( B o x 9 . 1 ) . Box 9.1 C u rren cy ex p o su re in th e m in in g secto r I n v e s t m e n t s i n t h e m i n i n g s e c t o r ( m i n e r a l s , o i l a n d g a s ) p r e d o m ­ i n a n t l y t a k e t h e f o r m o f p r o j e c t f i n a n c i n g . A m a i n c h a r a c t e r i s t i c o f t h i s t y p e o f f u n d i n g i s t h a t t h e g u a r a n t e e i s t h e q u a l i t y o f t h e p r o j e c t . T h e l o a n i s p a i d u n d e r a l o n g - t e r m c o n t r a c t w i t h t h e g r o s s e a r n i n g s o f t h e p r o j e c t i t s e l f . I n s o m e c a s e s t h e m i n i n g c o m p a n i e s e n t e r i n t o p a y m e n t a r r a n g e m e n t s w i t h o u t p u t i n s t e a d o f i s s u i n g o r d i n a r y d e b t . A b a n k p r o v i d e s u p - f r o n t c a s h a n d t h e c o m p a n y u n d e r t a k e s t o d e l i v e r t h e o u t p u t t o t h e b a n k a n d a r r a n g e s f o r t h e o u t p u t t o b e r e p u r c h a s e d a t a g u a r a n t e e d p r i c e . A s e c o n d c h a r a c t e r i s t i c i s t h a t b e f o r e i n v e s t i n g m i n i n g c o r p o r a t i o n s a l w a y s o b t a i n f r o m t h e h o s t c o u n t r y a f u l l g u a r a n t e e t h a t t h e r e w i l l b e n o v a r i a t i o n i n t h e i n v e s t m e n t c o n d i t i o n s , f r e e d o m o f c a p i t a l a n d c o m m e r c i a l m a n a g e m e n t , e s p e c i a l l y w i t h r e g a r d t o l o a n r e p a y m e n t s . T h e y o p e r a t e w i t h a n e s c r o w a c c o u n t a b r o a d , i n w h i c h t h e c o r p o r a t i o n h a s t h e r i g h t t o d e p o s i t t h e e x p o r t p r o c e e d s , a n d f r o m t h a t a c c o u n t , w i t h o u t i n f l o w i n t o t h e c o u n t r y , t o p a y t h e i n t e r e s t a n d m o r t g a g e s o n t h e l o a n s . G ra c ie la M o g u illa n s k y 1 6 3 B o t h c h a r a c t e r i s t i c s a r e r e l a t e d t o t h e l o n g m a t u r i t y o f m i n i n g i n v e s t ­ m e n t . T h e r e s u l t i s t h a t e n t r e p r e n e u r s a n d b a n k e r s , a t t h e m o m e n t o f i n v e s t i n g , b u i l d a p r o t e c t i v e u m b r e l l a a g a i n s t f i n a n c i a l c r i s e s . I f t h e p r o j e c t p r o d u c e s s u f f i c i e n t m i n e r a l s , o i l o r g a s t h e y s e l l t h e o u t p u t i n t h e i n t e r n a t i o n a l m a r k e t , r e c e i v e t h e i n c o m e a b r o a d a n d p a y o f f t h e f o r e i g n l o a n s , a n d a l l o f t h i s i s i n d e p e n d e n t o f e c o n o m i c c h a n g e s i n t h e h o s t c o u n t r y . B e c a u s e o f t h e r i s k a v e r s i o n t h a t p r e v a i l s i n d e v e l o p i n g c o u n t r i e s , m i n i n g c o r p o r a t i o n s m a n a g e a m i n i m u m o f t h e i r l i q u i d f u n d s i n s i d e t h e h o s t c o u n t r y . T h e h e a d o f f i c e o f t h e c o r p o r a t i o n c h o o s e s a n o p t i m u m o f i n t e r e s t r a t e , r i s k a n d t a x e x p o s u r e t o m a k e i t s f i n a n c i a l i n v e s t m e n t a n d i t i s a l w a y s d o n e o u t s i d e t h e c o u n t r y i n w h i c h t h e i n v e s t m e n t i s l o c a t e d . O n t h e o t h e r h a n d s o m e c o m p a n i e s h a v e c h o s e n t o h e d g e t h e v a l u e o f e x p e c t e d c o s t s b y i n t r o d u c i n g d e r i v a t i v e s i n t o t h e i r c u r r e n c y r i s k m a n a g e m e n t , b u t t h i s i s n o t a g e n e r a l p r a c t i c e . T h e d e v a l u a t i o n s t h a t o c c u r r e d a f t e r t h e T e q u i l a a n d A s i a n c r i s e s b r o u g h t b e n e f i t s t o t h e s e f i r m s b e c a u s e t h e c o s t o f s a l a r i e s a n d o t h e r l o c a l i n p u t s i n t e r m s o f s t r o n g c u r r e n c i e s ( y e n , m a r k , p o u n d o r e u r o ) d e c r e a s e d . (Source: B a s e d o n i n t e r v i e w s a t m u l t i n a t i o n a l c o m p a n i e s i n t h e m i n i n g s e c t o r . ) Multinational companies that are regionally and geographically diversified N e x t i n t h e o r d e r o f d e g r e e o f c u r r e n c y e x p o s u r e c o m e m u l t i n a t i o n a l c o m ­ p a n i e s w h o s e p r o d u c t i o n i s o r i e n t e d t o w a r d s t h e l o c a l m a r k e t b u t w h i c h i n v e s t i n m a n y c o u n t r i e s a n d r e g i o n s . S u c h c o m p a n i e s c a n b e f o u n d i n e v e r y b r a n c h o f t h e m a n u f a c t u r i n g s e c t o r . W h i l e t h e e a r n i n g s a r e o b t a i n e d i n l o c a l c u r r e n c y , l i a b i l i t i e s s u c h a s s h o r t - t e r m a n d l o n g - t e r m l o a n s a r e p a i d m a i n l y i n f o r e i g n c u r r e n c y . T h e s e f i r m s f a c e t w o p r i n c i p a l t y p e s o f c u r r e n c y r i s k e x p o s u r e . T h e f i r s t i s e c o n o m i c r i s k . I n t h e b u s i n e s s l i t e r a t u r e , a n d a l s o a m o n g m a n a g e r s , i t i s d i f f i c u l t t o f i n d a s i n g l e d e f i n i t i o n o f t h i s . I n g e n e r a l t h e c o n c e p t r e l a t e s t o t h e i m p a c t o f a d e v a l u a t i o n o f t h e p r e s e n t v a l u e o f t h e f u t u r e e a r n i n g s o f t h e f i r m . I t i s v e r y d i f f i c u l t t o m e a s u r e t h i s c o n c e p t b e c a u s e i t d e p e n d s o n t h e c o m p e t i t i v e c o n t e x t o f t h e f i r m a n d t h e e f f e c t o f t h e c u r r e n c y s h o c k o n c o m p e t i t o r s a n d c u s t o m e r s . A s c a n b e s e e n i n T a b l e 9 . 1 , m a n a g e r s r a r e l y h e d g e t h i s t y p e o f r i s k . T h e s e c o n d r i s k i s t r a n s a c t i o n r i s k e x p o s u r e , w h i c h i s e a s i e r t o m e a s u r e a n d t o h e d g e . T r a n s a c t i o n e x p o s u r e o r c a s h f l o w e x p o s u r e r e l a t e s t o t h e r e a l c a s h f l o w i n v o l v e d i n s e t t l i n g t r a n s a c t i o n s d e n o m i n a t e d i n f o r e i g n c u r r e n c y . 1 6 4 C orporate R isk M a n a g e m e n t a n d E xchange R a te V o la tility Table 9.1 Latin America: FDI and net capital transfer volatility, 1980-99 (coefficient of variation, per cent) 1980-85 1986-89 1990-95 1996-99 FDI 0.22 0.35 0.50 0.23 Net capital transfers 1.51 0.24 1.45 1.31 Source: ECLAC; b a la n c e o f p a y m e n ts o f 19 L a tin A m e ric a n c o u n tr ie s . Table 9.2 Most important subjects of hedging strategies (per cent) Accounting earnings Cash flows Balance sheet accounts Economic risk firm value United States 44 49 0.9 8 Germany 55 34 7.4 12 Source: B o d n a r a n d G e b h a rd t (1 9 9 8 ). A s T a b l e 9 . 2 s h o w s , 4 9 p e r c e n t o f U S f i r m s a n d 3 4 p e r c e n t o f G e r m a n f i r m s h e d g e a g a i n s t t h e r i s k i n v o l v e d i n t h i s . I n o u r s t u d y , m u l t i n a t i o n a l c o m p a n i e s w i t h b u s i n e s s i n m a n y c o u n t r i e s a n d r e g i o n s a l w a y s h e d g e d a g a i n s t t r a n s a c t i o n e x p o s u r e b u t v e r y s e l d o m a g a i n s t b a l a n c e s h e e t a c c o u n t o r t r a n s l a t i o n e x p o s u r e , t h a t i s , t h e i m p a c t o f c u r r e n c y v o l a t i l i t y o n t h e v a l u e o f a s s e t s a n d l i a b i l i t i e s . T h e r e a r e t w o m a i n r e a s o n s f o r s u c h a p o l i c y : ( 1 ) d e v a l u a t i o n i n o n e c o u n t r y c a n b e c o m p e n s a t e d w i t h r e v a l u a t i o n i n a n o t h e r ; a n d ( 2 ) i n t h e v e r y l o n g t e r m , a s s e t s a n d n e t w o r t h w i l l n o t b e a f f e c t e d b y c u r r e n c y v o l a t i l i t y b e c a u s e e x c h a n g e r a t e m o v e m e n t s m a i n l y d e p e n d o n p r o d u c t i v i t y . Multinational companies with investments concentrated in one region U n l i k e t h e a b o v e t y p e o f c o m p a n y , m u l t i n a t i o n a l c o m p a n i e s t h a t c o n c e n ­ t r a t e t h e i r i n v e s t m e n t s i n j u s t a f e w c o u n t r i e s o r a s i n g l e r e g i o n a n d p r o ­ d u c e e i t h e r f o r f o r e i g n o r f o r d o m e s t i c m a r k e t s u s u a l l y t a k e b a l a n c e s h e e t e x p o s u r e i n t o c o n s i d e r a t i o n . T h e e x p o s u r e a r i s e s f r o m t h e p e r i o d i c n e e d t o r e p o r t t h e c o n s o l i d a t e d w o r l d - w i d e o p e r a t i o n s o f t h e g r o u p i n o n e r e p o r t i n g c u r r e n c y . I n t h i s c a s e t h e y t r y t o f i n a n c e t h e i r i n v e s t m e n t s i n t h e d o m e s t i c f i n a n c i a l s y s t e m a s m u c h a s t h e y c a n , o r i n a b a s k e t o f c u r r e n c i e s t h a t a r e h i g h l y c o r r e l a t e d w i t h t h e l o c a l c u r r e n c y i n t h e l o n g t e r m . T h e y a l s o h e d g e t r a n s l a t i o n a n d t r a n s a c t i o n r i s k w i t h d e r i v a t i v e i n s t r u m e n t s : d e b t , e x p e c t e d d i v i d e n d s a n d c a s h f l o w m o v e m e n t s , a s d e s c r i b e d i n a n u m b e r o f s t u d i e s ( f o r e x a m p l e D a v i s etal., 1 9 9 1 ; G u a y , 1 9 9 9 ; P r é v o s t et al., 2 0 0 0 ; B a r t r a m , 2 0 0 0 ) . G ra d e la M o g u illa n s k y 1 6 5 M a n y m u l t i n a t i o n a l c o m p a n i e s e n t e r e d L a t i n A m e r i c a f o l l o w i n g t h e p r i ­ v a t i z a t i o n o f p u b l i c s e r v i c e s ( t e l e c o m m u n i c a t i o n , e l e c t r i c i t y , w a t e r a n d s a n i t a t i o n , r o a d s a n d p o r t s ) . T h e s e c o m p a n i e s c o u l d b e v i e w e d a s b e i n g m o s t e x p o s e d t o c u r r e n c y r i s k v o l a t i l i t y b e c a u s e t h e y o b t a i n t h e i r i n c o m e i n t h e l o c a l m a r k e t a n d m a k e h u g e i n v e s t m e n t s t h a t t h e l o c a l f i n a n c i a l s y s t e m s c a n n o t a f f o r d . S o i f t h e y f o l l o w a r i s k a v e r s e p o l i c y t h e y h a v e t o e n g a g e i n f i n a n c i a l h e d g i n g . S o m e m u l t i n a t i o n a l c o m p a n i e s - n a t u r a l m o n o p o l i e s o p e r a t i n g i n r e g u l a t e d m a r k e t s - h a v e n e g o t i a t e d t a r i f f s t h a t a r e f u l l y i n d e x e d t o t h e d o m e s t i c p r i c e o f t h e d o l l a r . I n o t h e r c a s e s t h e r e i s p a r t i a l i n d e x a t i o n , f o r i n s t a n c e b e c a u s e i n p u t s s u c h a s g a s a n d o i l a r e d e n o m i n a t e d i n t h a t c u r r e n c y , f o r r e p o s i t i o n o f t h e a s s e t s o r t h e c o s t o f e x p a n s i o n ( m a c h i n e r y f o r e l e c t r i c p o w e r p l a n t s a n d w a t e r t r e a t m e n t p l a n t s , t e l e c o m m u n i c a t i o n e q u i p m e n t , c o m p u t e r s a n d o t h e r i n f o r m a t i o n t e c h n o l o g y e q u i p m e n t a r e a l w a y s i m p o r t e d f r o m i n d u s ­ t r i a l c o u n t r i e s ) . A m o n g t h i s g r o u p t h e r e a r e v a r i o u s k i n d s o f c u r r e n c y r i s k s t r a t e g y . S o m e c o m p a n i e s a r e v e r y c o n s e r v a t i v e a n d h a v e a c e n t r a l i z e d r i s k p o l i c y . T h e s u b s i d i a r y r e p o r t s f i n a n c i n g m o v e m e n t s t o i t s h e a d o f f i c e , w h i c h h e d g e s t h e m a x i m u m o f t h e l e v e l o f e x p o s u r e . O t h e r s t r a t e g i e s s e t a g l o b a l l i m i t o f r i s k e x p o s u r e , s u c h a s o n e y e a r s t o t a l e a r n i n g s . T h e r e a r e a l s o c a s e s o f p u b l i c s e r v i c e m u l t i n a t i o n a l c o r p o r a t i o n s b e i n g h i g h l y i n d e b t e d i n f o r e i g n c u r r e n c y a n d h a v i n g b u s i n e s s e s c o n c e n t r a t e d i n o n e r e g i o n . F o r t h e m , t r a n s l a t i o n r i s k i s t h e m a i n f a c t o r i n h e d g i n g . I f a s t e p d e v a l u a t i o n o c c u r r e d t h e r e c o u l d b e a s h a r p r i s e i n t h e i r i n d e b t e d n e s s a n d a c o n s e q u e n t f a l l i n t h e v a l u e o f t h e c o m p a n y . M u l t i n a t i o n a l c o m p a n ie s in p u b l ic s e rv ices I n s u m m a r y , i t c a n b e c o n c l u d e d t h a t t h e d e g r e e o f c o m p a n i e s r i s k e x p o s u r e d e p e n d s n o t o n l y o n t h e m a g n i t u d e o f t h e i r i n d e b t e d n e s s b u t a l s o o n t h e i r m a r k e t o r i e n t a t i o n a n d d e g r e e o f d i v e r s i f i c a t i o n . S o m e c o m p a n i e s , s u c h a s e x p o r t f i r m s , d o n o t u s e h e d g i n g a t a l l b e c a u s e t h e c o s t s w o u l d b e g r e a t e r t h a n t h e b e n e f i t s . F o r o t h e r m u l t i n a t i o n a l c o m p a n i e s , s u c h a s f i r m s t h a t a r e o r i e n t e d t o w a r d s t h e l o c a l m a r k e t a n d h a v e l a r g e f o r e i g n c u r r e n c y d e b t s , t h e d e m a n d f o r d e r i v a t i v e s i s v e r y h i g h . I n t h i s c a s e , i n s t r u m e n t s i n t h e d e r i v a t i v e m a r k e t a r e a n e c e s s a r y c o m p o n e n t o f f i n a n c i a l m a n a g e m e n t , b e i n g i n d i s p e n s a b l e f o r s m o o t h i n g f l u c t u a t i o n s i n t h e i n t e r e s t a n d f o r e i g n e x c h a n g e r a t e s . Statistics in derivative markets C o m p r e h e n s i v e g l o b a l s t a t i s t i c s o n d e r i v a t i v e i n s t r u m e n t s a r e a v a i l a b l e f r o m t h e B a n k f o r I n t e r n a t i o n a l S e t t l e m e n t s ( B I S ) , w h i c h m e a s u r e s t h e t r a d i n g v o l u m e ( t u r n o v e r i n t h e n u m b e r o f c o n t r a c t s ) a n d t h e n o t i o n a l a m o u n t 1 6 6 C orporate R isk M a n a g e m e n t a n d E xchange R ate V o la tility o u t s t a n d i n g ( i n U S d o l l a r s ) o f d e r i v a t i v e s b y t y p e o f i n s t r u m e n t . T h e n o t i o n a l a m o u n t r e f e r s t o c a s h f l o w s u n d e r i n d i v i d u a l c o n t r a c t s a n d p r o v i d e s a r o u g h i n d i c a t i o n o f t h e p o t e n t i a l t r a n s f e r o f t h e r i s k a s s o c i a t e d w i t h t h e m . P r e s s r e l e a s e s f r o m t h e B I S 7 s h o w t h a t d u r i n g t h e p e r i o d 1 9 9 5 t o J u n e 1 9 9 8 t h e t o t a l a m o u n t o f d e r i v a t i v e s i n c r e a s e d v e r y r a p i d l y a t a g l o b a l r a t e o f 1 4 p e r c e n t p e r y e a r . T h e n i n t h e s i x - m o n t h p e r i o d b e t w e e n J u n e a n d D e c e m b e r 1 9 9 8 - i n t h e m i d s t o f t h e A s i a n c r i s i s - i n t e r e s t r a t e i n s t r u m e n t s u n d e r w e n t a n e x p l o s i v e r i s e w h i l e f o r e i g n e x c h a n g e c o n t r a c t s b e g a n t o f a l l . T h i s w a s a l s o t h e c a s e w i t h n o n - f i n a n c i a l c u s t o m e r s . T h e d y n a m i c o f t h e m a r k e t d u r i n g t h e f o l l o w i n g y e a r s c o n t i n u e d t o b e l e d b y i n t e r e s t r a t e i n s t r u m e n t s w h i l e f o r e i g n e x c h a n g e c o n t r a c t s m a i n t a i n e d a m o d e r a t e u p w a r d t r e n d . T h e i n t e r n a t i o n a l f i n a n c i a l m a r k e t o f f e r s a b r o a d v a r i e t y o f d e r i v a t i v e i n s t r u m e n t s f o r f o r e i g n e x c h a n g e r i s k m a n a g e m e n t ( s e e C h a p t e r 6 ) , i n c l u d i n g p l a i n v a n i l l a i n s t r u m e n t s s u c h a s f o r w a r d s , s w a p o p t i o n s a n d f u t u r e s , h i g h l y s o p h i s t i c a t e d c o m b i n a t i o n s o f s t r u c t u r e d d e r i v a t i v e i n s t m m e n t s ( f o r e x a m p l e c o l l a r s a n d s w a p o p t i o n s ) a n d h y b r i d d e b t w i t h e m b e d d e d d e r i v a t i v e s . A l t h o u g h c o m p a n i e s h a v e b e e n u s i n g d e r i v a t i v e s f o r m a n y y e a r s , l i t t l e i s k n o w n a b o u t t h e e x t e n t o r p a t t e r n o f t h e i r u s e b e c a u s e c o m p a n i e s h a v e n o t b e e n r e q u i r e d - o r n o t u n t i l r e c e n t l y i n t h e U n i t e d S t a t e s - t o m a k e p u b l i c t h e i r d e r i v a t i v e a c t i v i t i e s . C o r p o r a t e a n n u a l r e p o r t s ( b a l a n c e s h e e t a n d o f f - b a l a n c e s h e e t r e p o r t s ) , w h e n a v a i l a b l e , c a n b e c o n f u s i n g b e c a u s e t h e f i g u r e s c o r r e s p o n d t o a c c o u n t i n g p e r i o d s r a t h e r t h a n t o t h e e c o n o m i c e v e n t s i n w h i c h w e a r e i n t e r e s t e d , a n d b e c a u s e t h e f i n a n c i a l e x p o s u r e o r h e d g i n g t r a n s a c t i o n s o f s u b s i d i a r i e s a r e n o t a l w a y s r e p o r t e d b y m u l t i n a t i o n a l c o m ­ p a n i e s . W e s h a l l d e a l w i t h t h i s p r o b l e m b y b a s i n g o u r a n a l y s i s o n i n t e r v i e w s w i t h t h e t r e a s u r e r s o r f i n a n c e m a n a g e r s o f l a r g e c o m p a n i e s w i t h b u s i n e s s e s i n L a t i n A m e r i c a . 8 H ed g in g ta c tic s u sed in L atin A m erica n co u n tr ie s O n e o f t h e f i n d i n g s o f o u r i n t e r v i e w s i s t h a t t h e c o m p a n i e s i n q u e s t i o n c o i n c i d e d w i t h U S a n d G e r m a n c o m p a n i e s i n t e r m s o f t h e i r p r e f e r e n c e f o r s i m p l e f o r e i g n e x c h a n g e i n s t r u m e n t s , t h a t i s , o v e r - t h e - c o u n t e r ( O T C ) i n s t r u ­ m e n t s s u c h a s f o r w a r d s , s w a p s a n d o p t i o n s ( T a b l e 9 . 3 ) . T h e y d e a l m a i n l y w i t h t h e m a i n b a n k s i n t h e i n t e r n a t i o n a l f i n a n c i a l m a r k e t , s u c h a s C i t i b a n k a n d C h a s e M a n h a t t a n , S p a n i s h b a n k s s u c h a s S a n t a n d e r a n d B B V A , o t h e r E u r o p e a n b a n k s a n d i n v e s t m e n t b a n k s s u c h a s M e r r i l l L y n c h a n d M o r g a n S t a n l e y . T h e y n e g o t i a t e w i t h l o c a l b a n k s o n l y i n s p e c i a l c a s e s w h e n s m a l l l i a b i l i t i e s n e e d t o b e c o v e r e d . I n t h e i n t e r v i e w s t h e r e p r e s e n t a t i v e s o f t h e m u l t i n a t i o n a l c o m p a n i e s a s s e r t e d t h a t t h e i r c u r r e n c y r i s k p o l i c i e s w e r e a i m e d a t h e d g i n g t h e i r f i n a n ­ c i a l r i s k e x p o s u r e a n d n o t a t m a k i n g s p e c u l a t i v e g a i n s . T h e y i n s i s t e d t h a t t h e G ra c ie la M o g u illa n s k y 1 6 7 T a b le 9 .3 M o s t u s e d i n s t r u m e n t s i n t h e d e r i v a t i v e m a r k e t ( p e r c e n t ) OTC forwards Futures OTC swaps OTC options Exchange traded options Structured derivatives Hybrid debt United States 56.8 8.0 9.1 18.2 1.1 6.8 1.1 Germany 75.5 4.3 13.8 18.1 0.0 1.1 0.0 Source: B o d n a r a n d G e b h a rd t (1 9 9 8 ). m a i n p u r p o s e o f t h e t r e a s u r e r w a s t o s u p p o r t t h e b u s i n e s s o f t h e c o m p a n y , t h a t i s , t o m a k e a p r o f i t f r o m p r o d u c i n g g o o d s a n d s e r v i c e s . T h e y i n d i c a t e d t h a t t h e b e s t w a y t o d o t h i s w a s t o m a i n t a i n a f a i r l y s t a b l e f i n a n c i n g o r i n t e r e s t r a t e r e g i m e , a n d t h a t w a s t h e r e a s o n f o r m a k i n g c o n t r a c t s i n t h e d e r i v a t i v e m a r k e t s . T h i s a s s e r t i o n i s c o n f i r m e d b y S t u l z ( 1 9 9 6 ) a n d F i t e a n d P f l e i d e r e r ( 1 9 9 5 ) , w h o c o n c l u d e t h a t c o r p o r a t e r i s k m a n a g e m e n t r e s u l t s i n a r e d u c t i o n o f c o r p o r a t e c a s h f l o w v o l a t i l i t y , a n d t h e r e f o r e i n a l o w e r v a r i a t i o n i n f i r m v a l u e . T h e m a n a g e r s o f n o n - f i n a n c i a l c o r p o r a t i o n s a l s o i n d i c a t e d t h a t d u r i n g t h e p a s t d e c a d e , i n o r d e r t o a v o i d b e i n g t a k e n s u r p r i s e b y u n e x p e c t e d e v e n t s i n L a t i n A m e r i c a n c o u n t r i e s , t h e i r c o m p a n i e s h a d s e t u p t e a m s t o c o n d u c t c o u n t r y a n d r e g i o n a l m a c r o e c o n o m i c a n a l y s e s a n d m a n a g e f o r e i g n e x c h a n g e r a t e e c o n o m i c m o d e l s . T h e y a l s o s t u d i e d i n f o r m a t i o n f r o m i n t e r n a t i o n a l a g e n c i e s a n d i n v e s t m e n t b a n k s . B u t t h e b a n k i n t e r v i e w e e s h a d a n o t h e r p o i n t o f v i e w . I n t h e c a s e o f C h i l e t h e y a r g u e d t h a t f i n a n c e m a n a g e r s e n g a g e d i n a c t i v e f o r e i g n e x c h a n g e r i s k m a n a g e m e n t ( m a i n t a i n i n g o p e n p o s i t i o n s ) , w h i c h t h e y i n t e r p r e t e d a s s p e c u l a t i v e m a n a g e m e n t . T h e y d e d u c e d t h i s f r o m t h e s h o r t p e r i o d f o r w h i c h f i r m s t o o k d e r i v a t i v e s . I n t h i s c a s e t h e y w e r e e x p o s e d t o m o v e m e n t s o f t h e b a s e r i s k ( t h e d i f f e r e n c e b e t w e e n t h e s p o t p r i c e o f t h e a s s e t t o b e h e d g e d a n d t h e f u t u r e p r i c e o f t h e c o n t r a c t u s e d ) a n d t h e d i f f e r e n c e b e t w e e n t h e d o m e s t i c a n d t h e i n t e r n a t i o n a l r a t e o f i n t e r e s t . T h e a n s w e r g i v e n b y t h e f i n a n c e m a n a g e r s o f s u b s i d i a r i e s o f n o n - f i n a n c i a l c o r p o r a t i o n s w a s t h a t t h e c o n c e n t r a t i o n o f t h e m a r k e t a m o n g a f e w o p e r a t o r s a n d t h e l o w d e v e l o p m e n t o f t h e L a t i n A m e r i c a n d e r i v a t i v e m a r k e t s d i d n o t a l l o w t h e m t o e n g a g e i n o p t i m a l m a n a g e m e n t . T h i s w i l l b e a n a l y z e d i n t h e n e x t s e c t i o n . The Latin American derivative market M u l t i n a t i o n a l c o m p a n i e s i n L a t i n A m e r i c a t r y t o n e g o t i a t e d e r i v a t i v e c o n ­ t r a c t s i n t h e l o c a l m a r k e t s a s t h e i n s t r u m e n t s c a n b e o b t a i n e d t h e r e a t l o w e r c o s t . H o w e v e r t h e y f a c e s o m e r e s t r i c t i o n s i n t h a t t h e m a r k e t s h a v e o n l y b e e n r e c e n t l y d e v e l o p e d - i n t h e p a s t t w o t o f i v e y e a r s i n m o s t c a s e s . O n e o f t h e i n c e n t i v e s f o r t h e i r c r e a t i o n w a s t h e h u g e i n v e s t m e n t s t h a t w e r e b e i n g 168 C orporate R isk M a n a g e m e n t a n d E xchange R a te V o la tility m a d e b y m u l t i n a t i o n a l c o m p a n i e s s i n c e t h e p r i v a t i z a t i o n o f p u b l i c s e r v i c e s . T h e p r o c e s s b e g a n w i t h t h e a r r i v a l o f m u l t i n a t i o n a l c o m p a n i e s a n d t h e i r i n v e s t m e n t s , f o l l o w e d b y a d e m a n d f o r f o r e i g n c u r r e n c y l o a n s a n d t h e c o n s e q u e n t d e m a n d f o r d e r i v a t i v e s t o p r o t e c t t h e m f r o m c u r r e n c y r i s k . W i t h t h e e x c e p t i o n o f B r a z i l , t h e i n s t i t u t i o n a l f r a m e w o r k f o r d e r i v a t i v e s i n L a t i n A m e r i c a i s s t i l l v e r y w e a k . F o r e x a m p l e n o n - d e l i v e r y f o r w a r d c o n ­ t r a c t s i n t h e C h i l e a n c u r r e n c y w e r e n o t l e g a l i z e d i n C h i l e u n t i l 2 0 0 1 . I n t h e c a s e o f A r g e n t i n a t h e l e g a l f r a m e w o r k i s s t i l l b e i n g d i s c u s s e d i n p a r l i a m e n t , a n d i n M e x i c o a r e f o r m t o t h e l e g a l f r a m e w o r k h a s o n l y j u s t a l l o w e d l o c a l a n d i n t e r n a t i o n a l b a n k s t o a c t a s m a r k e t m a k e r s . N a t u r a l l y t h e d e r i v a t i v e m a r k e t d e v e l o p e d f i r s t i n t h e U n i t e d S t a t e s , p r i n c i p a l l y i n N e w Y o r k a n d C h i c a g o . B r a z i l h a s t h e m o s t s o p h i s t i c a t e d l o c a l d e r i v a t i v e m a r k e t w i t h m a n y t y p e s o f i n s t r u m e n t . A p p r o x i m a t e l y 2 7 p e r c e n t o f a l l d e r i v a t i v e s c o r r e s p o n d t o U S d o l l a r f u t u r e s . T h e s e a c c o u n t e d f o r o n l y 7 p e r c e n t o f t h e t o t a l i n 1 9 9 1 , b u t i n 1 9 9 7 t h e y p e a k e d a t 3 6 p e r c e n t . M a n y t y p e s o f O T C i n s t r u m e n t c a n a l s o b e f o u n d i n M e x i c o , i n c l u d i n g f o r e i g n e x c h a n g e r a t e o p t i o n s , s e c u r i t i e s a n d s w a p s . F o r t h e C h i l e a n c u r r e n c y , t h e d a i l y n e g o t i a t e d a m o u n t o f n o n ­ d e l i v e r a b l e f o r w a r d s ( N D F s ) i n t h e N e w Y o r k m a r k e t i s i n t h e r a n g e o f $ 2 5 0 m i l l i o n w h i l e i n t h e l o c a l d e l i v e r y f o r w a r d m a r k e t t h e s u m i s a r o u n d $ 6 0 0 m i l l i o n . I n t h e c a s e o f a t h i n m a r k e t s u c h a s t h a t i n P e r u , o n l y N D F c o n t r a c t s a r e m a d e , w h i l e i n B o l i v i a t h e r e i s n o d e r i v a t i v e m a r k e t a t a l l . A c c o r d i n g t o t h e m u l t i n a t i o n a l c o m p a n i e s i n o u r s u r v e y t h e b e s t w a y t o m a n a g e f i n a n c i a l r i s k i n e m e r g e n t m a r k e t s w a s t o e n t e r l o n g - t e r m c o n t r a c t s d u r i n g a p e r i o d o f e c o n o m i c s t a b i l i t y , w h e n i n s t r u m e n t s c o u l d b e f o u n d a t a l o w e r c o s t . M a k i n g l o n g - t e r m c o n t r a c t s w a s v e r y i m p o r t a n t f o r t h e c o m p a n i e s i n q u e s t i o n , e s p e c i a l l y i f a s t e p d e v a l u a t i o n w a s e x p e c t e d d u r i n g t h e n e x t s i x t o t w e l v e m o n t h s . T h e p u r p o s e w a s t o m a k e a b r i d g e o v e r t h e c r i s i s p e r i o d . H o w e v e r t h e m a n a g e r s , o f n o n - f i n a n c i a l c o r p o r a t i o n s s a i d t h a t t h i s w a s n o t a l w a y s p o s s i b l e b e c a u s e i n s t r u m e n t s w e r e n o r m a l l y a v a i l a b l e f o r o n l y a f e w m o n t h s . 9 F o r e x a m p l e t h e f o r w a r d c o n t r a c t s m a r k e t w a s l i q u i d f o r 4 2 o r 9 0 d a y s , a n d o n l y a f e w e n t e r p r i s e s c o u l d h e d g e f o r a y e a r o r m o r e . O n e r e a s o n f o r t h i s w a s t h e l a c k o f a s e c o n d a r y m a r k e t f o r l o n g - t e r m i n s t r u m e n t s . T h e r e w e r e n o m a r k e t m a k e r s , a n d l o n g - t e r m i n s t r u m e n t s w e r e n e g o t i a t e d i n t h e s t o c k m a r k e t . T h e e n t e r p r i s e s h a d t o w a i t u n t i l s o m e o n e w a n t e d t o n e g o t i a t e a l o n g - t e r m i n s t r u m e n t a n d s e t a p r i c e o n i t . S t a t i s t i c s p u b l i s h e d b y C e n t r a l B a n k o f C h i l e a r e c o n s i s t e n t w i t h w h a t w a s s a i d b y t h e m u l t i n a t i o n a l c o m p a n y m a n a g e r s . B e t w e e n 1 9 9 6 a n d 2 0 0 0 i n t h e f o r w a r d m a r k e t , m o r e t h a n 9 0 p e r c e n t o f p e s o - d o l l a r c o n t r a c t s w e r e f o r p e r i o d s o f l e s s t h a n 4 2 d a y s , a n d a s i m i l a r s i t u a t i o n p r e v a i l e d f o r U F - d o l l a r c o n t r a c t s ( T a b l e 9 . 4 ) . I n m a r k e t s w i t h a m a t u r i t y o f m o r e t h a n 4 2 d a y s , t h e d a i l y a v e r a g e v o l u m e n e g o t i a t e d w a s $ 2 2 m i l l i o n , w h i c h w a s a v e r y s m a l l a m o u n t i n t e r m s o f t r a n s a c t i o n s b y m u l t i n a t i o n a l c o m p a n i e s . Tab le 9 .4 F o r w a r d c o n t r a c t s i n C h i l e , 1 9 9 6 - 2 0 0 0 Peso-dollar forwards Peso-dollar forwards maturity period UF/dollar forwards UF-dollar forwards maturity period Accumulated annual amount ($ million) Up to 42 days/ total (%) More than 42 days/ total (%) Accumulated annual amount ($ million) Up to 90 days 91-360 days More than 360 days 1996 36 334 98.9 1.1 11 495 36.6 51.4 12.0 1997 96 166 96.3 3.7 15 885 33.4 50.9 15.7 1998 99 377 97.1 2.9 13 517 35.2 52.9 11.9 1999 101 623 96.5 3.5 23 889 38.4 46.7 14.9 2000 107 872 94.5 5.5 31 378 54.0 34.9 11.1 Source: C e n tra l B a n k o f C h ile , Informe Económico y Financiero (w w w .b c e n tra l.c l/). 170 C orporate R isk M a n a g e m e n t a n d E xchange R a te V o la tility F i g u r e s 9 . 1 a n d 9 . 2 s h o w t h e a m o u n t s a n d p r i c e s o f f o r w a r d c o n t r a c t s i n C h i l e . F i g u r e 9 . 1 s h o w s t h e a v e r a g e m o v e m e n t o f a l l p e s o - d o l l a r c o n t r a c t s , i n w h i c h s h o r t - t e r m i n s t r u m e n t s p r e d o m i n a t e . T h e i n s t r u m e n t s w e r e f i r s t u s e d i n 1 9 9 5 - 9 6 a n d s h o w e d a n u p w a r d t r e n d f r o m t h e b e g i n n i n g . T h e r e w a s a d r a m a t i c i n c r e a s e d u r i n g t h e A s i a n c r i s i s a n d t h e r e a f t e r t h e t o t a l a m o u n t n e g o t i a t e d e a c h m o n t h o s c i l l a t e d b e t w e e n $ 5 m i l l i o n a n d $ 7 m i l l i o n . T h i s c o i n c i d e d w i t h t h e p e r i o d o f h i g h v o l a t i l i t y i n t h e e x c h a n g e r a t e i n C h i l e . Figure 9.1 Chile: total forward contracts with non-financial corporations, 1995-2001 Source: C e n tra l B an k o f C h ile . Figure 9.2 Chile: forward contracts for more than 42 days with non-financial corpor­ ations, 1995-2001 Source: C e n tra l B a n k o f C h ile . Graciela Moguillansky 171 It is also interesting to observe that for contracts of more than 42 days, sizable demands occurred on only a few occasions. One explanation for this is that long-term forward contracts are more expensive than short-term ones. In 2001, in short-term operations the spread was 30 cents, but one-year instruments had a spread of 3 pesos. Chilean bankers argued that firms finance managers were unwilling to bear that cost and preferred to be exposed to basic risk, using short-term contracts that could be rolled over. According to the bankers, this was speculative management. To qualify the above statements, it should be said that during turbulent periods, or when a financial external shock occurred, the possibility of hedg­ ing via derivatives was more restricted and instruments were only available at very high prices. The price of a forward contract, F, depends on the spot value of the exchange rate, S, the local interest rate, iD, and the international interest rate, ix: F = S* (1 + iD) / (1 + ix) (9.1) Although the international interest rate is more stable during a financial or currency crisis, the value of the dollar in the spot market, S, and the difference between the domestic rate and the international interest rate may rise substantially. Moreover foreign exchange policy and monetary policy can serve to increase the cost of the instrument. This was the case in Chile after the Asian and Russian crises. Between 1998 and 1999 there was not only a strong devaluation but also a huge increase in the local interest rate (Figure 9.3). This presented a serious problem for hedges. If the contract ended in the middle of a crisis it would have been impossible to make a rollover at a reasonable price. The cost of rollover might have been more than the cost of the devaluation and the sum of losses could not compensate the use of the instrument. In Argentina, from 1999 the financial markets expected that the currency board would be abandoned. That year the differential cost for hedging was 21-25 per cent (compared with 18 per cent in Brazil and 7 per cent in Chile) because the expected volatility in the spot market increased the risk of hedging. In Brazil, during 1998 the Brazilian real was quoted in the forward market at 3.0 reals per dollar. In the worst point in the crisis it rose no higher than 2.20 and after that it fell to 1.75. A hedging with a forward contract at 3.0 would imply a huge loss instead of protection against devaluation. The lack of sophisticated derivative instruments, the short duration of hedging contracts and the shortage of liquidity are great disadvantages for national and multinational firms operating in Latin America. Moreover there is an absence of transparency and asymmetry of information. For example in Chile firms do not have access to the interbank and stock market prices of foreign currency. At the same time the demand for hedging by some firms 1 7 2 Corporate Risk Management and Exchange Rate Volatility Observed daily foreign exchange rate Domestic rate of interest Figure 9.3 Chile: daily foreign exchange rate and interest rate, 1996-2001 (pesos per dollar) Source: Based on Central Bank of Chile statistics. is very large in relation to the supply of foreign currency, so they have to use intermediaries in the market in order to prevent banks from knowing where the demand is coming from and consequently pushing up the cost of derivatives. One conclusion to be drawn from this analysis is that managers may wish to hedge their currency risk exposure but they are not prepared to pay a very high price for it. This is the reason why the development of local financial markets is very important for non-financial multinational corporations. Another conclusion is that due to the fragility of the Latin American deriva­ tive markets, instruments operate procyclically, become more expensive and are sometimes unobtainable in turbulent periods when they are most required. Exchange rate policy and currency risk policy In theory a currency board or a band regime present less risks than a flex­ ible exchange rate policy. But the finance managers interviewed stated that Graciela Moguillansky 173 currency risk management depended more on the confidence of investors in a policy than on the type of policy in question. Therefore it is not the type of foreign exchange rate policy but the inconsistency between that policy and the evolution of macroeconomic fundamentals that matters. A good example here is the Argentinean case, where by law one peso is equivalent to one dollar. There is now a risk of a very sharp step devaluation, as in any country with a very overvalued currency, and multinational companies are trying to avoid that risk by maintaining a very short cash position. The analysis is similar in the case of a band regime. If the exchange rate policy is not consistent with the macro fundamentals and the central bank makes continuous changes to the range or the centre of the band - thus changing the rules of the game - it is perceived that a floating rate exists, together with a high degree of currency volatility. In such cases currency risk management will be consistent with the perception of instability in the foreign exchange regime. For example in Chile between the Tequila and Asian crises, multinational companies in the telecommunication and elec­ tricity sectors hedged less than half of their total debt in foreign currency, due to the Central Banks credible foreign exchange policy and persistent revaluation of the exchange rate (see Chapter 13). However after the Asian crisis and during a period of instability in the range of the band, they began to hedge between 70 per cent and 100 per cent of their debt; a strategy that has continued with the floating exchange rate regime. In conclusion, currency risk management by multinational non-financial corporations does not depend solely on exchange rate policy - it is also related to the consistency of that policy and the evolution of the rest of the macroeconomic variables. Without consistency, companies will always have a perception of instability and changes to the rules of the game, causing a high degree of uncertainty and increasing the need for a more developed derivative market. A more developed derivative market could improve the financial conditions for FDI in Latin America. Currency risk management and the impact of the foreign exchange rate Fender (2000a, 2000b) shows that the use of financial derivatives to hedge against interest rate movements has a macroeconomic implication. If firms can stabilize their corporate cash flows with regard to interest rate changes, this will affect the impact of monetary impulses on investment spending as well as on economic activity.10 As a result the financial accelerator effects of monetary policy are likely to be reduced and the monetary authorities will lose some of their power. But what happens with the foreign exchange transmission mechanism? Negative external shocks, such as those which occurred during the Tequila, Asian and Russian crises, cause foreign exchange and financial market 17 4 Corporate Risk Management and Exchange Rate Volatility distrust. The impact of this distrust is transmitted to firms cash flows by the international interest rate, the domestic interest rate (if the firms also have loans in the domestic financial sector) and the foreign exchange rate. Expectation of a step devaluation obliges finance managers to react with a hedging strategy using the international or domestic derivative markets (Figure 9.4). The Latin American subsidiaries of international banks need to cover their currency exposure, and they do this by selling the local currency to local banks. If the economic situation is stable the local banks can risk some degree of exposure, but when there is a crisis they have to cover themselves by buying significant amounts of dollars on the spot foreign exchange market, thus affecting the foreign exchange rate. Just who loses most depends on the macroeconomic context before the crisis and on the current monetary and foreign exchange policy. In the case of Chile, after the Asian crisis the Central Bank was the greatest loser, losing $4 billion of reserves between 1998 and 1999. In Latin American countries, foreign exchange derivative markets tend to dry up in the middle of a turbulent period - short-term capital flows are rapidly remitted to the countries of origin and the local financial markets lose foreign currency liquidity - so instead of helping to smooth foreign exchange rate movements they induce greater volatility. This volatility is again transmitted to cash flow movements. The magnitude of the effect of this on firms depends not only on external factors, such as the countrys foreign exchange and monetary policy (Figure 9.5), which determines the eventual scale of the external shock, but also on internal factors, such as the activities of the firms (oriented Figure 9.4 Actors in a foreign exchange derivative market Graciela Moguillansky 175 Figure 9.5 M ultinational com panies currency risk m anagem ent and the foreign exchange market towards local or foreign markets), the diversity of their business (con­ centrated in only one region or distributed around the world), and their investment and financing policies and hedging strategy. Assuming that multinational companies in Latin America hedge mainly with short-term instruments, a crisis will induce them to make a rollover or increase the hedged amount. As Figure 9.5 shows, in this case the trans­ mission mechanism between the financial management of the firm and the exchange rate market goes through the financial system. The transmission mechanism goes directly from the firm to the exchange rate market (the bold arrow in Figure 9.5) if the financial strategy requires a reduction of exposure. The firm will change foreign exchange debt into local debt or accelerate the remittance of earnings, expected dividends and reserves. In this case the companies will put pressure on the foreign exchange market by buying dollars and reducing the degree of exposure. While such a response by just one company will not have macroeconomic consequences, if all the companies make the same move over a short period, serious pressure will be put on the foreign exchange rate and on the local financial market. If they all do so at once, the whole edifice will come down.11 During 2001 this happened in the Chilean foreign exchange market. Interestingly, it was caused not by an expected financial or currency crisis in that country but by the crisis in Argentina. 1 7 6 Corporate Risk Management and Exchange Rate Volatility Because of the low cost of the instruments associated with the interest rate - 4 per cent in the Chilean market compared with 18 per cent in Brazil - national and multinational corporations went to the Chilean financial and derivative markets to hedge their currency exposure while waiting for the Argentinean economy to stabilize. This not only affected the foreign exchange market but also put pressure on the financial system. If banks are without liquidity - as is often the case when a regional financial or currency crisis is expected - or there is increased uncertainty among bank managers, loans tend to be concentrated among large firms and credit is restricted for small and medium-sized enterprises. In general, credit also tends to be con­ centrated in the export sector, which is less vulnerable in such circumstances. Conclusions Macroeconomic studies that compare of the volatility of FDI with short-term capital flows conclude that the first is less volatile. While the business and microeconomic literature deals with the financial management of corpor­ ations and the instruments and models used for optimization, there is a lack of studies on the interaction between microeconomic currency risk management by corporations involved in FDI, and its macroeconomic effects on the volatility of the foreign exchange rate. In trying to explore this interaction this chapter has addressed three questions: • Is currency risk management by non-financial corporations affected by foreign exchange volatility and financial contagion? • Do the diverse exchange rate policies have different effects on multi­ national companies cash flow management? • Can we identify micro-macro transmission mechanisms between currency risk management and the foreign exchange market? In order to assess the link between currency risk management and its impact on the foreign exchange market we built a typology of financial strat­ egies, classifying firms by their degree of risk exposure, market orientation and degree of geographical diversification. Multinational companies in the export sector have the lowest degree of exposure since their incomes, loans and earnings are denominated in the local currency and therefore they do not need to hedge their transaction or translation risk. In fact they are the most important providers of foreign currency, thereby contributing to the liquidity of the foreign exchange market. These firms did not stop investing, paying salaries and buying local inputs during the turbulent 1990s. Their stable cash flow management can be observed in their subsidiaries’ balance sheets. Graciela Moguillansky 177 Multinational companies that are regionally and geographically diversified always hedge against transaction or cash flow exposure, but they very seldom hedge against translation (accounting or balance sheet) exposure. This is because devaluation in one country can be compensated by revaluation in another. The companies that face the greatest problems with currency risk exposure are multinational companies that are oriented towards the local market, whose investments are concentrated in one region or in the public service sector and whose earnings are in the local currency. In theory they are supposed to hedge the whole of their transaction and translation exposure. However it is very costly to hedge a significant proportion of the risk involved because of the weakness of the institutional framework, liquidity in periods of turbulence and the lack of instruments in the derivative market for Latin American currencies. In fact the difficulty of hedging has led to significant losses in accounting exposure, that is, in the value of assets and liabilities. In addition to the above, there is asymmetry of information between the financial sector and non-financial corporations, making it difficult for the latter to negotiate the value of the required instruments and increasing the cost of derivative instruments for long-term hedging. While the finance managers of subsidiaries justify their behaviour in those terms, bankers suggest that this is in fact speculative behaviour since finance managers of non-financial corporations prefer to have some risk exposure than to pay a high cost for derivatives. But the excessive cost of derivatives in turbulent periods support the arguments of the former. With regard to the second question, in countries with a currency board or a band regime, managers do not need to hedge their currency risk since in theory foreign exchange security is provided by the central bank. But finance managers state that without consistency between a countrys foreign exchange regime and its monetary and fiscal policy - that is, the macro- economic fundamentals - companies will perceive that changes have been made to the rules of the game and will therefore increase their hedging activities, as the recent Argentinean crisis dramatically illustrated. The answer to the third question depends on companies market orientation and degree of geographic diversification. The largest impact is generated by multinational companies in the public service sector or whose operations focus on the local market or region. Unfortunately the lack of statistical information makes it difficult to measure the magnitude of the impact, and for that reason we have only provided a basic idea of the transmission mech­ anisms between currency risk management and the foreign exchange market. Two transmission mechanism can be identified, both of which begin with the financial management of multinational non-financial corporations. One goes directly from the cash flow management of the firm to the foreign exchange market. This occurs when the multinational company decides to change its liabilities from foreign to local currency, or to increase the 1 7 8 Corporate Risk Management and Exchange Rate Volatility remittance of dividends. In both cases managers go to the foreign exchange market to buy dollars at the spot price. When this happens in the middle of a crisis and is widespread among firms, it puts downward pressure on the foreign exchange value of the local currency. The second transmission mechanism is an indirect one that goes from the financial management of the firm through the financial system. In this case it is banks that have to hedge their currency risk exposure, particularly if they are facing or expecting an international or regional financial crisis. This puts pressure on the local currency, the extent of which will depend on the capacity of the central bank to respond to the shock. This transmission mechanism can affect not only the country facing the currency crises but also neighbouring countries, as illustrated by the impact of the recent Argentinean crisis on the Chilean exchange rate. In that case the combination of a flexible rate with a monetary policy aimed at reacti­ vating the economy in Chile prompted Argentinean multinational firms to turn to the Chilean derivative market. Notwithstanding the need to improve the regulation of derivative markets to enhance countercyclical behaviour, further development of these markets would permit longer terms and a greater variety of instruments. These could in turn allow the stabilization of cash flow management, the reduction of translation risk and the avoidance of pressure by non-financial multinational companies on the foreign exchange market in turbulent periods. But while this might be a good solution for short-term microeconomic behaviour, it would not resolve the macroeconomic problems of countries facing foreign shocks in the context of inconsistency between foreign exchange policy and macroeconomic imbalances. Further studies of the macroeconomic impact of currency risk management by multinational corporations will require detailed national case studies, for which this chapter has provided a general framework and some guidelines on the factors to be examined. First, it will be necessary to conduct detailed studies of the functioning of the derivative markets and the institutional framework that governs their operations, including the volume and terms of transactions. Second, the foreign exchange and monetary policies of the country in question will have to be considered because of their impact on the financial and derivative markets. Finally, the impact on the foreign exchange rate of the strategies with which the different types of multinational and national corporation face those markets will have to be investigated. Notes * The idea of exam ining th e macroeconomic im pact of currency risk m anagem ent by m ultinational companies was suggested by Stephany Griffith-Jones, and this chapter has benefited from stim ulating conversations w ith her th roughout its developm ent. 1. See Ocampo (1999, 2000), Griffith-Jones and Ocampo (1999) and Goldstein (2000), am ong others. Graciela Moguillansky 179 2. W harton School and CIBC W ood G undy (1996); World of Banking (1995). 3. The exception was the second half of the 1980s, w hen short-term capital and loans did no t enter the region. 4. All these studies contrast w ith Claessens, D ws, bu t w ith observations coming from few countries (Claessens etal., 1995). 5. See Davis etal. (1991), Stern and Chew (1998), Guay (1999), Prevost etal. (2000) and Bartram (2000) for analyses of currency risk m anagem ent in non-financial corporations. 6. Because of the nature of their business, several m ultinational companies also hedge the com m odity price risk, using com m odity price derivatives for an im port­ an t portion of their projected output. For example in the N orth American gold m ining industry firms hedge over 26 per cent of their production, on average (Bartram, 2000). 7. See the BIS press releases for June 1998, 13 November 2000 and 16 May 2001. 8. Interviews were conducted w ith finance managers of companies w ith head­ quarters in Britain or Spain. We also draw on quarterly financial statem ents reported by m ultinational enterprises to the US SEC (Form 20-F). 9. In the derivative markets of developed countries, m aturity was betw een three and six years before th e financial crises of the 1990s, bu t th is range was reduced to one to three years after the Asian crisis. 10. See also Getler and Gilchrist (1994), Bernanke et al. (1996), O liner and Rudebusch (1996), Carpenter etal. (1998) and Fazzari etal. (2000). 11. See Patterns in financial markets: predicting th e unpredictable, The Economist, 2 June 2001. References Bartram, S. (2000) Corporate Risk M anagem ent as a Lever for Shareholder Value Creation, Financial Markets, Institutions and Instruments, 9, 5 (December). Bernanke, B., M. Getler and S. Gilrchrist (1996) The Financial Accelerator and the Flight to Quality, Review o f Economics and Statistics, 78. Bodnar, G. and G. G ebhardt (1998) Derivatives Usage in Risk M anagem ent by US and G erman Non Financial Firms: A Comparative Survey, NBER Working Paper no. 6705, Cambridge, MA: NBER. Carpenter, R. E. F., S. M. Petersen and C. Bruce (1998) Financing Constraints and Inventory Investment: A Comparative Study w ith High-Frequency Panel Data, Review o f Economics and Statistics, 80, 4 (November): 513-19. Claessens, S., M. P. Dooley and A. Warner (1995) Portfolio Capital Flows: Hot or Cold?, World Bank Economic Review, 9, 1 (January): 153-74. Davis, E., J. Coates, P. Collier and S. Longden (1991) Currency Risk Management in Multinational Companies, London: Prentice-Hall. ECLAC (2001) Foreign Investm ent in Latin America and the Caribbean 2000, LC/G.2125-P, Santiago: ECLAC. Fazzari, S. M., R. G. Hubbard and B. C. Petersen (2000) Investm ent-Cash Flow Sensitivities are Useful: A C om m ent, Quarterly Journal o f Economics, 115, 2 (May): 695-705. Fender, I. (2000a) ‘Corporate Hedging: The Impact of Financial Derivatives on the Broad Credit Channel of M onetary Policy, BIS Working Paper no. 94, Basel: BIS, November. (2000b) The Impact of Corporate Risk M anagem ent on M onetary Policy Transmission: Some Empirical Evidence, BIS Working Paper no. 95, Basel: BIS, November. 1 8 0 Corporate Risk Management and Exchange Rate Volatility Fite, D. and P. Pfleiderer (1995) Should Firms Use Derivatives to Manage Risk?, in W. Beaver and G. Parker (eds), Risk Management: Problems and Solutions, New York: McGraw-Hill. Ffrench-Davis, R. (ed.) (2001) Financial Crises in Successful Emerging Economies, W ashington, DC: Brookings Institution/ECLAC. and H. Reisen (eds) (1998) Capital Flows and Investment Performance: Lessons from Latin America, Paris: ECLAC/OECD. Froot, K. A., D. S. Scharfstein and J. C. Stein (1993) Risk M anagem ent: Co-ordinating Corporate Investm ent and Financing Policies, Journal o f Finance, 48, 5 (December). Getler, M. and S. Gilchrist (1994) ‘The Role of Credit Market Im perfections in the M onetary Transmission M echanism ’, Scandinavian Journal o f Economics, 95, 1. Goldstein, M. (2000) S trengthening the International Financial Architecture: Where We Stand?’, W orking Paper 00-8, W ashington, DC: Institute for International Economics. Griffith-Jones, S. and J. A. Ocampo (1999) International Capital Flows to Latin America: Their Im plications for International and N ational Policies’, LC/R.1954, Santiago: ECLAC. Guay, W. W. R. (1999) The Impact of Derivatives on Firm Risk: an Empirical Exam ination of New Derivatives Users, Journal o f Accounting and Economics, 26. H ausm ann, R. and E. Fernandez-Arias (2000a) Is FDI a Safer Form of Financing?, IDB Working Paper WP-416, W ashington, DC: IDB. (2000b) Foreign Direct Investm ent: Good Cholesterol?, IDB Working Paper WP-417, W ashington, DC: IDB. Lipsey, R. (2001) Foreign Direct Investm ent in Three Financial Crises, NBER Working Paper no. 84, Cambridge, MA: NBER. Ocampo, J. A. (1999) In ternational Financial Reform: The Broad Agenda, CEPAL Review, 69 (December). (2000) A Broad Agenda for International Financial Reform, in J. A. Ocampo, S. Zamagni, R. Ffrench-Davis and C. Pietrobelli (eds), Financial Globalization and the Emerging Economies, Santiago: ECLAC. Oliner, S. D. and G. D. Rudebusch (1996) Is There a Broad Credit C hannel for M onetary Policy?, Federal Reserve Bank o f San Francisco Economic Review, 1. Prevost, A. K., L. C. Rose and G. Miller (2000) Derivatives Usage and Financial Risk M anagem ent in Large and Small Economies: A Comparative Analysis, Journal o f Business Finance and Accounting, 27, 5-6 (June). Sarno, L. and M. P. Taylor (1999) H ot Money, Accounting Labels and the Permanence of Capital Flows to Developing Countries: An Empirical Investigation, Journal o f Development Economics, 59, 2 (August): 337-64. Stern, J. M. and D. H. Chew (1998) The Revolution in Corporate Finance, 3rd edn, Oxford: Blackwell. Stultz, R. M. (1996) Rethinking Risk M anagem ent, Bank o f America Journal o f Applied Corporate Finance, 9, 3: 8-24. W harton School and CIBC W ood G undy (1996) Survey of Derivatives Usage by US N on Financial Firms Report, Pennsylvania, PA: University of Pennsylvania, April. World of Banking (1995) Survey of Foreign Exchange Risk M anagem ent in US, World o f Banking, 14, 4. 1 0 T h e N e w B a s e l C a p i t a l A c c o r d a n d D e v e l o p i n g C o u n t r ie s : Is s u e s , I m p l i c a t i o n s a n d P o l i c y P r o p o s a ls Stephany Griffith-Jones and Stephen Spratt Introduction After the Asian crisis of 1997-98 bank lending to developing countries fell sharply and has since become negative. In June 1998 loans outstanding to developing countries totalled US$924 billion; by December 2000 they had fallen to US$753 billion, an annual decline of 7.9 per cent.1 It is in this con­ text that the implications of the new Basel Capital Accord for developing countries should be assessed. A particular concern is that the new accord may further discourage lending. It is clear that banks have become highly risk averse vis-à-vis developing (emerging) economies. However this increased awareness of the particular risks posed by this type of borrower mirrors a more general trend towards greater risk aversion and emphasis on the need for accurate risk assessment. This trend, with an increasing focus on efficiency in all parts of the banking business, is in part a response to competition from non-bank financial institutions. The latter are not subject to the same regulatory constraints as banks, a situation that has placed some banks at a competitive disadvantage. Consequently, given the fear that business will migrate from the regulated (bank) sector to the unregulated (non-bank) sector, banking regulators have come under pressure to act. It is argued that the 1988 Basel Capital Accord has forced banks to hold levels of regulatory capital that do not correspond to actual risks, as measured by the banks own internal models.2 This situation has created perverse incentives that have led to distortions in lending practices. In particular the capital requirements for lending to highly rated borrowers are more than banks would choose to hold, putting them at a commercial disadvantage with respect to non-bank institutions. Recognizing these trends, the Basel Committee has proposed a new capital accord with a strong focus on aligning regulatory capital requirements with actual risks. 181 1 8 2 The New Basel Capital Accord Whilst the effects on developing countries are clearly not central to the new proposals, it seems likely that, as with the 1988 accord, significant effects will be felt. This chapter outlines the areas with the highest potential impact - both positive and negative - before offering some policy recom­ mendations aimed at maximizing the former, minimizing the latter and avoiding a net negative impact. The new Basel Capital Accord Although the proposed new Basel Capital Accord is to be built on three mutually reinforcing pillars, it is likely that the changes proposed to the measurement of credit risk (under Pillar 1) will have the most far-reaching implications for developed and developing countries alike. Consequently it is this aspect of the new accord that will be the focus in this chapter. The proposals include three possible approaches to the measurement of credit risk, with increasing degrees of complexity: the standardized approach and the foundation and advanced internal-ratings-based (IRB) approaches. The new system proposed in the standardized approach addresses many of the concerns raised by developing countries about the 1988 accord. In particular the removal of the OECD/non-OECD distinction and the reduc­ tion of the incentive for short-term lending are positive proposals. Also, the removal of the sovereign ceiling would be of benefit to highly rated banks and corporates in less highly rated countries, regardless of OECD member­ ship. Overall, therefore, the proposals should, as envisaged, more closely align capital requirements with actual risk. The proposed use of external credit assessment institutions (ECAIs) has been criticized in some quarters. Whilst we too have some misgivings, these are primarily of a practical nature and need not prove insurmountable.3 On balance, therefore, the proposals contained in the standardized approach are to be broadly welcomed. Unfortunately, however, the standardized approach cannot be viewed in isolation. In our judgement the IRB approach, if imple­ mented in its current form, would have negative implications for developing countries. Consequently the net impact of the new accord on developing countries is likely to be determined by the extent to which the IRB approach comes to dominate the banking industrys relations with the developing world. The IRB approach Perhaps the most significant changes proposed under the new accord relate to the greater use of banks internal risk management systems. The rationale behind these changes is that greater sensitivity to the measurement of actual risk would enable banks more accurately to price and provide for risk. This would enable the banking system to function more efficiently and reduce Stephany Grifftth-Jones and Stephen Spratt 183 the perverse incentives created by the existing accord. The result, it is hoped, would be a sounder, more efficient banking system that would function better for the benefit of all concerned. This argument is based on the benefits that would result from a more efficient allocation of resources at the micro- economic level. However, while this may be true at the level of individual banks, it fails to take account of the potentially negative macroeconomic, systemic implications of the proposals. From the perspective of developing countries there are two major areas of concern. Cost and quantity of lending It seems probable that one impact of the new accord will be an increase in the quantity of loans to borrowers rated above BBB and a fall in loans to borrowers rated below BBB. Given that the majority of the latter are in the developing world, they are likely to see a reduction in overall levels of lending from internationally active banks. What lending does occur will be concentrated in highly rated sovereigns, corporates and banks. Patricia Jackson, head of the Bank of Englands Financial Industry and Regulation Division, puts it thus: For any bank, the effect of the internal ratings approach on required capital will depend on the risk profile of its particu­ lar book - high risk books will demand more capital than currently and low risk books less (Bank of England, 2001). Consequently there will be a strong incentive for banks to refocus their portfolios in the direction of higher-quality (lower-risk) lenders - that is, to reduce the proportion of developing-country lending and increase the proportion of lending to developed-country borrowers. A number of independent studies have attempted to assess the likely impact on the cost of borrowing for low-rated borrowers. Some have predicted alarming increases in the cost of borrowing, to the extent that developing countries will be effectively excluded from international bank lending (Reisen, 2001). Other research that also predicts a sharp rise in the cost of lending to lower-rated borrowers does not predict increases of the same magnitude (Powell, 2001). The various approaches, however, all point to a significant rise in the cost of lending to low-rated borrowers. Indeed this problem was also cited in submissions to Basel by a number of major international banks, some of which argued that the calibrations used by the Basel Committee were too conservative and therefore produced capital requirements, particularly for low-rated borrowers, in excess of those pro­ duced by their own internal models. For example Citigroup argued that under the new Accord, the calibration of capital causes regulatory minimum capital requirements to increase to inappropriately high levels when com­ pared to existing rules or internal risk models. Similarly the Credit Suisse Group contended that The calibration of high-risk grades in the IRB sanctions SMEs and emerging markets. Their access to capital from large institutions will be made significantly more difficult.4 1 8 4 The New Basel Capital Accord The Basel Committee appears to have largely accepted this point. Following the first consultation period, the committee initiated a quantitative impact study (QIS2) to assess the effect of the proposal on capital requirements. Overall the study found that, contrary to intentions, capital requirements would be higher under the proposals than under the existing accord for all groups in both the standardized and IRB foundation approaches. The results for the advanced IRB were more mixed, with most banks predicting a slight fall in requirements. In response to these findings the committee altered the calibration of the IRB curve, with the result that the regulatory capital curve was flattened quite significantly. A further impact study (QIS3) was announced for the autumn of 2002 to test the effects of these modifications, and as a consequence the release of the final consultative document was postponed from early 2002 to early 2003. One outcome of these modifica­ tions has been to reduce the capital requirements for lending to lower-rated borrowers from that implied in the original proposals. However, whilst this represents an improvement the capital requirements for lower-rated borrowers will still be substantially higher than under the existing accord. Hence the incentive for banks to refocus their portfolios towards higher-rated borrowers remains. Some have argued that the concern about the impact of the new proposals on the cost of bank lending is misplaced. Whilst it is not disputed that the capital requirements for lending to lower-rated borrowers will rise under the IRB approach,5 the suggestion is that banks price loans according to their own internal models, rather than on the basis of capital requirements. Consequently all the new accord will do is to bring the regulatory require­ ments into line with existing practice. However whilst this may be so for the most sophisticated international banks, it does not necessarily apply to all international banks that lend to emerging and developing economies: given the likely kudos of adopting the IRB approach it seems likely that even these less sophisticated banks will wish to do so, if possible. Furthermore, even for the most sophisticated banks this argument is only valid if the regulatory capital required is below that which the banks would choose to hold. If the regulatory requirements are above those indicated by the banks own models, they will be liable to bite and force an increase in the cost (and/or reduction in quantity) of lending to lower-rated borrowers. One factor that may well produce such an outcome is the failure of the proposals to take account of the benefits of international diversification. It has long been argued that one of the main benefits of investing in develop­ ing and emerging economies is their relatively low correlation with mature markets. If this is the case, then clear benefits - at the portfolio level - will accrue to banks with well-diversified international portfolios. That is, a bank with a loan portfolio that is distributed widely across a range of relatively uncorrelated markets is less likely to face simultaneous problems in all of those markets than a bank with loans concentrated in a smaller number of Stephany Grifftth-Jones and Stephen Spratt 185 relatively correlated markets. If this is so, then in order accurately to align regulatory capital with the actual risks a bank might face the accord should take account of this portfolio level effect: the capital requirements for a bank with a well-diversified international loan portfolio should reflect the lower total risk than that for a more concentrated portfolio. At present the pro­ posals contain no such considerations, suggesting that, in this area at least, the capital requirements may not accurately reflect actual risk. In order to resolve this issue we tested differential correlations between developed and developing markets, first with specific regard to international bank lending and profitability, and second in a more general macroeconomic sense (Griffith-Jones et al, 2002). Tests using each of our financial sector and macro variables, over all periods covered, strongly suggested that a bank with a loan portfolio that is well diversified across the major developed and developing regions will enjoy diversification benefits at the portfolio level: the correlation between the risks associated with loans to each of these regions is lower than for a bank with a loan portfolio that focuses only on developed markets. All of our results offer significant support for the validity of this position, and all are statistically significant. All the tests we performed, using a variety of variables over a range of time periods, provide strong support for the diversification hypothesis. Further evidence comes from a simulation exercise we undertook to assess the potential unexpected loss resulting from a portfolio that was diversified within developed countries, and one that was diversified across developed and developing regions. This exercise involved the construction of two simulated loan portfolios, the purpose being to assess the probable level of unexpected loss in each. Thus we could directly compare the simulated behaviour of the two portfolios. The results of our simulation show that the unexpected losses for the portfolio focused on developed-country borrowers would, on average, be almost 23 per cent higher than for the portfolio diversified across developed and developing countries. Given that capital requirements are intended to deal with unexpected loss, the fact that the level of unexpected loss in our simulation is lower for a diversified than for an undiversified portfolio is highly significant. Taken together with the statistical work on correlations, this evidence suggests that, so as to not penalize emerging and developing economies by incorrectly measuring the risk associated with lending to such countries, the Basel Committee should closely examine the practicalities of incorporating the benefits of international diversification into its final consultative paper. The argument that asset correlation is variable is self-evident. Furthermore the suggestion that this variability affects the level of risk in an overall port­ folio and should therefore be reflected in the capital requirements, would also seem to have force. Indeed the committee has recognized this fact with the modifications already made with respect to SME lending. Following the release of the original consultative document there was widespread concern 1 8 6 The New Basel Capital Accord that lending to SMEs would be adversely affected by a large increase in the capital requirements associated with such lending. After intensive lobbying the committee reconsidered the issue, and agreed that the treatment of SMEs should be separated from other corporate lending, with borrowers with less than 50 million euro in annual sales receiving an average reduction in capital requirements of about 10 per cent relative to larger corporates. The rationale for this modification is that the chance of a large number of SMEs defaulting simultaneously is less than for a smaller group of large borrowers - that is, the correlation between their probabilities of default is lower. Consequently a loan portfolio that is well diversified across a large number of SMEs will face lower overall risk at the portfolio level than one that focuses on a few larger borrowers. The results of our empirical work strongly suggest that a similar modification is justified with respect to inter­ national diversification. If such a modification is not made, then the risk and probability of default will not be accurately measured. This implies that the aim of the new accord - a more accurate pricing of risk to determine capital - will not be fully met. A further question is that even if the IRB curve is brought into line with those produced by banks internal models, is this a realistic assessment of the risk posed by developing-country borrowers? The absence of robust, long-term historical default data for all classes of borrower (certainly an issue in developing countries) produces great uncertainty about quantifiable risk. This uncertainty creates a strong incentive to herd, with developing countries periodically going in and out of fashion for reasons that are often only loosely associated with economic fundamentals. Thus it can be argued that market perception of the risk posed by developing countries is often overstated, sometimes understated, and only rarely objectively justified by economic fundamentals. Indeed these perceptions may well be, in some instances, the most significant fundamental of all. Given the fact that devel­ oping countries face a very different lending environment from developed- country borrowers, there appears to be a case for formally recognizing this difference and developing a distinct approach to regulatory capital. Procyclicality One of the most significant charges levelled at the new proposals is that they will exacerbate procyclical tendencies in the banking system. The probability of default (PD) is inherently procyclical in that during an upturn the average PD will fall, and therefore the incentive to lend will increase. Conversely, during a downturn the average PD will increase (due to more difficult economic circumstances) and therefore a credit crunch may develop, with all but the most highly rated borrowers having difficulty attracting funds. In addition, deteriorating economic conditions will cause existing loans to migrate to higher-risk categories, therefore raising the overall capital requirements and further deepening the downturn. The Basel Committee Stephany Griffith-Jones and Stephen Spratt 187 acknowledges this concern in the second consultative package, although The Committee has also considered the argument that a more risk-sensitive framework has the potential to amplify business cycles. The Committee believes that the benefits of a risk-sensitive capital framework outweigh this concern (Overview of the New Basel Capital Accord, p. 8, paragraph 40). However, as is the case with much of the new accord, the trade-offs in terms of costs and benefits are viewed primarily in terms of their impact on the major banks. It is likely that developing countries will feel the costs dis­ proportionately (reduced lending coupled with an increase in the frequency and scale of crises) while simultaneously receiving few of the benefits. If we assume that financial crises are connected with the business cycle, and accept that developing countries are disproportionately affected by such crises, it becomes clear that developing countries have more to fear from an amplified business cycle than countries in the developed world. Given that influential voices in the latter are expressing real concern about the impact of increased procyclical pressures, the developing countries fears are certainly not misplaced. The Basel Committee seems to have accepted the validity of this criticism. The flattening of the IRB curve will reduce the procyclical impact to some extent, and the next consultative document is likely to include a variety of measures to combat procyclicality. However the important question is whether the concrete measures proposed will be enough to offset the potentially negative effects of increased procyclicality. It is thought that the committee will propose the use of stress testing, but it is unlikely that this will be sufficient to eliminate the problems associated with procyclicality. These are of sufficient importance to warrant the incorporation of explicitly countercyclical mechanisms, and further research is clearly warranted in this area. It seems desirable to introduce forward looking provisions with an explicit countercyclical element at the time the new Basel Accord is implemented; this option needs to be urgently evaluated. A more fundamental question concerns the extent to which any measure will be able to offset the inherent procyclicality of a market-sensitive frame­ work while maintaining increased overall risk sensitivity, which is a central aim of the new accord. The net impact on developing countries and policy proposals Whilst the proposals contained in the standardized approach are broadly to be welcomed, in that they address many of the concerns expressed by developing countries about the existing accord, the introduction of IRB approaches - even after the modification of the original proposals - has very problematic implications. If the negative impact of the IRB approaches outweighs the positive effects of the standardized approach, from a 18 8 The New Basel Capital Accord developing-country perspective, then the new accord will merely give with one hand only to take more with the other. The expressed purpose of the new accord is to align regulatory capital more closely with actual risk. However the failure of the proposals to take account of the benefits of international diversification suggests that, in this instance at least, risk is not being accurately measured. That is, by excluding the possibility of banks capital requirements taking account of diversifi­ cation effects, the proposals effectively mean an inaccurate measure of risk at the portfolio level. The danger that the implementation of the IRB approach will result in a reduction in the quantity and/or an increase in the cost of bank lending to developing countries is compounded by the likely increase in the cyclic­ ality of such lending. The systemic implications of greater risk sensitivity in lending patterns are likely to impact on developed and developing coun­ tries alike, although more so on the latter given the smaller size of their economies vis-à-vis international capital flows. It is therefore crucial that the trade-off between microeconomic allocative efficiency and macroeco­ nomic systemic stability is more clearly thought through. Specifically, it is not clear that what is good for individual banks is necessarily good for the stability of the banking system as a whole, or for the economic prospects of the developing world in particular. Our policy proposals can therefore be summarized as follows. First, early adoption of the IRB approach is likely to have significant, possibly unintended, consequences and we therefore recommend postponing its implementation to allow for further research, specifically with regard to procyclicality and the impact on lending to developing countries by the major international banks. Second, if the IRB approach is to be implemented in something like its current form, it is essential that the regulatory requirements for low-rated borrowers are lowered at least to the levels suggested by the banks own models. This is the minimum requirement to prevent the accord worsening the existing situation, even if one accepts the proposition that banks currently price their loans according to internal models rather than regulatory capital. To this end, the clear benefits of diversification linked to lending to develop­ ing countries that we have demonstrated should be explicitly incorporated to allow an accurate measurement of risk. Given the changes already made to the proposals with respect to corporates and SME lending, as well as the fact that the changes we propose seem to have a solid empirical basis, there are no theoretical, empirical or practical reasons why changes should not be made in order to incorporate the benefits of international diversification. The fact that developing countries have no representation on the Basel Committee should not be a bar to this important change. A modification would not only be technically correct, but also supportive of the stated aim of the G7 governments to increase the role of private capital flows as an engine of growth and development for developing and emerging economies. Stephany Grifftth-Jones and Stephen Spratt 189 Third, serious attention should be paid to the adoption of countercyclical mechanisms to mitigate the procyclical elements of the IRB approach, rather than the currently suggested use of stress testing. One measure that is gath­ ering increased support is the Spanish provisioning approach: the practical workings of this mechanism should be empirically researched to ascertain the feasibility of extending such a system internationally. Fourth, the improvements contained in the standardized approach should be developed to reduce, if not eliminate, the incentives for short-term lending, and the number of risk buckets should be increased to reduce regulatory biases towards lending to certain categories of borrower. Finally, one aspect of the standardized approach that has attracted much attention is the proposal to use external credit rating institutions to assign ratings. Given that international financial stability can be viewed as a public good, there is a strong argument for having a public element in credit rating. Of the major international financial institutions, the Bank for International Settlements has the best track record in terms of spotting potential crises and has financial stability as its main objective, so it would be well placed to play a joint role with rating agencies. Concluding remarks The fact that the Basel Committee has decided to postpone the implemen­ tation of the new accord until a further consultative package has been assessed is to be welcomed. It is to be hoped that the concerns of developing countries are given sufficient weight in this process, which should be as transparent and open as possible. The 1988 accord, devised with the G10 banks in mind, rapidly became the industry standard. Similarly the new accord, whilst not primarily aimed at the needs of developing countries, will have serious and unavoidable consequences for many developing and emerging economies. Given the crucial importance of ensuring a stable and suitable level of financing to facilitate much needed economic development in the poorer parts of the world, it is vital that these issues are seriously addressed so that a net negative impact can be avoided. This can be done in ways that are consistent with a more precise measurement of risk and the strengthening of the international banking system, which are the main aims of the new Basel Capital Accord. Notes 1. An alternative way of viewing this is to examine banks net exposure to developing countries in terms of assets and liabilities. Banks exposure peaked in 1997 w ith a net credit position of US$147 billion. However net claims on developing coun­ tries th en fell by a staggering US$292.8 billion, and by 2000 banks had become net debtors to the tune of US$145 billion (see C hapter 5). 2. See Bank of England (2001). 3. For a more detailed discussion of these issues see the IDS finance website: w ww.ids.ac.uk/intfinance. 19 0 The New Basel Capital Accord 4. See C om m ents received on the Second Consultative Package, www.bis.org/bcbs/ cacom m ents.htm . 5. The fact th a t capital requirem ents overstate the risk for high-rated borrowers is a m ajor im petus behind the new proposals. However if these requirem ents are to be lowered and the overall level of capital in the banking system is to rem ain fixed at 8 per cent, th en th e requirem ents at the low-rated end m ust rise. References Bank of England (2001) Quarterly Bulletin, London: Bank of England, Spring. Griffith-Jones, S., M. Segoviano and S. Spratt (2002) Basel II and Developing C oun­ tries: Diversification and Portfolio Effects, h ttp://w w w .ids.ac.uk/intfinance/. Reisen, H. (2001) Will Basel II C ontribute to Convergence in International Capital Flows?, mimeo, Paris: OECD Development Centre. Powell, A. (2001) A Capital Accord for Emerging Economies?, Paper prepared while visiting research fellow at the Financial Sector Strategy and Policy division (World Bank), Bueros Aires: Universidad Torcuato Di Telia, http://w ww .utdt.edu/~apowell/ Capaccord.pdf. 1 1 T h e I n s t a b i l i t y o f t h e E m e r g in g - M a r k e t A s s e ts D e m a n d S c h e d u le * Valpy FitzGerald Introduction The expansion and contraction of portfolio capital flows and short-term bank lending from OECD countries in emerging markets during the past decade has generated a large and controversial body of literature. Most of the debate has focused on the effect of these flows on emerging markets themselves, and on the effect of host country policies on the attraction or retention of the flows. However the process by which credit providers and portfolio investors make their decisions is much more than simply deciding to supply a specific amount of capital to emerging markets at a given average risk and price, and then to allocate this between individual emerg­ ing markets according to local risk and return characteristics - the so-called fundamentals. In any market, changes in the level of transaction flows and the prices at which they take place must reflect shifts in either the demand schedule or the supply schedule (or both simultaneously), and both these schedules will be affected by agents expectations about the future evolution of the market. Fortunately increasing attention is being paid to two dimensions of what this chapter logically terms the demand for emerging-market assets. The first strand in the recent literature relates to what are frequently but somewhat misleadingly called the push and pull factors that determine capital flows at the macroeconomic level. The aggregate level of capital flows to emerging markets is held to be determined by the push factors, which include market conditions in the source country and the return on emerging markets as a whole. The pull factors are the conditions in the destination countries, which determine the allocation of the aggregate flow across the emerging markets. The second strand relates to the deter­ minants of investors decisions to purchase (or sell) emerging-market assets at the microeconomic level. Portfolio choice models thus include source- country conditions as determining the opportunity cost of capital (that is, the risk-free portion of the portfolio) and the overall asset stock; while 191 1 9 2 The Emerging-Market Assets Demand Schedule destination-country conditions determine the yield and risk of emerging- market assets. From the first strand it is apparent that shifts in aggregate asset demand (that is, changes in the push factors), such as OECD interest rate changes and G3 exchange rate fluctuations, account for at least half of the observed changes in capital flows, independently of the asset supply (that is, pull) conditions: the so-called fundamentals in emerging markets themselves. From the second strand it is clear that what matters to individual investors decisions is not only information about fundamentals but also the way in which the information is used, endogenous cycles in risk appetite and the effect of regulatory incentives - all of which are determined by conditions in the source country. In effect the demand schedule for emerging-market assets is three- dimensional. As well as price (or yield) on one axis, so to speak, and the quantity of assets on another axis, there exists a third dimension that can be broadly termed quality on another. This is no different in principle from the market for, say, cars - except that, as we shall see, quality is not a stable or exogenous factor. Nor, as we shall see, is it a market in lemons where quality is unknown to the buyer alone. The supply schedule (that is, emission or resale by government, company or bank concerned) has the same three dimensions. Ideally, quality is the given risk of debt default, dividend collapse or major devaluation, as determined by the fundamentals of the country and its companies, so that the interaction between stable demand and supply schedules will determine the price and quantity at which the market in assets clears. The changes in this equilibrium over time are the observed capital flows. Variations in asset quality when fundamentals alter due to external shocks or domestic politics will be reflected in changing prices and flows as markets adjust to the changed circumstances. Then the objective of emerging-market governments (and their international advisors) is to improve asset quality by sound (or sounder) management so that either asset prices improve (that is, yield spreads fall) or more assets can be supplied (that is, capital inflows are attracted) at the going price. Asset prices can be seen as information that is directly available to the market, but only in the form of past and current values and yields. However future prices (or indeed the appropriate long-term price trend) are an essen­ tial aspect of price and are a matter of investors expectations rather than measurable data. Moreover the quantity dimension is ambiguous for two reasons. First, what is recorded (for example in balance of payments statistics) is the value of flows made up of innumerable transactions (price multiplied by quantity), and while the number of securities transactions could in principle be counted there is no clear definition of the volume index to be used to aggregate them. Second, changes in the stocks of financial assets (which are what is recorded at the firm level) reflect not only new flows but Valpy FitzGerald 193 also stock revaluations. Ideally, then, we need records of asset stock volumes and prices, with the changes decomposed into flows and revaluations.1 The third dimension of quality is the most difficult to define. It should reflect risk, of course, but this cannot be ascertained merely from the volatility of returns in the past because it also contains market expectations of future yields and volatility (which may vary not only with the underlying fundamentals but also with market beliefs about that future) on the one hand, and the role of the asset in the investors portfolio - including its covariance with other assets, their respective yields and her or his degree of risk aversion - on the other. If markets clear properly and price fully reflects quality, this will not present a practical measurement problem, although it could still present an obstacle to the design of policy to reduce volatility. In terms of elementary algebra we have two equations (demand and supply) in three variables: price, quantity and quality (risk). This system cannot be solved without a third equation. If a single stable relationship between price and risk exists, as financial textbooks suppose, then this constitutes the third equation and the system can be solved - that is, there is market equilibrium. In practice, however, this stable relationship does not exist, so in effect there is market failure. The response of agents is to construct heuristic rules of thumb that reflect practical experience of the observed relationships between quality and quantity. This response is made explicit in management rules for credit rationing and portfolio benchmarking at the microeconomic level. It is also implicit in asset bubbles and regional contagion at the macro- economic level. Such quantity-quality linkages are a familiar characteristic of domestic financial markets. A backward-sloping credit supply curve occurs when lenders are increasingly unwilling to lend to borrowers as their debt mounts, and the offer of higher yields (that is, lower prices) does not stimulate more lending (that is, asset demand) because it reduces the capacity of the borrower to pay. By extension, further lending to a single client will increase the investor’s risk exposure, thus affecting quality as well as price. Hence profit maximization by lenders leads to a situation in which the demand for loans is not fully met at the current price (that is, the return for a given risk class). As a consequence there are shifts in the asset demand schedule (credit supply) that determine the credit flow. At the aggregate level these credit shifts have substantial effects on output - further affecting asset quality and amplifying the cycle. Finally, the way in which investors assess asset quality depends on the way in which the information is used, and not just on the asymmetry in its availability to buyer and seller that the textbooks assume. The path- dependent formation of expectations and the difficulty of assessing future contract compliance limit the ability of investors to adopt an optimal portfolio position, defined entirely by expected returns and measurable volatility. Indeed the widespread benchmark approach - defining a range 19 4 The Emerging-Market Assets Demand Schedule and a central position for portfolio composition - implies that an objective definition of asset quality is not available to be priced. Limits on exposure to a particular country by a single bank across all its asset purchases have a similar effect. This is the aspect of the demand function that is most diffi­ cult to assess, particularly because the way in which investing institutions use information (public or private) to reach this conclusion can change as well as the circumstances themselves. This chapter is structured as follows. The next section attempts to derive the main macroeconomic characteristics of the emerging-market asset demand schedule from the literature on push factors in capital flows, which emphasizes the asymmetric effect of changes in monetary conditions on OECD markets and pure contagion. It then reviews recent portfolio com­ position decisions by fund managers in order to establish the key micro- economic characteristics, particularly the roots of herding and risk appetite in bounded rationality. Bringing these two perspectives together provides the basis for a critique of official market interventions and their limited effect on demand conditions. The chapter concludes by suggesting that more determined efforts to stabilize and lengthen demand schedules may be needed to restore an orderly market in emerging-market assets. Push factors and credit cycles - the macroeconomic dimension of the asset demand schedule Changing investor perceptions are clearly related to international capital market instability. For instance before the Asian crisis five factors were considered to determine market access, or rather re-entry after the debt crisis of the 1980s (IMF, 1992: 45 etseq.): • Sound macroeconomic policies to reduce perceptions of country transfer risk. • Structural reforms such as privatization and financial liberalization to provide attractive assets in the form of equities and treasury bills. • The restructuring of existing commercial debt in order to reduce the disincentive effect of large debt burdens on private investment. • A solid record of servicing claims after the 1982 crisis to enhance reput­ ation among investors. • The reduced transaction costs implied by modern technology and integrated markets. All these factors were essentially related to the quality and supply of assets rather than the demand for them, despite the fact that the ERM crisis had recently demonstrated that private sector behaviour could be highly desta­ bilizing, and that self-fulfilling speculative attacks could be encouraged by the availability of bank credit for this purpose (IMF, 1993, particularly the Valpy FitzGerald 195 section on private sector behaviour during crisis). In particular, highly lever­ aged institutions such as hedge funds and the proprietary trading desks of investment banks could create rapid changes in the demand for particular asset classes and thus destabilize particular markets (IMF, 1994). It also became clear that speculative activities across the interstices of the inter­ national financial system were not simple arbitrage but actually created systemic settlement and liquidity risks (IMF, 1994: 34-7, 120-38). This somewhat belated recognition2 of the destabilizing potential of endogenous investor behaviour (despite the fact that domestic financial regulation took this for granted) prompted urgent official attention to the need to regulate international banking on a cross-border basis (IMF, 1997), herding behaviour by portfolio investors - particularly fund managers - and contagion between emerging markets (IMF, 1998: 69-71), and highlighted the need for ratings agencies to take account of the exposure of private banks as well as macroeconomic data (IMF, 1999: 101-15, 180-203). This overdue acceptance that demand schedule shifts are a major cause of instability in capital flows and beyond the control of emerging markets has not, however, been matched by an initiative to stabilize demand. As a consequence, formal analytical modelling of international capital markets in the aggregate (as opposed to the microeconomics of portfolio behaviour) has made little progress, in sharp contrast to the valuable contributions made by trade theory to the formulation of international trade policy. Sticky prices, market segmentation, heterogeneous investors, persistent currency misalignments despite arbitrage and the cost of scarce information all need to be accounted for if the model is even to approximate the real world in a useful way (Dumas, 1994). Indeed the divergence of asset prices from their fundamental values is a systemic characteristic of all capital markets, and while it is a zero sum game for those financial agents who are directly involved, the effects on the real economy are far from negligible and must be taken into account by regulators (Tobin, 1998: ch. 6). As the demand for and supply of emerging-market assets does not come into equilibrium, an explicitly disequilibrium econometric framework is clearly required in practice (Agenor, 1998). Models of credit crunches are a familiar approach to the analysis of domestic capital markets (Blinder, 1987) but are not generally used in international finance. Such models imply that a pecking order of FDI, debt and equity is required for such a framework, consistent with asymmetric information and finance theory (Razin et al, 1998). Above all the effect of demand changes on asset prices and flows is likely to be asymmetric in the sense that an increase (or decrease) in demand will not affect all assets equally, but rather prices and quantities stabilize the safer the asset. One of the few instances of this approach is the detailed examination of capital flows to four emerging markets - Brazil, Mexico, Thailand and Korea - by Mody and Taylor (2001). They have found that the short side of 19 6 The Emerging-Market Assets Demand Schedule the market, which can vary over the cycle, determines the level of flows. It is therefore possible to determine instances of international capital crunch, when flows are curtailed because of lender rationing. In particular their results show that higher US yield spreads are associated with credit crunches for emerging markets. Their analysis also highlights the part played by asymmetric information (as distinct from default risk) in conditioning capital flows. There is also ample evidence that domestic investors are better informed about payoffs in their own market than are foreign investors in both Europe (Gehrig, 1993) and Japan (Kang and Stulz, 1994), leading to home bias. There is also evidence that domestic investors moved out of markets in crisis before foreigners did in the cases of Korea (Kim and Wei, 1999) and Mexico (Frankel and Schmukler, 1996). This has led Brennan and Cao (1997) to suggest that while foreign equity purchases may be an increasing function of returns, due to the cumulative information advantage, news will cause foreign investors to revise their positions more than domestic ones will. The relative role of push and pull factors in separately determining fluc­ tuations in capital flows has been researched empirically, particularly in respect of the outward surge of the early 1990s, although there is no general consensus on the relative roles played by these factors. Calvo et al. (1993) stress external factors because reforming and non-reforming countries were similarly affected and at same time. The key factor was the poor return on safe assets in the G3 countries (especially the United States), which provided an incentive to search for higher returns. In the mid 1990s Fernandez-Arias (1996) concluded that push factors predominated, especially the falling US interest rates. By extension, sustained US asset price growth in the late 1990s explains the decline in demand, as well as supply quality problems in emerging markets themselves. Montiel and Reinhart (2001) have thus con­ cluded that the key push factors were those which reduced the attractiveness (risk-return characteristics) of industrial country debtors and therefore the demand for emerging-market assets. This was related to the business cycle: the collapse of Japanese asset prices and low US and European interest rates are cited for the early 1990s. Longer-term push (demand) factors included changes in the financial structure of industrial countries, such as the rise of mutual funds, where the small emerging-market share in their growing portfolios allowed for a longer-term upward trend. According to these authors, at least half of the observed variations in capital flows during the 1990s can be explained by these push factors. More recently attention has turned to the downturn in the capital flow cycle in the late 1990s. The cumulative stock positions for emerging- market bonds, loans and equity seem to indicate that a stable position was approached in the second half of the decade after the rapid stock expansion in the first half (Figure 11.1). In addition it is clear that towards the end of the decade there was a shift towards higher-quality assets, such as syndicated Valpy FitzGerald 197 Figure 11.1 Aggregate trends in emerging-market asset stocks, 1994-2001 (US$ billion) Source: IMF (2001). loans to affiliates of multinational corporations, investment-grade bonds and corporate equity traded on international exchanges. This might imply that the boom was in fact a stock readjustment following the earlier decline in demand due to the deterioration of asset quality (that is, the debt crisis) on the one hand, and the expansion of asset supply due to the privatization of utilities and financial liberalization on the other. The subsequent drought, then, reflected deteriorating asset quality and a reduced supply of assets as privatizations were completed and sovereign issuers reduced their public sector borrowing under adverse conditions (IMF, 2001). However Figure 11.2 suggests another explanation. It is clear that in the case of US mutual funds at least, the demand for emerging-market assets was closely correlated with the demand for international assets more generally. In other words the push factors determining the latter - including relative returns, portfolio diversification and home bias - were dominating the pull factor. A similar pattern can be observed for international bank portfolios, which kept on growing at the end of the decade while the emerging-market share steadily declined (ibid.: 23). Hence the divergence in the late 1990s can be attributed to a decline in asset quality (that is, to the successive emerging-market crises), although it should be remembered that this too was related to the previous upsurge of demand, which created an asset bubble. Similar effects have been detected in the bubble in technology stocks, in which emerging-market equities and bonds appear to constitute a single-asset, risk-return class for many institutional investors. As Figure 11.3 demonstrates, there is also evidence of an increasing cross­ correlation between emerging-market assets in times of crisis due to broad selling. For this high and variable degree of contagion, ‘common external 1 9 8 The Emerging-Market Assets Demand Schedule 1.0 0.8 0.6 0.4 0.2 0.0 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 Figure 11.2 Aggregate asset dem and com position, 1990-2001 (percentage of total net assets of all US equity m utual funds) Source: IMF (2001). 0.8 0.7 0.6 0.5 0.4 0.3 0.2 May 1998 Jan.1999 Sep.1999 May 2000 Jan.2001 Sep.2001 Figure 11.3 Aggregate trends in contagion, 1998-2001 (average cross-correlation of emerging debt markets) Source: IMF (2001). factors and lack of investor discrimination are the more likely explanators (ibid. 18). In downswings the lack of safe havens within an asset class also appears to increase cross-correlation. Eleven droughts of varying length have been identified between 1993 and 2001, defined as periods when the primary dollar market was effectively closed to the main non-investment- grade borrowers. Rate-spread widening and market volatility have been jd\ il » ___ _ Russian / Sjk default USHY September 11 J Brazil sell-off \ 1 /d e v a l u a t i o n \ Turkey \ devaluation US interest \ 1 . » rate concerns i „ r I f Q p Valpy FitzGerald 199 identified as key factors in such market closures: markets tend to reopen when spreads stabilize or narrow again. These factors also cause issuers to delay issuing, so there is a supply effect as well. However closure tends to be sudden and opening gradual, because while there has typically been a key discrete event that closes markets, there has typically not been a clearly identifiable discrete event that reopens them (ibid.: 20). In sum, it is clear from the macroeconomic evidence on capital flows that shifts in the demand schedule for emerging-market assets have dispropor­ tionate effects on both prices (yields) and quantities (flows), causing major macroeconomic shocks that in turn affect assets in terms of both quality (that is, economic stability and default risk) and supply. The factors that cause these shifts include the cost (interest rates) and availability of capital - that is, the OECD business cycle - on the one hand, and changes in risk aversion on the other. Risk aversion itself depends on home market conditions, and also on the experience of previous crises and the contagion of whole asset classes, independently of the underlying fundamentals, which change over time as collective perceptions of the causes of emerging-market instability change. To understand the changes in risk aversion it is necessary to turn to the microeconomic evidence on investor behaviour. Momentum trading and risk appetite - the microeconomic dimension of the asset demand schedule For some time it has been clear that (1) the microeconomic logic of invest­ ment behaviour in response to particular financial incentives and (2) the way in which investors use information can have severe consequences for the pricing of developing-country stocks, quite independently of the underlying fundamentals.3 The consequent asset bubbles can have a serious impact on the real economy in both developed and developing countries even in the presence of low inflation, fiscal balance and monetary rectitude (IMF, 2000). The principles of investor valuation in terms of the risk of and return on assets in a portfolio are well known, but the liquidity of emerging-market assets (almost a form of contract uncertainty) is also relevant when there is a possibility of market collapse. Liquidity then relates to the perception of other buyers reactions to news (herding and contagion), and to the anticipated actions of public authorities (so-called moral hazard). As a consequence, asset valuation methods and portfolio composition rules tend to be rather crude, being largely based on considerations of liquidity and exit possibilities (Clark et al., 1993). However there are limitations to the use of yield spreads on emerging- market bonds as evidence of markets perception of asset quality in the form of underlying default risk. A measure of yield dispersion and of comovements is necessary to determine whether the effects of shocks are common to all 2 0 0 The Emerging-Market Assets Demand Schedule the bonds surveyed, and the time profile of risk is needed to detect investors demand for liquidity. Moreover care is needed in interpreting yield spreads, since they are influenced by a variety of factors other than the perceived creditworthiness of the borrower including investors appetite for risk and the liquidity of particular instruments (Cunningham etal, 2001: 175). In particular, changes in risk appetite follow from change in preferences or institutional factors, such as the need to adjust portfolios following losses incurred on holdings of other risky assets (ibid.: 185). Yield dispersion increases over time as well as after crises, which can be interpreted as growing discrimination among investors in a cumulative learning process. However it is still the case that beyond investment grade4 the relationship between risk (as reflected in ratings) and price (reflected in yield spreads) tends to break down, particularly during droughts, when credit rationing severely reduces transaction volumes. Moreover, to the extent that the yield-spread term structure slopes upward (because default risk increases into the future), then average yield measures will be dis­ torted when composition changes through the cycle according to liquidity preference. We understand very little about how information is actually used in these investment decisions. In particular, perceptions of risk cannot reliably be based on an econometric analysis of past trends, due to the lack of data and the persistence of structural breaks. Under conditions of uncertainty not only is the most recent and timely information used (such as reserve levels or asset price trends, as used by chartists) rather than more informative data, but also judgement is strongly affected by the implicit models used by investors. Moreover in view of the cost of information (that is, research), its untimeliness and its uncertainty, portfolio investors logically prefer to move quickly in response to news. Finally, the incentives faced by fund managers (such as quarterly performance bonuses based on performance relative to the industry average) are widely considered to exacerbate this behaviour. In effect, as Keynes pointed out a long time ago, uncertainty cannot be reduced to risk or probability, rather it is related to the strength or degree of belief. Thus people evaluate the probability of events by the degree to which these events are representative of the relevant model or process (Kahneman et al., 1982: 97). Measurements of likely risk under circumstances that are difficult to imagine (low availability) or have not been experienced before are systematically underestimated as the event is felt to be unlikely. In general, although the language of probability can be used to express any form of uncertainty, the laws of probability theory do not apply to all variants of uncertainty with equal force (ibid.: 519). An interesting application of this insight can be found in De Grauwes model of the band of agnosticism in exchange rates, within which demand is stable but once breached leads to large demand shifts. This reflects rational behaviour in an uncertain world (De Grauwe, 1996: 181-206). Valpy FitzGerald 201 De Grauwe argues that the idea that economic agents compute a future exchange rate based on a model they believe in, then telescope it back into the present, is of little use in a world where economic agents have great difficulty in working out what the true model of the world is (ibid.: 189). Under these circumstances, small information costs lead to quite large asset price bands.5 De Grauwe suggests that the band of agnosticism is also a breeding ground for fads which, in the absence of credible alternatives, are elevated to important theories (ibid.: 202), and concludes that movements of real exchange rates are, within certain bounds, inexplicable (ibid.: 209) - all one can do is to make probabilistic statements about them. Another direction is provided by recent work on herding by investors, which indicates three possible causes: • Payoff externalities, where the payoff to an agent who adopts an action is positively related to the number of agents who adopt the same action. • Principal-agent considerations such that a manager, in order to maintain or gain reputation when markets are imperfectly informed, may prefer either to ‘hide in the herd’ to avoid evaluation or ride the herd to improve reputation. • Information cascades, where later agents, inferring information from the actions of prior agents, optimally decide to ignore their own informa­ tion (Devenow and Welck, 1996). Here too the use of information is as important as its availability. The macroeconomic variables discussed in the previous section also enter into standard models of portfolio optimization as the basis for asset allocation by fund managers (Disyatat and Gelos, 2001). Clearly, higher home interest rates, lower volatility in home assets, higher covariance between these and emerging-market assets, and higher risk aversion will all reduce demand for emerging-market assets independently of the supply conditions. Further, the benchmarking model explains pervasive herding behaviour and thus the momentum effect of demand for an asset becoming a positive function of quantity (capital flow). These models take both the risk aversion of investors and the characteristics of assets as given. There is, however, good reason to treat risk aversion (or risk appetite) as a variable in itself, one that not only changes but is also path dependent, varying with past experience of yields and bubbles and thus potentially strongly procyclical. Thus the prevalence of home bias, particularly under conditions of uncertainty, is clearly part of the problem for emerging markets as an asset class, and not just a structural factor. US pension funds hold between 1.5 per cent and 2.0 per cent of their port­ folios in emerging-market assets, mainly through mutual funds, which in turn account for about 10 per cent of market capitalization in host countries (Kaminsky etal., 2000b).6 Econometric analysis clearly indicates that funds 2 0 2 The Emerging-Market Assets Demand Schedule momentum trading in emerging-market equities is positive - they systematic­ ally buy winners and sell losers (Kaminsky etal, 2000a). Contemporaneous momentum (buying winners and selling losers) is stronger during crises; lagged momentum trading (buying past winners and selling past losers) is stronger when there are no crises. Investors also engage in contagion trading, that is, they sell assets from one country when asset prices fall in another. Kaminsky etal. also found differences between the behaviour of fund managers and direct investors, with managers being more likely to engage in momentum trading, partly because individuals flee mutual funds during crises even if the fundamentals do not warrant it. In a similar vein, Disyatat and Gelos (2001) have explored portfolio data for dedicated US mutual funds to assess whether they follow benchmarks or portfolio rebalancing rules. The authors found that benchmarking explains observed behaviour better than the rebalancing rule in the standard mean- variance optimization model, but they did not explore variations in risk aversion over time. The IMF, however, recognizes that risk appetite changes over time, and to identify this it uses the JP Morgan global risk aversion index (IMF, 2001), which measures monetary liquidity and credit premia (Figure 11.4). However, the Bank of England warns that it is difficult to construct robust indicators of risk appetite because of the difficulty of separating out the effects of pure contagion and underlying fundamentals in aggregate indicators7 (Cunningham etal., 2001: 185). It is therefore necessary to construct a model of risk aversion (or risk appetite) that suspends the constant absolute risk aversion (CARA) assump­ tion, allowing for observed cyclical behaviour in risk appetite and asymmetry through the cycle, with risk aversion rising suddenly in a crisis and only slowly declining afterwards. Kumar and Persaud (2001) suggest how this might be done. They argue that observed spreads should not be explained in terms of the difference between global risk (a) and the variance of the asset price (a2), as is conventionally done, but in terms of the product of risk appetite (K) and the standard deviation of the asset price (P). This defines the expected return E(R), which is measured as the difference between the long-term asset price, LR(P), and the current price, P. This formulation has two advantages: it allows risk appetite to be separately estimated, and it reflects the fact that variations in risk appetite will have proportionately larger effects on riskier asset prices: This formulation has the attractive property that the effect of global risk is symmetrical on emerging market asset prices, but the effect of risk appetite varies with the riskiness of the asset price itself: E(R) = a+ K log(T2) E(R) = LR(P) - P P = LR(P) - a - K Ioga2 (11.1) (11.2) (11.3) Valpy FitzGerald 2 0 3 1997 1998 1998 1999 1999 2000 2000 2001 2001 Figure 11.4 Global risk aversion Source: IMF (2001). A definition of JP Morgans LCPI The LCPI has two broad sub-components measuring liquidity and credit premia respectively. The indicators of a liquidity premia consist of the spread between on- and off-the-run US treasuries and US swap spreads. The credit premia indicators consist of US high-yield spreads, an emerging market bond index (the EMBI), JP Morgans Global Risk Aversion Index, and implied volatilities of the major exchange rates. An overall index is constructed by equally weighting the different sub­ components of the indicators. dP/da = -1 dP/dK = 21og a (11.4) It also means that K can be estimated separately as a coefficient in the regression of the volatility of an asset on its price. Empirical tests by Kumar and Persaud on leading emerging market currencies clearly demonstrate cyclical behaviour in risk appetite (K) and support the hypothesis that the more volatile (riskier) an asset is, the greater the rise in expected return in relation to the general level of risk. That is, the demand schedule for emerging market assets will be both steeper and more volatile than that for home assets. 2 0 4 The Emerging-Market Assets Demand Schedule At the microeconomic level, we can draw together the factors discussed above by exploring a simple framework for asset allocation in a portfolio made up of two asset classes:8 the emerging-market asset, 1, and the home asset, 2, with expected returns, r, and risk profiles, a2, such that: rl r2 of (11-5) The share, w, of emerging-market assets in the portfolio and the covariance between the two asset classes, r12, then determines its overall return, R, and variance, 22, characteristics: R = rxw + rz (l—w) (11-6) 22 = w2u2 + (1 - w)2 a2 + 2w(l - w)ui2 (11.7) The investors problem is to maximize their objective with respect to port­ folio composition, which is defined as follows: max = R - -g-A^2 (11-8)w 2 where A is the risk aversion coefficient. This then solves for the optimal value of the share of emerging-market assets, w*, in the portfolio: j\ + a^+2 jx r, + r + [*? + «id (11.9) From our point of view, the key benefit of this standard textbook result is that it enables us to construct an implicit asset demand schedule on the basis of the same characteristics of the asset demand schedule identified in the previous section. In other words the positive (negative) effect on the demand for emerging-market assets of a decrease (increase) in the home rate of return, r2, an increase (decrease) in the riskiness of home assets, a2, a fall (rise) in pure contagion, cri2, and above all an increase in risk aver­ sion, A. In sum, both empirical evidence and analytical insights indicate that the emerging-market asset schedule is relatively unstable and may respond to exogenous changes in risk appetite. In addition, momentum trading and investor herding combine to create asset bubbles quite independently of changes in the supply conditions or fundamentals. The effect of these demand fluctuations on individual emerging markets is asymmetric in the sense that demand is disproportionately more unstable for higher-risk assets. This evidence supports our interpretation of the nature of the asset demand schedule at the aggregate level, but also implies that changes in aggregate risk aversion should be made endogenous in a dynamic formulation. Valpy FitzGerald 2 0 5 An orderly market - the effects of official interventions on the asset demand schedule In combination, the two previous sections imply that if the market is to become more orderly and if capital flows to developing countries are to increase in both volume and maturity, supply-side measures alone will not be sufficient. Therefore we must turn to the issue of intervention in asset demand. If a full set of prices does not exist, or if perfect information on them is not available, even if firms and households act perfectly competitively (taking prices as parametric) then the market equilibrium - if it exists - is not welfare maximizing (Atkinson and Stiglitz, 1980). This is particularly true of financial markets, because a full set of futures markets, and of markets for all risks, usually does not exist. Again the presence of externalities such as the liquidity effect of major agents leaving the market can also lead to market failure or an absence of markets. Firms (or individuals or governments) cannot issue unlimited bonds at a given risk premium over current interest rates because the risk premium depends on the amount borrowed and the collateral available. Lenders will not lend even at higher interest rates (or even more collateral) because this would increase the risk and dissuade good borrowers. The profit-maximizing loan book for a bank thus takes the form of rationing - that is, a limit on the overall level of loans to particular classes of borrower or types of asset. Asymmetric information (where borrowers have better knowledge of the likelihood of default than do lenders) will lead to the situation where assets may be sound, but no one is willing to lend - that is, a collapsed market (Hiller, 1997). In these circumstances a small increase in the perceived risk for some borrowers, or a reduction in the overall supply of funds, can cause the credit market to collapse for a whole class of borrowers (Mankiw, 1986). The consequences for macroeconomic stability in a single economy are now widely recognized (Stiglitz and Weiss, 1992), and logically they are even more significant for international capital markets. Specifically, the absence of full market clearing leads to a serious problem with market access: low-income countries do not have access to international bond markets (at whatever premium) while middle-income countries can easily lose access due to regional contagion or political events (World Bank, 2000). Asymmetric information problems are to some extent resolved by rating agencies, although their record is very mixed (IMF, 1998, 1999). Externalities also exist in the form of overheating on market upswings and liquidity problems on downswings, both of which may justify supervisory oversight and last-resort lending. Contract risk in the case of equities is not great, and the legal costs of transactions are reduced by the use of American or Global Depository Receipts in developed-country markets. However in the case of 2 0 6 The Emerging-Market Assets Demand Schedule bonds there are serious externality and contract problems in cases of bond default and debt workouts, where the interests of individual bondholders may not coincide, thus causing a common action problem. In the case of bank lending there should be fewer information problems because banks possess both expertise and information from their branches. The risk of default, however, remains high due to liquidity problems and financial fragility in emerging markets, so banks tend to make only short-term loans, and preferably to other banks and multinational affiliates. What is more, bank lending tends to become highly volatile in response to political and regional events, and to be strongly procyclical; so it does not provide sup­ port in times of economic difficulty, and tends to increase credit availability during macroeconomic booms. Broadly speaking we can identify three traditional forms of public inter­ vention in the flow of private capital to emerging markets: • Intermediation between developed-country lenders (that is, global capital markets) and developing countries, based on the particular advantages of information, diversification or contract enforcement that such institutions have over the private sector in order to provide longer-term loans than the market is willing to offer, or to gain access for countries that are not considered creditworthy; this being the role of the World Bank and the other (regional) multilateral development banks. • Efforts to ensure that financial contracts are more likely to be enforced, either by improving the economic and institutional strength of the borrowing country, or by using international leverage to ensure that con­ tracts are honoured in debt work-outs; and for longer-term lending to offer investment insurance facilities and export credit guarantees on the same principle. • Provision of countercyclical finance as a lender of last resort in situ­ ations where the borrower is fundamentally solvent but there is a liquidity shortage due to market expectations that become self-fulfilling when the maturities of borrowers assets and liabilities are mismatched (the role of the IMF); helping to restructure and refinance outstanding developing country liabilities where longer-term solvency obtains, and to allocate the costs of writing off debt when the borrower is insolvent - equivalent to bankruptcy proceedings in national private sectors. All three forms of intervention relate to what we have defined as the supply schedule for emerging-market assets. More recently the dissemin­ ation of reliable information to capital markets on the quality of assets and borrowers, thus reducing the asymmetric information problem, has become the key element in the G7 Financial Stability Forums (FSF) Compendium of Standards9 for the strengthening and extension of existing systems of Valpy FitzGerald 2 0 7 global financial supervision, increasing the availability and timeliness of information (mainly official statistics) to the markets. The positive incentive for compliance despite the high administrative cost is that emerging markets that adhere to the new rules will enjoy enhanced market access, although this is only a potential benefit. The penalties for non-compliance are clearer: financial regulators in OECD countries can apply penalties or constraints such as capital requirements on investors acquiring assets in non-compliant countries; and official lenders (particularly the IMF) can refuse to support non-compliant countries. These disincentives might be effective in reducing foreign interest in non-compliant countries, but they also tend to reinforce the cyclical nature of investors interest in emerging markets and thus undermine sustainable growth in developing countries. Moreover, as we have seen, the market does not always use information effectively as much depends on the models used to analyze statistical data. These models are generally backward looking (which leads to overshooting), while traders react to news that does not reflect the underlying fundamen­ tals. The rules proposed by the FSF that attempt to define best practice in emerging-market policies related to economic reform and policy conduct are problematic because what constitutes sound fundamentals is not always agreed (for example the acceptability of capital controls) and indeed tends to change over time.10 Precisely because capital markets do not function well on their own, developed countries maintain a high degree of prudential regulation of their own national capital and banking markets in order to ensure the integrity of markets by regulating creditors as much as - if not more than - debtors (Goodhart etal., 1998). Nonetheless international measures to stabilize capital flows that affect source countries have been very limited. An increased role for rating agencies in rating countries or companies, as proposed by the Basel Committee, could even risk increasing the negative procyclical features of bank lending and make it more difficult for poorer countries (and companies in those countries) to gain access to bank lending. The current proposals for banks would also lead to the greater use of banks own value-at-risk (VaR) models when setting regulatory capital requirements, which could strengthen - rather than reduce - the propensity for boom-bust flows and the bias against emerging markets. The proposal for the revision of bond contracts to permit majority bond­ holder decisions (the so-called collective action clauses) in situations of debt restructuring is an important step forward, but it does not constitute a measure to alter the demand schedule. In effect such measures alter bond quality by making the consequences of default more certain and thus allowing better risk pricing. This is in marked contrast to the OECD markets, where fiscal and regulatory incentives are used to encourage institutional investors to take longer-term positions (Davis, 1995). Table 11.1 shows key elements of investment regulation of pension funds in a number of industrialized countries (OECD, 2001). It is clear that the UK Table 11.1 In v e s tm e n t re g u la tio n o f p e n s io n funds in n in e O E C D co untries , 2 0 0 1 Direct limits on domestic asset holding (%) Equity Real estate Corporate bonds Investment funds Loans Bank deposits Direct limits on foreign investment Austria Belgium 50 20 65 h 302 403 France 651,0 .5 2 0 Germany 301, 102 25 30 50 30 403 10 504, 50s * Non-euro investm ents and foreign property investm ents, 50 per cent m axim um * Localization requirem ent: only assets located in EU, but includes securities issued by authorized institutions; 65 per cent OECD equities, 5 per cent foreign investm ent funds, non-OECD equities barred 50 30 per cent EU equity, 25 per cent EU property, I ta ly 2 0 Japan * * * * * Spain * \ 102 * * * io 6 UK * * * * No employer- related loans US * * * Notes: * N o limits. 1 Quoted equity. 2 Unquoted. 3 Joint limit. 4 Mortgage loans. 5 Other. 6 If no mortgage guarantee. Source: O E C D (2001, correct as at May 2001), abridged by Alex Cobham. 20 Debt and equity securities no t traded in regulated markets: OECD 50 per cent, non-OECD barred. Non-OECD traded in regulated markets 5 per cent * * 15 No limits for OECD countries * * * * 209 2 1 0 The Emerging-Market Assets Demand Schedule and US pension funds are among the least closely regulated in the developed world. The pressure for more active portfolio allocation to manage risk and the need for higher returns to support an ageing population mean that emerging-market assets could be a valuable component of portfolios if the market becomes less cyclical. There is no explicit regulatory constraint on pension funds holding securities issued by (or backed by assets of foreign investors in) developing countries. In contrast other EU pension funds are much more closely regulated and there are considerable restrictions on their portfolio composition. This is mainly designed to reduce the risk of funds failing but also to generate a market for long-term domestic government and corporate debt and property mortgages. In sum, despite the fact that demand shifts account for a large part of emerging-market instability because of their asymmetric effects, official inter­ vention has been concentrated almost entirely on asset supply conditions. Interventions that could affect demand, such as new information standards and bank capital adequacy rales, will probably have little effect at best or further destabilize demand at worst. Conclusions This chapter has demonstrated how shifts in the demand schedule for emerging market assets affect asset prices, asset quality (for example default risk) and asset stocks, and thus capital flows. In doing so it has identified a number of points at which macroeconomic theory, evidence on aggregate flows, microeconomic evidence and theory on portfolio adjustment can be brought together to define the key components of this demand schedule. It has established that shifts in the demand schedule, independently of conditions in emerging markets, account for a large part of the changes in observed capital flows. But the task is far from complete as we still lack a formal analytical definition of this schedule. A corresponding definition of the supply schedule - including the determinants of borrowing decisions and the interactive effects of the flows on asset quality - will also be needed to construct a well-grounded, reduced-form estimation model for econometric testing of the data. Nonetheless some tentative policy conclusions can be drawn from the argument so far. First, the G3 governments should pay more attention to the negative effects on emerging markets of volatility in the OECD capital markets. Relatively small fluctuations in G3 interest rates and exchange rates (and the related capital account variations resulting from investment-saving imbalances) cause absolute shifts in the emerging-market asset demand schedule that are very large in relation to the economies of the host coun­ tries. However the fact that the G3 governments are unwilling (or unable) to adopt mutual macroeconomic coordination rules in order to sustain their Valpy FitzGerald 21 1 own economies implies that they are unlikely to do so in order to help developing countries. Given the inevitability of macroeconomic cycles in the G3 zone, there appear to be two other policies that could stabilize capital flows to emerging markets from the demand perspective. The first would be to encourage - by a combination of regulatory changes and tax incentives - G3 institutional investors to acquire and hold emerging-market assets of a longer maturity than at present. This would both shift the demand upwards and reduce its volatility over the cycle by increasing risk appetite on a structural basis. The advantages to institutional investors would, of course, be higher long-term yields without the excess risk generated by the market instability of the past decade. The second would be to create greater liquidity in the market by encour­ aging market makers (such as international financial institutions) to make an explicit commitment to countercyclical intervention by standing ready to buy assets from the private sector during the downswing of the cycle (when risk appetite declines) and sell during the upswing. This form of liquidity provision would probably be more effective than the present practice of last- resort lending when crises occur, particularly as it would reduce the ex ante volatility of emerging-market assets and thus enhance their attractiveness to institutional investors. Notes * Earlier versions of th is chapter were presented to th e WIDER/ECLAC seminars on Capital Flows to Emerging Markets since the Asian Crisis in Santiago de Chile (8-9 March 2001) and Helsinki (1-18 October 2001). I w ould like to thank colleagues at these seminars for their critical yet constructive com m ents. 1. This problem is discussed in depth in Luttick (1998), w ho also addresses th e major inconsistencies between asset-liability and inflow -outflow statistics, recorded by the countries of origin and destination. 2. Not th a t th is had been absent from the critical economics literature, of course, from Keynes th rough to Kindleberger. 3. See IMF (1995), particularly the section on institutional investor behaviour and the pricing of developing country stocks (pp. 37-44). 4. According to the Bank of England, the spread/rating curve tends to the origin, moves th rough 250 basis points at M oody’s A2 and 500 basis points at B3, becoming asym ptotic to infinity beyond B3 (C unningham et al., 2001). 5. The size of the band (that is, the speculative estimate of future exchange rate m inus forward price) m ust logically be greater th an the square root of the volatility m ultiplied by the risk aversion coefficient and the cost of inform ation. An increase of 1 per cent in inform ation costs as a proportion of th e gain from the transaction can w iden the band w idth by 20 per cent under reasonable param eter assumptions. 6. These are World Bank estimates for 1997; the total assets am ounted to US$50-70 billion. 7. Such as JP M organs EMBI global index (IMF, 2001). 2 1 2 The Emerging-Market Assets Demand Schedule 8. In fact it w ould be m ore realistic to build a ‘decision tree in the way tha t trade modellers do (derived from models of aggregate consum ption), allowing for successive stages of disaggregation. Thus the first division would be between hom e and international assets, the second w ithin international assets between the OECD and emerging markets, the th ird w ithin emerging markets between regions, and so on. But the essence of the m odel would be similar. 9. The FSF Compendium o f Standards contains the work of six separate bodies: the Basel Comm ittee on Banking Supervision (BCBS), the Com m ittee on Payment and Settlement Systems (CPSS), th e International Association of Insurance Supervisors (IAIS), the International M onetary Fund (IMF), the International O rganisation of Securities Commissions (IOSCO) and the Organisation for Economic Co-operation and Development (OECD). 10. As has, for th a t matter, th e con ten t of and support for the so-called W ashington Consensus. References Agenor, P -R. (1998) The Surge in Capital Flows: Analysis of Push and Pull Factors, International Journal Finance and Economics, 3: 39-57. Atkinson, A. B. and J. E. Stiglitz (1980) Eectures on Public Economics, New York: McGraw-Hill. Blinder, A. S. (1987) C redit Rationing and Effective Supply Failures, Economic Journal, 97: 327-52. Brennan, M. J. and H. H. Cao (1997) In ternational Portfolio Investm ent Flows, Journal o f Finance, 52: 1851-80. Calvo, G. A., L. Leiderman and C. M. Reinhart (1993) Capital Flows and Real Exchange Rate Appreciation in Latin America, IMF Staff Papers, 40, 1: 108-51. Caouette, J. B., E. I. A ltm an and P. Narayan (1998) Managing Credit Risk: The Next Great Financial Challenge, New York: Wiley. Clark, E., M. Levasseu, and P. Rousseau (1993) International Finance, London: C hapm an and Hall. C unningham , A., L. D ixon and S. Hayes (2001) Analysing Yield Spreads on Emerging Market Sovereign Bonds, Bank o f England Financial Stability Review, December: 175-86. Davis, E. P. (1995) Pension Funds: Retirement-Income Security and Capital Markets, Oxford: C larendon Press. De Grauwe, P. (1996) International Money, 2nd edn, Oxford: Oxford University Press. Devenow, A. and I. Welck (1996) Rational Herding in Financial Economics’, European Economic Review, 40: 603-15. Disyatat, P. and R. G. Gelos (2001) The Asset Allocation of Emerging Market Funds, IMF Working Paper W P/01/11, W ashington, DC: IMF, August. Dumas, B. (1994) Partial Equilibrium Versus General Equilibrium Models of the Inter­ national Capital Market, in F. van der Ploeg (ed.), The Handbook o f International Macroeconomics, Oxford: Blackwell, 301-34. Femanadez-Arias, E. (1996) The New Wave of Private Capital Flows: Push or Puli, Journal o f Development Economics, 48, 2: 389-418. Frankel, J. and S. Schmukler (1996) C ountry Fund Discounts, Asymmetric Inform ation and the Mexican Crisis of 1994: Did Local Investors Turn Pessimistic Before International Investors?’, NBER Working Paper no. 5714, Cambridge, MA: NBER. Gehrig, T. (1993) An Inform ation Based Explanation of th e Domestic Bias in International Equity Investm ent, Scandinavian Journal o f Economics, 21: 97-109. Valpy FitzGerald 2 1 3 Goodhart, C., P. H artm ann, D. Llewellyn, L. Rojas-Suarez and S. Weisbrod (1998) Financial Regulation, London: Routledge in association w ith th e Bank of England. Hiller, B. (1997) The Economics o f Asymmetric Information, Basingstoke: Macmillan. In ternational M onetary Fund (IMF) (1992-1999) International Capital Markets: Developments, Problems and Key Policy Issues, W ashington, DC: IMF. (1995) Private Market Financing for Developing Countries, W ashington, DC: IMF. (2000) World Economic Outlook, W ashington, DC: IMF, May. (2001) Emerging Market Financing, W ashington, DC: IMF, November. Kahneman, D., P. Slovic and A. Tversky (1982) Judgement Under Uncertainty: Heuristics and Biases, Cambridge: Cambridge University Press. Kaminsky, G., R. K. Lyons and S. Schmukler (2000a) Managers, Investors and Crises: M utual Fund Strategies in Emerging Markets, NBER Working Paper no. 7855, Cambridge, MA: NBER. a n d (2000b) M utual Fund Investm ent in Emerging Markets: An Overview, World Bank Economic Review, 15, 2: 315-40. Kang, J -K. and R. M. Stulz (1994) ‘W hy is There a Home Bias? An Analysis of Foreign Portfolio Equity Ownership in Japan, Journal o f Financial Economics, 46: 3-28. Kim, W. and S -J. Wei (1999) Foreign Portfolio Investors Before and During a Crisis, NBER Working Paper no. 6968, Cambridge, MA: NBER. Kumar, M. S. and A. Persaud (2001) Pure C ontagion and Investors Shifting Risk Appetite: Analytical Issues and Empirical Evidence, IMF Working Paper 01/134, W ashington, DC: IMF. Lane, P. and G. M. Lilesi-Ferretti (1999) The External W ealth of Nations: Measures of Foreign Assets and Liabilities for Industrial and Developing Countries, IMF Working Paper 99/115, W ashington, DC: IMF. Luttick, J. (1998) Accounting for the Global Economy: Measuring World Trade and Investment Linkages, Basingstoke: Macmillan. Mankiw, N. G. (1986) The Allocation of Credit and Financial Collapse, Quarterly Journal o f Economics, 101: 455-70. Mody, A. and M. P. Taylor (2001) International Capital Crunches: The Time-Varying Role of Inform ational Strategies, IMF W orking Paper 02/43, W ashington, DC: IMF. M ontiel, P. and C. M. Reinhart (2001) The Dynamics of Capital M ovem ents in Emerging Economies During the 1990s, in S. Griffith-Jones, M. F. M ontes and A. N asution (eds), Short-term Capital Flows and Economic Crises, Oxford: Oxford University Press for UNU/WIDER, 3-28. OECD (2001) Survey o f Investment Regulation o f Pension Funds, Paris: OECD. Razin, A., E. Sadka and C. W. Yuen (1998) A Pecking Order of Capital Inflow and International Tax Principles, Journal o f Intemaional Economics, 44: 45-68. Stiglitz, J. and A. Weiss (1992) Asymmetric Inform ation in Credit Markets and its Implications for M acroeconomics, Oxford Economic Papers, 44. Tobin, J. (1998) Money Credit and Capital, New York: McGraw-Hill. World Bank (2000) Global Development Finance 2000, W ashington, DC: World Bank. P a rt II N a tio n a l P o lic y R esp o n ses II 1 2 C a p i t a l A c c o u n t a n d C o u n t e r c y c l i c a l P r u d e n t i a l R e g u la t io n s i n D e v e l o p i n g C o u n t r i e s * José Antonio Ocampo The association between capital flows and economic activity has been a strong feature of the developing world, and particularly of emerging markets, for a quarter of a century. This highlights the central role played by the mechanisms that transmit externally generated boom-bust cycles in capital markets to the developing world, as well as the vulnerabilities they engender. The strength of business cycles in developing countries, and the high economic and social costs they generate, are thus related to the strong connections between domestic and international capital markets. This implies that an essential objective of macroeconomic policy in develop­ ing countries is to reduce the intensity of capital account cycles and their effects on domestic economic and social variables. This chapter explores the role of two complementary policy tools in achieving these objectives: capital account regulations and countercyclical prudential regulation of domestic financial intermediation. After a brief look at the macroeconomics of boom- bust cycles, the chapter focuses on the possibility of directly affecting the source of the cycles through capital account regulations, and then considers the role of countercyclical regulations. The macroeconomics of boom-bust cycles Capital account cycles in developing countries are characterized by the twin phenomena of volatility and contagion. The first is associated with significant changes in risk evaluation during booms and crises of what international market agents consider to be risky assets, which involve a shift from an appetite for risk (or more properly, an underestimation of risks) to a ‘flight to quality (risk aversion). The second implies that, due to information asymmetries, developing countries are pooled together in risk categories that are viewed by market agents as strongly correlated. Beyond any objective 2 1 7 2 1 8 Capital Account and Countercyclical Regulations criteria that may underlie such views, this practice turns such correlations into a self-fulfilling prophecy. Capital account volatility is reflected in variations in the availability of financing, in the procyclical pattern of spreads (narrowing during booms, widening during crises) and in the equally procyclical variation of matur­ ities (reduced availability of long-term financing during crises). Such cycles involve both short-term movements - such as the very intense movements observed during the Asian and, particularly, the Russian crises - and, perhaps primarily, medium-term fluctuations, as the two cycles experienced over the last three decades indicate: The boom in the 1970s was followed by a debt crisis in a large part of the developing world, and another boom in the 1990s was followed by a sharp reduction in net flows after the Asian crisis. Due to contagion, such cycles tend to affect all developing countries, although with some discrimination by the market, reflecting the perceived level of risk of specific countries or groups of countries. The main way in which the economic literature has explored the effects of external financial cycles on developing countries is by analyzing the mechanisms through which vulnerability is built up during capital-account booms. This may lead to the endogenous unstable dynamics analyzed by Minsky (1982) and Taylor (1998), among others, whereby the accumulation of risk leads to a sudden reversal of flows, and eventually to, a financial crisis. Alternatively the accumulated vulnerability is reflected in sensitivity to an exogenous shock, for example a contagion effect generated by a crisis in other developing countries or a downturn in financial markets in the indus­ trialized world. Thus in addition to the effects of traditional trade shocks, new sources of vulnerability have arisen. These are associated with the flow and balance- sheet effects of capital account fluctuations on domestic financial and non- financial agents, and with the impact of such fluctuations on macroeconomic variables. Some of these effects are transmitted through public sector accounts, but the dominant feature of the new generation of business cycles in developing countries is the sharp fluctuation in private spending and balance sheets. The macroeconomic effects are amplified if the stance of macroeconomic policy is procyclical, as market agents actually expected it to be. The credibility of macroeconomic authorities and domestic financial intermediaries plays a key role throughout this process. If the fiscal policy stance is procyclical, temporary public sector revenues and readily accessible external and domestic financing induce an expansion of public sector spending, which is later followed by an adjustment when those conditions are no longer present. Furthermore, during the downswing interest payments follow an upward trend due to devaluation and to increased domestic interest rates and international spreads. This trend, together with downward pressure on public sector revenues, triggers a procyclical cut in primary spending, but this may be insufficient to avoid a sudden jump in public sector debt ratios. José Antonio Ocampo 2 1 9 The structure of public sector debt plays a crucial role in this dynamic. In particular, if most of the public sector debt is short term the necessary rollovers considerably increase the financing requirements during the crisis, thus undermining confidence in the capacity of the government to service the debt. If the short-term debt is external, risk premiums increase and the availability of financing may be curtailed. If it is domestic, there may be strong pressure on interest and exchange rates, as asset holders’ high liquidity facilitates the substitution of foreign assets for public sector debt securities. As in the past, exchange rate fluctuations also play an important part in the business cycle, but their flow effects are now mixed with, or even dominated by, the wealth effects they have in economies with large net external liabilities. The capital gains generated by appreciation during the upswing helps to fuel the private spending boom, whereas the capital losses generated by depreciation have the opposite effect in the downturn. Further­ more such gains induce additional net inflows when there are expectations of exchange rate appreciation, and the opposite effect if depreciation is expected, thus endogenously reinforcing the capital account cycle. The income effects may have similar signs, or at least in the short run, if the traditional conditions for the contractionary effects of devaluation (or the expansionary effects of appreciation) are met (Krugman and Taylor, 1978). Policy-induced overvaluation of the exchange rate, generated by anti- inflationary policies that anchor the price level to a fixed exchange rate, accentuate these effects. Domestic financial multipliers play an additional role through their effects on private spending and balance sheets. Indeed the domestic financial sector is both a protagonist and a potential victim of the macroeconomics of boom-bust cycles. The external lending boom facilitates domestic credit expansion and private sector spending during the upswing, but private sector debt overhangs accumulated during the boom subsequently trigger a deterioration in portfolios and a contraction in lending and spending during the downswing. At the same time banks and other financial inter­ mediaries have inherent weaknesses that make them particularly vulnerable to changes in market conditions since they operate with high leverage ratios; they can be affected by maturity mismatches between deposits and lending (which are essential to their economic role of transforming maturities), and are subject to market failures that affect the assessment of credit risk. Market failures are associated with information asymmetries, adverse selection and (possibly) moral hazard, all of which distort risk assessments and the allocation of funds to investment (Stiglitz, 1994; Mishkin, 2001). Buoyant expectations and their effects on the value of assets and liabilities may cause market agents to underestimate risks during booms. Overestima­ tion of credit quality increases the speed of credit growth. In many cases, under the pressure of increased competition banks relax their standards of risk appraisal and make loans to borrowers with a lower credit quality. 2 2 0 Capital Account and Countercyclical Regulations This strategy is more frequent in the case of new participants in the mar­ ket, since the older and larger institutions tend to retain the best-quality borrowers. Overall a deterioration of banks balance sheets results from the excessive risk taking that characterizes lending booms, but it only becomes evident after a lag. De Lis et al. (2001) refer to a strong positive impact of credit growth on problem loans with a lag of three years. Eventually the risks that have built up are revealed in a rise in non­ performing loans. In the absence of new capital, which is hard to raise when balances have deteriorated, banks are forced to cut lending even if borrowers are willing to pay higher interest rates. The protection provided by loan-loss provisions and capital may be insufficient to absorb the adverse shocks. The severity of the ensuing credit crunch depends on the magnitude of the credit boom and its effects on credit quality, and may be exacerbated by the fragility of the balance sheets of non-financial firms. Even the best- run banks may find it difficult to manage a shock that severely affects their clients. The accumulation of currency and maturity mismatches on the balance sheets of both financial and non-financial agents is an additional source of vulnerability. Mismatches are associated with asymmetries in the finan­ cial development of industrialized and developing countries - that is, the considerable incompleteness of markets in the latter (Ocampo, 2002a). In particular domestic financial sectors in developing countries have a short­ term bias. Domestically financed firms thus have significant maturity mis­ matches on their balance sheets. Whereas small and medium-sized enterprises (SMEs) are unable to avoid such mismatches, large corporations may compensate for them by borrowing in external markets, but firms operating in non-tradable sectors then develop currency mismatches. A variable mix of maturity and currency mismatches is therefore a structural feature of non-financial firms balance sheets in developing countries. Domestic asset prices reinforce these cyclical dynamics. The rapid increase of asset prices during booms (particularly of stocks and real estate) stimulates credit growth. In turn, lending booms reinforce asset demand and thus asset price inflation. The resulting wealth effects intensify the spending boom. This process is further reinforced by the greater liquidity that characterizes assets during periods of financial euphoria. However this behaviour also increases the vulnerability of the financial system during the subsequent downswing, when debtors have difficulty serving their obligations and it becomes clear that the loans did not have adequate backing or that asset price deflation has reduced the value of collateral. Asset price deflation is reinforced as debtors strive to cover their financial obligations and creditors seek to liquidate the assets received in payment for outstanding debts under conditions of reduced asset liquidity. The negative wealth effect of decreasing asset prices contributes to the contraction of the economy and the credit crunch that follows in its wake. José Antonio Ocampo 221 Monetary policy has a limited degree of freedom to smooth out the dynamics of boom-bust cycles under all exchange rate regimes. In a fixed exchange rate regime, reserve accumulation during the boom fuels monetary expansion, which together with falling international spreads leads to a reduction in domestic interest rates. Under a floating exchange rate, both can be avoided, but only by inducing exchange rate appreciation, which also has expansionary wealth effects. Intermediate regimes (including dirty floating) generate variable mixes of these effects. A contractionary monetary policy will induce, in all cases, endogenous incentives that amplify the capital surge. The typical instrument of a contractionary monetary policy - that is, sterilized foreign-exchange reserve accumulation - also has large quasifiscal costs. The inducement to borrow abroad is also reflected in additional currency mismatches in the portfolios of either financial or non-financial intermediaries. The opposite types of pressure arise during a downswing, thereby exposing the accumulated financial vulnerabilities. Under a fixed exchange regime or a dirty float, the increase in interest rates and the reduction in financing generated by contractionary monetary policy aimed at containing speculative attacks on the currency exert strong pressure on weak balance sheets, particularly on agents with significant maturity mismatches. In a floating exchange rate regime, strong pressure is placed on agents with currency mismatches. The frequency and intensity of financial crises is thus associated with the vulnerabilities generated by boom-bust cycles. In historical perspective, the frequency of twin external and domestic financial crises is indeed a striking feature of the period that started with the breakdown of the Bretton Woods exchange rate arrangements in the early 1970s (IMF, 1998; Bordo etal, 2001). The most important policy implication of this is that developing- country authorities need to focus their attention on crisis prevention - that is, on managing booms - since in most cases crises are the inevitable result of poorly managed booms. Focusing attention on crisis prevention recognizes, moreover, an obvious fact: that the degree of freedom of the authorities is greater during booms than during crises. The way crises are managed is not irrelevant, however. In particular, different policy mixes may have quite different effects on economic activity and employment, as well as on the domestic financial system (see Chapter 13; see also ECLAC, 2002; Ocampo, 2002b). Capital-account regulations The dual role of capital-account regulations As we have seen, the accumulation of risks during booms depends not only on the magnitude of private- and public-sector debts but also on maturity and currency mismatches on the balance sheets. Thus capital account 2 2 2 Capital Account and Countercyclical Regulations regulations potentially have a dual role: as a macroeconomic policy tool to provide some room for countercyclical monetary policies that smooth out debt ratios and spending; and as a liability policy to improve private sector external debt profiles. Complementary liability policies should also be adopted, particularly to improve public sector debt profiles. The emphasis on liability structures rather than on national balance sheets recognizes the fact that, together with liquid assets (particularly international reserves), they play an essential role when countries face liquidity constraints; other assets play a secondary role in this regard. Viewed as a macroeconomic policy tool, capital account regulations aim at the direct source of boom-bust cycles: unstable capital flows. If they are successful, they provide some room to lean against the wind during periods of financial euphoria through the adoption of a contractionary monetary policy and/or reduced appreciation pressures. If effective, they also reduce or eliminate the quasifiscal costs of sterilized foreign exchange accumulation. During crises they provide breathing space for expansionary monetary policies. In both cases, capital account regulations improve the authorities ability to mix additional degrees of monetary independence with a more active exchange rate policy. Viewed as a liability policy, capital account regulations recognize the fact that the market rewards sound external debt profiles (Rodrik and Velasco, 2000). This reflects the fact that, during times of uncertainty, the market responds to gross (and not merely net) financing requirements, which means that the rollover of short-term liabilities is not financially neutral. Under these circumstances a maturity profile that leans towards longer-term obligations will reduce domestic liquidity risks. This indicates that an essen­ tial component of economic policy management during booms should be measures to improve the maturity structures of both the private and the public sectors external and domestic liabilities. On the equity side, foreign direct investment (FDI) should be preferred to portfolio flows, as the former has proved to be less volatile than the latter. Both types of equity flow have the additional advantage that they allow all risks associated with the busi­ ness cycle to be shared with foreign investors, and FDI may bring parallel benefits (access to technology and external markets). These benefits should be balanced against the generally higher costs of equity financing. Innovations in capital account regulations in the 1990s A great innovation in this sphere during the 1990s was unquestionably the establishment of an unremunerated reserve requirement (URR) for foreign- currency liabilities in Chile and Colombia. The advantage of this system was that it created a simple, non-discretionary and preventive (prudential) price-based incentive that penalized short-term foreign-currency liabilities more heavily. The corresponding levy was significantly higher than the level suggested for an international Tobin tax: about 3 per cent in the Chilean José Antonio Ocampo 2 2 3 system for one-year loans, and an average of 13.6 per cent for one-year loans and 6.4 per cent for three-year loans in Colombia in 1994-98. As a result of the reduced supply of external financing after the Asian crisis, the system was phased out in both countries. Other capital account regulations com­ plemented reserve requirements, particularly the one-year minimum-stay requirement for portfolio capital (lifted in May 2000) and approval (subject to minimum requirements) for the issuance of ADRs and similar instruments in Chile, as well as the direct regulation of portfolio flows in Colombia. The effectiveness of reserve requirements has been the subject of a great deal of controversy.1 There is broad agreement that they were effective in reducing short-term debt flows and thus in improving or maintaining good external debt profiles. However in contrast to this positive view of these regulations as a liability policy there has been widespread controversy about their effectiveness as a macroeconomic policy tool. This question has been made more complex by the fact that neither country was free from the strong pressures generated by the external financing cycle that emerging economies faced during the 1990s, or from the effects of procyclical macro- economic policies (Ocampo, 2002b). However, judging from the solid evidence that exists on the sensitivity of capital flows to interest rate spreads in both countries, it can be asserted that reserve requirements do influence the volume of capital flows at given interest rates.2 This may reflect the fact that national firms access to external funds is not independent from their maturities - that is, that the substi­ tution effect between short- and long-term finance is imperfect on the supply side - and/or that the available mechanisms for evading or eluding regulations may be costly.3 In any case, a significant part of the history of these regulations, particularly in Chile, was associated with the closing of regulatory loopholes.4 Alternatively, the URR allows the authorities to main­ tain higher domestic interest rates at a given level of capital inflows, and thus of the money supply. Hence in broader terms the usefulness of reserve requirements as a macroeconomic policy tool depends on the ability to affect capital flows, domestic interest rates or both, with the particular com­ bination being subject to policy choice.5 To the extent that capital flows affect the supply of foreign exchange, exchange rates may also be affected. Given the numerous channels through which the URR can affect the economy, the effectiveness of these regulations can best be measured by a broad index of monetary pressures that includes capital inflows, domestic interest rates and exchange rates. This is the procedure used below. In Colombia, where these regulations were modified more extensively during the 1990s, there is strong evidence that increases in the reserve require­ ments reduced flows (Ocampo and Tovar 1998, 1999) or, alternatively, were effective in increasing domestic interest rates (Villar and Rincon, 2002). Similar evidence is available for Chile (see Larrain et al., 2000; Le Fort and Lehman, 2000; for interest rate spreads see De Gregorio etal., 2000). The 2 2 4 Capital Account and Countercyclical Regulations evidence of effects on exchange rates is more mixed, though this may reflect the difficulties inherent in exchange rate modelling (Williamson, 2000: ch. 4). Some problems in the management of these regulations were associated with changes in the relevant policy parameters. The difficulties experienced in this connection by the two countries differed. In Chile the basic problem was the variability of the rules pertaining to the exchange rate, since the lower limits of the exchange rate bands were changed on numerous occasions before the exchange rate was allowed to float in September 1999. During capital account booms, this gave rise to a safe bet for agents bringing in capital, since when the exchange rate neared the floor of the band (in pesos per dollar) the probability that the floor would be adjusted downward was high. In Colombia the main problem was the frequency of the changes made to the reserve requirements. Changes foreseen by the market sparked speculation, thereby diminishing the effectiveness of such measures for some time after the modification. It is interesting to note that in both countries the reserve requirements were seen as complementary to, rather than a substitute for, other macroeconomic policies, which were certainly superior in Chile. In particular the expansionary and contractionary phases of monetary policy were much more marked in Colombia, and this countrys fiscal position deteriorated throughout the decade. Malaysia also made major innovations in its capital account regulations in the 1990s. In January 1994 it prohibited non-residents from buying a wide range of domestic short-term securities and established other limitations on short-term inflows; these restrictions were lifted later in the year. These measures also had a preventive focus, but were quantitative rather than price-based. They proved highly effective, indeed superior in terms of reducing capital flows and asset prices than the Chilean regulations (Palma, 2002). They also improved the countrys debt profile (Rodrik and Velasco, 2000). However, after they were lifted a new wave of debt accumulation and asset price increases developed, though the debt profile was kept at more prudential levels than in other Asian countries hit by the crisis in 1997 (Kaplan and Rodrik, 2001; Palma, 2002). An additional innovation came with the Asian crisis. In September 1998 Malaysia established strong restrictions on capital outflows. The main objec­ tive was to eliminate offshore trading of the local currency - that is, the segmentation of its demand - by restricting its use to domestic operations by residents. Ringgit deposits abroad were made illegal, and it was deter­ mined that those held abroad by nationals had to be repatriated. Trade transactions had to be settled in foreign currency. It was also decided that ringgit deposits held in the domestic financial system by non-residents could not be converted into a foreign currency for a year. In February 1999 this regulation was replaced by an exit levy on the principal, with a decreasing rate for investments held for a longer period and no tax on those held for José Antonio Ocampo 225 more than a year. For new capital inflows, an exit tax on capital gains was established, with a higher rate for capital that stayed less than a year (30 per cent; 10 per cent otherwise). The exit tax was reduced to a flat 10 per cent in September 1999; in January 2001 it was decided that it would henceforth apply only to portfolio flows held for less than a year, and in May 2001 it was eliminated altogether. Significant discussions have taken place on the effects of these controls. Kaplan and Rodrik (2001) provide the strongest argument on the effective­ ness of the regulations.6 Drawing on previous studies, they show that the regulations were highly effective in rapidly closing the offshore ringgit market and reversing financial market pressure, as reflected in the trends in foreign exchange reserves and exchange and interest rates. The removal of financial uncertainties, together with the additional scope for expansionary monetary and fiscal policies, led to a speedier recovery of economic activity, lower inflation and better employment and real wage performance than comparable IMF-type programmes during the Asian crisis. This is true even adjusting for the improved external environment when the Malaysian controls were imposed, and despite the fact that the country did not receive large injections of capital; indeed the initial reaction of external capital markets to the regulations was negative. Figure 12.1 offers a simple way to view the effectiveness of capital account regulations in the three countries. Based on similar indicators used in the literature, it calculates an index of expansionary monetary pressures. Since a capital surge generates expansionary effects through three different channels - the accumulation of international reserves, an appreciation of the exchange rate and a reduction in interest rates - the index weights the trends of these three indicators by their standard deviation during the period analyzed. A simple inspection of the graph indicates that the Malaysian controls were extremely effective, both in reversing the strong expansionary effect of capital surges in 1994 and in stopping the strong contractionary effects generated by capital outflows in 1998. The price-based capital account regulations in Chile and Colombia had weaker effects, particularly in the first case. Indeed the introduction of such regulations in Chile in June 1991 and their strengthening in May 1992 was not accompanied by a reversal of the expansionary trend;7 those instituted in July 1995 had a more discernible effect. In Colombia, which used price-based regulations more aggressively, the effects were stronger. In particular the movement in the index of expansionary pressures was more closely tied to changes in capital account regulations in 1993-97. In both countries the capital account turned con­ tractionary in 1998, with the reduction in the URR having only a negligible effect on this trend. Overall the innovative capital account regulations in the 1990s served as useful instruments, both for improving debt profiles and for improving the exchange rate/monetary stance trade-off. However the macroeconomic 2 2 6 Chile Colombia Malaysia 0.250.20 0.150.10 0.05 -0.05 -0.10 -0.15 Figure 12.1 Index of expansionary m onetary pressures, 1990-2000 A A Imposition or relaxation of restrictions on capital inflows, respectively (the direction of the * ■ arrows indicates the expected effect on the index) ^ ^ Imposition or relaxation of restrictions on capital outflows, respectively \r\dex = aR +be -c i, where R = international reserves corrected by the log trend e = the twelve-month variation of the real exchange rate, i = the real deposit interest rate, and a, b, c are the standard deviations of R, e and /, respectively. Source: Estimates based on IMF data. (m)ooos fosé Antonio Ocampo 2 2 7 effects depended on the strength of the regulations, which were only temporary and operated as speed bumps rather than as permanent restrictions, to use Palmas (2002) expression. The basic advantages of the price-based instrument used by Chile and Colombia were its simplicity, its non-discretionary character and, as we shall see in the following section, its neutral effect on corporate borrowing decisions. The more quantitative-type Malaysian system had stronger short-term macroeconomic effects. It must be emphasized that these systems were designed for countries that chose to be integrated into the international capital markets. In the case of Colombia the transition from the old type of exchange controls to price- based capital account regulations was, in effect, a liberalization of the capital account, as reflected in the increased sensitivity of capital flows to interest arbitrage incentives (Ocampo and Tovar, 1998).8 Traditional exchange controls and capital account regulations may there­ fore be superior if the policy objective is significantly to reduce domestic macroeconomic sensitivity to international capital flows. India provides an alternative successful example in this regard. Despite the slow and cautious liberalization that has taken place in India since the early 1990s, this country still largely relies on quantitative restrictions on flows: overall quantitative ceilings, minimum maturities for external borrowing and end-use restrictions (most of which have been liberalized in recent years), plus the prohibition of borrowing in foreign currencies by non-corporate residents; direct regu­ lation (including, in some instances, explicit approval) of portfolio flows in the case of non-residents, as well as of ADRs and investment abroad by domestic corporations; some sectoral restrictions on FDI; and minimum maturities and interest rate regulations on deposits by non-resident Indians (Habermeier, 2000; Reddy, 2001; Rajaraman, 2001; Nayyar, 2002). It must be emphasized that, despite the reduced sensitivity to the Asian crisis and the increased macroeconomic autonomy that this system has allowed, India has not been entirely detached from external financing cycles. In contrast to the successful experiences previously analyzed, crisis-driven quantitative controls generate serious credibility issues and may be ineffect­ ive, as a strong administrative capacity is essential for any capital account regime to be effective. This implies that a tradition of regulation may be necessary, and that permanent regulatory regimes that are tightened or loosened through the cycle may be superior to the alternation of different (even opposite) capital account regimes. In broad terms this means that it is essential to maintain the autonomy to impose capital account regulations and thus the freedom to reimpose controls if necessary (Rajaraman, 2001; Reddy, 2001; Ocampo, 2002a, 2002b). This is indeed a corollary of the incomplete nature of international financial governance (Ocampo, 2002a) and a basic lesson from the Malaysian experience. Also, traditional quan­ titative capital account regulations and direct approval of sensitive flows (external portfolio flows, issuance of ADRs and investment abroad by 2 2 8 Capital Account and Countercyclical Regulations residents) can make perfect sense if they are sufficiently well managed to avoid loopholes, high administrative costs and, in particular, corruption. Indeed simple quantitative restrictions that rule out certain forms of indebt­ edness (for example short-term foreign borrowing, except trade credit lines, or borrowing in foreign currency by residents operating in non-tradable sectors) are also preventive in character and easier to administer than price- based controls (Ariyoshi et al., 2000). These restrictions are more attractive and effective when domestic financial development is limited, but they may become obstacles to financial development. Indeed this may, be viewed as one of the basic costs of capital account regulation. More broadly, there may be inherent trade-offs between domestic financial deepening and capital account volatility (due in part to the dismantling of capital controls). We shall explore some aspects of these trade-offs in the following section. Certain regulations on current-account transactions (export surrender requirements or the obligation to channel trade transactions through certain approved intermediaries) and effective segmentation of the market for finan­ cial instruments denominated in the domestic currency may be essential to guarantee the effectiveness of regulations. This implies a need to avoid or strongly regulate the internationalization of the domestic currency, as well as to take a highly conservative approach to domestic financial dollarization (Reddy, 2001). These are in fact common features of the four case studies considered above; and in the case of Malaysia, achieving this objective involved dismantling the offshore market for the domestic currency. It should be emphasized again that capital account regulations should always be seen as an instrument that, by providing an additional degree of freedom to the authorities, facilitates the adoption of sensible countercyclical macroeconomic policies. Hence it can never be a substitute for them. Complementary liability policies Prudential regulation and supervision can, in part, be substituted for capital account regulations. Indeed the distinction between capital controls and prudential regulations that affect cross-border flows is not clear cut. In par­ ticular, higher liquidity (or reserve) requirements for the financial systems foreign currency liabilities can be established, and domestic lending to firms operating in non-tradable sectors that have substantial foreign-currency liabilities can be discouraged by more stringent regulatory provisions. The main problem with these options is that they only indirectly affect the foreign-currency liabilities of non-financial agents, and indeed may encourage them to borrow abroad. Accordingly they need to be supplemented with other regulations, including rules on the types of firm that can borrow abroad and the prudential ratios with which they must comply; restrictions on the terms of corporate debts that can be contracted abroad (minimum maturities and maximum spreads); public disclosure of the short-term external liabilities of firms; regulations requiring rating agencies to give fosé Antonio Ocampo 229 special weight to this factor; and tax provisions for foreign-currency liabil­ ities (for example no or only partial deductions for interest payments on international loans).9 Some of the most important regulations of this type concern external borrowing by firms operating in non-tradable sectors. A simple rule that should be considered is the strict prohibition of foreign borrowing by non-financial firms without income in foreign currency or restrictions on the maturities (only long term) or end use (only investment) of such borrowing. Price-based capital account regulations may thus be a superior alternative and may be simpler to administer than an equivalent system based on prudential regulations plus additional policies aimed at non-financial firms. Among their virtues, vis-à-vis prudential regulation and supervision, we should also include the fact that they are price-based (some prudential regulations, such as prohibitions on certain types of operation, are not), non- discretionary (whereas prudential supervision tends to be discretionary in its operation) and neutral in terms of the choice made by corporations between foreign-currency-denominated borrowing in the domestic market versus the international market. Indeed equivalent practices are used by private agents, for example the selling fees imposed by mutual funds on investments held for a short period in order to discourage short-term holdings (JP Morgan, 1998: 23). In the case of the public sector, specific legal limits and regulations are required. Direct approval of borrowing and the establishment of minimum maturities and maximum spreads by the Ministry of Finance or the central bank may be the best liability policy. Provisions of this sort should cover the central administration as well as autonomous public sector agencies and subnational governments (ECLAC, 1998: ch. 8). Such regulations should apply both to external and to domestic public-sector liabilities. The most straightforward reason for this is that residents who hold short-term public-sector securities have, in periods of external or domestic financial instability, other options besides rolling over the public sector debt, including capital flight. This is even more so if foreigners are allowed to purchase domestic public sector securities. Thus when the gross borrowing requirements are high, the interest rate will have to increase to make debt rollovers attractive. Higher interest rates are immediately reflected in the budget deficit, thereby rapidly changing the trend in public sector debt, as happened in Brazil prior to the 1999 crisis. In addition rollovers may be viable only if the risk of devaluation or future interest rate hikes can be passed on to the government, which generates an additional source of destabilization. Mexico’s widely publicized move in 1994 to replace peso-denominated securities (Treasury Certificates, or Cetes) with dollar-denominated bonds (Tesobonos), which was one of the crucial factors in the crisis that hit the country late that year, was no doubt facilitated by the short-term profile of Cetes (Sachs etal., 1996; Ros, 2001). 2 3 0 Capital Account and Countercyclical Regulations The short-term structure of Brazils debt was also the reason why, after late 1997, fixed-interest bonds were swiftly replaced by variable-rate and dollar- denominated securities, which cancelled out the improvements that had been made in the public debt structure in previous years. It is important to emphasize that, despite its fiscal deterioration, no substitution of a similar magnitude was observed in Colombia during the 1998-99 crisis; this countrys tradition of issuing public sector securities with a minimum one-year matur­ ity is a significant part of the explanation (Figure 12.2). Thus a sound maturity profile for domestic public sector debt is an essential complement to a sound public and private external debt profile when trying to reduce the degree of vulnerability to capital account shocks. Furthermore, on strictly prudential grounds, external borrowing by the public sector generates currency mismatches (except for public sector firms operating in tradable sectors) and should thus be avoided. However this principle should not be translated into simple prohibitions for two reasons. The first reason is macroeconomic in character. To the extent that external private capital flows are procyclical, it is reasonable for the public sector to follow a countercyclical debt structure strategy. This means that, during capital account surges, it should reduce the borrowing requirements and adopt a liability policy aimed at substituting domestic for external liabilities. The opposite is true during periods of reduced private flows. Indeed in this case the public sector may be one of the best net suppliers of foreign exchange, thanks to its better access to external credit, including credit from multilateral financial institutions. Such external borrowing may also be helpful in maintaining a better external debt profile and avoiding private borrowing abroad at excessively high spreads during crises. The second reason relates to the depth of domestic bond markets, which determines the ability to issue longer-term domestic debt securities. This attribute includes the existence of secondary markets and active agents (market makers) that provide liquidity for these securities. In the absence of these preconditions the government faces a serious trade-off between maturity and currency mismatches, a trade-off that is typical of all domestic agents that produce non-tradable goods and services. Indeed a domestic market for public sector debt securities with an excessive short-term bias can be extremely destabilizing during a crisis. It may therefore make sense to choose a debt mix that includes an important component of external liabil­ ities, despite the associated currency mismatch. In the long term the objective of the authorities should be to deepen the domestic capital markets. Indeed, due to the lower risk levels and the greater homogeneity of the securities it issues, the central government has a vital function to perform in the development of longer-term primary and secondary markets for domestic securities, including the creation of benchmarks for private sector instruments. The development of such markets will not eliminate the need for an active external liability policy, however, as deeper capital markets are also more Brazil Colombia Mexico ■ Primary deficit ■ Internal debt interest Q External debt interest payments payments 1994 1995 1996 1997 1998 1999 l Primary deficit □ External debt interest payments ■ Internal debt Interest payments 1991 1992 1993 1994 1995 1996 ■ Primary deficit Q External debt interest payments ■ Internal debt interest payments Domestic public-sector debt (as of December) Composition of the federal governments domestic debt 1994 1995 1996 1997 1998 1999 I US$ dollars ■ Variable rate □ Fixed rate D Inflation indexed Composition of the national government’s domestic debt 1996 1997 1998 1999 ■ US$ dollars □ Fixed rate □ Inflation indexed Compostion of the federal governments domestic debt 1991 1992 1993 1994 1995 1996 ■ US$ dollars ■ Variable rate b Fixed rate a Inflation Indexed Figure 12.2 Fiscal deficit and public debt: Brazil (1994-99), Colombia (1994-99) and Mexico (1991-96) Source: Central Bank of Brazil; IDEA; Ministry of Finance of Colombia; Secretary of Finance and Public Credit of Mexico; Bank of Mexico. 231 232 Capital Account and Countercyclical Regulations likely to cause vo la tile portfo lio flows. U n fo rtu n a te ly th e trade-offs are n o t sim ple in th is regard as in te rn a tio n a l in s titu tio n a l investors m ay help to develop dom estic capital m arkets. Thus th e au thorities m u st choose betw een less volatile ex ternal cap ita l flows an d th e deve lopm en t o f deeper, liqu id dom estic cap ita l m arkets. C hile s decision to e lim inate th e one-year m in i­ m u m m atu rity for portfo lio flows in M ay 2000, as well as C olom bias decision in 1996 to allow foreign in v estm en t funds to partic ipa te in th e dom estic m arket for pub lic sector securities, m ay be u n d ersto o d as a choice for th e second of these o p tio n s a t th e cost of ad d itio n a l capital acco u n t volatility. Sim ilar trade-offs m ay be faced in re la tion to th e d eve lopm en t of deep dom estic p rivate-sector stock an d b o n d m arkets. The role of countercyclical prudential regulations M ic r o - a n d m a c r o e c o n o m i c d i m e n s i o n s o f p r u d e n t i a l p o l i c i e s As we have seen, th e origins of problem s th a t erup t du ring financial crises are associated b o th w ith excessive risk tak ing d u ring boom s, as reflected in a rap id increase in lend ing , a n d w ith m a tu rity an d cu rrency m ism atches on financial an d n on -financia l agen ts balance sheets. In m a n y coun tries these problem s are related to inadequa te risk analysis by financial agents, as well as w eak p m den tia l regulation an d supervision of th e dom estic financial systems. The co m b in a tio n o f these factors becom es explosive u n d e r co n d itio n s of financial liberalization in th e m idst o f a bo o m in ex ternal financing . The u n d erestim a tio n of risks th a t characterizes en v iro n m en ts o f econom ic o p ti­ m ism is th e n com b in ed w ith in adequa te practices for eva lua ting risks, b o th b y private agents a n d by supervisory agencies. This underscores just h o w im p o rta n t th e sequencing of financial liberal­ ization processes is. This becam e ev iden t du ring th e first w ave of financial crises th a t h it Latin Am erica in th e early 1980s (see for exam ple Diaz- A lejandro, 1988: ch. 17) b u t was b road ly ignored in la ter episodes of financial liberalization in th e develop ing w orld. Since th e Asian crisis it has finally becom e a m ainstream idea. Indeed it is now w idely recognized th a t financial liberalization shou ld take place in a suitable in s titu tio n a l setting, w h ich includes strong p ruden tia l regulation an d supervision. Such regulation shou ld ensure, first o f all, th e solvency of financial in s titu tio n s by estab­ lish ing appropria te cap ita l adequacy ratios relative to th e risk assum ed by le n d in g in stitu tio n s, strict write-offs o f questionab le portfo lios a n d ap p ro ­ p riate standards of risk diversification. Properly regulated an d supervised financial system s are structura lly superior in term s of risk m an ag em en t since th ey create incen tives for financial in term ediaries to avoid assum ing unm anageab le risks. To th e ex ten t th a t agents assum e th a t th e sources of financial risks have a m acroeconom ic origin, th e trad itio n a l m icroeconom ic focus of p ru d en tia l fosé Antonio Ocampo 233 regu la tion an d supervision m u st be co m plem en ted w ith regulations th a t take acco u n t of such m acroeconom ic factors. This is particu larly tru e in developing countries, w here th e dynam ics associated w ith b o o m -b u s t cycles in ex ternal f inancing are particu larly in tense . D ue a t te n tio n shou ld th u s be paid to th e links betw een dom estic an d ex ternal financing , th e links am o n g these factors an d asset prices an d econom ic activity, an d th e links betw een dom estic financial risks an d varia tions in in te rest an d exchange rates. T he basic p rob lem in th is regard is th e inab ility of ind iv idual financial in term ediaries to in te rnalize th e collective risks assum ed du rin g bo o m periods, w h ich are essentially o f a m acroeconom ic character a n d therefore en ta il co o rd in a tio n problem s th a t exceed th e possibilities o f an y o n e agent. M oreover risk assessm ent a n d trad itio n a l regula tory tools, inc lud ing Basel standards, have a procyclical bias in th e w ay th e y operate. Indeed in a system in w h ich loan-loss p rovisions are tied to loan delinquency, p recau tionary regulatory signals are ineffective du ring boom s, an d hence do n o t ham p er credit grow th. O n th e o th e r h a n d th e sharp increase in lo an de linquency d u rin g crises does reduce financial in s titu tio n s capital, a n d hence th e ir lend ing capacity. This, in co n ju n c tio n w ith th e greater subjectively perceived level o f risk, triggers th e c red it squeeze th a t characterizes such periods, th e reb y reinforcing th e dow nsw ing in econom ic activ ity an d asset prices, an d in tu rn th e quality o f th e portfo lios o f financial in te rm ed iaries.10 Indeed th e sudden in tro d u c tio n of strong regulatory standards du ring a crisis m ay w orsen a credit squeeze, so a lth o u g h th e au tho rities m u st adop t clearly defined rules to restore confidence d u rin g a financial crisis, th e app lica tion of stronger standards shou ld be gradual. In o rder to avoid m oral hazard problem s, th e au tho rities m u st never bail o u t th e ow ners o f financial in s titu tio n s b y guaran tee ing th a t th e ir losses w ill be w ritten off, u p to th e ir n e t w orth , if regulators have to in te rv en e in these in stitu tions. In order to take accoun t of th e m acroeconom ic factors th a t affect risks, in strum ents need to be designed th a t will in troduce a countercyclical elem en t in to p ru d en tia l regu la tion an d supervision. In th is regard th e m ajo r in s tru ­ m e n t is u n d o u b te d ly forw ard-looking provisions. Such provisions shou ld be estim ated w h en loans are disbursed o n th e basis o f expected or la ten t losses, tak ing in to acco u n t th e full business cycle, ra th e r th a n o n th e basis of loan de linquency or short-term expectations of fu tu re lo an losses, w h ich are h igh ly procyclical. This m eans, in fact, th a t p rov ision ing shou ld approach th e criteria trad itiona lly follow ed by th e insu rance in d u stry (where p rovi­ sions are m ade w h e n th e insu rance policy is issued) ra th e r th a n th e b ank ing industry . This practice could help to sm o o th o u t th e cycle by increasing p rovisions or reserves du rin g cap ita l accoun t surges, th u s h e lp ing to reduce th e credit cru n ch th a t takes place du ring busts. I t m u st be em phasized th a t all regulatory approaches have clear lim its an d costs th a t ca n n o t be overlooked. P rudentia l regulation involves som e n o n ­ price signals, an d p ru d en tia l supervision is full o f in fo rm atio n problem s an d 234 Capital Account and Countercyclical Regulations is a d iscre tionary activ ity th a t is susceptible to abuse. Som e classic objectives of p ruden tia l regulation , such as risk diversification, m ay be difficult to a tta in w h en m acroeconom ic issues are a t th e ro o t o f th e difficulties. The experi­ ence o f m an y industria lized coun tries ind icates th a t even w ell-regulated system s are sub ject to period ic episodes of euphoria , w h en risks are u n d e r­ estim ated. The recen t crisis in A rgentina is a specific case in w h ich a system o f p ru d en tia l regulations th a t was considered to be on e o f th e best in th e develop ing w orld - w ork ing w ith in th e fram ew ork o f a financia l sector characterized by th e large-scale presence of m u ltin a tio n a l banks - clearly failed to avert th e effects o f m ajo r m acroeconom ic shocks o n th e dom estic financial system . M oreover, b e in g able to separate cyclical from long-term tren d s is always a difficult task, as an y process th a t involves learn ing will always generate p a th -d e p en d e n t m echan ism s in w h ich short- an d long-te rm dynam ics are in te rconnec ted . Learning processes inc lude th o se associated w ith th e fo rm ation of expectations of fu tu re m acroeconom ic events, w h ich is particu larly d ifficult in develop ing econom ies facing substan tia l shocks (H eym an, 2000). M oreover m a n y regulatory practices aim ed a t correcting risky practices on th e p art o f financial in term ediaries sh ift th e underly ing risks to non-financia l agents, th u s generating ind irec t risks th a t are expressed in credit risks. The n e t effect o f regu la tion o n banks vu lnerab ilities is therefo re partial, as th e literatu re on th e m ig ra tio n o f risks indicates. T hus regu la to ry standards th a t establish low er risk ratings for short-term credits a n d reduce m ism atches betw een th e m atu rities o f b an k deposits a n d le n d in g will reduce d irect ban k in g risks, b u t will also reinforce th e sho rt-term bias in lend ing . M aturity m ism atches are th e reb y displaced to non -financia l agents. Indeed th e n e t effect o f th is type o f regu la tion m ay be an in ad eq u a te supp ly of long-te rm financing an d reduced fixed cap ita l investm en t. Also, p ru d en tia l regulations th a t forbid banks to h o ld currency m ism atches in th e ir portfo lios will reduce th e ir d irect risk, b u t m ay encourage non -financia l agents to borrow abroad. The risks assum ed by corporations, particu larly th o se opera ting in non-tradable sectors, will eventually be translated in to credit risk by dom estic financial in s titu tio n s th a t are also th e ir creditors. For th e sam e reason, s tronger regu la tion will resu lt in h ig h e r spreads in dom estic financial in te rm ed ia tio n , particu larly if i t results in m ore s tringen t dom estic vis-à-vis in te rn a tio n a l regulatory practices, w h ich is a likely o u t­ com e given th e stronger vo la tility o f develop ing countries. H igher spreads will generate incen tives for co rporations w ith d irect access to in te rn a tio n a l cap ita l m arkets to borrow abroad, th u s increasing th e like lihood of currency m ism atches in th e portfo lios o f these agents. T hey m ay also result in a subop tim al supp ly o f financ ing for SMEs, or an excessively sho rt-te rm bias in th e supply of cred it for such firm s. In all these cases th e reduced v u ln e r­ ab ility o f th e dom estic financial sector w ill have as a coro llary th e m a tu rity an d currency m ism atches of non-financial agents (as well as suboptim al fixed José Antonio Ocampo 235 capita l investm en t), w h ich m ay becom e credit risks for dom estic financial agents du ring th e d o w n tu rn . T he d ifferen tia tion betw een system ic an d non-system ic risks th a t is typical in portfo lio risk analysis is particularly relevant in th is regard. The form er depends o n th e correlation of th e price fluctuations of each particu lar asset w ith prices for th e en tire m arket an d arises from exposure to co m m o n factors (for exam ple econom ic policy or th e business cycle) w hile non-system ic risks d epend o n th e ind iv idual characteristics of each stock an d m ay be reduced by diversification. W hereas th e second type of risk can be reduced by ade­ quate regulations aim ed a t im proving m icroeconom ic risk m anagem ent, th e first canno t, an d in th e face of system ic risks th e use of co m m o n risk m a n ­ agem en t techn iques can actually resu lt in greater m acroeconom ic vo la tility (Persaud, 2000). Thus to a large extent, m acroeconom ic risks th a t are sys­ tem ic in character can on ly b e shifted to o th e r m arket agents w ith in a spe­ cific econom y an d are on ly au then tica lly diversified w hen ex ternal econom ic agents are w illing to assum e th em . N onetheless countercyclical p ruden tia l policies can help to reduce th e collective risks th a t agents m ay assum e d u r­ ing periods of euphoria . They can also help to generate im proved incentives for financial agents th a t behave procyclically (those exposed to industries w ith h ig h system ic risks). In all cases, as in th e case of cap ita l con tro ls, im proved p ru d en tia l regula­ tio n , inc lud ing th e in tro d u c tio n of strong countercyclical co m p o n en ts th a t take in to accoun t th e m acroeconom ics of b o o m -b u st cycles, is a com plem en t b u t n o t a substitu te for appropria te countercyclical m acroeconom ic policies. I n s t r u m e n t s t o p r o t e c t a g a i n s t c r e d i t r i s k U nder generally accepted acco u n tin g principles, p rovisions shou ld cover expected losses, th o u g h of a n u n ce rta in m agn itude , an d are th u s registered as expenses, w hile reserves app ly to unexpected losses an d are p art o f capital. These p rincip les also im ply th a t banks shou ld charge a n in te rest p rem ium for expected risk w hile stockholders shou ld cover unexpected risks. A ccoun ting practices also d iffe ren tia te betw een general a n d specific prov i­ sions. In m ost coun tries th e ca lcu lation of specific prov isions is d o n e o n an ind iv idual basis for com m ercial loans an d o n a poo led basis for retail loans. G eneral p rovisions are estim ated o n th e basis o f pools o f loans, o r th e to ta l portfo lio . In som e coun tries th e y are trea ted as reserves, a n d as such as capital, w hile in o thers th e y are sub tracted from assets. W ith trad itiona l accoun ting m ethods, specific provisions are m ade shortly before o r even after a loan becom es de lin q u en t. In th is sense a system based w ho lly o n th is type o f p rov ision will n o t reflect th e tru e credit risk o f th e loan portfo lio and, as ind icated above, will be in h e re n tly procyclical. T he rules o n general provisions an d reserves are usually m ore flexible an d allow for m ore forward- looking approaches in th e appraisal o f risk. 236 Capital Account and Countercyclical Regulations In som e countries th e au tho rities (th e go v ern m en t o r th e cen tra l bank) take a restrictive app roach an d establish s ta tu to ry rules th a t d eterm ine th e level o f provisions. In o thers th e system varies from a strict fo rm ula to statistical approaches th a t use h istorical data, in fo rm atio n on peer groups an d m ore explicit in te rn a l risk m odels. Several OECD coun tries allow th e c o n s titu tio n of fo rw ard-looking p rovisions based on past experience an d th e expectation of fu tu re events. H ow ever m ost o f th e m are o rien ted tow ards th e sho rt term , u sing a one-year ho rizon to m easure risk. The best-know n excep tion to th is rule is Spain, w h ich in D ecem ber 1999 issued a regu la tion requ iring countercyclical prov isions calcu lated by sta tis­ tical m ethods. T he m ain feature of th is approach is th e es tim atio n of la te n t risk based o n past experience over a period lo n g en o u g h to cover a t least on e business cycle. This generates a dynam ic in w h ich provisions b u ild u p du ring econom ic expansions an d are d raw n u p o n du rin g dow n tu rn s (Poveda, 2000; De Lis e ta l ., 2001). The m ajo r in n o v a tio n o f th is system is its explicit recogn ition th a t risks are incurred w h en credits are approved an d disbursed, n o t w h en th e y fall due. M ore particularly, u n d e r th is schem e statistical o r actuarial p rovisions for la ten t risks m u st be estim ated for hom ogeneous categories o f credit accord ing to th e possib le loss th a t a typ ical asset (loan, guaran tee , in te r ­ b an k or fixed in co m e portfo lio investm en t) in each category is expected to involve, es tim ated o n th e basis o f a full business cycle. E ither th e in te rn a l risk m an ag em en t m odel o f th e financial in s titu tio n or th e s tandard m odel p roposed by th e Banco de España can be used for th a t purpose. The la tter establishes six categories, w ith an n u a l p rov ision ing ratios th a t range from 0 to 1.5 per cen t. These statistical p rovisions m u st be accum ulated in a fund, to g e th er w ith special p rov isions (trad itional prov isions for n on -perfo rm ing assets or th e perfo rm ing assets o f borrow ers in financial difficulties) an d recovered n o n -p erfo rm in g assets.11 The fu n d can be used to cover loan losses, th u s in effect en tire ly substitu ting for special prov isions if resources are available in adequate am oun ts. If th is is so th e provisions actually follow th e cred it cycle. A lthough th e accum ula tion an d draw ing dow n of th e fu n d m ade u p by statistical an d specific provisions has a countercyclical dynam ic, th is on ly reflects th e cyclical p a tte rn of b an k lend ing . In th is regard th e system is, strictly speaking, cycle-neutra l ra the r th a n countercyclical, b u t it is certain ly superior to th e trad itiona l procyclical p rovision ing for loan losses o r forward- looking p rov ision ing based o n sho rt tim e horizons. Therefore a system such as th is shou ld be co m plem en ted by strictly countercyclical p ru d en tia l provisions, decreed by th e regulatory a u th o rity for th e financial system a w hole, or by th e supervisory a u th o rity for special financial in stitu tio n s, o n th e basis of objective criteria. These criteria could inc lude th e g row th ra te of credit, th e bias in lend ing tow ards sectors ch a r­ acterized by system ic risks or th e grow th of fore ign-currency-denom inated José Antonio Ocampo 237 loans to non -tradab le sectors. V oluntary p ru d en tia l p rovisions could also be encouraged. In b o th cases it is essential th a t tax deductib ility be g ran ted to th e provisions. Indeed accoun ting an d tax a tio n rules co n trib u te to failures in risk assessm ent because, in general, th e y m ake it necessary to register events th a t have already occurred. T he foregoing analysis ind icates th a t an appropria te policy for m anag ing th e m acroeconom ic effects o f b o o m -b u s t cycles in develop ing countries shou ld involve a m ix tu re of: (1) forw ard-looking provisions for la ten t risks, to be m ade w h en credit is g ran ted so th a t financia l in term ediaries will have to take accoun t of th e risks th e y incu r th ro u g h o u t th e en tire business cycle; an d (2) m ore d iscrete countercyclical p ru d en tia l prov isions based o n a series o f objective criteria. Specific p rovisions shou ld be m anaged to g e th er w ith forw ard-looking provisions, as in th e Spanish system . As we shall see in th e follow ing sections, these provisions shou ld be supp lem en ted by regulations in o th e r areas. Reserves or general p rovisions p lay a less clear role an d in fact are n o t d istinguishable from th e role of cap ita l in covering unexpected losses. A system of p rovisions such as th is w ould certa in ly be superior to th e use o f cap ita l adequacy ratios to m anage th e effects o f business cycles. C apita l adequacy requ irem ents shou ld in stead focus o n long-te rm solvency criteria ra th e r th a n o n cyclical perform ance. Insofar as developing coun tries are likely to face m ore m acroeconom ic volatility, th e re m ay be an a rg u m en t for requ iring h igher cap ita l-asset ratios (see th e add itiona l argum en ts below), b u t th e re is n o n e for requ iring th a t cap ita l adequacy requ irem en ts shou ld be, as such, countercyclical. It shou ld also be rem em bered th a t th e stricter standards in develop ing coun tries for th e m an ag em en t o f m acroeconom ic risks - in term s of p ro ­ visions, capital o r o th e r variables - increase th e costs o f financial in te r­ m ed iation , thereby reducing in te rn a tio n a l com petitiveness a n d creating arbitrage incen tives to use in te rn a tio n a l financial in te rm ed ia tio n as a n alter­ native. Also, p ru d en tia l policies are certa in ly n o t a so lu tion for th e risks th a t procyclical m acroeconom ic policies m ay generate. P r u d e n t i a l t r e a t m e n t o f c u r r e n c y a n d m a t u r i t y r i s k s , a n d v o l a t i l e a s s e t p r i c e s Experience indicates th a t currency a n d m a tu rity m ism atches are essential aspects o f financia l crises in developing coun tries. P ruden tia l regu la tion shou ld th u s establish strict rules to p reven t currency m ism atches (includ ing those associated w ith hedg ing an d related operations) an d to reduce im balances betw een th e m atu rities o f th e assets an d liabilities o f financial in term ediaries. In add ition , liqu id ity regulations shou ld be estab lished to m anage such im balances. The strict p ro h ib itio n of currency m ism atches in th e portfolios of financial in term ediaries is th e b est rule. T he au tho rities shou ld also closely m o n ito r 238 Capital Account and Countercyclical Regulations th e in te rm ed ia tio n of sho rt-te rm ex ternal credits. As w e have seen, th e currency risks o f no n -fin an cia l firm s, particu larly th o se opera ting in n o n ­ tradable sectors, m ay eventually tu rn in to credit risks for b an k s .12 This po in ts to th e need for b e tte r m o n ito rin g o f th e currency risks o f these firms, an d probably for specific regulations o n len d in g to firm s in n o n -tradab le sectors w ith substan tia l liabilities in foreign currency. In particular, regulations could be used to establish m ore s tringen t p rovisions an d /o r risk w eigh ting for th o se opera tions, o r a stric t p ro h ib itio n on le n d in g in foreign currencies to non -financia l firm s w ith n o incom e in th o se currencies; cap ita l accoun t regulations w ou ld have to establish com plem en ta ry no rm s for d irect borrow ing ab road by these firm s (see above). In add ition , p ru d en tia l regu la tion needs to ensure adequate levels of liqu id ity for financia l in term ediaries so th a t th ey can h an d le th e m ism atch betw een th e average m atu rities of assets a n d liabilities th a t is in h e re n t in th e financial system s essential fu n c tio n of transfo rm ing m aturities, w h ich generates risks associated w ith vo la tility in deposits an d /o r in te rest rates. This underscores th e fact th a t liqu id ity an d solvency problem s are far m ore closely in te rre la ted th a n trad itio n ally assum ed, particu larly in th e face of m acroeconom ic shocks. Reserve requirem ents, w h ich are strictly an in s tru ­ m e n t o f m o n e ta ry policy, p rovide liqu id ity in m a n y countries, b u t th e ir declin ing im p o rtan ce m akes it necessary to find new tools. M oreover th e ir trad itio n a l structu re is n o t geared to th e specific objective of ensuring financial in te rm ediaries liqu id ity in th e face of th e m a tu rity m ism atches th e y h o ld in th e ir portfo lios. An im p o rta n t in n o v a tio n in th is area was th e system created in 1995 in A rgentina, w h ich set liqu id ity requ irem en ts based o n th e residual m a tu rity of financial in s titu tio n s liabilities ( th a t is, th e n u m b e r of days rem ain in g before reach ing m a tu rity ).13 These liqu id ity requ irem en ts - o r a system of reserve requ irem ents w ith sim ilar character­ istics - have th e ad d itio n a l advantage th a t th e y offer a d irect incen tive to th e financial system to m a in ta in an appropria te liability structure . The quality o f th e assets w ith w h ich th e liqu id ity requ irem en ts are m e t is obvi­ ously a crucial factor. In th is regard it m ust be p o in te d o u t th a t allow ing such assets to be invested in public sector bon d s was an essential w eakness of th e A rgen tinean system , as it increased th e v u ln e rab ility of th e financ ia l system to pub lic sector d eb t restructuring , a risk th a t tu rn e d in to reality in 2001. The v a lua tion o f assets used as collateral for loans also presen ts problem s w h en these assets exh ib it price volatility, because in m a n y cases ex ante assessm ents m ay be sign ifican tly h igher th a n ex p o s t prices. Limits o n loan- to-value ratios a n d rules to ad just th e value of collateral for cyclical price varia tions sh o u ld be adop ted . O ne app roach in th is regard is th e m ortgage lend ing value, a v a lu a tio n procedure applied in som e European countries th a t reflects long-te rm m arket trends in real estate prices based o n experi­ ence (ECB, 2000). José Antonio Ocampo 239 T he proposal for th e new Basel Accord a ttem p ts to align risk w eights w ith th e evaluations of ex ternal cred it ra tin g agencies. U nfo rtuna te ly th is w ould in troduce a n add itiona l procyclical bias, given th e procyclical p a tte rn of credit ratings (see C hap te r 7). The h ig h co n cen tra tio n o f th e ra tin g in d u stry is a n add itiona l arg u m en t against ad o p tin g th is recom m enda tion . M oreover it w ou ld be d ifficult to apply th is p ractice in develop ing coun tries du e to th e absence of adequate credit ratings for m ost firm s. Conclusions This ch ap te r has explored th e com plem en ta ry use of tw o in s tru m e n ts to m anage cap ita l acco u n t vo la tility in developing countries: cap ita l accoun t regulations a n d th e countercyclical p ru d en tia l regu la tion of dom estic f in an ­ cial in term ediaries. These in stru m en ts shou ld be seen as com p lem en ta ry to countercyclical m acroeconom ic policies, b u t n e ith e r o f th e m can nullify th e risks th a t procyclical m acroeconom ic policies can generate. O verall th e innova tive cap ita l accoun t regulations of th e 1990s can be seen as useful in stru m en ts in term s of im prov ing deb t profiles an d facili­ ta tin g th e a d o p tio n of (possibly tem porary) countercyclical m acroeconom ic policies. T he m a in advantages of th e price-based u n rem u n e ra te d reserve req u irem en t p ioneered by C hile an d C olom bia are its sim plicity, non - d iscre tionary character an d neu tra l effect o n corporate borrow ing decisions. T he m ore q u an tita tiv e M alaysian system has been show n to have stronger short-term m acroeconom ic effects. Traditional quan tita tive exchange controls m ay be superior if th e objective of m acroeconom ic policy is significantly to reduce dom estic m acroeconom ic sensitiv ity to in te rn a tio n a l cap ita l flows. P ruden tia l reg u la tio n an d superv ision can , in part, be su b stitu te d for these direct regulations o n th e capital account. The m ain p rob lem w ith th is o p tio n is th a t it has, a t best, in d irec t effects o n th e foreign-currency liabilities o f non-financia l agents an d m ay encourage th e m to borrow abroad. A ccordingly th e y n eed to be su p p lem en ted w ith o th e r d isincen tives for ex terna l bo rrow ing by th o se firm s. U n rem u n era ted reserve requ irem en ts m ay be a superior a lternative a n d m ay be sim pler to adm inister. In th e case of th e pub lic sector, d irec t regu la tion of ex tern a l bo rrow ing sh o u ld be co m b in ed w ith a strategy a im ed a t th e d ev e lo p m en t o f dom estic b o n d m arkets. P rudentia l regu la tion an d superv ision shou ld take in to acco u n t n o t on ly m icroeconom ic risks b u t also th e m acroeconom ic risks associated w ith b o o m -b u s t cycles. In particular, in stru m en ts n eed to be designed th a t will in troduce a countercyclical e lem en t in to p ru d en tia l regu la tion an d super­ vision . M ore specifically, we argue for a regulatory ap p ro ach th a t involves a m ix tu re of: (1) forw ard-looking provisions for la ten t risks, w ith provisions to be m ade w hen credit is g ran ted o n th e basis o f th e cred it risks th a t are expected th ro u g h o u t th e full business cycle (this was th e app roach adop ted 240 Capital Account and Countercyclical Regulations by th e Spanish au thorities); an d (2) m ore discrete countercyclical p ru d en tia l provisions, to be app lied by th e regulatory a u th o rity to th e financial system a w hole, or by th e supervisory au th o rity for special financia l in stitu tio n s, on th e basis o f objective criteria (for exam ple th e g row th rate o f credit, o r th e grow th of cred it for specific risky activities). C apital adequacy requ irem en ts should focus o n long-term solvency criteria an d should n o t be countercyclical, b u t it m ay be advisable for coun tries facing strong cyclical f luctuations to establish h igher cap ita l-asse t ratios. The system of countercyclical p ruden tia l regulation an d supervision should be co m plem en ted by regulations in o th e r areas. In particular, p ru d en tia l regu la tion shou ld estab lish strict rules to p reven t currency m ism atches (includ ing those incu rred by firm s opera ting in n o n -tradab le sectors w h en borrow ing in foreign currency), liqu id ity requ irem en ts a n d lim its o n loan to collateral value ratios or rules o n th e v a lua tion of collateral designed to reflect long-term m arket trends in asset prices. N o te s * This chapter h as b en efited from jo in t w ork undertaken w ith M aria Luisa C h iap p e for th e Expert G roup o n D ev e lo p m en t Issues (EGDI), M in istry o f Foreign Affairs o f Sw eden. 1. For d o cu m e n ts th a t support th e e ffectiven ess o f th e se regu lations in C h ile see A gosin (1998), Larrain e ta l . (2000), Le Fort an d L ehm an n (2000), A gosin and F french-D avis (2001) an d Palm a (2002). For a m ore m ix ed v ie w see V aldés-Prieto a n d Soto (1998) A riyoshi e ta l . (2000), D e G regorio e ta l . (2000) an d Laurens (2000). For stron g v iew s o n the ir p o sitiv e effects in C o lo m b ia see O cam p o an d Tovar (1998 , 1999) an d Villar an d R incón (2002); for a m ore m ix ed v ie w see C árdenas an d Barrera (1997) an d C árdenas an d Steiner (2000). 2 . Indeed ev id en ce o f th e in sen s itiv ity o f th e v o lu m e o f cap ita l flow s to capital acco u n t regu lations co m es from eco n o m etr ic analysis in w h ich URR is n o t in c lu d ed as a d eterm in an t o f in terest rate spreads b u t rather as a n a d d ition a l factor a ffectin g capita l flow s. T his m ay be seen as an in ad eq u ate eco n o m etr ic sp ecification . 3. Som e o f th e se m ech a n ism s, su ch as th e u se o f h ed g in g , en a b le in vestors to cover so m e o f th e effects o f th e se regulations, but in large part th is is d o n e b y transferring risks (m ore specifically , th e risk associated w ith longer-term fin an cin g) to o ther agents w h o w o u ld o n ly b e w illin g to a ssu m e th e m at an ad eq u ate reward. M ore generally, if there is n o stable extern al d em a n d for th e d o m e stic currency, h ed g in g m ay be availab le o n ly in lim ited qu an tities, a fact th a t affects th e m aturities and costs in vo lv ed . 4. In Brazil so m e au th ors h a v e argued th a t th e capital a cco u n t regu lations, w h ich in clu d ed a m ech a n ism sim ilar to th e URR (direct tax a tio n o f capita l flow s), w ere in effec tiv e d u e to w idespread lo o p h o le s associated w ith th e ex is ten ce o f so p h is ti­ cated d o m estic fin an cia l in stru m en ts (A riyoshi e t a l. , 2000; Garcia an d V alpassos, 2000). H ow ever th e y provid e n o statistica l ev id en ce com parab le to th a t available for C h ile an d C o lom bia . 5. T his is th e very apt in terp retation p rovid ed b y W illiam son (2000: ch . 4). Indeed w ith th is in terp retation th e co n flic tin g ev id en ce o n th e C h ilea n system largely disappears. José Antonio Ocampo 241 6. See A riyosh i e t a l. (2000), Ó tker-Robe (2000) an d Rajaraman (2001) for a d d ition a l ev id en ce o f th e e ffectiven ess o f th e se regu lations. 7. T he lev e l o f th e URR m a y a cco u n t for th is result. V aldés-Prieto an d Soto (1998) fin d ev id en ce o f a th resh o ld effect, w h ic h w o u ld ex p la in w h y th e se regu lations w ere o n ly e ffective in red u cin g cap ita l flow s in 1 9 9 5 -9 6 . It m u st b e em p h asized th a t th is d oes n o t im p ly a better eva lu a tio n o f th e overall m a cro eco n o m ic p o licy package o f 1 9 9 5 -9 6 com p ared w ith th a t o f 1 9 9 1 -9 2 . A gosin an d Ffrench-D avis (2001) argue that, o n broader grounds, m a cro eco n o m ic m a n a g e m en t in th e earlier part o f th e 1990s w as m ore appropriate. 8. T his is captured in o ther stu d ies (for exam p le C árdenas an d Steiner, 2000) th r o u g h th e use o f a d u m m y variable for th e period during w h ic h th e URR w as in p lace, an d has b e e n in terpreted (inaccurately, accord in g to th e a ltern ative v iew p resen ted in th e text) as ev id en ce aga inst th e e ffectiven ess o f regu lations. 9. For an analysis o f th e se issues see W orld Bank (1999: 151) an d Stiglitz and B hattacharya (2000). 10. For recent an alyses o f th e se issues an d p o licy o p tio n s for m a n a g in g th e m , see BIS (2001: ch . 7), B orio e ta l . (2001), C lerc e ta l. (2001) and Turner (2002). 11. In a d d ition , general p rov ision s eq u iv a len t to 0 per cen t, 0 .5 per ce n t an d 1 .0 per cen t o f three classes o f assets are required. 12. For an analysis o f th e risks associa ted w ith n on-tradab le sectors see Rojas-Suárez (2001). 13. B anco C entral de la R epública A rgentina (1995), 1 1 -1 2 . R e f e r e n c e s A gosin , M . (1998) C ap ita l In flo w an d In v e s tm e n t P erform ance: C h ile in th e 1990s, in R. F french-D avis an d H. R eisen (eds), C a p ita l In f lo w s a n d In v e s tm e n t P e rfo rm a n c e : Lessons fro m L a t in A m e r ic a , Paris an d Santiago: OECD D e v e lo p m e n t Centre/ECLAC. an d R. F french-D avis (2001) ‘M an agin g C apital In flow s in C hile, in S. G riffith- Jones, M . F. M o n tes an d A. N a su tio n (eds), S h o rt-te rm C a p ita l F lo w s a n d E co n o m ic C rises, N ew York an d O xford: O xford U n iversity Press for UNU/W IDER. A riyoshi, A., K. H aberm eier, B. Laurens, I. Ó tker-Robe, J. I. C anales-K riljenko and A. K irilenko (2000) C a p ita l C o n tro ls : C o u n try E xperiences w ith T h e ir Use a n d L ib e ra l­ iz a t io n , O ccasional Paper 190, W ash in gton , DC: IMF. B anco C entral d e la R epública A rgen tin a (1 9 9 5 ) In fo rm e A n u a l, B u en o s Aires, O ctober. Bank for In tern ational S ettlem en ts (BIS) (2001) 7 1 s t A n n u a l R eport, Basel: BIS, June. Bordo, M ., B. E ichengreen , D. K lingebiel an d M . S. M artinez-Peria (2001) Is th e Crisis P roblem G row in g M ore Severe?, E co n o m ic P o lic y , 3 2 (April). Borio, C., C. Furfine an d P. Low e (2001) Procyclicality o f th e F inancial System and Financial Stability: Issues an d P o licy O ptions, in M a rry in g the M a c ro - a n d M ic ro - P ru d e n tia l D im e n s io n s o f F in a n c ia l S ta b ility , BIS Papers n o . 1, Basel: BIS, M arch. C árdenas, M. an d F. Barrera (1997) O n th e E ffectiveness o f C apital C ontrols: T he E xperience o f C o lom b ia D uring th e 1 9 9 0 s’, J o u rn a l o f D e v e lo p m e n t E conom ics , 54 , 1 (O ctober). an d R. Steiner (2000) ‘Private C apital Flow s in Cc lom bia, in F. Larrain (ed.), C a p ita l F lo w s , C a p ita l C o n tro ls , a n d C u rre n cy C rises: ,a t in A m e ric a in the 1 9 9 0 s , A n n Arbor, MI: U n iversity o f M ich igan Press. Clerc, L., F. D rum etz an d O. Jaudoin (2001) To W hai E xtent are Prudential and A cco u n tin g A rrangem ents Pro- or C ou n tercyclica l w ith Respect to O verall F inancial 242 Capital Account and Countercyclical Regulations C on d ition s? , in M a r ry in g th e M a c ro - a n d M ic ro -P ru d e n t ia l D im e n s io n s o f F in a n c ia l S ta b ility , BIS Papers n o . 1, Basel: BIS, M arch. D e G regorio, J., S. Edwards an d R. V aldés (2000) C ontrols o n C apital Inflow s: D o T hey W ork J o u rn a l o f D e v e lo p m e n t E conom ics , 63 , 1 (O ctober). D e Lis, E S., J. M artinez an d J. Saurina (2001) C redit G row th , P roblem Loans and C redit Risk P rov ision in g in Spain, in M a r ry in g th e M a c ro - a n d M ic ro -P ru d e n t ia l D im e n s io n s o f F in a n c ia l S ta b ility , BIS Papers n o . 1, Basel: BIS, M arch. D íaz-A lejandro, C. E (1988) Trade, D e v e lo p m e n t a n d th e W o r ld E conom y. Selected Essays o f C a rlo s F. D ia z -A le ja n d ro , ed ited b y A ndrés V elasco, O xford: Basil B lackw ell. ECLAC (1998) T h e F is c a l C ove n a n t. S trengths, W eaknesses, C ha llenges, Santiago: ECLAC. (2002) G row th w ith Stability: F in an cin g for D ev e lo p m en t in th e N e w Inter­ n a tio n a l C o n tex t’, L ib ro s de la C E P A L, 67 (M arch). E uropean C entral Bank (ECB) (2 0 0 0 ) A sset Prices a n d B a n k in g S ta b ili ty , Frankfurt am M ain: ECB, April. García, M. G. P. an d M . V. F. V alpassos (2000) C apital Flow s, C apital C on tro ls, an d C urrency Crisis: T h e Case o f Brazil in th e 1990s, in F. Larrain (ed .), C a p ita l F lo w s , C a p ita l C o n tro ls , a n d C u rre n cy C rises: L a t in A m e ric a in the 1 9 9 0 s , A n n Arbor, MI: U n iversity o f M ich igan Press. H aberm eier, K. (2 0 0 0 ) Indias E xperience w ith th e L iberalization o f C apital Flow s Since 1991, in A riyosh i e ta l . (2000). H eym an, D. (2000) ‘M ajor M acroecon om ic U psets, E xpectations an d Policy Responses, C EPAL R eview , 70, (Santiago). In te r n a tio n a l M o n eta ry F und (IMF) (1 9 9 8 ) W o r ld E c o n o m ic O u tlo o k , 1 9 9 8 - F in a n c ia l C rises: C h a ra c te ris tic s a n d In d ic a to rs o f V u ln e ra b il ity , W ash in g to n , DC: IMF, May. JP M organ (1998) W o r ld F in a n c ia l M a rk e ts , N ew York: JP M organ, 7 October. Kaplan, E. and D. Rodrik (2001) D id th e M alaysian C apital C on tro ls W ork?, N B E R W o rk in g P aper n o . 8 1 4 2 , C am bridge, MA: NBER, February. Krugm an, P. an d L. Taylor (1978) C ontractionary Effects o f D evalu ations, J o u rn a l o f In te rn a t io n a l E conom ics , 8. Larrain, F., R. Labán an d R. C h u m acero (2000) W hat D eterm in es C ap ita l Inflow s? A n Em pirical A nalysis for C hile, in F. Larrain (ed .), C a p ita l F lo w s , C a p ita l C o n tro ls , a n d C urre n cy C rises: L a t in A m e r ic a in the 1 99 0 s , A n n Arbor, MI: U n iv ersity o f M ich igan Press. Laurens, B. (2000) C h ile’s E xperience w ith C on tro ls o n C apital In flow s in th e 1 9 9 0 s’, in A riyoshi e t a l. (2000). Le Fort, G. and S. L ehm an (2000) El Encaje, lo s Flujos d e C ap ita les y e l Gasto: u n a E valuación Em pírica, D o c u m e n to de T ra b a jo n o . 64 , Santiago: C entral Bank o f C hile, February. M insky, H. P. (1982) C a n I t H a p p e n A g a in ? : Essays o n In s ta b i l i t y a n d F in an ce , A rm onk, NY: M . E. Sharpe. M ishk in , F. (2001) T h e E conom ics o f M oney, B a n k in g a n d F in a n c ia l M a rk e ts , 6 th ed n , B oston , MA: A d d ison W esley L ongm an. N ayyar, D . (2002) C apital C on tro ls an d th e W orld F inancial A u thor ity - W hat C an w e Learn from th e In d ian E xperience?, in J. E atw ell an d L. Taylor (eds), In te rn a t io n a l C a p ita l M a rk e ts - System s in T ra n s it io n , N ew York: O xford U n iversity Press. O cam p o, J. A. (2002a) In tern ational A sym m etries an d th e D esig n o f th e In ternational Financial System , in A. Berry (ed .), C r it ic a l Issues in F in a n c ia l R e fo rm : A V ie w fro m the S outh , N ew Brunsw ick, NJ: T ransaction. José Antonio Ocampo 243 (2002b) D ev e lo p in g C ountries A n ti-C yclical Policii s in a G lob alized W orld, in A. D u tt an d J. Ros (eds), D e v e lo p m e n t E conom ics a n d s tru c tu ra lis t M a croe co n om ics : Essays in H o n o u r o f L an ce T a y lo r, A ldershot: Edward Elg ir. an d C am ilo Tovar (1998) C apital Flows, Savings ar d In v estm en t in C olom bia , 1 9 9 0 -9 6 , in R. F french-D avis an d H. R eisen (eds), C a p ita l F lo w s a n d In v e s tm e n t P e rfo rm an ce : Lessons fro m L a t in A m e ric a , Paris an d Santiago: OECD D ev e lo p m en t C entre an d ECLAC. a n d (1999) Price-Based C apital A ccou n t R egulations: T he C o lo m b ia n Exper­ ie n c e ’, F in a n c ia m ie n to de l D e s a rro llo Series, n o . 8 7 (LC /L.1262-P), Santiago: ECLAC. Ótker-Robe, I. (2000) M alaysia’s Experience w ith th e U se o f C apital C ontrols, in A riyoshi e t a l. (2000). Palm a, G. (2002), The Three R outes to F inancial Crises: T he N eed for C apital C ontrols, in J. Eatwell an d L. Taylor (eds), In te rn a t io n a l C a p ita l M a rk e ts - System s in T ra n s it io n , N ew York: O xford U n iversity Press. Persaud, A. (2 0 0 0 ) S e n d in g th e H e rd O f f th e C l i f f Edge: T h e D is tu r b in g In te ra c t io n betw een H e rd in g a n d M a rk e t-s e n s itiv e R is k M a n a g e m e n t P rac tices , L ondon: State Street. Poveda, R. (2000) L a R e fo rm a d e l S is tem a de P ro v is io n es de In s o lv e n c ia , Madrid: B anco d e España, January. Rajaraman, I. (2001) M an agem en t o f th e C apital A ccount: A S tudy o f India and M alaysia, m im eo , N ew D elh i, N a tio n a l In stitu te o f Public F inance a n d Policy, M arch. Reddy, Y. V. (2001) O p eration alis in g C apital A ccou n t Liberalisation: T he Ind ian E xperience’, D e v e lo p m e n t P o lic y R ev iew (O verseas D ev e lo p m e n t In stitu te), 19, 1 (M arch). Rodrik, D. an d A. V elasco (2000) Short-Term C apital Flow s, A n n u a l W o r ld B a n k C onference o n D e v e lo p m e n t E conom ics 1 9 9 9 , W ash in gton , DC: W orld Bank. Rojas-Suárez, L. (2001) Can In tern ational C apital Standards S tren gth en Banks in Em erging M arkets, m im eo , W ash in gton , DC: In stitu te for In tern ational E conom ics, October. Ros, J. (2001) From th e C apital Surge to th e F inancial Crisis a n d B eyond: M ex ico in th e 1990s, in R. F french-D avis (ed.), F in a n c ia l C rises in S uccessfu l E m e rg in g E conom ies, W ash in gton , DC: B rookings Institution/EC LA C . Sachs, J., A. T ornell an d A. V elasco (1 9 9 6 ) ‘T h e M ex ica n P eso Crisis: S u d den D ea th or D ea th Foretold?, N B E R W o rk in g P a p e r n o . 5 5 6 3 , C am bridge, MA: NBER, May. Stiglitz, J. E. (1994) The Role o f th e State in F inancial M arkets, Proceedings o f the W o r ld B a n k A n n u a l C onference on D e v e lo p m e n t E conom ics 1 9 9 3 , W ash in gton , DC: W orld Bank. an d A. Bhattacharya (2000) The U n d erp in n in g s o f a Stable an d E quitable G lobal F inancial System : From O ld D ebates to a N ew Paradigm , A n n u a l W o r ld B a n k Conference o n D e v e lo p m e n t E conom ics 1 9 9 9 , W ash in gton , DC: W orld Bank. Taylor, L. (1998) C apital M arket Crises: L iberalisation , F ixed E xchan ge Rates an d M ark et-D riven D e s ta b ilisa tio n , C a m b r id g e J o u rn a l o f E c o n o m ic s , 2 2 , 6 (N ovem ber). Turner, P. (2002) Procyclicality o f R egulatory Ratios, in J. Eatw ell an d L. Taylor (eds), In te rn a t io n a l C a p ita l M a rk e ts - System s in T ra n s it io n , N ew York: O xford U n iversity Press. Valdés-Prieto, S. an d M. Soto (1998) The E ffectiveness o f C apital C ontrols: T heory an d E vidence from C h ile ’, E m p ír ic a , 25 (D ordrecht: Kluwer). 2 4 4 Capital Account and Countercyclical Regulations Villar, L. and H. R in con (2002) The C o lo m b ia n E co n o m y in th e N in eties: C apital Flow s and Foreign E xchan ge R egim es, in A. Berry (ed.), C r it ic a l Issues in F in a n c ia l R efo rm : A V ie w fro m th e S outh , N ew Brunswick: Transaction. W illiam son , J. (2000) E xchange Rate R egim es for Em erging M arkets: R eviv ing th e Interm ediate O p tion , P o lic y A n a lyse s in In te rn a t io n a l E conom ics , 60 , W ash in gton , DC: In stitu te for In tern ational E conom ics, Septem ber. W orld Bank (1999) G lo b a l E c o n o m ic Prospects a n d the D e v e lo p in g C o u n trie s , 1 9 9 8 -9 9 - B e yo nd F in a n c ia l C ris is , W ash in gton , DC: W orld Bank. 1 3 How Optimal are the Extremes? Latin American Exchange Rate Policies during the Asian Crisis* Ricardo Ffrench-Davis and Guillermo Larrain O ne co m m o n feature of th e coun tries m ost affected by th e Asian crisis an d its shockw aves - such as T hailand , M alaysia, Indonesia, th e Republic of Korea an d Brazil - is th a t th e y h ad exchange rate system s th a t in d ifferent versions w ere closer to pegged system s th a n to floating system s (they were o ften called so ft pegs). C ountries w ith exchange rate bands, such as Israel, C hile an d C olom bia also suffered, w hile floating countries such as Australia, N ew Z ealand an d M exico apparen tly fared better. Based o n th is , m any observers have concluded th a t in te rm ed ia te exchange rate system s are dangerous an d th a t op tim ality is located a t th e extrem es. This chap te r evaluates th is conclusion by analyzing th e experiences of th ree d ifferen t exchange rate systems: T hose of A rgentina, C hile an d M exico, w h ich have diverging exchange rate policies, a t least form ally.1 A stra igh t observation of recen t events is th a t coun tries w ith pegged system s, such as th e currency boards in H ong Kong an d A rgentina, suffered sign ifican t con tag ion in tim es of in te rn a tio n a l financial stress. A rgentina experienced deep recessions du rin g b o th th e M exican an d th e Asian crisis. H ong Kong suffered a recession as a consequence of th e Asian crisis, b u t du rin g th e M exican crisis g row th m erely decelerated from 5.4 per cen t in 1994 to 4 .0 per cen t in 1995. T here are reasons to believe th a t com pletely rigid exchange rate system s am plify ex ternal shocks. A pparen tly th e y p u t overly strong a n d therefore unrea listic requ irem en ts o n dom estic flexibility, particu larly o n w age an d price flexibility. The am plifica tion effect arises du rin g a n external shock w hen agents consider th a t th e shock m ay be strong en o u g h to induce th e au tho rities to m odify th e exchange rate policy; th is is particu larly so w hen th e exchange rate appears to be overly appreciated . Rigid system s are therefo re p ro n e to changes in m arket se n tim e n t a n d cred­ ib ility (or a t least eventually , w ith th e exception of full dollarization). Likewise exchange rate b an d s d id n o t fu n c tio n well du rin g th e Asian crisis. In m an y cases th is was partly th e resu lt of m an ag em en t o f th e bands. 245 246 Latín American Exchange Rate Policies The huge increase in capital inflow s to em erg ing econom ies betw een 1990 an d 1997 p u t severe upw ard pressure o n th e value of dom estic currencies. T he response in term s of exp an d in g th e size of bands or apprecia ting th e m caused a credibility loss. S ubsequently th e b an d s h ad troub le ad ap tin g to th e new real exchange rate w h en th e Asian crisis appeared a n d capital inflow s sudden ly stopped . These events aggravated th e b an d s m ism an ag em en t an d therefo re caused a fu rth e r credibility loss. T he m ajo r benefit o f th e b a n d sys­ tem arises in tim es of n o rm ality w hen th e re are n o severe or one-sided shocks. In such circum stances bands can m a in ta in exchange rate stability an d partially absorb th e effects o f s tandard shocks. C onsequen tly th e exchange rate m ore efficiently fulfils its allocative role betw een tradables an d n o n ­ tradables. The m a in troub le w ith b ands appears in tim es of financial distress. After a general discussion, th is chap te r exam ines th e experiences of th ree sym bolic cases of exchange rate policies. O n th e cu rrency bo ard side, it considers th e experience of A rgentina in o rder to u n d e rs ta n d th e appeal th is system has h a d for o th e r countries, som e of w h ich later dollarized. It th e n exam ines C hile for th e case of in te rm ed ia te regim es an d M exico for th e floating regim e. The analysis focuses o n th e period in w h ich th e Asian crisis to o k place. Exchange rate regime and stability of financial and real sectors T he Asian crisis a n d its a fte rm ath caused a considerable shock n o t on ly in Asia b u t in Latin A m erica as well, b u t w ith vary ing degrees o f in tensity . C hile was by far th e m ost directly affected due to its sign ifican t trade rela­ tions w ith Asia. But as em erging-m arket spreads increased, especially after th e Russian default, Brazil an d A rgentina also felt its consequences. Later th e Brazilian deva lua tion in tro d u ced add itiona l uncerta in ties th a t affected all of Latin America. It was therefo re a period of in stab ility a n d large shocks. Table 13.1 com pares th e ou tcom e in term s of th e financial an d o u tp u t v o la tility o f a n u m b e r of coun tries w ith d ifferent in itia l exchange rate regim es in th e period im m edia te ly after th e explosion of th e Asian crisis. In o rder to com pare financial an d real volatility, we co n stru c t a financial volatility index (FVI), w h ich can be com puted in dependen tly o f th e exchange rate (ER) regim e.2 If CV deno tes th e coefficient of varia tion , th e in d ex is defined sim ply as FVI = CV(ER) + CV(reserves) + C V (nom inal in terest rates). W h en a co u n try faces a period of stress it n o rm ally reacts by deprecia ting th e exchange rate , selling in te rn a tio n a l reserves or increasing in te rest rates. In fixed exchange rate regim es, v o la tility appears in reserves an d in te rest rates, w hile in a p u re float v o la tility sh o u ld appear in th e exchange rate an d in te rest rates. Bands o r d irty floating system s co m b in e all th ree e lem ents. Real sector vo la tility is cap tu red u sing th e s tandard dev ia tion of GDP grow th. Ricardo Ffrench-Davis and Guillermo Larraín 2 47 Ta b le 13 .1 V olatility in se lected cou n tr ies during in tern a tio n a l fin a n cia l turm oil, 1 9 9 7 (Q 3)-99 (Q 4) I n i t i a l exchange ra te system C o e ff ic ie n t o f v a r ia t io n o f the leve ls o f V o la t i l i t y o f G D P (s .d .) (% ) N o m in a l exchange ra te (% ) (a ) In te rn a t io n a l reserves (% ) (b) In te re s t ra tes (»/a) (b) In d e x o f f in a n c ia l v o la t i l i t y (% ) (a ) + (b ) + (c) A rgentina Fixed 0 .0 7.9 13.1 2 1 .0 5.3 H o n g K ong Fixed 0.1 3 .9 2 3 .0 2 7 .0 5.5 Australia Float 5 .7 14.5 14.2 3 4 .4 0 .6 M ex ico Float 8 .5 5 .6 2 2 .6 3 6 .7 1.9 N ew Z ealand Float 7.8 5 .7 2 7 .4 4 1 .0 2.3 C h ile Band 8 .2 8 .2 31.1 47 .5 5.3 C o lo m b ia Band 16.7 8 .2 26 .4 51 .3 4.5 T hailand Soft p eg 9 .4 9 .0 42 .1 60 .5 7.3 M alaysia Soft peg 9 .8 19 .0 37 .9 66 .7 7.8 Brazil Soft p eg 25.1 26 .8 26 .4 78.3 1.6 Korea Soft p eg 14 .8 36 .4 30 .7 81 .9 8.5 Source: Calculations based on IMF data. Table 13.1 ranks th e coun tries accord ing to th e ir financial vo la tility index an d reveals five im p o rta n t a n d to som e ex ten t surprising conclusions ab o u t th e role o f exchange rate policy du ring th e Asian crisis: • R anking countries accord ing to th e ir financial vo la tility in d ex results in th e ir being grouped accord ing to th e ir exchange rate system . • Fixed system s appear to have delivered m ore n o m in a l stability th a n alternative system s, b u t th e y displayed m ore vo la tility in a real variable, nam ely GDP grow th. • F loating regim es h a d th e low est GDP volatility, b u t th e y displayed greater financial v o la tility th a n fixed systems. • Soft pegs displayed th e w orst co m b in atio n of financial an d real volatility. • Bands fell in to an interm ediate position, w ith higher financial volatility th a n credible fixed system s a n d m ore real vo la tility th a n floating regim es. Som e qualifica tions are requ ired a t th is p o in t. First, th e lesser financial vo la tility in fixed exchange rate regim es was probably d u e to th e fact th a t in th e period in ques tion th e re w ere n o serious challenges in A rgentina or H ong Kong to th e stability o f th e exchange rate policy.3 Therefore it can be concluded th a t a credible fixed exchange rate policy delivers greater financial stability. But it also follow s th a t, despite hav in g h a d credible exchange rate policies, A rgentina a n d H ong Kong also h ad h ig h o u tp u t volatility. 248 Latin American Exchange Rate Policies In th e case of A rgentina, som e observers have suggested th a t th e prob lem was due to rig id ity in th e labour m arket, b u t th e fact th a t H ong K ong also experienced greater v o la tility suggests th a t th is arg u m en t m ay be overstated. M oreover if we com pare th e tw o coun tries in fla tio n records we find th a t th e y w ere n o t significantly dissim ilar: du rin g th is period cum ulative an n u a l in fla tio n in A rgentina was - 0 .4 per cen t w hile in H ong Kong it was 1.8 per cen t. Therefore prices co n trib u ted m ore to real deprecia tion in A rgentina th a n th e y d id in H ong Kong.4 Second, as we shall see, th e C h ilean b a n d was already suffering from lack o f credibility du rin g th e period considered. Therefore faced w ith a shock as strong as th e Asian crisis, w h en th e stabilizing p roperties o f th e rigid p a rt o f th e b a n d m echan ism shou ld have appeared, th e y d id n o t because credibility h ad been lost. H ence it can be concluded th a t w h en faced w ith a shock a non-cred ib le b a n d causes h ig h volatility, b o th financia l an d real. W h a t ca n n o t be argued is th a t th e lack of credibility is in h e re n t in th e b an d system . Third, soft pegs displayed th e w orst perform ance. A nalyzed ex p o st th e soft peggers all h ad repressed exchange rates an d in som e cases th e m arket d id n o t have en o u g h in fo rm atio n o n fundam en ta ls (for instance, short-term ex ternal liabilities). W h en a currency is overvalued an d th e re is pressure for correction , soft peg system s are p ro n e to specu la tion a n d th u s financial volatility. Four, floating regim es d id b e tte r in term s of real variables b u t less so in te rm s of financial volatility. Beyond th e exchange rate v o la tility th a t is in h e re n t in a floating system , in te rest rates sw ang in floating countries as m u c h as th e y d id in coun tries w ith pegged system s. F lo tation cou ld n o t avoid in te rest rate volatility. As is clear from Table 13.1, policy reactions differed considerab ly am o n g th e countries. For instance, desp ite th e float A ustralia used its in te rn a tio n a l reserves qu ite intensively, w h ile N ew Zealand used in terest rates m ore intensively. A m ong th e floaters, M exico was th e m ost in tensive user o f th e exchange rate. Table 13.1 also suggests th a t each co u n try chose d ifferen t com binations of n o m in a l deprecia tion , reserve accum ula tion an d in terest rate changes w h en facing th e shocks. It appears th a t, for th e countries in th e sam ple, th e less harm fu l financial consequence in term s of g row th was vo la tility in th e exchange rate, as can be seen in Figure 13.1. This im plies th a t exchange rate changes m ay have been effective in p roducing th e necessary expend itu re sw itch ing to reduce th e n e t d em an d for tradables an d m in im ize th e im pact o n non -tradab les.5 Also, it appears th a t th e m ost harm fu l response was in te r­ est rate changes. T he ad ju s tm en t of ex ternal disequilibria te n d ed to w ork as a global dem and-reducing too l, generating u n em p lo y m e n t an d idle capital in non -tradab le sectors. Beyond th e exchange rate system , coun tries ab ility to sm o o th th e cycle is correlated w ith th e ir financial in teg ra tio n w ith th e rest o f th e w orld. The Ricardo Ffrench-Davis and Guillermo Larraín 249 Volatility of GDP F ig u re 1 3 .1 GDP v o la tility versus various fin an cia l v o la tilit ie s (per cen t) Notes: Each point represents the ordered pair of volatility in GDP and some definition of finan­ cial volatility (in exchange rate, reserves or interest rates). The numbers on linear regressions refer to the partial correlation. Source: Calculations based on IMF data. U nited States runs a n en o rm o u s cu rren t acco u n t deficit b u t th e m arket does n o t ask for its im m edia te correction (nor do th e au tho rities th in k it is necessary), as has h ap p en ed m a n y tim es in Latin America. A m ong th e reasons for th is is th e fact th a t foreigners have a h ig h d em an d for dollar- d en o m in a ted assets, a n d th a t th e U nited States does n o t n eed to m ake its financial ob ligations co n tin g en t o n com m odity price m ovem en ts as its econom y is so diversified th a t th e negative covariance of shocks is p robab ly strong en o u g h to stabilize overall risk. H ence to reduce th e dom estic im pact of ex ternal shocks it is necessary to im prove th e quality o f Latin Americas financial links w ith th e rest of th e w orld. Three m e th o d s have been discussed recently. O ne is to create a foreign d em an d for assets d en o m in a ted in th e n a tio n a l currency, as inspired by th e A ustralian an d N ew Z ealand cases. The degree of in te rn a tio n a l f in an ­ cial in teg ra tio n of these tw o OECD countries is far m ore th a n th a t o f a typical em erg ing econom y. A m ong o th e r th ings, th ey have offshore m arkets for securities issued in dom estic currencies (see C hap te r 4), an d are therefore able to hedge th e ir exposure to exchange rate risk in th e ir non -tradab le 250 Latin American Exchange Rate Policies sectors.6 Second, accord ing to C aballero (2001), Latin A m erican financial in stru m en ts are incom ple te in th a t th ey are n o t c o n tin g en t o n th e m ain shocks faced by these econom ies. If C h ilean bon d s w ere co n tin g en t o n th e price of copper, a n ex ternal shock w ould be less d em an d in g in term s of cu rren t accoun t ad ju s tm e n t.7 It is n o t obvious th a t a typical em erg ing econom y will m ove quickly in e ith e r o f these d irections. Third, th e quality of financial links could be im proved w ith p ru d en tia l m acroeconom ic po li­ cies on excessive sho rt-term or liqu id ex ternal liabilities, th e size of th e ex ternal deficit a n d th e apprecia tion of th e real exchange rate in periods of cap ita l surges.8 The m ain b enefit o f th e floating regim e appears w h en significant, long- lasting shocks em erge abruptly . In th is case a pure floating regim e delivers a rap id ad ju stm en t in th e exchange rate an d th e au tho rities stay o u t o f th e scene, th u s keep ing its credibility in tact, except w h en dep recia tion leads to in fla tion an d th e co u n try has adop ted a n in fla tio n ta rge ting schem e. By increasing th e exchange rate risk perceived by th e public, it also b e tte r p re­ pares agents fo r sudden shocks. Conversely floating regim es cause signifi­ can tly h igher exchange rate instab ility across th e cycle, w h ich m ay have harm fu l effects o n grow th, w ith ineffic ien t allocative signals. In particu lar a floating regim e c a n n o t avoid overva luation in episodes of capital surge. We shall n o w briefly analyze th e behav iou r o f exchange rate regim es in th e period from th e M exican crisis to 1999, using ou r m easures o f financial an d real volatility. Figure 13.2 considers th ree subperiods: on e encom passing th e M exican crisis (the fo u rth q u arte r o f 1994 to th e first qu arte r 1996) a n o rm al subperiod betw een th e second quarte r of 1996 an d th e th ird quarte r o f 1997, an d th e o n e in w h ich th e Asian crisis took place (the fo u rth quarte r o f 1997 to th e fo u rth qu arte r o f 1999). Figure 13.2 suggests th a t in crisis periods th e re is a h igher co rrela tion b etw een financial a n d real vo la tility th a n in no rm al periods. In no rm al periods th e co rre la tion betw een financial a n d real variables is a lm ost zero. H ow ever th e co rrela tion varies b etw een crises, an d surprisingly it was h igher in th e M exican crisis th a n in th e Asian one. This can be exp lained by th e fact th a t the degree o f con tag ion was less du ring th e M exican crisis as, am o n g th e countries in th e sam ple, it on ly spread to A rgentina.9 H ence th e h ig h R2 reflects a statistical issue ra th e r th a n an econom ic one. If th e data are decom posed according to th e exchange rate regim e prevail­ ing at th e b eg in n in g of each period, M exico appears in th e group of bands in on e period an d as a float in th e la tte r tw o (Figure 13.3). The figure shows th a t, across crises, th e m ore stable behav iou r in financial an d real term s was exhib ited by floating regim es. W h en negative shocks arrived, all system s b u t th e floating ones exh ib ited h ig h financial an d /o r real volatility, w ith soft pegs perfo rm ing worst. Pegged system s appear to have a curious property : w ith o u t negative shocks th e y display low real an d financia l volatility , b u t w hen th e re is a shock, financia l vo la tility rem ains m u c h th e sam e an d th e Ricardo Ffrench-Davis and Guillermo Larraín 251 I c3 9.0 8.0 7.0 6.0 5.0 g 4.0 CD 3.0 2.0 1.0 0.0 ♦ Mexican crisis ■ Asian crisis • No crisis ■ Korea 1998 R2 = 0.13 20.0 40.0 60.0 80.0 Financial volatility 100.0 120.0 F igure 1 3 .2 Real an d fin a n cia l v o la tility in three ep iso d es (per cen t) Source: Based on IMF data. shock translates in to real sector volatility. Bands exh ib it sim ilar behav iour w ith respect to real vo la tility in stress periods, b u t w ith greater financial volatility. It is in te resting to n o te th a t in n o rm al tim es, floating regim es cause rela­ tively m ore financial vo la tility th a n do th e o th e r systems, b u t d u ring a crisis overall vo la tility is reduced in floating regim es.10 In lig h t o f th e above considerations, an idea l b u t crude exchange rate system th a t m ig h t be able to m in im ize real sector vo la tility w ould involve a tw o-pronged approach . In n o rm a l tim es, w h en shocks are sm all an d un ifo rm ly distributed , m anaged flexibility o r a craw ling b an d w ould increase stability an d therefo re grow th. W h e n large shocks appear a n d th e ir d istri­ b u tio n is biased in th e sam e negative d irec tion (term s of trade fall, ex ternal financ ing declines an d so on), th e n ideally th e re shou ld be a tem porary sw itch to a floating regim e. H ow ever im p lem en tin g such a system w ou ld be difficult. First, it w ou ld be p rob lem atic to de term ine w h e th e r a shock was large or sm all, tem porary or p e rm a n e n t.11 Second, in o rder to be successful, fixed exchange rate regim es n eed full credibility in d e p e n d e n t o f th e shock suffered; such an ideal sw itch ing exchange rate system is incom patib le w ith a fixed rate system . 252 Latin American Exchange Rate Policies 9.0 8.0 7.0- 6.0- .g’ 13 5.0-1 D 4.0 (5 3.0 2.0 1.0 0.0 ♦ Band ■ Float a Pegged • Soft peg ■ Korea 1998 HK 1998 Argentina 1998 a Chile 1998 A • t l * : ■ K ^ Colombia 1998 A Argentina 1995 New Zealand 1998 20.0 40.0 60.0 80.0 Financial volatility F ig u re 1 3 .3 E xchange rate regim es sin ce 19 9 4 (per cent) Source: Based on IMF data. A Mexico 1995 100.0 120.0 Argentina: low inflation and output volatility under the currency board After experiencing hyperin fla tion in 1989 an d 1990, in 1991 A rgentina adop ted an ex trem e exchange rate policy: a currency board . This system , like th e trad itiona l fixed exchange rate system , links th e n a tio n a l currency, in th is case th e peso, in a given p ro p o rtio n to a foreign currency. In A rgentina th e parity was fixed one-to -one w ith th e US dollar. In th e trad itiona l fixed exchange rate system th e cen tra l b an k is able to realign th e parity a t its dis­ cre tion an d has th e freedom to con tro l th e q u an tity of h igh-pow ered m oney. H ow ever in A rgentina p arity was fixed by law (the C onvertib ility Law) an d th e cen tral b an k was requ ired to m a tch an y increase in h igh-pow ered m o n ey w ith an accum ula tion o f in te rn a tio n a l reserves. In th is sense it was a n extrem e version of a fixed exchange rate system , w ith n o space for dom estic m acroeconom ic policy. Of course th e m ost radical o p tio n was sim ply to suppress th e dom estic currency an d fully dollarize. T he m ain reason for th e ad o p tio n of a currency b o ard in A rgentina in 1991 was to fig h t hyperin fla tion , th a t is, th e strategy was a deliberate Ricardo Ffrench-Davis and Guillermo Larraín 253 an ti-in fla tio n ary device. Between 1975 an d 1990 th e low est in fla tio n rate in A rgentina was 90 per ce n t (1986), a n d du ring th e h y p erin fla tio n years it scored as h ig h as 3079 per cen t (1989). After th e im p lem en ta tio n o f th e currency board , an n u a l in fla tion fell to below 5 per cen t in 1994, an d th e n to an average of - 0 .3 per ce n t betw een 1996 a n d 2000. At th e sam e tim e as in fla tion was collapsing, GDP grow th was accelerating. After a n average rate of - 0 .9 per cen t in th e 1980s, g row th resum ed an d averaged 4.1 per ce n t in th e 1990s. This was due to th ree m a in factors. First, a ro u n d th e tim e th a t convertib ility was adop ted , in te rn a tio n a l liqu id ity increased significantly. U n til 1994 A rgentina w as able to a ttrac t a huge am o u n t o f capital, fu rth er encouraged by its m assive p rivatiza tion program m e. This, in co m b in a tio n w ith th e m echanics o f convertib ility described before, p rov ided a sign ifican t stim ulus to aggregate dem and , expectations an d econom ic activ ity .12 Average GDP grow th in th e period 1991-94 was 7.9 per cen t. H ow ever at th e en d of 1994 M exico devalued its currency, an d th e suspicion th a t A rgentina w ou ld follow suit increased its sovereign risk from 434 bp over Treasuries in 1994 to 1259 in 1995 (Table 13.2). T he n e t capital inflow of US$4.3 b illion in th e last quarte r of 1994 reversed ab rup tly to an ou tflow of US$3.3 b illion in th e first quarte r o f 1995. The result was a severe recession in w h ich GDP fell by 2.9 per cen t in 1995 an d u n em p lo y m e n t rose to 18 per cen t. H ow ever in 1996-98 cap ita l flows re tu rn ed an d o u tp u t recovered. T hen betw een Septem ber 1998 an d February 1999 th e Russian defau lt a n d th e Brazilian deva lua tion again induced capital outflow s an d a recession th a t lasted over th ree years. H ence th e A rgentinean experience after 1995 was on e of low g row th accom pan ied by significant volatility, associated w ith th e instab ility of cap ita l flows. Second, th e acceleration of g row th in th e first ha lf o f th e 1990s was th e resu lt n o t on ly of capital inflow s b u t also of som e im p o rta n t structural reform s, tw o of w h ich m erit specific m en tio n : trade reform a n d p rivatization . Trade policy in A rgentina to o k place u n d e r th e fram ew ork of MERCOSUR, th e free trade agreem ent A rgentina signed w ith Brazil, Paraguay an d Uruguay. After th is trade liberalization exports soared from US$18 b illio n in 1990 to a peak of US$34 b illion in 1998. W ith regard to privatization , as described by Larrain an d W inograd (1997), given th e in itia l size of th e pub lic sector an d th e low p roductiv ity levels in public com panies, th e m assive program m e u n d ertak en in th e first h a lf o f th e 1990s resu lted in huge gains in th e average value added per w orker in privatized firm s, especially in th e n o n ­ tradable sector. This n o t on ly h ad a positive im pact o n grow th b u t also h e lped to reduce th e overapprecia tion of th e real exchange ra te .13 Third, a m ost relevant an d usually ignored factor, th e accelera tion of g row th in A rgentina, is linked to th e poo r recessive sta rting p o in t. Take as a b en ch m ark 1974, th e year in w h ich real GDP per cap ita reached its peak. After 1974 th e re was a steady de terio ra tion in GDP an d by 1990, th e year before convertib ility was adop ted , it was 16 per cen t below th a t in 1974, 254 Latin American Exchange Rate Policies Ta b le 1 3 .2 Argentina: capita l flow s, real ex ch a n g e rate and m a cro eco n o m ic perform ­ an ce, 1 9 9 4 -9 9 1 9 9 4 1 9 9 5 1 9 9 6 1 9 9 7 1 9 9 8 1 9 9 9 C urrent accou n t balance (US$ m illio n ) - 1 1 158 - 5 191 - 6 843 - 1 2 497 - 1 4 603 - 1 2 3 1 2 N et foreign direct in v estm en t (US$ m illio n ) 2 620 4 112 5 348 5 503 4 5 4 6 2 2 665 N et p ortfo lio in v estm en t (US$ m illion ) 8 389 1 8 9 3 9 8 3 2 10 887 8 3 3 7 - 6 323 All o thers (US$ m illio n ) 341 - 1 100 - 3 451 8 35 4 9 9 0 - 1 637 C h an ge in reserves (US$ m illio n ) - 6 7 5 - 2 3 1 1 3 258 3 162 4 0 9 0 2 013 Total capita l in flo w s (US$ m illio n ) 10 4 8 4 2 879 10 100 15 659 18 694 14 325 W ith o u t FDI (US$ m illio n ) 7 864 - 1 233 4 752 1 0 1 5 6 14 148 - 8 3 4 0 Average spread over FRB 434 1 2 5 9 635 301 6 0 8 726 G row th o f m o n e y su p p ly (%) 11.6 - 1 . 8 14.4 12.3 - 0 . 9 - 2 . 9 External d eb t/ exports (%)* 5 4 0 .8 470 .1 4 6 1 .0 4 7 1 .3 5 3 0 .6 6 0 6 .9 External d eb t/ G DP (%)* 33 .3 3 8 .2 40 .3 42 .5 4 6 .9 50 .1 Terms o f trade in d ex (ann u al average) 101.5 101 .8 109 .8 108 .4 102.5 96 .4 GDP grow th (%) 5 .8 - 2 . 9 5.5 8.1 3 .9 - 3 . 0 Real exch a n g e rate (average 1 9 8 7 -9 0 = 100) 58 .6 66 .0 67 .9 66.1 64 .2 56 .6 * Outstanding public and private debt at year end, as a share of annual exports and annual GDP, respectively. Source: BBVA; IMF/EFI. hav in g fallen sharp ly since 1988. Two in te rp re ta tio n s can be m ade o f this: th a t convertib ility an d th e structu ra l reform s m en tio n e d above w ere able to correct th e lo n g -stand ing loss in o u tp u t per capita; a n d th a t g row th was relatively easy to achieve initially, due to th e significant gap betw een actual GDP an d p o ten tia l GDP.14 The g row th recovery in th e early 1990s a n d th e im pressive d rop in in fla ­ tio n w ere p robab ly th e m a in reasons w hy convertib ility a ttrac ted so m u ch a tte n tio n in th e in te rn a tio n a l econom y. H ow ever th e cu rrency bo ard had Ricardo Ffrench-Davis and Guillermo Larraín 255 pitfalls, m a in ly its d ependence o n in te rn a tio n a l cap ita l flows, a variable th a t w as far from th e sphere of in fluence o f th e dom estic au thorities . O n to p of th a t, vo la tility increased due to a rela tively new p h e n o m e n o n in th e in te rn a tio n a l econom y: financ ia l co n tag io n an d th e g lobaliza tion of financ ia l vo la tility (Ffrench-Davis an d O cam po, 2001). But co n tag io n attacks all coun tries m ore o r less equally, th e difference a m o n g th e m being th e d ifferential in econom ic fundam en ta ls an d th e capacity to correct them , particu larly w h e n th e y are m isaligned. A fixed exchange ra te system adds a n o th e r p o te n tia l risk, n am ely forced rea lignm en t, w h ich is n o rm ally p re ­ ceded by efforts to avoid it. In th is sense fixed exchange rate system s m ay am plify th e orig inal ex ternal shock. In Table 13.2 it is show n th a t in th e recession years, 1995 an d 1999, th e cap ita l flows to A rgentina decreased significantly. The o th e r side of th e coin was a sign ifican t increase in sovereign spread. Between 1994 an d 1995, as sta ted earlier, th e d ifferen tia l cost o f public sector borrow ing increased by 825 bp. After a sharp drop in 1996 an d again in 1997, d u rin g th e Asian crisis th e spread increased to 608 b p in 1998 an d 726 bp in 1999. In th e con tex t o f a n o p en cap ita l account, th is im plies an increase in th e dom estic cost o f borrow ing. T he reduced cap ita l inflow s an d th e h ig h e r cost of bo rrow ing resulted in a sudden h a lt in m o n ey supp ly grow th a n d tw o sign ifican t recessions, a relatively sh o rt o n e in 1995, w ith a loss o f 2.9 per ce n t in real GDP, a n d a qu ite long one in 1999-2000, w h en GDP fell by 4.0 per cen t. A rgentina an d U ruguay were th e on ly tw o Latin A m erican countries to suffer a dom estic recession in b o th th e financial crises.15 The crawling-band approach in Chile In th e early 1990s, in th e co n tex t o f m assive cap ita l inflow s, th e C hilean au tho rities iden tified tw o m ain priorities for m acroeconom ic m anagem en t, an d particu larly exchange rate policy. First, as th e econom y was p ro n e to h uge cycles16 it was crucial to achieve sustained m acroeconom ic stability. Second, it was v ita l to em phasize g row th as th e d o m in a n t criterion in policy m aking. This m e an t assigning exports a strategic role, in term s o f b o th expansion an d diversification. Several works, in c lu d in g those by C aballero an d C orbo (1990) an d ECLAC (1998: ch . 4), n o te th a t in o rder for exports to be an eng ine of grow th, m a in ta in in g th e level an d stab ility of th e real exchange ra te is crucial. The C hilean au thorities considered th a t th is could be placed in jeopardy if capital surges caused excessive exchange rate apprecia tion , an d th a t th e re w ou ld be greater fu ture vo la tility if th e d irec tion of n e t flows w en t in to reverse. In th e early 1990s th e au tho rities decided to regulate th e foreign exchange m arke t a n d cap ita l inflow s in o rder to p rev en t large m isa lignm en ts in th e real exchange ra te relative to w h a t th e y assum ed to be its long -te rm trend . 256 Latin American Exchange Rate Policies T he in te n tio n was to m ake long -te rm fu n d am en ta ls prevail over sho rt-te rm factors, based o n th e assu m p tio n th a t th e re was b ehav iou ra l asym m etry b etw een th e m arket a n d th e m o n e ta ry au tho rities : th e la tte r n eed ed a lo n g ­ te rm p la n n in g h o rizo n w h en seeking sustainab le m acroeconom ic stability, in co n tra st to p rivate agents, w ho opera ted m ore in ten siv e ly a t th e sh o rt­ te rm en d of th e m arke t a n d w ere rew arded w ith profits d u rin g th a t te rm . In o rder to deal w ith m arket uncerta in ty , ra th e r th a n se tting a u n iq u e price th e au tho rities u sed a craw ling b a n d cen tred o n a reference price th a t was linked to a basket com prising th e dollar, th e D eu tschm ark a n d th e yen, w eigh ted accord ing to th e ir share in C h ilean trad e .17 The cen tre o f th e b an d craw led accord ing to in fla tio n d ifferen tia l criteria, th u s fo llow ing a PPP rule ad ju sted by estim ates o f n e t p ro d u c tiv ity im p ro v em en ts in C hile. T he changes tak ing place in th e global financial m arkets, th e increasing in te rn a tio n a l approval o f C hile s econom ic policies, h ig h dom estic in te rest rates an d th e sm o o th tran s itio n to dem ocracy s tim ula ted a cap ita l in flow to C hile from m id 1990. This flow was earlier a n d relatively stronger th a n in o th e r em erging econom ies an d was quickly reflected in an apprecia ting real exchange rate. B eginning in Ju ly 1990, th e m arket ra te lay a t th e apprecia ted ex trem e of th e band . D uring th e follow ing m o n th s th e econom ic au thorities designed a new m acroeconom ic policy th a t, co n tra ry to th e fash ion am ong m ultila tera l in s titu tio n s a n d financial agents for across-the-board open in g o f th e capital account, was based o n th e p red ic tion th a t th e large ex ternal supply of financing was n o t sustainable an d th a t short-term factors affecting th e cu rren t accoun t, such as th e h ig h price of copper, w ou ld te n d to reverse in th e m ed ium te rm .18 The set o f policies th a t follow ed were designed to prov ide a p ru d en tia l m acroeconom ic en v iro n m en t in o rder to achieve sustainab le equilibria. In Ju n e 1991 a non -in te rest-bearing reserve req u irem en t o f 20 per cen t was im posed o n foreign loans. Reserves h a d to be m a in ta in ed a t th e cen tra l b an k for a m in im u m of 90 days an d a m ax im um of one year. C entral b an k p ro p o n en ts of a d irty float argued th a t th e prevailing rules, w ith a pure band , an increasingly active in fo rm al m arket a n d a m ore porous form al m arket, w ou ld lead to th e exchange rate m o v in g tow ards e ith er ex trem e of th e b a n d (it h a d already h it th e ceiling in 1989-90, an d th e floor la ter on). This p ro m p ted th e b an k to in itia te d irty floating in M arch 1992. T hereafter th e rate fluc tua ted w ith in a range of o n e to eigh t percen tage p o in ts above th e floor for several years, w ith th e b an k co n tin u in g to m ake purchases b u t also som e sales (overall th e re was a significant n e t accum ula­ tio n of reserves). In th e ensu ing m o n th s US in terest rates c o n tin u ed to decline, encouraged by th e recession th e U nited States was experiencing, w h ich p u t pressure o n C hiles C entral Bank. H ow ever th e C h ilean econom y was b o o m in g an d its GDP grow th ra te h ad risen in to tw o digits. For reasons of m acroeconom ic equilib rium th e cen tra l b an k decided to increase ra th e r th a n low er th e Ricardo Ffrench-Davis and Guillermo Larraín 257 dom estic in te rest rates. In o rder to m ake space for m o n e ta ry policy in th e co n tex t of c o n tin u ed capital inflows, th e reserve req u irem en t was tigh tened . In M ay 1992 it was raised to 30 per cen t an d was ex tended to tim e deposits in foreign currency, an d in 1995 to purchases of C hilean secondary ADRs by foreigners. The period over w h ich th e deposit h ad to be m a in ta in ed was ex tended to o n e year, regardless of th e m a tu rity o f th e inflow. P erm anen t m o n ito rin g was conducted in o rder to iden tify loopholes, w h ich w ere th e n closed. In general, evasion was qu ite lim ited (Zahler, 1998; Le Fort an d L ehm ann , 2000). The system of reserve requ irem en ts an d taxes o n foreign len d in g was d irected a t relative m arket prices. T he im plicit tax rate o n inflow s increased dram atically as m aturities shortened . For in stance by 1995, for inflow s w ith a one-year te rm it stood a t 4 per cen t, w hile for 90 day-term s it represen ted a cost o f 13 per cen t (Agosin a n d Ffrench-Davis, 2001). W ith th e ou tb reak of th e Asian crisis an d th e subsequen t scarcity of financial inflow s, th e reserve requ irem en t rate was reduced to 10 per ce n t an d th e n to zero in 1998. As a resu lt o f th e policy m ix im p lem en ted in 1990-94, p lus th e im proved te rm s of trade in 1995 after th e Tequila crisis exp loded in la te 1994 a n d its effects spread to A rgentina, C hile m a in ta in ed a solid ex ternal sector (a sm all deficit o n th e cu rren t account, a sustainable exchange rate an d a lim ited am o u n t of short-term ex ternal liabilities). Therefore th e across-the-board cut-off in liqu id fu n d in g for Latin Am erica d id n o t d am p en th e C hilean econom y. Towards m id 1995 cap ita l flows began to re tu rn to th e region, an d w ith special in ten sity to Chile. G iven th e expecta tions of currency app recia tion w h en th e Tequila shock was over, th e large in te rest rate d ifferential betw een th e peso a n d th e dollar gave foreign portfo lio an d sho rt-te rm investors a p rofitab le bet, in sp ite of th e price th ey h ad to pay for en terin g th e C h ilean financial m arket (in th e form of th e reserve requ irem en t). The tren d tow ards app recia tion could have been curbed by in tensify ing th e price restric tions o n inflow s (th a t is, increasing th e size of th e reserve requ irem en t; Le Fort an d L ehm ann , 2000). H ow ever th e au tho rities m ore or less m a in ta in ed th e in ten s ity of th e policy too ls th e y w ere using in 1996-97, an d a consequence cap ita l inflow s over­ w helm ed th e dom estic m arket. T he cen tra l b an k was un ab le to p rev en t a sign ifican t real app recia tion of th e peso a n d th is co n trib u ted to a w iden ing of th e cu rren t acco u n t deficit, w h ich clim bed to 5.7 per cen t of GDP in 1996-97 (Table 13.3). In th e nego tia tions for a free trade agreem ent w ith C anada th e C hilean authorities successfully defended th e m ain tenance of th e reserve requirem ent as a po licy too l to regulate financial inflow s. But th e general overoptim ism in dom estic an d foreign financial m arkets, th e w idespread ag reem ent th a t th e crisis h ad been left b e h in d an d th e risky te m p ta tio n to speed th e reduc­ tio n of dom estic in fla tio n w ith exchange-rate apprecia tion , w eakened th e policy of sustainable m acroeconom ic equilibria. 258 Latin American Exchange Rate Policies Table 13.3 Chile: capital flows, exchange rate and macroeconomic performance, 1990-2000 1 9 9 0 -9 5 1 9 9 6 -9 7 1 9 9 8 1 9 9 9 2 0 0 0 A ctual GDP grow th (%) 7.8 7.4 3 .9 - 1 .1 5 .4 P roductive cap acity grow th (%) 7.8 6 .8 7.3 5 .9 4 .2 In v estm en t ratio (% o f GDP) 26.1 31 .6 3 2 .2 26 .9 26 .6 In fla tion (%) 14.7 6.3 4 .7 2.3 4.5 C urrent acco u n t b a lan ce - 2 .5 - 5 . 7 - 6 . 2 - 0 . 2 - 1 . 6 (% o f GDP) Fiscal balan ce (% o f GDP) 1.8 2.1 0 .4 - 1 .5 0 .1 Terms o f trade (% o f GDP) 0 .2 - 1 . 4 - 3 . 0 0 .2 0 .0 N et capita l in flo w s (% o f GDP) 6.9 8 .0 2 .8 - 0 . 9 1.7 Real exch a n g e rate (1 9 8 6 = 100) 99 .5 8 1 .4 78 .0 82 .3 8 5 .9 Note: The terms of trade effect are expressed in current prices. Sources: Central Bank of Chile; Ffrench-Davis (2002). The au tho rities exchange-rate m an ag em en t d id n o t deter speculative inflow s after 1995. In spite o f th e ir form al adhesion to a craw ling b an d in 1996-97, in o rder to apprecia te th e b an d (beyond a form al b ro ad en in g of th e b an d to ± 12 .5 per cent), in 1997 th e au tho rities tinkered w ith th e w eights assigned to each currency, m aking th e peg to a currency basket rather th a n th e dollar less credible. In N ovem ber 1994 th e w eigh t of th e US dollar h ad been reduced from 50 per ce n t to 45 per cent, reflecting th e falling use of th a t currency in C h ilean trade. In January 1997 it was arb itrarily raised to 80 per cen t. Also, th e ex terna l in fla tion used to correct th e referential exchange rate was overestim ated by 10 percen tage p o in ts betw een 1995 an d 1997, generating considerable additional revaluation. Furtherm ore an annua l 2 per cen t app recia tion of th e reference ra te h ad been set in N ovem ber 1995, based o n th e assu m p tio n th a t C hilean p roductiv ity w ou ld grow faster th a n th a t of its m a in trad in g partners. T he Asian crisis n o tab ly w orsened te rm s of trade in 1998-99 an d Chile found itself w ith a n overvalued real exchange rate an d a deficit o n th e curren t acco u n t th a t was m ore th a n tw ice as large as th e average for 1990 -95 .19 C apital outflow s began in late 1997 an d accelerated in 1998-99, induc ing a n exchange rate dep recia tion in th e co n tex t o f a relative price co rrec tion process after th e sign ifican t m acroeconom ic im balance created in 1996-97. Since 1991 cap ita l outflow s h a d b een encouraged as a w ay of alleviating apprecia ting pressures o n th e exchange rate. Pension funds h ad b een allow ed to invest up to 16 per ce n t o f th e ir to ta l asset abroad, in gradual steps. H ow ever th e h ig h e r rates o f re tu rn o n financial assets in C hile th a n abroad an d expectations of peso apprecia tion h ad discouraged foreign in v estm en t by C hilean in s titu tio n a l investors. By m id 1997 p ension funds h a d invested m erely 0.5 per c e n t o f th e ir funds abroad. The ou tflow sped u p w ith th e Ricardo Ffrench-Davis and Guillermo Larraín 259 Asian crisis, w h en th e con tag io n to Chile reversed expectations from appre­ cia tion to deprecia tion . W ith in a sh o rt period th e ou tflow from p ension funds reached th e equ ivalen t o f 4.8 per cen t o f GDP. This w orsened Chiles ex ternal p osition an d was a n im p o rta n t source of th e sharp m o n e ta ry co n ­ trac tio n in 1998-99. The C entral Bank had been soft w ith th e apprecia ting pressures in 1996-97, b u t i t sharply repressed th e depreciating pressures a t th e en d of 1997, arguing th a t in an overheated econom y deva lua tion w ould be too in flationary . In Septem ber 1999, w h en th e econom y was already in reces­ sion, th e cen tra l b an k an n o u n c ed th e suspension of th e exchange ra te b an d to enable a substan tia l devalua tion u n d e r a freely floating rate. T he stabilizing p roperties of a b a n d em erge w h e n th e re is credibility in its param eters, nam ely th e level o f th e cen tral parity, th e rate of crawl an d th e band s w id th . The craw ling b a n d - th e in te rm ed ia te regim e in force in Chile u n til 1999 - gradually lost credibility due to its m ism anagem en t.20 Indeed th e lack of active in te rv en tio n to enforce th e band , th e various rea lign ­ m e n ts to th e cen tra l parity an d /o r th e w id th of th e b an d , a n d th e arbitrary changes in th e w eights used to determ ine th e central parity all gave th e signal th a t th e param eters could be changed a t w ill.21 Eventually th e m o n e tary au tho rities recognized th e n eed to correct th e excessively apprecia ted real exchange rate. The period o f active in te rven tion in capital inflow s an d th e m anagem en t of th e real exchange rate was correlated w ith a h ig h rate o f productive capacity u tiliza tion . The negligible gap betw een effective a n d p o te n tia l GDP achieved in 1991-97 proved to be a d e term in in g factor in th e sign ifican t increase in cap ita l fo rm atio n an d p o ten tia l GDP (Agosin, 1998). In fact th e in v estm en t ratio rose 10 p o in ts in 1990-98 com pared w ith 1982-89, a n d GDP grow th jum ped from 2.9 per cen t a year to 7 per cen t (Table 13.3). W ith th e recessive a d ju s tm e n t in 1999 a n d th e lack of v igorous recovery in 2000 -1 , th e in v e s tm e n t ra tio lo st n ea rly o n e h a lf o f its p rev ious gain. O ur in te rp re ta tio n is th a t th e in te n s ity of w h a t was a n u n av o id ab le d ow nw ard a d ju s tm e n t w as associa ted w ith th e d isequ ilib ria in 1996-97 , first th e excessive ap p rec ia tio n a n d th e n th e delay in a llow ing a d ep re­ cia tio n in 1998. T hereafter th e au th o ritie s failed to ex p lo it all th e positive features o f th e C h ilean eco n o m y th a t w ou ld allow m o v e m en t tow ards th e p ro d u c tio n fron tier, th u s en co u rag in g econom ic e m p lo y m e n t an d cap ita l fo rm a tio n . Mexico: the oldest floating exchange rate regime in Latin America T he ad o p tio n of a floating exchange rate regim e in M exico was th e ou tcom e o f a full-scale b alance o f p ay m en t crisis in D ecem ber 1994. Before th a t, since O ctober 1992, M exico h a d used an exchange rate b a n d in w h ich th e floor 260 Latin American Exchange Rate Policies was fixed in n o m in a l term s an d th e ceiling craw led daily. In spite of th e fact th a t th e econom y grew a t an average of on ly 3.8 per ce n t per year betw een 1989 an d 1993, M exico a ttracted a lo t o f a t te n tio n for tw o reasons. First, it becam e a lead ing co u n try in term s of p rivatization , w ith revenues of 3.3 per cen t o f GDP in 1991 an d 1992. Second, in 1993 M exico jo ined th e N o rth A m erican Free Trade A greem ent (NAFTA), an d th is led to its becom ing a m em ber of th e OECD. These tw o associations resulted in th e rap id liberal­ ization of capital flows. T he m arkets reacted positively to these events, as reflected in th e fact th a t 49 per cen t o f to ta l cap ita l inflow s to Latin Am erica w en t to M exico in 1990-93. O n average th e co u n try received US$23.6 b illio n per year, 83 per ce n t o f w h ich consisted o f flows o th e r th a n foreign d irect in v es tm en t (FDI). O n th e dom estic fron t, h igher expected re tu rns even tua lly led to a b oom in private expend itu re . As a result th e deficit o n th e cu rren t acco u n t rose from US$7 b illion in 1990 to US$30 b illion in 1994 an d th e real b ilateral exchange rate w ith th e U n ited States apprecia ted 30 per cen t in four years. A ccording to Ros (2001) th e M exican crisis was n o t th e ou tcom e of inconsistency in econom ic policy, n o r a self-fulfilling m echan ism . Instead h e p o in ts to (1) th e p a rt played by th e ill-conceived percep tion th a t th e shocks being faced by M exico - h igher in te rest rates in th e U nited States an d politica l tu rm o il a t h o m e - w ere tem porary , an d (2) percep tions of th e h igh cost involved in tig h ten in g m o n e ta ry policy in early 1994 or m odify ing th e exchange rate policy. These tw o considerations led th e g o v ern m en t to sell in te rn a tio n a l reserves an d increase th e issuance of do lla r-denom inated , short-term Tesobonos against th e peso -denom ina ted Cetes. Reserves fell from US$26 b illion in th e first quarte r o f 1994 to US$16.5 b illion th ree m o n th s later. The deb t n o t on ly changed d en o m in a tio n b u t th e average te rm sho rtened as well. US$28.6 b illion in Tesobonos w ere due to m atu re in 1995, 35 per c e n t o f th is d u rin g th e first qu arte r (Ros, 2001). G iven th e sta te of th e in te rn a tio n a l reserves, th is p u t th e co u n try in danger of defau lt an d eventually led to speculative attacks o n th e peso. The n ew go v ern m en t tried to change th e b an d by low ering th e ceiling by 15 per cen t, b u t it was to o late an d it was forced to q u it th e b a n d system . At th e sam e tim e in terest rates rocketed, m ark ing th e start o f th e severe an d costly Tequila crisis (Calvo an d M endoza, 1996).22 A ccording to C arstens an d W erner (1999) th e crisis h a d th ree aspects. First, short-term cap ita l inflow s encouraged an d financed th e overspend ing th a t caused th e ab o v em en tio n ed cu rren t accoun t deficit. Second, even if th e pub lic deb t a n d th e fiscal balance suggested a h ea lth y public sector, th e sh o rt m a tu rity o f th e stock o f g o v ernm en t deb t exposed th e c o u n try to a financial pan ic (ibid.) In th a t con tex t, an y dou b t ab o u t th e will of m arkets to co n tin u e ro lling over th e existing deb t w ou ld have caused an attack on M exicos ex ternal debt. Finally, a severe b ank ing crisis occurred. After th e exchange rate b a n d was ab an d o n ed an d a float was adop ted , th e re was an Ricardo Ffrench-Davis and Guillermo Larraín 261 ab ru p t deva lua tion of abou t 95 per cen t betw een just before th e crisis an d M arch 1995. To avoid th e in fla tionary consequences of th is devaluation , th e cen tra l b an k tig h ten ed m o n e ta ry policy by raising th e in te rest rate from 16 per cen t in D ecem ber 1994 to 86 per cen t th ree m o n th s later. Fiscal policy was tig h ten e d by 2.6 per cen t o f GDP in 1995. This co n trac tio n ary package resulted in a sharp recession in w hich GDP fell by 6.2 per cen t an d dom estic dem an d by 12.9 per cent. Just after th e crisis th e re was a b rief experim en t w ith m o n e ta ry targeting , b u t as in fla tion cam e dow n an d th e re was strong evidence of in stab ility in th e d em an d for m oney, th e cen tra l b an k started to set an n u a l in fla tio n targets (Ortiz, 2000). The m ain elem ents o f th e cu rren t fram ew ork are (1) th e m ed ium -term goal of reducing in fla tio n to th e in te rn a tio n a l level in 2003, w ith an n u a l in fla tion targets, (2) m o n e tary policy actions based o n an assess­ m e n t o f in fla tionary pressures, a n d (3) a tran sp a ren t system based o n th e pub lica tion of quarte rly in fla tion reports. A basic difference betw een M exico an d o th e r in fla tio n targeteers is th e form ers choice of policy in s tru m e n t. W hile m o st in fla tio n targeteers use th e sho rt-term in te rest rate, th e M exican cen tra l b an k uses a reserve opera ting procedure know n as th e co rto . This system causes sign ifican t short-term vo la tility in n o m in a l in te rest rates, lead ing to a m ore stable exchange rate an d hen ce a m ore stable in fla tionary env ironm en t. Between 1996 an d 2000 M exico en joyed a relatively prosperous period in w h ich GDP grow th averaged 5.3 per cent; how ever by 2000 th e econom y was clearly overheated . Indeed in th a t year GDP grew 6.9 per cen t, well beyond w h a t had b een estim ated, th e real exchange rate h ad apprecia ted 13 per cen t since 1997 an d th e deficit o n th e cu rren t acco u n t h a d m ore th a n doub led over th e sam e period, desp ite th e h ig h oil prices (Table 13.4). W ith regard to th e float, th is was n o t a pu re float as th e re was a com pli­ cated rule to regulate in te rv en tio n in th e foreign exchange m arket. The rule inc luded a tw o-pronged approach in w h ich a n o p tio n m echan ism was used to accum ulate reserves an d a co n tin g en t sale was used w h en th e cen tral b ank w an ted to m in im ize a sudden deprecia tion . This app roach was aim ed at figh ting peso apprecia tion an d accum ulating in te rn a tio n a l reserves. H ad th e cen tra l b an k in te rv en ed directly in th e spo t m arket th e ou tcom e w ould have b ee n m ore sim ilar to th a t achieved w ith a n exchange rate b a n d o r a soft peg. The m echan ism , n o w abandoned , was asym m etric in th a t it p u t greater em phasis o n stopp ing a sudden deprecia tion th a n o n stopp ing a sudden app recia tion (Galán e ta l . , 1999). This in te rv en tio n m echan ism an d M exicos surrender to in te rest rate vo la tility ra th e r th a n exchange rate vo la tility resu lted in M exico en joy ing a significant degree o f exchange rate stability. The ad o p tio n of th e floating regim e co incided w ith a period of h ig h an d relatively stable GDP grow th an d significant financial stability. Of course a substan tia l p a rt of th is was due to th e fact th a t M exicos largest trad in g partner, th e U n ited States, T ab le 1 3 .4 M exico: capita l flow s, real ex ch a n g e rate an d m a cro eco n o m ic p erform ance, 1 9 9 2 -2 0 0 0 1 9 9 2 1 9 9 3 1 9 9 4 1 9 9 5 1 9 9 6 1 9 9 7 1 9 9 8 1 9 9 9 2 0 0 0 Current acco u n t balance (US$ m illio n ) - 2 4 4 4 2 - 2 3 4 0 0 - 2 9 6 6 2 - 1 575 - 2 3 3 0 - 7 4 4 8 - 1 6 0 9 0 - 1 4 325 - 1 7 6 9 0 N et capita l in flo w s (US$ m illio n ) 2 6 1 8 7 30 632 12 465 - 1 4 735 6 190 21 447 19 300 18 6 0 2 2 4 8 0 0 C hanges in reserves (US$ m illio n ) - 1 173 - 6 0 5 7 18 398 - 9 648 - 1 8 0 6 - 1 0 5 1 2 - 2 138 - 5 9 2 - 2 8 2 4 GDP grow th (%) 3 .6 2 .0 4 .4 - 6 . 2 5 .2 6 .8 5.0 3 .8 6.9 Terms o f trade (1995 = 100) 105 .0 104.9 103.3 100 .0 102 .8 1 04 .0 100.4 102 .3 107 .4 Real ex ch a n g e rate (average 1 9 8 7 -9 0 = 100) 74 .0 70.3 72.1 106 .0 9 5 .4 83 .5 84 .0 76.7 71 .6 External d eb t/ GDP (%) 3 2 .0 3 2 .4 33 .2 57 .9 47 .3 3 7 .2 38.1 34 .7 2 5 .9 Source: ECLAC. 262 Ricardo Ffrench-Davis and Guillermo Larraín 263 experienced dynam ic grow th u n til 2000, w ith a substan tia l increase in im ports (particularly from M exico). The story changed sharp ly for b o th from late 2000. Concluding remarks In th e co n tex t o f th e m ore in teg rated w orld econom y, exchange rate policy is crucial as it is th e variable th a t links n a tio n a l prices to foreign prices. It also affects re tu rns in m a n y sign ifican t sectors o f th e econom y, such as th e p ro d u c tio n of exportables. Also, being an in te rn a tio n a l b en ch m ark it acts as a gauge to dom estic investors, an d also affects shadow prices. T he review in th is chap te r o f th e A rgentinean, C h ilean an d M exican experiences show s th a t a policy th a t is su itab le in on e m acroeconom ic e n v iro n m en t m ay n o t be so in another. Each exchange rate system has its ow n logic an d requires m easures to en h a n ce its credibility. In th is sense, a crucial p o in t to bear in m in d w h en ad o p tin g a n exchange rate policy is th e cost o f sw itch ing to a n a lternative policy if it fails. H ow ever in som e cases, public discussion o n an exit strategy m ay h ave a negative effect o n th e credibility o f th e policy, for exam ple in fixed exchange ra te regim es. C redible pegged system s p rom ise greater (nom inal) financia l stability, an d to som e ex ten t th a t was th e case in A rgentina du rin g th e period exam ­ ined . But th e requ ired co m p lem en ta ry po licy is h ig h price-level flexib ility in o rder to ad ju st to negative real shocks by cu ttin g prices. T he long-te rm cred ib ility of th is system there fo re depends o n h ig h flexibility in th e labour m arket a n d an active fiscal po licy to respond adequate ly to negative shocks. W ith o u t these m easures, pegged system s are p ro n e to greater real sector volatility . Floating system s induce m ore real stability b u t a t th e price of increased financial instability . There m ay also be a cost in term s of g row th as th e real exchange rate loses pow er to allocate resources, in w h ich case it is necessary to consider th e use of o th e r policy in stru m en ts to p ro m o te exports, such as tech n o lo g y policy, trade policy an d so on. F loating system s are useful in tim es of financial distress w h en th e au tho rities have doub ts ab o u t th e level o f th e real exchange rate, th e n a tu re of th e shock th e y face an d th e ir response to it, as flo ta tion enables th e m to avoid jeopard izing th e ir rep u ta ­ tio n by defend ing th e w rong exchange rate. Finally, bands are useful in tim es of n o rm ality w h en th e re are n o large shocks o n th e horizon . In th is s ituation , bands help to stabilize th e n o m in a l exchange rate an d hen ce th e real exchange rate, w h ich has a positive effect o n exports an d grow th. But b an d s are o f less use if a large shock occurs an d th e au tho rities fail to m ake a p ro m p t an d adequate response, because th ey o p en th e w ay to speculation a n d significant financial instability . Probably th e best policy here is active in tram arg ina l in te rv en tio n w ith in th e band . In te rv en tio n is likely to be m ore effective w h en th e exchange rate is kep t far 264 Latín American Exchange Rate Policies from th e edges of th e b an d (M undaca, 2000). This suggests th a t th e re m ay be som e op tim al b a n d w id th , as th e C h ilean experience shows. C orner so lu tions d o n o t have sym m etrical consequences. E xchange rate policy m akes a d ifference w h en significant capital surges occur an d sub­ sequen t shocks cause a sudden reversal o f th e flows (W illiam son, 2000; Ffrench-Davis an d O cam po, 2001). M ost significant increases in th e supply o f ex ternal financ ing are n o t one-off events b u t a process th a t takes tim e, as in 1977-81, 1990-94 a n d 1996-97. W hen cap ita l inflow s occur th e cu rren t acco u n t deteriorates, asset prices increase an d th e real exchange rate app re­ ciates. D ifferent exchange rate policies deliver different com binations of these th ree elem ents. W ith pegged system s, an upw ard surge in foreign capital flows creates a d em an d boom , w ith consequences for asset prices, probably a crow ding o u t o f dom estic savings an d a w orsening of th e ex terna l balance. In fla tion in non-tradab les m ay lead to real apprecia tion . W ith floating regim es a n o m in a l app recia tion will take place, m ak ing th e process of real apprecia tion faster (and h en cefo rth po ten tia lly m ore d isruptive if th e increased liqu id ity is transito ry) th a n w ith th e pegged system . In fact w h en th e force b e h in d th e cap ita l surge is external, sm all econom ies m ay suffer from significant overvaluation . Pegs te n d to w ork be tte r in th e upw ard phase of th e cycle, b u t after th e peak th e float does b e tte r in te rm s of th e necessary expend itu re sw itching. As show n by W yplosz (1999) an d Ros (2001), in th is type of cycle th e re is th e possibility o f m ultip le equilibria based o n self-fulfilling beliefs: expec­ ta tio n s of m ore inflow s (outflows) m ay fu rth e r apprecia te (depreciate) an already apprecia ted (depreciated) currency. Exchange rate in stab ility is n o t costless, an d large dev ia tions from th e equ ilib rium level by th e real exchange rate are n o t costless either. Exports, in term s of b o th g row th a n d d iversification , b enefit from stable en v ir­ o n m e n ts (ECLAC, 1998: ch . 4). Therefore exchange rate po licy faces tw o challenges w h en a ttem p ts are b e in g m ade to im prove overall g row th p er­ form ance: th e need to m axim ize real exchange rate stability w ith o u t pegging th e currency, an d th e n eed to avoid sign ifican t cu rrency m isalignm ents , th a t floating does n o t im pede. Bands, th e obvious so lu tion , m ay address b o th b u t th e y are sensitive to large shocks.23 Irrespective of th e policy adop ted , cen tra l banks m u st concern them selves w ith b o th th e level an d th e stab ility o f th e exchange rate . In th is respect, a n d desp ite w h a t has h ap p e n ed since th e Asian crisis, craw ling bands are still an o p tio n to consider. Latin A m erican financial in strum ents suffer from at least tw o shortcom ings. O ne is linked to th e in s tru m e n ts them selves, in th a t th e y lack con tingency m easures to deal w ith th e shocks th a t are co m m o n in Latin A m erican co u n ­ tries. The o th e r is linked to th e m arkets, w here th e re is a lack o f sustainable foreign d em an d for in stru m en ts d en o m in a ted in local currencies. M acro- econom ic policies m ay expand in term s of addressing b o th in stru m en ts an d Ricardo Ffrench-Davis and Guillermo Larraín 265 m arkets, b u t it is n o t clear a t all th a t coun tries will be able to do b o th th ings in sign ifican t ways in th e sh o rt term . In th e cu rren t phase of th e cycle, w h en th e re is a sign ifican t shortage of capital inflows, m an y countries in Latin America have m oved tow ards across- the-board liberalization of th e capital account. However policy m akers will need to take care w h en th e cycle m oves in to th e n ex t phase. Recent experi­ ence in em erg ing econom ies show s th a t th e b ehav iou r of cap ita l inflow s can be in co n sis ten t w ith m acroeconom ic sustainability , particu larly in term s of th e stability o f th e exchange rate an d econom ic activity. Therefore th e au tho rities need to follow closely th e developm ents in various m arkets an d have flexible policy packages ra th e r th a n single, rigid policy tools. N otes * W e ack n ow led ge th e c o m m e n ts m a d e b y Am ar Bhattacharya, S teph an y G riffith- Jones, José A n to n io O cam p o, A vinash Persaud, H elm ut R eisen, R ogerio Studart an d H eriberto Tapia. All rem a in in g errors are our responsib ility . T he o p in io n s expressed in th is chapter are th o se o f th e au th ors and d o n o t n ecessarily reflect th o se o f ECLAC or th e BBVA. 1. See Fischer (2001) an d Levy an d Sturzenneger (1999) for a c la ssifica tion o f ex ch a n g e rate regim es. 2. For a recent d iscu ssio n o f th e sources o f v o la tility in Latin A m erican eco n o m ies, see Rodrik (2001). 3 . This b eco m es ev id en t w h e n w e con sid er A rgentina in 200 1 . 4. H ow ever w e h a v e n o t co n tro lled for th e degree o f overva lu ation o f th e ex ch a n g e rate in each country. Because in A rgentina th e exch an ge rate w as u sed exp lic itly as an anti-in fla tion ary dev ice and it appreciated sharply in 1 9 9 1 -9 2 , th e required fall in d o m estic prices an d w ages w as greater th a n th a t w h ic h e ffe c tiv e ly to o k p lace. 5. T his d o es n o t tack le th e p rob lem p o sed b y th e n eg a tiv e effect o f real ex ch a n g e rate in sta b ility o n th e p ro d u ction o f tradables an d th e d iversification o f exports. See C aballero an d C orbo (1990) an d ECLAC (1998). 6. A recent m o v e in th is d irection has in v o lv ed C hile . There h a v e b een tw o b o n d issues, o n e b y th e IADB an d th e o th er b y th e g o v ern m en t o f U ruguay in instru­ m en ts d en o m in a ted in C h ilean p esos in d ex ed to C h ilean in fla tio n . 7. C h ile d ev e lo p ed an e ffic ien t p roxy b y esta b lish in g a copper stab iliza tion fund . O ther cou n tr ies h a v e a lso u tilized funds, su ch as th e Fondo C afetero in C o lom b ia , an d th e o il stab iliza tion funds in M exico an d V enezuela. 8. Real ex ch a n g e rate m isa lig n m en t can a lso occur in d ev e lo p ed eco n o m ies , for e x a m p le th e h u g e sw in gs o f th e US dollar in th e 199 0 s an d its sharp appreciation v is -à -v is th e euro sin ce 1998 (W illiam son , 2 0 0 0 ). For em erg in g eco n o m ies , see Ffrench-D avis an d O cam p o (2001). 9. C ou n tries n o t in c lu d ed in th e sam ple w ere a lso subject to co n ta g io n , in c lu d in g Peru an d Uruguay. 10. T he title ch o se n b y Braga e t a l. (2001), D o n t F ix , D o n ’t F lo a t, is in lin e w ith th is sort o f argum ent. 11. T his proposal is co n sis te n t w ith th e c o n te n t an d title o f Frankel (1999). 12. In th e m ea n tim e th e real ex ch a n g e rate appreciated sharply, th e d eficit o n th e current acco u n t rose an d gross capital form a tio n recovered o n ly m o d e stly (Frenkel e t a h , 1998). 266 Latin American Exchange Rate Policies 13. M ost o f th e p rivatized co m p a n ie s b e lo n g ed to th e non -trad ab le sector. In th ese firm s, average p rod u ctiv ity per w orker rose after privatization . T he lin k to real ex ch a n g e rate is becau se - contrary to th e B alassa-Sam uelson effect, in w h ic h n et p rod u ctiv ity grow th in th e tradable sector causes a real app reciation o f th e currency - th e tran sm iss ion m ech a n ism w as a red u ction in th e real cost o f th e services p rod u ced b y th o se com p an ies. T his p rod u ctiv ity ga in d o es n o t con sid er th a t all u n e m p lo y e d h ad zero p roductiv ity . As su ch overall p rod u ctiv ity grow th , w h ic h takes a cco u n t n o t o n ly o f em p lo y ed p eo p le b u t o f all th e labour force, increased b y m u c h less. 14. In fact an n u a l grow th in 1 9 8 8 -2 0 0 0 w as a m ere 2 .3 per cen t. It can b e assum ed th a t th e gap b e tw een e ffective an d p o ten tia l GDP in 1991 w as q u ite large. 15. Several LACs exp er ien ced a recessive gap (The gap b e tw een effectiv e a n d p o te n ­ tia l GDP), but a b so lu te GDP k ep t rising. Average GDP grow th drop p ed from 5 .2 per cen t in 199 4 an d 199 7 to 1.1 per ce n t in 1995 an d 0 .3 per cen t in 1999 . 16. In 1975 an d 198 2 C h ile h ad exp erien ced th e sharpest recession s o f all Latin A m erican countries; see F french-D avis (2002: ch s 1, 6). 17. C h ile w as a p io n eer in im p le m e n tin g ex ch a n g e rate p o lic ies based o n th e various craw ling-peg approaches (W illiam son , 1981). T h is h a p p en ed b etw een April 1965 an d July 197 0 . Subsequently , from O ctober 1973 to June 197 9 , a seco n d experi­ m e n t o f th is k in d w as carried o u t. In th e 1980s, after th e 1982 crisis, a craw ling p eg w as rein stated an d th is e v o lv ed in to a craw lin g b an d , w h ic h c o n tin u e d u n til Septem ber 1999 (Ffrench-D avis, 2002: ch s 4, 10). 18. In ad d itio n C h ile w as c o m in g o u t o f a p ro fo u n d debt crisis, w h ic h h a d b een acco m p a n ied b y sharp ex ch a n g e rate d ep reciation . C o n se q u en tly there w as room for so m e eq u ilib ra tin g ap p recia tion . H ow ever as agents ex p ec ta tio n s ch an ged from p ess im ism to o p tim ism , th e y so u g h t a n e w stock o f in v e stm e n t in th e em ergin g m arket over a sh ort period o f tim e . T his im p lied ex cessiv e ly large tran­ sitory in flow s. 19. A n en larged d efic it o n th e current a cco u n t in 1 9 9 5 -9 7 , ad justed b y th e trend in th e term s o f trade, w as p ro o f o f an o verly appreciated ex ch a n g e rate th a t ad justed faster th a n p rod u ctiv ity im p ro v em en ts. W e c o n te n d th a t th e actual appreciation in 1 9 9 0 -9 4 h a d b een eq u ilibratin g (g iven th e m oderate d efic it o n th e current acco u n t an d an ap p reciation th a t w as softer th a n in all o th er em erg in g Latin A m erican cou n tr ies). See F french-D avis (2000: ch . 10). 2 0 . T he band an d its cen tre h a d b een cred ib le for a lo n g tim e. M agen d zo e t a l. (1998), u sin g data u n til 1997 , before th e A sian crisis reached C hile , f in d th a t cred ib ility in th e b an d h a d decreased , b u t th e y d o n o t q u a n tify th e degree o f cred ib ility that h ad ex isted prior to th a t tim e. 21 . A ccording to K rugm an (1991) there is ex o g e n o u s full cred ib ility in th e bands param eters w ith o u t in tram arginal in te rv en tio n . T he ‘h o n e y m o o n e ffe c t’, tha t is, stab iliz in g sp ecu la tion , appears becau se o f su ch credib ility . In practice cred­ ib ility an d rep u ta tio n n eed ed to b e b u ilt u p b y th e centra l bank . Intram arginal in te rv en tio n d irected at en forc in g th e lim its o f th e b an d w as crucial as w ith o u t it sp ecu la tion w o u ld te n d to b e destab iliz ing . 22 . Larrain e t a l. (2000) sh o w th a t cred it risk a gen cies a lso fa iled to p lay a co u n ter­ cyclical role. T he m ain tw o agencies dow ngraded their rating o n ly after th e devalu ­ a tio n to o k p lace. 23 . W yp losz (1996), c o m m e n tin g o n a paper b y Leiderm an (1996), states th a t th e argum ents in favour o f b an d s w ere so stron g th a t it w as d ifficu lt to b e sceptical ab ou t it. H ow ever h e m e n tio n s so m e o f th e e lem en ts th a t u ltim a te ly led bands Ricardo Ffrench-Davis and Guillermo Larraín 267 in to trouble, a m o n g w h ic h w as th e lev e l o f th e band, th a t is, h o w it co u ld cop e w ith ch an ges in th e real ex ch a n g e rate (for exa m p le in resp onse to a shock) tha t lay b ey o n d th e lim its o f th e band. References A gosin , M. R. (1998) Capital In flow an d In vestm en t Perform ance: C h ile in th e 199 0 s’, in R. Ffrench-D avis an d H. R eisen (eds), C a p ita l In f lo w s a n d In v e s tm e n t P e rfo rm an ce : Lessons fro m L a t in A m e ric a , Paris an d Santiago: ECLAC an d OECD D ev e lo p m en t C entre. an d R. F french-D avis (2001) M anaging C apital In flow s in C h ile , in S. G riffith- Jon es, M . F. M on tes an d A. N a su tio n (eds), S h o rt-T e rm C a p ita l F lo w s a n d E co n o m ic C rises, Oxford: O xford U n iversity Press for UNU/W IDER. Braga d e M acedo, J., D . C o h en an d H. R eisen (2001) M onetary In tegration for Sustained C onvergence: Earning Rather T han Im p orting C redib ility, in D o n t F ix , D o n t F lo a t, Paris: OECD D ev e lo p m en t C entre. C aballero, R. (2001) M a cro e co n o m ic V o la t i l i t y in R e fo rm e d L a t in A m e ric a , W ash in gton , DC: IDB. an d V. C orbo (1990) The Effect O f Real E xchange Rate U n certa in ty o n Exports: Em pirical E vidence, The W o r ld B a n k R eview , 3, W ash in gton , DC: W orld Bank. C alvo, G. A. an d E. G. M en d oza (1996) Petty C rim e an d C ruel P un ishm en t: Lessons from th e M exican D ebacle, A m e r ic a n E c o n o m ic R eview , 86 , 2 (M ay). C arstens, A. an d A. W erner (1999) M exicos M on etary P olicy Fram ew ork U nder a F loating E xchange Rate R egim e, B anco d e M éx ico W orking Paper n o . 9 905 , M exico City: B anco de M éxico . ECLAC (1998) P o lic ies to Im p ro v e L in ka g es w ith the G lo b a l E co n om y, Santiago: F ondo de C ultura E conóm ica an d ECLAC. Ffrench-D avis, R. (2000) R e fo rm in g th e R eform s in L a t in A m e r ic a : M acroeconom ics , Trade, F in an ce , L on d on and N ew York: M acm illan an d St M artins Press. (2002) E c o n o m ic R e fo rm s in C h ile : F ro m D ic ta to rs h ip to D em o cra cy , A n n Arbor, MI: U n iversity o f M ich igan Press. and J. A. O cam p o (2001) The G lob a liza tion o f F inancial V olatility , in R. Ffrench- D avis (ed.), F in a n c ia l C rises in Successfu l E m e rg in g E conom ies, W ash in gton , DC: B rookings Institution/EC LA C . Fischer, S. (2001) E xchange Rate Regim es: Is T he Bipolar V iew Correct?’, J o u rn a l o f E c o n o m ic Perspectives, Spring. Frankel, J. A. (1999) ‘N o Single C urrency R egim e Is R ight for All C ountries or at All Tim es, Essays in In te rn a t io n a l F inance , 215 , Princeton , NJ: P rinceton U n iversity Press. Frenkel, R., J. M. Fanelli and C. M o n v ecch i (1998) C apital F low s an d In vestm en t P erform ance in A rgentina, in R. F french-D avis an d H. R eisen (eds), C a p ita l F lo w s a n d In v e s tm e n t P e rfo rm an ce : Lessons fro m L a t in A m e ric a , Paris: OECD/ECLAC. G alán, E., G. D uclau d and J. Garcia (1999) U na Estrategia d e A cu m u lac ión d e Reservas M ed ian te O p cion es d e V enta de Dólares: El C aso D e M éx ico ’, m im eo , M ex ico City: B anco de M éxico . Krugm an, P. (1991) Target Z ones an d E xchange Rate D yn am ics, Q u a rte r ly J o u rn a l o f E conom ics , 56 , 3: 6 6 9 -8 2 Larraín, G. an d C. W inograd (1997) ‘P rivatisations M assives: le Cas de lA rgentine et d u C h ili’, Revue E co n om iq ue , 47 , 6: 1 3 7 3 -1 4 0 8 . H. R eisen an d J. v o n M altzan (2000) ‘Em erging M arket Risk an d Sovereign Credit R atings’, in H. R eisen (ed .), P ensions, C a p ita l F lo w s a n d A g e in g , N orth am p ton : Edward Elgar. 2 6 8 Latin American Exchange Rate Policies Le Fort, G. an d S. L eh m an n (2000) El Encaje, lo s Flujos de C apita les y el Gasto: u n a E valuación E m pírica’, W orking Paper n o . 64, Santiago: B anco C entral de C hile, February. Leiderm an, L. (1996) E xchange Rate Bands: th e Case o f Israel, in R. H au sm an n and H. R eisen (eds), Shock P rone E conom ies, Paris: OECD D ev e lo p m en t C entre. Levy, E. and F. Sturzenneger (1999) C lassify ing E xchange Rate Regim es: D eeds vs W ords, m im eo , B u en os Aires: U niversidad Torcuato di Telia. M agen d zo , I., P. Rojas an d R. Vergara (1998) Bandas Cam biarías: E xperiencia C h ilen a , 1 9 9 0 -1 9 9 4 , in F. M orandé an d R. Vergara (eds), A n á lis is E m p ír ic o de l T ip o de C a m b io en C h ile , W ash in gton , DC: G eorgetow n U niversity, C entro d e E studios P úb licos and ILADES. M undaca, G. (2000) ‘T he Effect o f In terv en tio n s o n R ealign m en t Probabilities, J o u rn a l o f In te rn a t io n a l F in a n c ia l M a rk e ts , 10. Ortiz, G. (2000) C om m entary: H o w S hou ld M on etary P olicym akers React to th e N ew C h allen ges o f G lobal E co n o m ic In tegration , m im eo , M ex ico City: B anco de M éxico. Rodrik, D. (2001) W h y Is There So M uch E con om ic Insecurity in Latin Am erica, E C L A C R eview , 73 (April). Ros, J. (2001) From th e C apital Surge to th e F inancial Crisis an d Beyond: th e M exican E con om y in th e 1990s, in R. F french-D avis (ed.), F in a n c ia l C rises in Successful E m e rg in g E conom ies, W ash in gton , DC: Brookings Institution/EC L A C . W illiam son , J. (ed .) (1981) T h e C ra w lin g -p e g , L ondon: M acm illan. (2000) E xchange Rate R egim es for Em erging M arkets: R eviv in g th e In term ediate O p tion , P o lic y A n a lyse s in In te rn a t io n a l E conom ics , 60 , W ash in gton , DC: In stitu te for In tern ational E conom ics, Septem ber. W yp losz, C. (1996) C o m m en t, in R. H au sm an n an d H. R eisen (eds), Shock P rone Econom ies, Paris: OECD D ev e lo p m en t C entre. (1999) ‘In tern ation a l F inancial Instability, in I. Kaul, J. G runberg an d M . Stern (eds), G lo b a l P u b lic Goods, N e w York: O xford U n iversity Press. Zahler, R. (1998) The C entral Bank an d C h ilean M acro eco n o m ic P olicy in th e 1990s, C EPAL R eview , 6 4 (April). 1 4 Countercyclical Fiscal Policy: A Review of the Literature, Empirical Evidence and Some Policy Proposals* Carlos Budnevich Introduction At th e b eg in n in g o f th e 1990s th e U nited States experienced a recession, b u t th e US governm ents large budget deficit d id n o t allow th e use of a d is­ cre tionary countercyclical fiscal po licy to stim ula te th e econom y. W ith th e e lim in a tio n of budget deficits in recen t years, th e use of d iscre tionary fiscal policy has re-em erged. In fact, in th e face of an econom ic d o w n tu rn th e U nited States recen tly enacted a tax reform th a t reduced tax rates. Sim ilarly in C hile a law to reduce personal incom e tax rates has b een approved by th e g o v ern m en t in o rder to cool aggregate d em an d an d im prove efficiency. B oth coun tries have considered exp an d in g th e ir fiscal expend itu re to accelerate th e ir econom ic recovery. D iscretionary countercyclical fiscal po licy again appears to be a feasible op tion . Over th e last decade m an y of th e w orld s cen tra l banks have changed th e ir procedure for co n d u c tin g m o n e ta ry policy. Decisions o n th e n a tu re of m o n e ta ry policy have becom e m ore explicit, m ore tran sp a ren t, m ore system atic an d m ore sensitive to changes in in fla tion . In th e case of th e U n ited States, C hile an d several o th e r countries, these new policies have been very effective in reducing in fla tion , a lth o u g h th e ir effect o n th e stability of th e real econom y du rin g dow n tu rn s has b een questioned . The ap p ro p ria te m acroeconom ic ro le o f fiscal po licy w h e n m o n e ta ry po licy is system atically an d s trong ly reacting to changes in in fla tio n is ev iden t: to susta in pub lic acco u n ts a n d p lay a coun tercyclical role. The task of coun tercyclical m o n e ta ry po licy can b e described as try in g to keep real GDP n ea r p o te n tia l GDP w h e n in fla tio n is o n target. O f course w ith th e effects of a ch an g e in m o n e ta ry po licy occu rring w ith lo n g an d v ari­ able lags, th e cen tra l b a n k m ig h t n o t be able to m a tch aggregate d em an d w ith p o te n tia l GDP rap id ly en o u g h to p rev e n t in c ip ie n t in fla tio n from beco m in g a reality. 269 270 Countercyclical Fiscal Policy There is som e controversy abou t w h e th e r cen tra l bankers shou ld try to ad just in te rest rates in order to change aggregate d em an d in th e way described here. This issue has b ro u g h t to th e debate th e possib ility of using fiscal policy as a countercyclical device. W h en discussing fiscal po licy issues a d is tin c tio n shou ld be m ade betw een d iscre tionary changes in taxes an d spending, an d changes in taxes an d spend ing due to au to m atic stabilizers, such as increased spend ing o n u n em p lo y m e n t benefit a n d th e decrease in tax revenue caused by reductions in incom e du ring a recession. B oth types o f change in taxes a n d spend ing affect aggregate dem and , b u t th e au to m atic ones m ay be m ore pred ic tab le an d w ork m ore quickly th a n th e discre­ tio n a ry ones. This chap te r discusses d iscre tionary countercyclical m o n e ta ry an d fiscal policies. It analyzes th e role o f au tom atic stabilizers in fiscal policy, an d reviews concepts, m easurem ents an d m ethodo log ical issues to assess th e stance of fiscal policy. It th e n analyzes fiscal policy reactions to ex ternal shocks, pub lic an d ex ternal f inance an d th e econom ics of stab ilization funds in coun tries w hose exports consist m ain ly of vo la tile com m odities. An analysis o f th e role o f fiscal policy in Latin Am erica follows, in c lu d in g C hiles recen t experience w ith fiscal policy. N ext, som e proposals for fiscal reform are discussed. The macroeconomic role of discretionary countercyclical monetary and fiscal policy Fiscal po licy has tw o m acroeconom ic objectives: to sustain pub lic accounts an d to regulate aggregate dem and . It is m ore or less ev iden t th a t policy efforts have co n cen tra ted o n th e first objective, leav ing th e stabilizing role to m o n e tary policy. Sustainability o f pub lic d eb t im plies keep ing th e long -run solvency of th e go v ern m en t so as to satisfy its in te rtem p o ra l budget constra in t. Public deb t financing o f pub lic deficits is sustainab le if in te rest rates are low er th a n th e g row th of th e econom y. W h en in terest rates exceed GDP g row th th e persist­ ence of a p rim ary deficit leads to an explosion of pub lic debt, endangering th e solvency of th e public sector. U nder trad itio n a l Keynesianism , fiscal policy m u st r a n surpluses u n d er full em p lo y m en t a n d allow for deficits du ring recessions. M acroeconom ic stab ilization requires sym m etric, countercyclical regu la tion of aggregate dem and . K eynesianism differs from th e neoclassical view in th e reco m m en ­ d a tio n of m ore active policies, resu lting in m ore p ro n o u n ce d fluctuations in fiscal accounts b u t always w ith a n u ll resu lt o n average in th e cycle. Strict fiscal d iscip line in n o rm al circum stances is requ ired to preserve th e ability to in tervene w hen adverse econom ic events occur. Fiscal discipline and flexibility are tw o fu n d am en ta l p rincip les of budget policy u n d e r econom ic globalization. Fiscal discipline is essential to th e credibility o f m acroeconom ic Carlos Budnevich 271 policy, w hile flexibility is needed to face unexpected shocks in a h igh ly vo la tile econom ic en v iro n m en t. If fiscal policy can sh ift aggregate d em an d an d change real GDP in th e sh o rt term , how shou ld th is pow er be used? From a norm ative perspective, a reasonable countercyclical goal of fiscal po licy will b e th e sam e as th a t of m o n e ta ry policy: to keep real GDP close to p o ten tia l GDP w h en in fla tion is o n target. H ow ever countercyclical fiscal po licy m ay n o t be needed if a cen tra l b an k w isely uses its pow er to m ove th e aggregate d em an d curve to try to keep real GDP in line w ith p o ten tia l GDP. H ow ever th is m ay n o t be th e case for em erg ing m arkets th a t are sub ject to sizeable shocks to th e term s of trade a n d th e capital account, an d w here the re are frequen t ex ternal financing constrain ts. In fact using b o th policies in a com plem entary m an n er m ay b e tte r d istribu te th e b u rd en of th e ir effects betw een d ifferen t m arkets. As argued by Taylor (2000) n o t all recen t developm ents suggest a sm aller role for d iscre tionary fiscal policy. If m o n e ta ry policy targets in fla tio n a t a rate near zero th e re is a risk th a t th e sho rt-term in terest rate will approach its low er b o u n d of zero in a recession.1 W h a t can an d shou ld cen tra l banks do to stabilize o u tp u t a n d em ploy­ m en t? A ccording to King (1999) th e u n ce rta in effect o f m o n e ta ry policy o n real variables - o rig ina ted in transm ission m echan ism s th a t are n e ith e r sufficiently well u n d ersto o d n o r sufficiently stable over tim e - pu ts a co n ­ siderable co n s tra in t o n th e ab ility o f cen tra l banks to target real variables. This leads to th e conclusion th a t m o n e ta ry policy shou ld focus o n keeping in fla tio n close to its ta rge t a n d n o t o n fin e tu n in g o u tp u t.2 A ccording to Taylor (2000), w h en m o n e ta ry policy reacts to th e sta te of th e real econom y, expecta tions th a t m o n e ta ry policy is try in g to exp lo it th e Phillips curve m ay develop, reducing its credibility a n d its scope to respond . To recover credibility, m o n e ta ry po licy shou ld focus en tire ly a n d public ly o n reacting to in fla tion , so th a t th e cen tra l b an k can develop a strong rep u ta tio n as an in fla tion fighter, w hile fiscal policy shou ld focus o n th e countercyclical job of keep ing real GDP close to p o ten tia l GDP. Experience has show n th a t, w ith th e excep tion of au to m atic fiscal stabil­ izers, im p lem en ta tio n lags are m u c h sho rte r for m o n e ta ry po licy th a n for fiscal policy, w h ich pu ts legislated changes in fiscal policy a t a d isadvantage as countercyclical tools. The cen tra l b an k can m ake ad ju stm en ts in in te rest rates relatively quickly - all th a t is needed is a board m eetin g an d a vote, an d th e n to convey th e decision to th e trad in g desk, w here th e sho rt-term in terest rate is changed. F urtherm ore th e use of trad itio n a l d iscre tionary fiscal po licy can m ake th e job of a fully au to n o m o u s cen tra l b an k m ore difficult, because of th e need to spend tim e forecasting th e size of fiscal proposals an d d e term in in g th e p robab ility th a t such proposals will be passed. This can be coun tered w ith strong day-to-day co o rd in a tio n an d in fo rm atio n exchanges betw een b o th in stitu tions. 272 Countercyclical Fiscal Policy O ne w ay of overcom ing th e lack of tim eliness an d pred ic tab ility of cu rren t fiscal policy is to give th e governm ent, in co n su lta tio n w ith th e cen tral bank, th e au th o rity to raise o r low er th e value-added tax (VAT) rates an d pen sio n fu n d co n trib u tio n s, o r to accelerate o r decelerate certain public spending. The role of automatic stabilizers in fiscal policy Econom ic fluctuations have a significant effect o n pub lic accounts. Fiscal au to m atic stabilizers are defined as public earnings an d expenses th a t are directly linked to th e econom ic cycle. A utom atic stabilizers are those elem ents of fiscal policy th a t te n d to m itigate o u tp u t fluctuations w ith o u t an y explicit governm en t action . They inc lude all co m p o n en ts o f th e g o v ern m en t budget th a t act to offset fluc tua tions in effective d em an d by reducing taxes an d increasing g o v ern m en t spend ing du ring a recession, a n d do in g th e opposite du ring an expansionary cycle. Perhaps th e m ost com m o n ly analyzed au to ­ m atic stabilizer is incom e tax, w hich reduces th e m ultip lie r effects of d em and shocks th ro u g h th e m arg inal ta x a tio n of incom e fluctuations. A progressive incom e tax w ith h ig h m arg inal rates can substan tia lly reduce fluctuations in after-tax incom e an d private spend ing w ith o u t th e n eed for explicit discre­ tio n ary policy changes. M oreover au tom atic stabilizers avoid th e im p lem en ­ ta tio n tim in g problem s th a t cause d iscre tionary policy to lag b e h in d events. A utom atic stabilizers m u st be triggered by a shock th a t causes econom ic activ ity to fall or rise. As argued by A uerbach an d Feenberg (2000), th e effectiveness of an au to m atic stabilizer n o t on ly depends o n h o w m u c h of a change in d isposable incom e it produces, b u t also o n how significant th e effect is o n private co n su m p tio n . Potentially, progressive incom e taxes, value-added taxes, taxes o n corporate profits an d u n em p lo y m e n t insu rance p rem ium s an d benefits can serve as au to m atic stabilizers. O ne of th e m ost fam iliar m easures of th e sensitiv ity of taxes to incom e changes is th e elasticity of aggregate incom e taxes w ith respect to changes in aggregate incom e. This elasticity serves as an ind icato r o f th e tax system s overall progressiveness. For a given level of taxes, th e h ig h e r th e elasticity th e sm aller th e change in after-tax incom e th a t results from a given change in incom e before tax. However, in term s o f m easuring th e tax system s role as an au tom atic stabilizer th e incom e elasticity of taxes has a severe sh o rt­ com ing: it is in v arian t w ith respect to w h e th e r th e share of incom e taken as taxes is h ig h or low. If taxes take a large share o f th e econom y th e y will be m ore able to act as a n au to m atic stabilizer th a n if th e y take a sm aller share. Key d e te rm in an ts o f th e m agn itude of au to m atic fiscal stabilizers are th e share of tax revenues, an d th e size of tax an d expend itu re elasticities, w ith respect to GDP. For o u tp u t to be stabilized it is necessary for th e m itiga ting effect o f taxes due to changes in before-tax incom e to transla te in to m ore stable h ouseho ld Carlos Budnevich 273 consum ption . However, a h igh reaction of consum ption to a short-term shock to cu rren t disposable incom e requires th e presence of a liqu id ity co n stra in t th a t reduces ho u seh o ld co n su m p tio n to below its desired level. Any change in tax paym en ts m ust transla te in to changes in aggregate d em an d if au to ­ m atic stabilizers are to succeed. For exam ple th e effect o f corporate incom e taxes o n co n su m p tio n will be ten u o u s if th e ow nersh ip of corporate stock is strongly co n cen tra ted am ong ind iv iduals w h o are un likely to face liqu id ity constra in ts . In th e case of sta te u n em p lo y m e n t benefit, it is im p o rta n t to n o te th a t th is fluctuates in response to rises a n d falls in u n em p lo y m e n t du ring th e business cycle. The re la tionsh ip betw een o u tp u t fluctuations an d changes in th e level o f u n em p lo y m e n t benefit depends o n th e re la tionsh ip b etw een o u tp u t a n d u n em p lo y m en t, th e e x ten t o f u n em p lo y m e n t covered by u n em p lo y m e n t insurance, th e rate of benefits d em an d ed by those w ho are eligible, an d th e fraction of lost wages th a t is replaced by u n em p lo y m e n t benefit. It is im p o rta n t to create en o u g h room for au tom atic stabilizers to w ork fully du rin g a recession in o rder to co m p lem en t th e regu la to ry role of m o n e ta ry policy. In Latin Am erica fiscal policy has n o t p layed a co u n te r­ cyclical role. D uring recessions, fiscal policy is typically o rien ted tow ards keeping financial solvency u n d e r contro l, w hile d u ring boom s expend itu re te n d s to ex p an d w ith th e cycle. It is necessary to design a n in s titu tio n a l fram ew ork th a t w ill ensure th e consistency of fiscal policy, such as stab ilization funds from tax revenues.3 Such m echan ism s can w ork countercyclically to allow saving du ring boom s an d w ithdraw als for spend ing purposes du rin g crises.4 Public spend ing m an ag em en t m u st follow clear, long-te rm sustainability criteria. The m ain countercyclical co m p o n en ts shou ld be social safety n e t p rov ision an d th e presence of a tax revenue stab ilization fund. Review of concepts and measurement issues in fiscal policy Follow ing Heller e ta l . (1985), th is section reviews th e ex isting techn iques for assessing th e stance of fiscal policy, w ith th e purpose of characterizing th e expansionary or co n trac tio n ary n a tu re of cu rren t fiscal policy. T he first approach , used by th e IMF, m easures th e to ta l im pulse or in itia l stim ulus to aggregate dem and arising from fiscal policy, w hether d iscretionary or o therw ise, du ring a given period. C oncep tually it identifies as a fiscal im pulse an y change in th e actual budget th a t is n o t caused by th e business cycle. The idea is to o b ta in a new m easure of th e budget in iso lation from endogenous forces th a t arise from changes in GDP. The IMF m easure currently m akes n o d is tin c tio n betw een a change in aggregate d em an d th a t results from a d iscre tionary budget decision an d o n e th a t results from au tom atic fiscal stabilizers. 274 Countercyclical Fiscal Policy The approach starts by estab lish ing a base year in w h ich th e tax revenue to effective o u tp u t ratio , t0, an d th e public spend ing to p o te n tia l o u tp u t ratio , g0, co rrespond to a period of m acroeconom ic stability, in c lu d in g a ba l­ ance betw een p o te n tia l a n d effective GDP. The cyclically neu tra l b u d g e t is derived from th e actual budget by assum ing th a t n o m in a l tax revenues are u n it elastic w ith respect to ac tua l n o m in a l o u tp u t, an d n o m in a l governm en t expend itu res are u n it elastic w ith respect to p o ten tia l o u tp u t valued a t cu rren t prices. This gives a b en ch m ark to d e term ine w h e th e r fiscal policy is procyclical, neu tra l o r countercyclical. G row th in expend itu re th a t is above, equal to o r below p o te n tia l o u tp u t, yp t, g row th is respectively defined as expansionary, n eu tra l o r contractionary . Similarly, g row th in tax revenues th a t is above, equal to o r below effective o u tp u t, yt, grow th is respectively classified as contractionary, neu tra l or expansionary, regardless of th e source of th e change in revenue (d iscretionary tax increase, progressive tax structure). This sim ple IMF app roach calculates th e cyclically neu tra l b u d g et u n d e r th e assum ption of u n ita ry elasticities of expend itu re an d revenue w ith respect to p o te n tia l a n d actual o u tp u t, therefo re allocating th e co n trib u tio n o f au tom atic stabilizers to th e fiscal im pulse. A change in pub lic deficit has a cyclical character w h en it is du e to th e difference betw een cu rren t an d p o ten tia l GDP. A structu ra l deficit is equ i­ v a len t to th e difference betw een th e effective deficit an d th e cyclical deficit. An effective deficit in excess of th e cyclically neu tra l deficit is deem ed expansionary , relative to th e base-year fiscal stance. The effective budget surplus, B t, can be decom posed in to tw o elem ents: th e cyclically n eu tra l budget surplus, t0 y t - g0 yp t, an d th e fiscal stance, Fist, w h ich rep resen t th e dev iations be tw een th e cyclically neu tra l budget surplus an d th e effective bu d g et surplus: B t = t0 y t - g0 yp t - Fist (14.1) A ny increase (reduction) in th e budget surplus above th e cyclically n eu tra l budget leads to a con trac tio n ary (expansionary) stance in fiscal policy. The fiscal im pulse, FIt, is defined as th e change (first difference) in th e fiscal stance m easure: FIt = Fist - Fist - ! = dG t - g 0 dypt - (d T t - t0 dy t) (14.2) T he fiscal im pu lse in a given period reflects th e change in th e fiscal stance. T he fiscal im pulse a t b est provides a m easure of th e m ag n itu d e of th e in itia l stim ulus to aggregate d em an d arising from th e n e t changes of fiscal policy in a given period. O ne ad v an tag e o f th is ap p ro a ch is th e s im p lic ity of th e ca lcu la tio n a n d in fo rm a tio n req u irem en ts . To ca lcu late th e fiscal im pulse , o n e o n ly needs ac tu a l a n d p o te n tia l o u tp u t g row th , a set o f base-year p u b lic ex p e n d itu re a n d p u b lic rev en u e to o u tp u t ratios, a n d th e ch an g e in th e ac tu a l b u d g e t balance. H ow ever such a m easu re m ay m iss th e in te n s ity an d d irec tio n o f Carlos Budnevich 275 th e effects. In fact th e e lastic ity o f tax revenues w ith respect to o u tp u t is an em p irica l m a tte r th a t is likely to vary w ith th e ra te o f in f la tio n a n d th e effects o f p rogressiv ity a n d ad m in is tra tiv e lags in co llec tion . In p a rticu la r th e e lastic ity of VAT d ep en d s o n th e co m p o sitio n of p riv a te co n su m p ­ tio n o f du rab le an d n o n -d u ra b le goods, th e e lastic ity of im p o rts w ith respect to GDP a n d th e cyclical b eh a v io u r o f evasion . In fact, as du rab le c o n su m p tio n is m ore sensitive to eco n o m ic ac tiv ity th a n n o n -d u ra b le c o n su m p tio n , a h ig h e r p ro p o rtio n o f durab les m ay raise th e in co m e e lastic ity of VAT. T he e lastic ity o f g o v e rn m e n t ex p en d itu res is also an em pirica l issue. This approach also suffers from th e so-called balanced b u d g et m ultip lier problem . The m easure im plicitly assum es th a t equal increases in governm en t spend ing an d taxes provide n o ad d itio n a l stim ulus to aggregate dem and , w hereas m ost co n v en tio n a l m odels im ply th a t a change in g o v ernm en t spend ing has a larger effect o n incom e th a n an equ iva len t transfer o r tax change. Therefore th is m e th o d m u st be com bined w ith an approach to m easure expend itu re o n goods an d services, transfers an d taxes o n a m ore disaggregated basis to ob ta in a f ind ing o n th e p o ten tia l im pact o n aggregate dem and . M oreover, as th is tech n iq u e calculates th e fiscal im pulse residually, it will inc lude th e effects n o t on ly of changes in fiscal policy a n d th e subsequen t effects o f au tom atic stabilizers, b u t also of structura l changes in th e econom y. Finally, th e ca lcu la tion of th e fiscal stance on ly adjusts th e b u d g et for devi­ ations of o u tp u t from its p o ten tia l level - a p rob lem also en co u n te red w ith o th e r techn iques. T he effects o f prices, in te rest rates (b o th real a n d n om ina l) an d th e exchange rate are ignored. The OECD provides an alternative techn ique th a t has tw o m ajor differences from th e IMF m easure. First, th e elasticities o f cyclically n eu tra l expend itu re a n d revenue w ith respect to real o u tp u t are n o t constra ined to u n ity in th e OECD m eth o d . H ence th e OECDs fiscal im pulse ind icato r is free from a u to ­ m atic stabilizer effects. Second, th e OECD m e th o d uses ratios of expend itu re an d revenue to p o ten tia l an d actual o u tp u t, respectively, in th e previous period, n o t base-period values. T he OECD app roach has a larger data req u irem en t th a n th e IMFs m e th o d as it includes estim ates of go v ern m en t expend itu re an d revenue elasticities. The elasticity o f public expend itu re is a fu n c tio n of th e m ag n itu d e of th e subsidies given to th e unem ployed . The relative im p o rtan ce of th e cyclical deficit depends o n th e size of incom e elasticity of tax revenues, th e o u tp u t gap m easured by th e d ifference betw een effective an d p o ten tia l o u tp u t an d th e p ro p o rtio n of tax revenues relative to th e level of econom ic activity. A nother m e th o d is th e w eigh ted standard ized surplus m easure. This provides a good em pirical estim ate of fiscal policy aim ed at m easuring dis­ cre tionary ac tion b y th e au thorities. T he m e th o d was first developed by Blinder an d G oldfeld (1976) u sing US data. S im ulation tech n iq u es are 276 Countercyclical Fiscal Policy em ployed to decom pose th e budget in to au to n o m o u s (exogenous) an d induced (endogenous) com p o n en ts . The fiscal im pulse is defined as th e change in th e exogenous co m p o n en t o f th e budget. In th e IMFs cu rren t fiscal im pulse m ethodo logy th e grow th of g overnm ent expenditures o th e r th a n u n em p lo y m e n t benefits is regarded as cyclically neu tra l if it is equal to p o ten tia l o u tp u t g row th. U n em p lo y m en t benefits are excluded from th e base-year expend itu re ratio an d from actual expend itu re in a given period, im p ly ing th a t an y changes in u n em p lo y m e n t benefits are trea ted as a fully cyclical p h en o m en o n . As u n em p lo y m e n t benefits d epend o n th e sta te o f th e econom y, th is m e thodo logy im plicitly assum es th a t eco­ n o m ic recovery w ill re tu rn th e u n em p lo y m e n t rate to th e level p revailing in th e base year. It is im p o rta n t to stress th a t, dep en d in g o n th e policy question , certain m easures of th e fiscal budget will be m ore adequate th a n others. If th e policy ques tion cen tres o n th e short-term financial pressure caused by th e govern ­ m en ts financ ing requ irem ents, th e n th e re is a strong case for a budget balance m easure th a t accurately reflects th is pressure. T he cash base budget data dom inates in th is regard. H ow ever if th e m ain concern is to analyze th e effects of g o v ern m en t expend itu re an d revenue policy o n aggregate m acro- econom ic variables, such as co n su m p tio n an d investm en t, th e n a strong case can be m ade for u sing n a tio n a l accoun t data w h en co n stru c tin g th e fiscal im pulse, so th a t th e budgetary data is m ore system atically rela ted to aggregate dem and . Stabilization funds, public and international finance, fiscal policy and external shocks C om m odity price risk is th e risk th a t com m odity prices m ay change rapidly, substan tia lly an d unpredic tab ly . G overnm ents typically bear tw o kinds of com m od ity price risk. First, m a n y governm ents ob ta in substan tia l revenue from com m odity p roductio n /ex p o rta tio n . Second, m a n y g overnm ents try to sm o o th som e dom estic com m o d ity prices to m itigate th e social, econom ic an d political im pact of large an d frequen t changes in prices. In th e absence of f in an c in g o p p o rtu n itie s , w h en prices go do w n for a p roducer or u p for a consum er, th e go v ern m en t has to cu t expend itu re or raise o th e r revenue. This is difficult to do qu ickly an d efficiently. Increasing spend ing w h en export prices rise is easier, b u t it is difficult to do efficiently. Reliance o n com m o d ity revenue norm ally leads to s top -go fiscal policy. It is also likely to m ake fiscal policy procyclical. O th er p rob lem s inc lude th e difficulty of p lan n in g , such as basing a budget o n com m o d ity price assum p­ tio n s th a t cou ld tu rn o u t to be very w rong. D eveloping coun tries typ ically base th e ir in te rn a tio n a l trade o n a few com m odity exports an d im ports th a t are subject to h ig h ly vo la tile m arket prices. A practice th a t has b een extensively used in th e past has b een for Carlos Budnevich 277 governm en ts to establish stab ilization funds to reduce com m o d ity price volatility, to m ake prices an d revenues m ore pred ic tab le an d to keep ex p en d ­ itu re in line w ith p erm a n en t incom e flows. For com m od ity producers, th e fu n d accum ulates resources w h en th e in te rn a tio n a l spo t price is above its reference price, an d vice versa. For com m odity consum ers, th e fu n d sub­ sidizes dom estic co n su m p tio n w h en th e spo t price is above its reference level, a n d vice versa. R ecent em pirical w ork o n com m o d ity prices show s th a t m o st com m od ity prices even tua lly revert to th e ir m ean - a requ irem en t for a stab ilization fu n d to be viable - b u t on ly very slowly, w ith th e average reversal tim e being m easured in years ra th e r th a n m o n th s . H ence a com m o d ity stab ilization fu n d has to be very large to be effective. F urtherm ore, in th e case of an export (im port) stab ilization fu n d it is strongly recom m ended to in itia te it in scenarios o f h ig h (low) prices ra th e r th a n long-te rm or tren d prices, so th a t th e fu n d can finance subsequen t negative price situa tions.5 M any countries have ab an d o n ed these funds as g o v ernm en t in te rv en tio n to stabilize com m od ity prices an d reduce u n ce rta in ty has o ften proved ineffective an d costly. N onetheless th e re are som e successful cases, such as th e com m odity stab ilization funds in C hile (copper) an d C olom bia (coffee), w h ich are aim ed a t stabilizing com m odity -rela ted go v ern m en t revenues instead of prices. W h en governm ents collect com m odity -rela ted revenues, these funds are appropriate m echanism s for separating the term s of trade cycle from th e fiscal cycle. They are characterized by th ree elem ents: (1) a reference price for raw m aterial, de term in ed in th e budget fo rm u la tion and , based o n conservative, m edium -term projections; (2) a fund th a t accum ulates resources d u rin g boom s a n d pays o u t du rin g adverse periods; an d (3) opera ting m les th a t estab lish a re la tion betw een price fluctuations an d co n trib u tio n s to or w ithdraw als from th e fund. Instead of se tting u p a stab ilization fund, governm en ts can borrow or ru n dow n assets w h en th e in te rn a tio n a l price goes against th em . T he p rob lem is th a t w h en th e coun try m ost needs fund ing it is less likely to be able to ob ta in it. Also, m a n y coun tries do n o t have significant foreign assets to dispose of. F urtherm ore it is po litica lly difficult to generate a sufficient surplus to repay th e deb t w h en th e s itua tion is reversed, lead ing to solvency problem s. To hedge against com m od ity price volatility, policy m akers can consider th e use of com m od ity derivatives. This has several advantages: com m odity derivatives reduce u n ce rta in ty ab o u t fu tu re revenues, th e y rely o n m arket prices ra th e r th a n adm in istra tive prices, th e y sh ift th e risk ou tside th e co u n try an d th e y reduce th e cost o f com m o d ity financing , th u s increasing th e cred itw orth iness of th e com m o d ity producer. H ow ever a d isadvantage is th a t th e y will n o t p rev en t a persis ten t deterio ra tion of or sudden spikes in com m odity prices.6 T hey typically m itigate th e short-term effects o n o u tp u t o f adverse price m ovem en ts,7 b u t as th e y concen tra te o n th e short-term they are u nab le to m a tch th e long p ro d u c tio n h o rizo n of som e com m odities. 278 Countercyclical Fiscal Policy In theory, if price shocks are o f a p e rm a n en t n a tu re it is be b e tte r to ad just ra th e r th a n to use com pensa to ry financing . H ow ever th e ques tion is how quickly to ad ju st to th e new price con d itio n s in o rder to m in im ize dom estic ad ju stm en t costs w ith an incom ple te derivatives m arket. Let us prov ide a form al fram ew ork to analyze a price stab ilization schem e for co n su m p tio n purposes.8 Suppose th e go v ern m en t w ishes to m in im ize th e cost o f expected , E , quad ra tic dev iations of th e dom estic p rice from th e in te rn a tio n a l price, ( p t - p * ) 2 9 T he go v ern m en t is against th e quick ad justm en t of dom estic prices over tim e (p t - p t - i ) 2, so it negatively w eights quadra tic dev iations of th e cu rren t dom estic prices from past dom estic prices. As is well d o cu m en ted in th e literature , if in te rn a tio n a l prices follow a ran d o m w alk process, a stab ilization schem e will be n e ith e r feasible no r sustainable w ith o u t explicit fiscal su p p o rt.10 If th e g o v ern m en t is concerned ab o u t ad ju s tm en t costs, th e re is a sm o o th in g role for prices even if th e shock is o f a p e rm a n en t natu re . If th e g o v ern m en t does a ttac h a negative w eight to th e quick a d ju s tm e n t of dom estic prices it is b e tte r to in tro d u ce a form al stab ilization schem e, such as a form al price b an d w ith rules ra th e r th a n an im plicit b an d w ith n o rules. The governm ents o p tim iza tio n prob lem is to m in im ize th e fo llow ing cost function : M in a E ( p t - p * ) 2 + b E ( p t - p t - \ ) 2 (14.3) subject to th e ran d o m w alk process follow ed by in te rn a tio n a l prices: P t* = p t - 1* + th (14.4) T he op tim al stab ilization policy will lead to th e sm o o th in g of in te rn a l prices based o n th e fo llow ing rule: p t = b /(b + a)pt - i + a/{b + a)pf_!* (14.5) Intu itively , th e h ig h e r th e cost a ttac h ed to th e a d ju s tm e n t o f dom estic prices over tim e (b) an d th e low er th e w eigh t given to dev ia tions o f th e local price w ith respect to in te rn a tio n a l prices (a), th e m ore gradual th e o p tim al process o f ad ju stm en t for in te rn a l prices will be to new in te rn a tio n a l cond itions. D uring ex ternal boom s, m o n e tary sterilization m ust be perform ed th ro u g h th e generation of a fiscal surplus. In th e presence of a com m odity stabilization fund , a h igher (lower) co m m o d ity export price is au tom atica lly transfo rm ed in to a h igher (lower) fiscal surplus by th e rules of accum ula tion (depletion) o f th e fund. U nder such con d itio n s th e ad ju stm en t effort does n o t rely on h igher tax a tio n or low er pub lic expenditure. If th e ow nersh ip of a com m od ity export is pub lic (foreign), th e n a stabil­ ization fund (FDI financing) will stabilize th e econom y th ro u g h a n adequate response b y public savings (profit repatriation). In th e case of m ining, projects typically m atu re in several years. The associated deb t for p ro jec t finance has Carlos Budnevich 279 to pay in te rest periodically, w hile am ortiza tion typically takes place after construc ting th e p lan t. If th e re is a n excess o f cash flow generation , th e last in s ta lm en t of th e loan is p repaid , w hile th e opposite occurs u n d e r a defic it.11 To deal w ith shocks th a t trigger ex ternal crises, co n tin g en t policies based o n sim ple, easily verifiable rules, a n d a fu n c tio n o f variables n o t d irectly con tro lled by th e au tho rities can be of h e lp .12 The first step is to iden tify a sm all set of shocks th a t cap ture a large share of triggering factors. For exam ple positive in d ex atio n to th e term s o f trade an d inverse in d ex atio n to an in d ica to r o f tigh tness in in te rn a tio n a l financial m arkets such as th e EMBI spread w ould probab ly suffice as in d ex a tio n m echan ism s for in te rest paym en ts o n pub lic an d ex ternal debt, o r for pub lic expenses th a t are less costly an d ineffic ien t to stop. Indexa tion to th e price of a co m m o d ity avoids m a n ip u la tio n an d m oral hazard problem s, due to its exogenous natu re . Several firm s have experim en ted w ith com m odity -indexed bonds, b u t m ost seem to hedge co m m o d ity price vo la tility u sing th e op tio n s m arkets. W ith respect to c o n tin g en t public d eb t m anagem en t, private sector in v es tm en t w ith pub lic sector insu rance represen ts a strictly procyclical fiscal policy, as guaran tees are freely given du rin g boom s, w h en th e private sector invests, an d fall due du ring dow n tu rns. The general policy p rescrip tion w ould instead suggest es tab lish ing an explicit public sector fu n d financed by a n insu rance p rem ium charged to th e private sector, w h ich is essential in countercyclical policies today. It is im p o rta n t to recognize th a t u n em p lo y ­ m e n t insurance, public w orks guarantees, deposit in su rance an d m in im u m pension guaran tees shou ld be explicit, lim ited an d financed by taxes or p rem ium charges. Ex an te fu n d in g has a relative advantage a n d ex p o s t financ ing a relative d isadvantage in sm o o th in g cash flows along th e p a th to im proved stabiliza­ tion . Flat rate p rem ium s are m ore appropria te th a n risk ad justed p rem ium s for sm o o th in g a n d stabilizing in th e course o f th e cycle, as risk ten d s to be low du rin g boom s an d h ig h du rin g dow n tu rns. In a sm all o p en econom y fiscal policy has to p lay a countercyclical role w h en ex ternal shocks occur. W h e n capita l inflow s are a private sector p h e n o m e n o n th e fiscal accoun ts m ay n o t be s tren g th en ed enough , th u s req u irin g a n increase in taxes o r a re d u c tio n in pu b lic ex p en d itu re . In c o m b in a tio n w ith tig h t m o n e ta ry policy a n d restrictive fiscal policy, m easures devo ted to lim iting cap ita l surges m ay be considered. W h en th e accum ula tion of in te rn a tio n a l reserves is a ttrib u tab le to a n expo rt boom , it is difficult to q u es tio n th a t th e h igher g enera tion of saving shou ld be an effort m ade by th e sector th a t d irectly benefits from it. If th e ex ternal surplus has its o rig in in th e private sector, it is m ore d ifficult to d istribu te th e savings equitab ly .13 T he use of a tem porary restrictive fiscal policy m ay be of help w hen th e re are surges in cap ita l inflow s. A lthough such a policy w ou ld n o t stop th e inflow s, it could co n ta in th e in fla tionary im pact a n d reduce aggregate 280 Countercyclical Fiscal Policy d em an d .14 As th e n eed to issue public deb t is reduced, it is also possible th a t a restrictive po licy m ay h e lp to low er dom estic in te rest rates. If tax changes are transito ry an d th e re are borrow ing constra in ts , a n increase in taxes m ay be effective in co n tro llin g absorp tion . As corporate taxes, progressive incom e taxes, value added taxes an d custom s du ty revenues norm ally have an o u tp u t elasticity of greater th a n one, strong capital inflow s w ill help finance g row th in abso rp tion above GDP, lead ing to an increase in tax collection. Follow ing a structural surplus rule, th e g o v ernm en t shou ld save m ore a n d o b ta in a h ig h e r effective su rp lus.15 H ow ever w ou ld th a t be enough? Probably n o t. Therefore in ad d itio n to th e au tom atic stabilizers, policy m akers m igh t consider m easures to increase VAT, payroll taxes or co n trib u tio n s to th e p ension fu n d or th e u n em p lo y m e n t insu rance fund . This w ould b e tte r d istribu te th e b u rd en of m o n e ta ry an d fiscal policy to c o n ta in absorp tion . If strong cap ita l inflow s generate an abso rp tion th a t exceeds p o ten tia l GDP, a co n trac tio n ary d em an d policy will be required . If th e cen tra l b an k applies a restrictive m o n e ta ry policy, th e n quasifiscal losses an d fu rthe r cap ita l inflow s w ill take place. To avoid such a v icious circle, it m ay be m ore desirable to app ly a co n trac tio n ary fiscal policy. Conversely, w h en m assive cap ita l outflow s take place a n d th e econom y is overheated , b o th co n trac­ tio n a ry fiscal an d m o n e ta ry policies m ay be needed. Public sector and the level of activity: theory and empirical evidence U nder Keynesian u n em p lo y m en t an d th e need to reduce th e fiscal deficit an d pub lic debt, fiscal ad ju s tm en t m easures w ill depress th e econom y. A public deficit u n d e r these co n d itio n s expands th e level of activity. U n d er th e neoclassical full e m p lo y m e n t m odel, th e repercussions o f fis­ cal po licy d e p e n d o n th e n a tu re of th e fiscal ad ju s tm e n t. Tax increases th a t lead to d is to rtio n s in m ark e t prices o r an increase in c u rre n t ex p e n ­ d itu res th a t are ex p ected to be f in an c ed by fu tu re taxes w ill h av e a c o n ­ tra c tio n a ry effect o n th e level o f eco n o m ic activ ity . R eductions in b o th ex p e n d itu re a n d tax te n d to increase th e level o f eco n o m ic activ ity . A cred ib le cu t in e x p e n d itu re w ill p ro m p t ex p ec ta tio n s o f reduced taxes, p ro d u c in g positive supp ly -side effects th a t w ill increase GDP in th e sh o r t­ te rm . Supply-side m odels assum e th a t fiscal a d ju s tm e n t is ex p a n sio n a ry if it is based o n e x p e n d itu re red u c tio n s, b u t c o n tra c tio n a ry if taxes are ra ised .16 O ther m odels describe m acroeconom ic behav iou r accord ing to th e level o f public debt. W h e n th e stock of public deb t approaches defau lt level, an increase in th e deficit significantly raises th e p robab ility of inso lvency an d of h igher in terest rates, leading to reduced dom estic activity .17 Carìos Budnevich 281 In th e Latin A m erican con tex t, G avin e t al. (1996) have fo u n d th a t th e vo la tility o f m acroeconom ic ou tcom es is greatly au g m en ted by th e h igh ly procyclical fiscal responses in th e region. Procyclical fiscal responses are m ost p ro n o u n ced d u ring recessions an d th e y stem from th e fact th a t access to in te rn a tio n a l cap ita l m arkets o ften van ishes in th e face of adverse shocks, forcing a fiscal co n trac tio n in an already w eakened econom y. T hus policy m u st be concerned w ith ensu ring fiscal susta inab ility an d solvency. But th e w eak re la tionsh ip w ith in te rn a tio n a l capital m arkets is due to th e vo la tility of th e m acroeconom ic e n v iro n m en t in Latin America, an d creates th e need for large fiscal ad ju stm en ts th a t can be po litica lly unfeasible, th u s reducing cred itw orth iness an d p ro m p tin g investors to exit from th e reg ion a t th e first sign of tro u b le .18 A ccording to G avin e t al., deficits in Latin Am erica vis-à-vis th e dom estic financia l system (or taxes) are th ree tim es larger th a n in th e OECD co u n ­ tries. F urtherm ore th e tax base in Latin Am erica is h ig h ly vo latile an d procyclical. Latin Am erica relies extensively o n non -tax , ind irec t tax a tio n an d trade taxes. W ith regard to spend ing patterns, G avin e t al. n o te th a t Latin Am erica spends a h igher p ro p o rtio n o n in te rest paym ents, capital expend itu re an d wages, an d less o n n o n -in te re st transfers th a n do OECD countries. M oreover Latin Am erica exh ib its less flexibility in tim es of crisis as in te rest paym ents o n deb t te n d to increase. F urtherm ore Latin Am erica pays h igher an d m ore variable co u n try risk p rem ium s th a n th e OECD countries. T he ratio of fiscal deficit to GDP in Latin Am erica is tw ice as vo la tile as in th e OECD coun tries (ibid.) Fiscal deficit w ith respect to th e financial system is five to te n tim es m ore vo latile th a n in th e OECD. W h en GDP increases, th e surplus in OECD coun tries increases, b u t in th e Latin A m erican region th ey te n d to rem ain stable o r fall. Tax revenues are also m ore sensitive in Latin Am erica th a n in th e OECD. This im plies th a t pub lic spend ing in Latin Am erica is h igh ly procyclical an d fiscal ou tcom es are particu larly con trac tionary du rin g recessions. In te rn a tio n a l cap ita l flows to Latin Am erica o ften d isappear just w h en th e y are needed to finance a countercyclical fiscal policy. G iven th e region s precarious access to in te rn a tio n a l financial m arkets, procyclical fiscal m eas­ ures are th e best too ls available to th e fiscal au thorities. Precarious cred it­ w o rth in ess is ro o te d in w eak fiscal s tru c tu re s in a v o la tile m acro en v iro n m en t. Talvi a n d Vegh (2000) prov ide a po litical ex p lan a tio n o f th e puzzling behav iou r of fiscal policy in developing countries. S tarting from th e observation th a t f luctuations in th e tax base are m u c h larger in developing countries th a n in th e G7 countries, full tax sm o o th in g w ould im ply ru n n in g large budgetary surpluses in good tim es an d large budgetary deficits in bad tim es. However, due to po litical constra in ts it m ay be im possib le to ru n large budgetary surpluses w h en tim es are good. If a g o v ernm en t is unab le 282 Countercyclical Fiscal Policy to generate large en o u g h surpluses du ring expansions it is forced to borrow less du ring recessions in o rder to satisfy th e solvency constra in t. The p a tte rn o f procyclical fiscal deficits in Latin Am erica has been in te r­ p reted as arising from subop tim al policies, an d probab ly from th e financial constra in ts faced by th e governm ents concerned . H ow ever accord ing to C aballero (2000, 2001), w h en ex ternal financial shocks are a n im p o rta n t cause of fluctuations, th e econom ic au tho rities shou ld o p tim ally d istribu te th e ir scarce in te rn a tio n a l resources am o n g dom estic agents in order to sm o o th th e differences in financial distress. A lthough in princip le it m ay be possible to follow a countercyclical taxation an d /o r fiscal sp en d in g po licy th a t could com pletely elim ina te th e variance in GDP grow th, th e possib ility o f ach iev ing such a degree of flexibility seems unrealistic. T ax-sm ooth ing considerations, th e difficulty of ad justing an d con tro lling wages, th e n eed to m ake expend itu res requ ired by law an d th e tim e needed to bu ild pub lic w orks m ay reduce th e au th o ritie s ab ility to exercise th e requ ired degree of flexibility for countercyclical purposes. A stop -go process in in v es tm en t is likely to generate w aste, an d therefo re a m ore stable spend ing p a tte rn m ay im prove m atters. The experience of Chile T he role played b y fiscal policy in C hile has been ex tensively analyzed an d debated . Its in te rp re ta tio n is n o t easy, since a lth o u g h a n average surplus of 1.9 per cen t o f GDP was m a in ta in ed in 1990-97, pub lic spend ing grew strongly a t 6.5 per cen t. Increased public spend ing o n h ea lth , education an d o th e r social prov isions was financed th ro u g h increased taxes an d revenues linked to th e coun try s strong econom ic grow th, an d con trib u ted to a fu rther expansion of aggregate dem and . T he key d ev e lo p m en ts in C hile s fiscal po licy in th e p as t 15 years have b een th e m a in te n a n c e of a fiscal surp lus b e tw een 1985 a n d 1998, a n d th e c rea tio n o f a copper stab iliza tion fu n d in 1985 an d a pe tro leu m stab iliza tion fu n d in 1991. T he p u rpose of th e copper stab iliza tion fu n d is to stabilize pu b lic ex p en d itu re , w hile th e p e tro leu m fu n d is in te n d e d to sm o o th th e v o la tility o f in te rn a tio n a l prices o n th e a d ju s tm e n t p a th of dom estic oil prices. In th e case of th e copper stab iliza tion fu n d , a t th e b eg in n in g of each year th e b u d g e t office sets a reference price, a n d w ith ­ draw als an d deposits are m ade q u arte rly as a step fu n c tio n of ac tua l an d reference prices. T he fin an ce m in is te r decides th e a m o u n t an d th e tim in g of w ithdraw als for tw o precise purposes: to co m p lem en t in co m e w h en th e effective price is sign ifican tly below th e b u d g et p ro jec tions, or to p repay deb t du rin g boom s. Chile has also exh ib ited partia l flexibility in respect o f VAT in th e recen t past, as in 1996 th e g o v ernm en t was allow ed by law to set th e VAT rate Carlos Budnevich 283 betw een 16 per cen t a n d 18 per cen t. In th e even t th e au tho rities decided to increase VAT from 17 per cen t to 18 per ce n t to help finance th e education reform s.19 Ffrench-Davis an d Tapia (2001) argue th a t fiscal policy in th e period 1990-95 was very p ruden t. The increases in social expend itu re w ere financed w ith new tax revenues an d fiscal policy strictly follow ed th e accum ulation or d ep le tion rules of th e copper stab ilization fund. W ith regard to fiscal responsib ility for th e excess aggregate d em an d th a t took place in 1996-97, fiscal expend itu re (7.9 per cent) rose m ore th a n GDP grow th (7.4 per cent). H ow ever th e fiscal sector in C hile on ly accoun ted for 20 per cen t of th e econom y an d therefo re th e m a in im pulse for aggregate d em an d grow th (8.5 per cent) m ust have com e from th e private sector. The even tua l fiscal co n trib u tio n was clearly insufficient. The fiscal budget was show ing a surplus a n d th e go v ern m en t n o t on ly rejected new loans from th e W orld Bank an d th e IDB b u t also prepaid debt. The effective fiscal surplus was even h ig h e r as th e copper stab ilization fu n d was accum ulating resources a t th e tim e. In 1999 Chile ran a fiscal deficit for th e first tim e since 1985. At th e en d of 1999 th e coun try s m acroeconom ic policies sh ifted tow ards m ore rules an d a less d iscre tionary fram ew ork, w ith m o n e ta ry po licy follow ing a n in fla tio n target approach . The go v ern m en t th a t to o k pow er in M arch 2000 proposed to recover th e fiscal surplus b y estab lish ing a structu ra l b u d g et surplus rule o f 1 per cen t, s ta rting in 2001. The fiscal policy rule allows th e op era tio n o f au to m atic stabilizers in th e budget an d avoids th e need for fine-tun ing accord ing to th e phase of th e econom ic cycle, leaving th is role to m o n e ta ry policy. W hile som e ex p en d ­ itu res a n d revenues d ep e n d o n th e evo lu tion of th e econom y, a n im p o rta n t p ro p o rtio n of expenses an d revenues are n o t flexible because th e y represen t legal com m itm en ts. The new m e th o d of p reparing th e budget in C hile delivers ind icators for iden tify ing th e stance of fiscal policy, avoids a procyclical bias in public finance, allows eva lua tion of th e m acroeconom ic im pact of fiscal policy, ensures th e stability an d c o n tin u ity o f fiscal policy an d reinforces fiscal d iscipline. In th e co n s tru c tio n o f th e structu ra l balance ind icator, th e go v ern m en t has considered th e existence o f a strong revenue co m p o n en t o rig ina ting in th e p ro d u ctio n of copper th a t exhib its m ean reversion in its price behaviour. The structural balance excludes th e cyclical effect o f GDP (the gap betw een effective a n d p o ten tia l o u tpu t) an d ran d o m effects of th e price of copper. T he structu ra l bu d g et is n o t o n ly explained by au to n o m o u s decisions of th e g o v ernm en t (discretion) b u t also reflects f luctuations in th e fiscal balance th a t are due to factors o th e r th a n th e business cycle. Taxes an d copper revenues are believed to be cyclical; spend ing is assum ed to be non-cyclical. T he m eth o d o lo g y adop ted by C hile for defin ing th e 284 Countercyclical Fiscal Policy structural b u d g et surplus follows th e OECD m ethod , allow ing for a tax revenue elasticity w ith respect to GDP th a t is d iffe ren t from unity : In Tpt - In Tpt _j = 1,05 * (In Ypt - In Ypt _ i) (p e rm an e n t tax revenue increases) (14.6) In T t - In Tt _j = 1,05 * (In Yt - In y t _j) (curren t tax revenue increases) (14.7) In Rcut = In Pcut + In Qcut (cu rren t revenues from copper) (14.8) In RScut = In Pcupt + In Qcut (trend revenues from copper) (14.9) There is a clear separation betw een th e structural co m p o n en t an d th e cyclical co m p o n en t o f th e effective balance th a t allows th e o p era tio n of au tom atic budgetary stabilizers.20 S tructural surpluses allow tran sito ry fiscal deficits u p to th e desired levels an d avoid th e ineffic ien t co n trac tio n o f spend ing d u rin g recessions. They also avoid th e overexpansion of expend itu res using transito ry w indfall fiscal revenues. This policy p rom otes saving, enables th e financing of co n tin g en t liabilities, com pensates th e cen tra l b an k deficit a n d saves financial resources for future generations w ho will n o t b enefit directly from non-renew able resources such as copper. The new policy fram ew ork brings to g e th er greater responsib ility a n d transparency in th e ad m in istra tio n of public resources. Total C h ilean pub lic d eb t is relatively sm all, reach ing 14.2 per cen t of GDP in 2000. C o n tin g en t liabilities do n o t com prom ise th e fiscal balance in th e sh o rt te rm , a lth o u g h th e y m ay do so in th e m ed iu m term . C o n tin g en t liabilities linked to m in im u m pensions are estim ated a t US$7.2 b illion ,21 a n d th e C h ilean g o v ern m en t proposes to p u t fiscal surpluses in to a fu n d to finance fu ture social security expenditure. Fiscal policy proposals As n o te d by M assad (1998), w ith increasing cap ita l m ob ility a h igher degree of flexibility in fiscal policy is required to keep public savings h ig h in periods of strong capita l inflows. To reduce th e procyclical behav iou r of C hiles GDP, B udnevich an d Le Fort (1997) suggest lim itin g th e g row th of public ab so rp tio n (the relevant m acroeconom ic ind icator) to p o ten tia l o u tp u t g ro w th .22 T hey p o in t to th e n eed for escape clauses, an d consider it desirable to allow som e flexibility in respect of public in v estm en t an d em ergency situations. In th e area of tax flexibility, B udnevich an d Le Fort argue th a t VAT m ay be a useful too l because of its b road base, h ig h revenue response, lower efficiency costs an d red istribu tive character. It has several o th e r advantages, such as its ab ility to help stabilize co n su m p tio n , its qu ick collection response an d th e sim plicity o f its ad m in is tra tio n . VAT changes operate th ro u g h ad ju stm en ts Carlos Budnevich 285 to disposable incom e as well as to relative prices. A m ong th e costs o f VAT flexibility are an increased m e n u of costs an d greater sho rt-term in fla tio n instability , w h ich te n d to lim it th e p o ten tia l use of such a m echan ism .23 An add itiona l cost of u sing taxes as countercyclical devices is th e u n ce r­ ta in ty th e y generate. B udnevich a n d Le Fort also argue th a t it m ay be useful to com plem en t VAT flexibility w ith som e incom e tax flexibility.24 M oreover, given th a t th e p ro fit base has a m u c h h ig h e r cyclical f lu c tu a tio n th a n GDP, an d given th e progressive structu re of personal incom e tax, b o th corporate an d personal incom e tax co n s titu te au tom atic stabilizers. The creation of a stabilization fund w ould com plem en t th e countercyclical fiscal policy proposal, for th e purpose of m o n ito rin g an d accum ulating th e countercyclical responses of fiscal policy. The fund shou ld accum ulate (pay ou t) resources w h en add itiona l (lower) revenues are o b ta in ed because o f increases (reductions) in th e VAT rate w ith respect to its long-term level. To ensure th e transito ry n a tu re of such a policy, B udnevich an d Le Fort p ropose floor a n d ceiling levels for th e stab ilization fu n d of 0 per cen t an d 8 per ce n t o f GDP. If one of these lim its w ere to be h it, a m ech an ism shou ld be activated to increase or reduce taxes, as applicable. In th e Latin A m erican con tex t, G avin e t al. (1996) suggest th a t th e fiscal budget shou ld be consisten t w ith a gradual m o v em en t tow ards th e desired deb t levels in th e m ed ium term . This m eans th a t fiscal surpluses shou ld be accum ulated an d n e t public deb t reduced du ring econom ic boom s, a n d th a t th e fiscal balance shou ld be allow ed to m ove in to deficit du ring contractions. The au tho rs n o te th a t it is hard to reverse pub lic spend ing co m m itm en ts an d to change tax rates in response to changes in long-term fundam entals . Fiscal deficit an d deb t shou ld ad just in response to transito ry shocks. They propose as an opera tional fiscal target a cyclically ad justed fiscal deficit, tak ing in to acco u n t differences betw een cu rren t an d fu tu re expectations of th e level o f o u tp u t, th e level of dom estic absorp tion , th e te rm s o f trade an d th e real exchange rate. M eanw hile th e Business C ouncil o f A ustralia (1999) has explored th e possibility of re-engineering A ustralian in stitu tions to increase th e tim eliness a n d effectiveness of fiscal policy. W hen th e re is a sharp an d serious deterio ­ ra tio n in n a tio n a l incom e, for exam ple as a resu lt o f a sudden decline in th e te rm s of trade, th e m ost appropria te econom ic response w ou ld be a sm all an d tem porary n o m in a l wage cut. If short-term wage flexibility is p u t in place before th e occurrence of shocks, a capacity for rap id ad ju stm en ts can be b u ilt in to w age se tting in stitu tions, for exam ple by allow ing a p o rtio n of wages to be paid in th e form of bonuses linked to profits.25 Profits w ou ld be less vo la tile an d b oom s an d busts w ou ld be m oderated , an d th e im pact on labour costs an d firm s incen tive to h ire an d fire w ou ld be countercyclical. B onuses can h av e p rocyclica l effect o n em p lo y ees co n su m p tio n . Empirically, how ever, countercyclical effects are d o m in an t. W hile th e 290 Countercyclical Fiscal Policy 11. Project fin a n ce le n d in g in m in in g is a lso stab iliz in g as d eb t p a y m en ts accelerate or decelerate d ep en d in g o n cash flo w behaviour, w h ic h b asica lly reflects th e price o f th e p roduct so ld . For m o re deta ils see B u d n ev ich e t a l. (2001). 12. See C aballero (2 0 0 0 , 2 0 0 1 ) for m ore details. 13. In fact w ith a fiscal surplus it is p ossib le to reduce th e m on eta ry base an d in terest rates b y p rep ayin g p u b lic extern al debt an d red u cin g th e d em a n d for fu n d in g . 14. Our analysis o f cap ita l flow s assu m es n o effect o n th e d em a n d for m on ey . 15. This o n ly takes p lace if tax reven u e ex p a n sio n s ab ove G DP grow th are cyclical. 16. See Frenkel an d Razin (1989) for m ore details. 17. For m od e ls ex p la in in g su ch behaviour, see Bertola an d D razen (1993) and Sutherland (1995). 18. T his effect is in ad d itio n to th e typ ical key price m isa lig n m en ts an d un su sta in ab le a ccu m u la tio n o f p u b lic debt. 19. In fact th is tax rate f lex ib ility w as n o t u sed for cou n tercyclica l purposes. 2 0 . To m easure th e structural b u d get an estim ate o f p o te n tia l o u tp u t is required. T he first step is to estim ate a C ob b -D o u g la s p ro d u ction fu n c t io n for th e C h ilean e co n o m y , an d th e se co n d is to ca lcu late p o ten tia l o u tp u t as th e va lu e o f th e p ro­ d u ctio n fu n c t io n eva lu ated at trend in p u t levels. 21 . Estim ate b y th e M in istry o f F inance. 22 . A lternative w ays o f ca lcu la tin g p o te n tia l o u tp u t grow th can b e fo u n d in M orandé and Vergara (1997) an d Ffrench-D avis (2001). 23 . B u d n evich an d Le Fort (1997) prop ose a lim ited variation o f VAT o f ± 1 per cen t. 2 4 . A ccording to s im u la tio n exercises co n d u cte d for C h ile b y B u d n evich an d Le Fort (1997), a h y p o th e tica l cou n tercyclica l fiscal p o lic y co u ld reduce th e variance o f G DP grow th b y 2 4 per cen t. T his red u ction in th e varian ce o f GDP grow th is d u e in 58 per c e n t to th e stab ilization o f p ub lic absorp tion grow th , w h ile th e rest correspond to th e o p era tion o f cou n tercyclica l stab iliz in g taxes. 2 5 . T his practice is w idespread in cou n tr ies su ch as Japan, Taiw an an d Korea. 2 6 . A sim u la tio n c o n d u cte d b y th e B usiness C o u n cil o f Australia (1999) suggests that i f a b o n u s system h a d b een op eratin g at th e tim e o f th e last m ajor recession there w o u ld h ave b e e n a m u c h m ore m oderate fall in e m p lo y m e n t in Australia th a n in fact to o k p lace. 27 . See C aballero (2 0 0 0 , 2 001) for further details. 28. H ow ever in fla tion ary bias d o es n o t affect u n d erly in g in fla tio n , relevant for p o licy decision s. 29. O n occasion , in ad d itio n to trad itional m acro eco n o m ic m an a g em en t instrum ents, Singapore has u sed its co m p u lso ry sav in gs v eh ic le , th e C entral P rovident Fund, w ith so m e success. 30 . C om p ulsory p e n s io n fu n d system s u su ally p roh ib it th e u se o f accu m u la ted fun d s as collateral for o b ta in in g loan s. R eferences A uerbach, A. an d D. Feenberg (2000) The S ign ifican ce o f Federal Taxes as A utom atic Stabilizers, J o u rn a l o f E co n o m ic Perspectives, 14, 3: 3 7 -5 6 . Bertola, G. an d A. D razen (1993) Trigger P oin ts and B udget Cuts: E xp la in in g th e Effects o f Fiscal A usterity, A m e r ic a n E co n o m ic R eview , 83 , 1: 1 1 -2 6 . Blinder, A. an d S. M. G o ld fe ld (1976) N ew M easures o f Fiscal an d M on etary Policy, 1 9 5 8 -1 9 7 3 , A m e r ic a n E c o n o m ic R eview , 66, 5: 7 8 0 -9 6 . B udnevich , C., F. Larrain an d J. Q uiroz (2001) Sector M inero y M ercado d e C apitales en C hile, In stitu to d e E conom ía , P ontific ia U niversidad C ató lica d e C hile , report prepared for th e M in istry o f th e E conom y, M in in g an d Energy, C hile. Carlos Budnevich 291 an d G. Le Fort (1997) ‘La P olítica Fiscal y e l C ic lo E con óm ico , R evis ta de la C epa l no . 6 1 , Santiago: ECLAC, April. B usiness C ou n cil o f Australia (1999) A void ing B oom /B ust: M acro eco n o m ic Reform for a G lobalized E conom y, D is c u s s io n P aper n o . 2, M elbourne: BCA, O ctober, 1 -7 6 . Caballero, R. J. (2000) M acroeconom ic V o la tility in Latin Am erica: A V iew an d Three Case Studies, paper prepared for LACEA m eetin g , May. (2001) C op in g w ith C h ile ’s E xternal V ulnerability: A F inancial Problem , m im eo , Santiago: B anco C entral de C hile . C ashin , P., H. Liang an d C. J. M cD erm ott (1999) H ow P ersistent are Shocks to W orld C o m m o d ity Prices, D iscu ssion Paper 9 9 /8 0 , W ash in gton , DC: IMF. Ffrench-D avis, R. (2001) E c o n o m ic R e fo rm s in C h ile , A nn Arbor, MI: U n iversity o f M ich igan Press. an d H. Tapia (2001) Three V arieties o f P o licies to Face C apital Flow s A bundance in C hile, in R. F french-D avis (ed .), F in a n c ia l C rises in S uccessfu l E m e rg in g E conom ies, W ash in gton , DC: Brookings In stitu tion . Frenkel, J. A. an d A. Razin (1996) F is c a l P o lic ies a n d G ro w th in the W o r ld E conom y, 3rd ed n , C am bridge, MA: MIT Press. G avin , M ., R. H au sm an n , R. Perotti an d E. Talvi (1996) M anaging Fiscal P o licy in Latin A m erica an d th e Caribbean: V olatility, P rocyclicality an d L im ited C redit­ w orth in ess, W orking Paper 3 2 6 , W ash in gton , DC: IDB, O ffice o f th e C h ief E conom ist, M arch, 1 -2 3 . H eller, P. S., R. Haas an d A. M ansur (1985) A R eview o f th e Fiscal Im pulse M easure w ith Estim ates o f th e Structural B udget B alance, dep artm en ta l m em oran d u m , W ash in gton , DC: Fiscal Affairs an d Research D epartm ent, IMF. King, M . A. (1999) C h allen ges for M on etary Policy: N ew an d O ld, B a n k o f E n g la n d Q u a rte r ly B u lle t in , 39 , 4: 3 9 7 -4 1 5 . M ariner, R. (2000) Estrategias d e Política E conóm ica e n u n M u n d o Incierto: Reglas, Indicadores, Criterios, C uade rnos d e l lip e s , 45 . M assad, C. (1998) La P olítica M onetaria e n C hile, E co n om ía C h ile n a , 1, 1 (A ugust). M orandé, E an d R. Vergara (eds) (1997) A n á lis is E m p ír ic o d e l C re c im ie n to en C h ile , W ash in gton , DC: G eorgetow n U niversity: C entro de E studios P úb licos e Hades. Sutherland, A. (1995) Fiscal Crises an d A ggregate D em and: C an H igh Public D ebt Reverse th e Effects o f Fiscal Policy?, CEPR W o rk in g P aper 1246 , L ondon: CEPR. Talvi, E. an d C. V egh (2000) Tax Base V ariability an d Procyclical Fiscal Policy, N B E R W o rk in g P aper n o . 7499, C am bridge, MA: NBER, January. Taylor, J. (2 0 0 0 ) ‘R eassessing D iscretion ary Fiscal P o licy , J o u rn a l o f E c o n o m ic Perspectives, 14, 3: 2 1 -3 6 . Varangis, P. an d D . Larson (1996) D ealin g w ith C o m m o d ity Price U ncerta in ty , P o lic y Research W o rk in g P a p er 1667 , W ash in gton , DC: In tern ational E conom ics D epartm ent, C o m m o d ity P olicy an d A nalysis U n it, W orld Bank, O ctober, 1 -4 3 . 1 5 Financial Regulation and Supervision in Emerging Markets: The Experience of Latin America since the Tequila Crisis B arbara S ta llin gs a n d R ogerio S tu d a r t Introduction The increasing in teg ra tio n of in te rn a tio n a l financial m arkets poses new challenges to dom estic financial m arkets everywhere, b u t especially those in em erging econom ies. The financia l crises of 1994-95 a n d 1997-98 sounded w ake-up calls to Latin A m erica an d East Asia, respectively, ind ica ting th a t regu la tion an d superv ision needed to be s tren g th en ed substantially . Since th e n im p o rta n t steps have been taken to im prove th e rules an d ensure th e ir im p lem en ta tio n , b u t financia l regu la tion a n d superv ision do n o t take place in a vacuum . O n th e on e h a n d th e y m ust be consisten t w ith dom estic m acro- econom ic policies, an d th ey need a supportive m acroeconom ic en v iro n m en t in w h ich to operate - as th e A rgentine crisis th a t began in 2001 show s on ly to o well. O n th e o th e r h a n d th e y have to take in to accoun t th e in te rn a tio n a l rules set by th e Bank for In te rn a tio n a l Settlem ents (BIS), th e In te rn a tio n a l M onetary F und (IMF) an d o th e r in stitu tions. The issue th a t links th is chapter w ith th e o thers in th e UNU/WIDER project is th a t vo la tility - deriv ing from in te rn a tio n a l capital flows as well as m acro- econom ic trends in ind iv idual countries - is a lead ing cause of financial crises. Problem s in ind iv idual banks can set off cha in reactions because of th e direct links be tw een banks, an d because of th e effects th a t b an k collapses can have o n borrow ers capacity to h o n o u r th e ir com m itm en ts. This is th e m ain rationale for th e concep t o f system ic risk. Financial regulation is m ean t to m itigate system ic risk by im posing restrictions o n th e w ay in w h ich banks finance th e ir opera tions an d allocate th e ir portfolios. The aim is to ensure th a t they conduct adequate assessm ents o f th e risks im plied in the ir activities, m ake provisions for expected losses an d m a in ta in en o u g h capital to absorb unexpected losses. 292 Barbara Stallings and Rogerio Studart 293 There is a good deal of evidence th a t financial activity is h igh ly procyclical. This prob lem goes beyond th e usual asym m etric in fo rm atio n p rob lem an d has to do w ith a t least tw o processes. First, increasing confidence am o n g ind iv idual investors tends to generate a self-fulfilling process of change in asset prices. As investors becom e m ore op tim istic , th e y try to ex pand th e ir h o ld ings of such assets a t a pace th a t is far m ore rap id th a n th a t o f th e ir supply. Boom s in asset prices th e n te n d to corroborate p ast expectations, lead ing to fu rth e r op tim ism . Ind iv idual risk assessm ent th u s changes w ith th e sta te o f collective en thusiasm . Second, banks are also procyclical, even th o u g h th e ch a in of reaction is slightly different. W aves of op tim ism in th e b an k in g sector lead to an expansion of lend ing , w h ich affects th e level of aggregate d em an d an d th u s th e incom e a n d cash flow of consum ers an d th e productive sector. In tim es of expansion , real an d financial asset prices increase, as does th e value of collateral. T h rough these self-fulfilling p ro ­ cesses, banks te n d to increase th e ir leverage a n d th u s th e ir vu lnerab ility to changes in th e variables th a t affect th e ir risks: econom ic activ ity an d level of em p loym en t (credit risk), borrow ing in terest rates (liquidity risk) an d asset prices (m arket risk). This chapter exam ines financial sector behaviour in Latin America, a lthough m a n y of th e sam e problem s a n d a ttem p ts a t so lu tions can be fo u n d in o th e r em erg ing econom ies.1 It begins w ith a brief look a t th e structure o f th e financial sector as a w hole, w h ich has changed substan tia lly over th e last decade. D espite these changes, banks co n tin u e to d o m in a te th e sector an d so th e analysis focuses o n th em . In th is con tex t, th e ch ap te r tu rn s n ex t to th e regulatory an d supervisory system s for banks an d to developm ents since th e M exican crisis in 1994-95. It also looks briefly a t th e new in te rn a tio n a l guidelines being p roposed by th e BIS an d th e IMF to investigate w hether th e y can help shelter th e b an k in g system s from th e types of shock th e y have suffered in th e recen t past, o r w h e th e r th e y are likely to create add itiona l problem s. The ch ap te r th e n looks a t case studies o f four of th e m o st im p o rta n t coun tries in th e region: A rgentina, Brazil, C hile an d M exico. By exam in ing th e experiences of these coun tries we can gain a b e tte r idea of how th e changes cam e abou t an d th e w ay in w hich ind iv idual co u n try characteristics have affected th e opera tion of th e financial system s. These tw o sections provide evidence th a t b an k regu la tion an d supervision in Latin Am erica have im proved in recent years, b u t m u c h rem ains to be done. The chap te r concludes w ith a set of policy recom m endations. We are certain ly n o t th e first to discuss these topics, as over th e past few years th e re has b een an explosion of research o n th e financial sector in develop ing countries, in c lu d in g issues of regu la tion an d superv ision .2 We draw o n th e theore tical an d em pirical d im ensions of th is litera tu re w here relevant, an d b rin g it to bear o n th e issues u n d e r consideration in th e UNU/ WIDER research project. 294 Financial Regulation and Supervision The financial sector in Latin America in the 1990s Liberalization, crisis and rescue: some stylized facts The essential background for u n d ers ta n d in g cu rren t developm ents in th e financial sector in Latin Am erica is th e financial liberalization process, b o th dom estic an d in te rn a tio n a l, th a t to o k place in th e 1980s a n d 1990s in m ost countries. C hile was a n im p o rta n t excep tion in th a t b o th liberalization an d crisis preceded th o se of its ne ighbours by at least a decade. M oving from a system in w h ich th e au tho rities set in te rest rates, d irected cred it an d held a large share of b an k deposits as requ ired reserves, govern ­ m en ts freed com m ercial banks to m ake th e ir ow n decisions o n borrow ers, loan vo lum e a n d prices. At approx im ate ly th e sam e tim e, cap ita l accoun t liberalization enab led local banks to engage in transac tions in foreign currencies an d allow ed foreign in s titu tio n s to en ter local m arkets. Such changes were frequen tly m ade w ith o u t th e re being an adequate regulatory a n d supervisory system in place, w h ich co m p o u n d ed th e problem s for bankers w ho lacked sufficient experience in co n d u c tin g cred it analyses of local borrow ers a n d w ere n o t conversan t w ith th e com plexities of in te r­ n a tio n a l financial m arkets. The typical results w ere credit boom s, m ism atches betw een m aturities an d currencies, an d even tua lly bank ing crises. As seen in th e em blem atic C h ilean case (but also la ter in M exico, East Asia an d A rgentina), errors by dom estic actors prov ided th e basis for such crises, an d if th is was com bined w ith ex ternal shocks th e s itu a tio n becam e far m ore serious (see H eld an d Jim énez, 2001). G o v ern m en t rescues ten d ed to follow a s tan d ard procedure. In th e first in stance th e y involved th e takeover of no n -p erfo rm in g loans, th e recap ita lization of banks a n d liqu idations an d m ergers, usually invo lv ing foreign in stitu tions. Later, in an a ttem p t to p rev en t fu tu re crises, regu la tion a n d supervision w ere stepped up, greater in fo rm ation an d transparency w ere required an d deposit in su rance was som etim es p u t in place.3 In th e process th e characteristics o f th e sector changed significantly. Characteristics of the new financial sector The financial sectors in Latin A m erican coun tries rem ain bank-based, b u t th e y have u n d erg o n e a n u m b er of im p o rta n t changes in recen t years. First, th e size an d d ep th o f th e financia l sector increased in m ost coun tries du ring th e 1990s. In p art th is was th e resu lt of th e d ram atic dec line in in fla tion th ro u g h o u t th e region, such th a t in m ost coun tries prices rose a t single-digit rates com pared w ith th e th ree- o r four-digit rates o ften fo u n d in th e 1980s. Thus individuals, h ouseho lds a n d firm s becam e m ore w illing to h o ld m o n ey an d o th e r financial assets, p rov id ing th e necessary prerequisite for th e developm en t o f robust financial system s. Better in s titu tio n s com plem en ted th e behav iou r of ind iv idual agents.4 Table 15.1 gives an idea o f th e ex ten t of th e tren d tow ards financia l deepening , u sing M 2 as a share of GDP as Barbara Stallings and Rogerio Studart 295 Table 15.1 Money supply (M2) as share of GDP, 1992-2000 (per cent) 1 9 9 2 1 9 9 4 1 9 9 6 1 9 9 8 2 0 0 0 L a t in A m e ric a A rgentina 14 21 23 2 9 3 2 Brazil n .a . n .a . 28 31 29 C hile 38 37 43 46 50 C olom bia 20 20 20 24 26 C osta Rica 32 32 33 33 35* M exico 29 28 26 28 21 A s ia Republic o f Korea 39 41 43 58 80 M alaysia 72 80 92 95 103 P hilip p in es 36 47 56 61 62 T hailand 75 78 81 103 106 * Figure for 1999. Source: Based on IMF international financial statistics. an indicator. It shows an increase for four o f th e six Latin A m erican countries during th e decade; th e p ro m in en t exception was Mexico. The biggest increase was in A rgentina, a lth o u g h C hile h ad th e h ighest levels. T he tab le also show s data for four Asian countries. The in te rreg ional con trast is strik ing in tw o senses: n o t on ly w ere th e levels h igher in every case in Asia, b u t th e rate of increase was also higher. Second, th e ex isting banks w ere allow ed to engage in new activities, resu lting in th e fo rm ation of so-called un iversal banks. In general th is was th e resu lt of th e deregu lation of b ank ing activities, w h ich led to b an k oper­ ations expand ing in to securities trad in g an d insurance an d increased th e ir real estate activities. D eregulation also enab led banks to ow n non -financia l firm s. This tre n d m oved in ta n d em w ith events in m a tu re econom ies,5 b u t un like som e o f th e latter, th e securities m arkets in em erg ing econom ies w ere still very u n d erd e v e lo p e d a n d shallow . T herefore m o st b a n k p o r t­ fo lio diversification was in to short-term securities, in su rance an d real estate activities. Third, foreign in s titu tio n s becam e increasing ly sign ifican t actors in th e financial sector. T heir greater ro le was p a rt of th e liberalization process, as new sectors w ere o pened to foreign partic ipa tion . Three vehicles w ere used by foreign banks an d financial service firm s to en ter develop ing-coun try m arkets: privatizations, m ergers an d acquisitions, an d greenfield investm ent. C onsequently , as can be seen in Table 15.2, foreign assets as a share of to ta l assets rose substan tia lly in all seven Latin A m erican coun tries for w h ich da ta is available (Argentina, Brazil, C hile, C olom bia, M exico, Peru an d Venezuela); th e increase for M exico w ould be m u ch greater if th e recen t 2 9 6 Financial Regulation and Supervision Tab le 1 5 .2 Foreign bank assets as share o f to ta l bank assets, 1 9 9 4 -2 0 0 0 (per cent) 1 9 9 4 1 9 9 9 2 0 0 0 L a t in A m e ric a A rgentina 17.9 4 8 .6 49 Brazil 8 .4 16.8 23 C hile 16.3 5 3 .6 54 C olom bia 6 .2 17.8 26 M exico 1.0 18.8 24 Peru 6 .7 33 .4 40 V enezuela 0 .3 41 .9 42 C e n tra l Europe C zech R epublic 5 .8 49 .3 66 H ungary 19.8 5 6 .6 62 P o la n d 2.1 5 2 .8 70 Turkey 2 .7 1.7 n .a . A s ia Korea 0 .8 4 .3 3 M alaysia 6 .8 11.5 18 T hailand 0 .5 5 .6 12 Sources: IMF (2000: 153) for 1994 and 1999; BIS (2001: 25) for 2000. sale of th e coun try s second largest b an k w ere inc luded in th e table. It is in te resting to n o te th a t th e re w ere sim ilar trends in Eastern Europe b u t n o t in Asia.6 Fourth, the re was a decrease in th e nu m b er of banks - especially in Latin America an d Asia - as a result of th e m ergers an d acquisitions just m en tioned , inc lud ing privatiza tions (Table 15.3). W hat is som ew hat surprising is th a t th is process d id n o t resu lt in a significant increase in co n cen tra tio n . Indeed in Asia an d Eastern Europe the re appears to have been a decrease in concen ­ tra tion . In Latin Am erica th e share of th e largest ten banks rose, b u t n o t by a large am o u n t. This im plies th a t th e in s titu tio n s th a t d isappeared from th e m arket were th e sm allest ones. Fifth, th e re was som e expansion of capital m arkets. This d eve lopm en t h ad several causes: th e increase in portfo lio flows to th e region u n til 1998; th e p rivatization of social security an d th e deregu lation of private in s titu tio n a l investors, w hich led to an increase of investm ents in securities; an d th e v ir­ tuous circle created by th e process o f stab ilization a n d securities m arket expansion in som e econom ies in th e region. Table 15.4 show s o n e ind icato r o f th is trend: th e vo lum e of deb t securities issued in dom estic m arkets (both in abso lu te am o u n ts an d as a share of th e w orld to ta l) betw een 1989 an d 2000. W hile th is indicates th a t such issues in Latin America expanded rapidly d u rin g th e period, m ore th a n doub ling betw een 1992 an d 2000, th e vast Table 15 .3 Indicators of concentration in the banking sector, 1994 and 2000 (share in total deposits) 1 9 9 4 2 0 0 0 N u m b e r La rg e s t Largest H H In d e x N u m b e r Larg e s t Larg e s t H H In d e x o f ban ks 3 ban ks 1 0 banks o f banks 3 b an ks 1 0 banks L a t in A m e ric a A rgentina 2 0 6 39.1 73.1 756.9 113 3 9 .8 80 .7 8 6 5 .7 Brazil 245 4 9 .9 78.8 1 2 2 0 .9 193 5 5 .2 85 .6 1 2 7 8 .6 C hile 37 39 .5 79.1 8 3 0 .4 29 39 .5 8 2 .0 8 5 7 .9 M ex ico 36 48 .3 80 .8 1 0 0 5 .4 23 56 .3 94 .5 1 3 6 0 .5 V enezuela 43 43 .9 78.6 9 7 9 .2 42 4 6 .7 75.7 9 23 .1 A s ia R epublic o f Korea 30 5 2 .8 86 .9 1 2 6 3 .6 13 43 .5 77.7 8 9 9 .7 M alaysia 25 4 4 .7 78.3 9 1 8 .9 10 4 3 .4 82 .2 1 0 0 5 .1 P h ilip p in es 41 3 9 .0 80 .3 819 .7 27 3 9 .6 73.3 7 89 .9 T hailand 15 47 .5 83.5 1 0 3 1 .7 13 41 .7 79.4 8 5 4 .4 C e n tra l Europe C zech R epublic 55 72 .0 97 .0 2 1 0 1 .5 42 6 9 .7 90.3 1 757 .8 H ungary 40 5 7 .9 84 .7 1 578 .8 39 51 .5 80 .7 1 2 4 1 .8 Poland 82 52 .8 86 .7 1 2 6 3 .6 77 43 .5 77.7 8 9 9 .7 Turkey 72 4 0 .7 79.1 9 5 7 .2 79 35 .9 72.0 7 1 0 .2 Source: IMF (2001: 11). 297 Table 15.4 Outstanding amounts of debt securities issued in domestic markets, 1989-2000 (US$ billion and per cent) US$ billion Percentage of total 1989 1992 1997 2000 1989 1992 1997 2000 All issuers 14 149.7 18 713.2 25 572.7 29 951.3 100.0 100.0 100.0 100.0 OECD (excl. Mexico) 13 790.0 18 231.8 24 631.3 28 852.9 97.5 97.4 96.3 96.3 France 605.8 956.3 1 102.5 1 068.1 4.3 5.1 4.3 3.6 Germany 729.4 1 260.2 1 732.1 1 688.9 5.2 6.7 6.8 5.6 Japan 2 558.5 3 355.5 4 399.3 6 088.8 18.1 17.9 17.2 20.3 United States 6 682.2 8 546.5 12 071.7 14 571.6 47.2 45.7 47.2 48.7 Latin America 101.2 190.5 448.7 446.3 0.7 1.0 1.8 1.5 Argentina 44.7 15.5 27.3 38.5 0.3 0.1 0.1 0.1 Brazil n.a. 111.0 344.5 297.0 n.a. 0.6 1.3 1.0 Chile 7.0 17.4 36.5 34.9 0.0 0.1 0.1 0.1 Mexico 49.5 46.6 38.5 72.3 0.3 0.2 0.2 0.2 Peru n.a. n.a. 1.9 3.6 n.a. n.a. 0.0 0.0 Source: B a s e d o n BIS d a t a (w w w .b i s . o r g / p u b l / q c s v 0 2 0 3 /a n x l 6 a . c s v ). Barbara Stallings and Rogerio Studart 299 majority of the increase was due to a single country - Brazil. Moreover the regions share of total issues remained minuscule. All these trends have implications for regulation and supervision. The risks associated with the increasing strength of financial crises, a greater mix of activities, the increasing operational complexity of the activities under­ taken by banks and a bigger foreign presence can all complicate the tasks of regulators and supervisors. A particular danger in recent years has been the increased occurrence of twin crises: simultaneous crises in the banking and foreign exchange markets. As Kaminsky and Reinhart (1999) argue, when two crises take place simultaneously they are far more severe than when they occur in isolation. As a consequence of these new challenges, regulators and supervisors must be better trained, and in some cases they will need greater support from their governments. At the same time the new circumstances may also offer advantages if the banks see it as being in their collective interest to improve their image and if foreign supervisory institutions provide useful support. Insofar as the local financial sector becomes more sophisticated, there will also be a need for coordination among the regulators of the various components. Regulation and supervision: the state o f the art Drawing on an important new database created by the World Bank,7 we can sketch out the current situation with respect to the regulation and supervision of the banking sector in many Latin American countries at the end of the 1990s. Table 15.5 provides a set of indicators on banking regulation in seven Latin American countries, plus the United States as a benchmark. The most widely known indicator is the minimum capital-asset ratio requirement, currently set at 8 per cent by the BIS through the Basel I agreement. While the United States sets its minimum at the 8 per cent level, as do Chile and Mexico, the other Latin American countries have higher ratios, with Brazil and Argentina at the top of the list with 11 per cent and 11.5 per cent respectively. A similar situation is found with the actual risk-adjusted ratio. With the exception of Bolivia, all Latin American countries maintain higher ratios than the 12 per cent found in the United States. Again, Argentina and Brazil have the highest ratios.8 Several other indexes are presented in Table 15.5. The capital stringency index includes adherence to the BIS guidelines, but also various measures of the degree to which leverage potential is limited (for precise definitions see Barth eta l, 2001a). With a range from 1 to 6, where 6 is the most stringent and the US benchmark is at 4, only Argentina among the Latin American countries has a score of 6, followed by Bolivia and Peru; Venezuela is last with a score of 2. The capital regulation index combines the previous index with one measuring the type of assets that can count toward the 300 Financial Regulation and Supervision Table 15.5 Bank regulation: selected indicators Argentina Brazil Bolivia Chile Mexico Peru Venezuela US Minimum capital- asset ratio requirement (%) 11.5 11.0 10.0 8.0 8.0 9.1 10.0 8.0 Actual risk-adjusted capital ratio (%) 16.4 15.8 11.4 12.3 13.0 12.7 14.0 12.0 Capital stringency index 6.0 3.0 5.0 3.0 4.0 5.0 2.0 4.0 Capital regulation index 8.0 6.0 8.0 5.0 7.0 6.0 2.0 6.0 Overall bank activities and ownership restrictiveness index 1.8 2.5 3.0 2.8 3.0 2.0 2.5 3.0 Source: B a r th et al. ( 2 0 0 1 a ) . capital-asset ratio, with a range of 1 to 9. On this indicator Argentina and Bolivia have the highest degree of stringency, followed by Mexico, with Venezuela again at the rear. The activities and ownership index deals with the types of activity that banks can engage in and restrictions on who can own a bank. This qualitative index ranges from 1 to 4, with the United States at 3. Unlike other indicators, Argentina allows the greatest freedom to banks, while Mexico and Bolivia are the most restrictive. It is clear from the data in Table 15.5 that regulation has many dimensions, with some countries being stricter on some than on others. Nonetheless there is some indication of a cross-country pattern. To measure this we con­ structed a summary index (the overall regulation index, ORI) by dividing the values in each row of Table 15.5 by the average of that row and then summing them up by country. Figure 15.1 presents the result of these calculations. The figure shows that regulation is strictest in Argentina, followed by Bolivia; Venezuela is the least restrictive. Nonetheless it is important to note that the United States has a lower level of restrictions than do many Latin American countries. Likewise Chile, which is commonly regarded as having the best regulatory and supervisory system in Latin America (Held and Jiménez, 2001), does not rank highly on the overall index. It could be hypothesized that an inverted U-shaped relationship is involved, whereby banks become more self-regulating after some level of development (and/or some minimal level of experience) is attained. Thus lower scores do not necessarily indicate poor regulation and supervision. On the contrary they may indicate that a country has advanced to the point where it can allow Barbara Stallings and Rogerio Studart 301 Argentina Brazil Bolivia Chile Mexico Peru Venezuela US Figure 15.1 Overall regulation index (ORI) Source: B a s e d o n T a b le 1 5 .5 ; s e e t e x t f o r m e t h o d o l o g y . individual financial institutions a little more autonomy with respect to regulation, or for market-based regulation to play a larger role. At the same time it is clear that very strong macroeconomic shocks can undermine even the highest scores and lead to banking crises, as the Argentine situation in 2001-2 shows. Table 15.6 uses the same data to examine trends in bank supervision. While more attention is typically devoted to the matter of regulation, the best regulations are of little use if they are not enforced. The number of professional supervisors per bank varies widely, from 0.1 in the United States to 11.5 in Mexico, but there seems to be only a very weak relationship between the number of supervisors and their attributes, as measured by the official supervisory index.9 The latter indicator is the sum of 16 measures of supervisory power to deal with abnormal situations and the degree of discretion supervisors have in such circumstances. The less the discretion and the greater the power, the higher the index. With the United States at 14, only Brazil has a higher ranking, while Bolivia and Mexico have the lowest. A subset of the 16 items on the supervisory power index is found in the index of forbearance discretion. Argentinean supervisors have the least discretion, while Chilean and Venezuelan supervisors have the most; the United States is in the middle. The last two items in Table 15.6 deal with what the World Bank calls private monitoring. The index on this factor measures whether an external audit is required, the percentage of the ten largest banks that are rated by international rating agencies, the degree of accounting disclosure and director liability, and the lack of an explicit deposit insurance scheme. On a scale of 1 to 8, the United States, Argentina, Chile and Peru score 8, while 302 Financial Regulation and Supervision Table IS.6 Bank supervision: selected indicators Argentina Brazil Bolivia Chile Mexico Peru Venezuela US Professional bank supervisors per institution 2.4 4.0 6.0 3.0 11.5 3.6 1.0 0.1 Official supervisory index 12.0 15.0 11.0 13.0 10. 14.0 14.0 14.0 Prompt corrective action index n.a. 6.0 n.a. 3.0 3.0 4.0 5.0 5.0 Restructuring power index 3.0 3.0 3.0 3.0 3.0 3.0 3.0 3.0 Declaring insolvent power index 3.0 3.0 3.0 3.0 3.0 3.0 3.0 3.0 Forbearance discretion index 3.0 2.0 2.0 1.0 2.0 2.0 1.0 2.0 Supervisor tenure index 6.2 15.0 6.0 n.a. n.a. 13.5 n.a. 7.0 Likelihood that supervisor will move into banking index 3.0 2.0 3.0 3.0 1.0 3.0 3.0 1.0 Percentage of top ten banks rated by international credit rating agencies 100.0 100.0 20.0 50.0 n.a. 50.0 40.0 100.0 Private monitoring index 8.0 8.0 7.0 8.0 6.0 8.0 6.0 8.0 Source: B a r th etal. ( 2 0 0 1 a ) . Mexico and Venezuela are lowest at 6. The percentage of top banks rated by international agencies is 100 per cent for the United States, Argentina and Brazil, and 20-50 per cent for the other countries in our sample. To obtain a summary view of supervision in each economy we created an overall supervision index (OSI), following the same methodology used to construct the ORI. Figure 15.2 shows the OSI values for the countries in our sample. Argentina, Brazil and Mexico have the highest ratings (the strictest supervisory standards), with Venezuela at the low end, along with Bolivia (which paradoxically has a comparatively high ORI). As with the overall index on regulation, the United States and Chile rank lower than the Latin American countries with the highest scores, again suggesting the inverted-U interpretation. The data presented in Tables 15.5 and 15.6 and in Figures 15.1 and 15.2 have several problems: they represent only a single point in time, they are Barbara Stallings and Rogerio Studart 303 Argentina Brazil Bolivia Mexico Venezuela Figure 15.2 Overall supervision index (OSI) Source: B a s e d o n T a b le 1 5 .6 ; s e e t e x t f o r m e t h o d o l o g y . overview measures that summarize a large amount of information in a single number, and they give a somewhat mechanical impression of a very com­ plex problem. To obtain a better idea of some of the details as well as the changes in the regulatory and supervisory systems in recent years, we have to turn to other studies of the region. We shall consider two such studies before turning to our own country analysis. In one of the most important studies, Aguirre (2000) stresses that sig­ nificant changes had been made in banking legislation in almost all of the 17 countries he surveyed. In general, these changes were made in response to crises or serious problems in the countries banking systems. He identifies the key changes as less public-sector ownership, greater foreign participation, broader scope for banking activities and improvements in the supervisory and regulatory authority. With respect to the latter, he focuses mainly on institutional factors, such as the agency that performs the supervision and the scope of the mandate of such institutions (only banking, or also insurance and securities activities). He found a wide difference across countries, but admits that the literature is not conclusive on the relative merits of different systems. The second study, by Livacic and Saez (2000), focuses specifically on supervision. Again noting the improvements during the 1990s, the authors emphasize the gap between the rules on the books and the ability of super­ visors to enforce them. Examples include loans to related clients and the treatment of overdue loans. They suggest various remedies, including the provision of more resources (financial and human) and greater autonomy for supervisors. 304 Financial Regulation and Supervision Basel II and the IMF financial sector assessment programmes Most of the changes in bank regulation and supervision in Latin America have been made in response to events in individual countries or, to some extent, in the region more broadly (especially the Mexican crisis of 1994-95). Nonetheless developments at the international level have also played a part. In particular the BIS and the Basel Committee on Banking Super­ vision have been influential in putting these issues onto the agenda and homogenizing the standards in developed and developing countries. At the moment, however, the international standards themselves are in a state of flux and the proposed changes pose new challenges to developing country institutions. The Basel Capital Adequacy Accord (Basel I), introduced in 1988, was a milestone in banking regulation. The 8 per cent minimum capital requirement for internationally active banks, which was adopted by over 100 countries (including most in Latin America), clearly contributed to financial stability. Nonetheless the criticism began to be voiced that the approach was too rigid and simplistic and that it did not correspond to actual levels of risk. Developing countries were especially concerned that the rules provided incentives for short-term rather than long-term lending. Basel II was meant to correct the problems identified by introducing more complex alternatives for determining risk, including the use of models developed by individual banks. Experts studying the potential impact on developing countries feared that the new approach could have a negative impact on those economies in two ways. First, the new risk categories were likely to lead to a significant decline in lending to developing countries or greatly increase the cost. Second, the new system would be inherently pro­ cyclical, increasing the frequency of crises that have an especially negative impact on the developing world. Partly because of these criticisms, the implementation of Basel II was postponed to allow further study (for further details see Chapter 10). In a parallel initiative the IMF and World Bank introduced some 60 stand­ ards and codes (ROSCs) to increase financial stability by offering policy benchmarks. These have been incorporated into the IMFs surveillance of member countries economies through the financial sector assessment programmes. While agreeing that the measures could be helpful, developing- country representatives have complained that they had no say in determining the standards and that implementing all of them would be an extremely expensive undertaking. At the same time they fear that not being able (or willing) to comply would further reduce their chance of obtaining finance. (For a discussion of the codes and standards from a developing country perspective see IMF Survey, 2 April 2001.) Barbara Stallings and Rogerio Studart 305 N ational responses to recen t f in an c ia l crises Financial structure and changes before the Tequila crisis Moving beyond regional trends, a consideration of individual country cases can deepen our understanding of the reform process as well as the problems that remain. The four countries that have been selected - Argentina, Brazil, Chile and Mexico - have much in common but also important differences in timing, operational characteristics and the macroeconomic environment in which the financial sector operates. All four economies went through a process of financial liberalization at some point between the 1970s and the 1990s, which resulted in changes in the way banks operated and eventually in banking crises. Chile was the first to embark on the liberalization process, beginning shortly after the military coup in 1973. Changes included the freeing of interest rates, eliminating directed credit, reducing the reserve requirements and relaxing regulation and supervision more generally. As in the other three cases it was followed by a rapid increase in lending and then a banking crisis in 1981-84. The crisis forced the authorities to take immediate action, and they restructured the banking sector by intervening in 21 private financial institutions, including the two largest banks in the country. Later 14 of these institutions were liquidated and the rest were rehabilitated and privatized again. Soon after the crisis, policy makers introduced changes in regulation and supervision that drew on the lessons learnt from the previous experience. The crisis thus led to a modern system of prudential regulation and increased supervisory capacity by the state. A new banking law was promulgated in 1986, encompassing a lower debt-to-capital ratio, reserve requirements according to banks leverage position, mandatory information disclosure to the public, a partial public guarantee of deposits, restrictions on loans to related clients, and a strict separation between the core business of banks and their subsidiaries. After the introduction of the restrictions, external financial liberalization was implemented gradually. Firms were initially allowed to issue bonds and shares in external markets, and subsequently institutional investors (banks, pension fund managers and insurance com­ panies) were permitted to hold external assets and capital controls were gradually eased. Further changes in 1997 included adoption of the Basel Committees 8 per cent rule (for more details see Budnevich, 2000; Field and Jiménez, 2001). The other three countries began the liberalization process a decade or more later as part of a broader economic reform package that was typical of the region (see Stallings and Peres, 2000). The measures introduced were similar to those in Chile in the 1970s, but each countrys measures had individual characteristics that distinguished its package from the others. 306 Financial Regulation and Supervision After a long period of recovering from the 1982 debt crisis, Mexico embarked on an ambitious financial liberalization process in 1988; interest rates were freed, the liquidity requirements were eliminated, credit alloca­ tion directives were abolished and the previously nationalized banks were reprivatised. The response of the banking system was almost immediate. There was a rapid growth of lending (around 30 per cent per year in real terms from 1989-94), and the share of loans to the private sector rose from 10 per cent to 40 per cent of GDP (Yacamán, 2001). But as admitted by most analysts, the first years of privatization were characterized by reckless - sometimes fraudulent - lending (EIU, 2001; 7) due to poor regulation and supervision, weak credit-analysis procedures and lack of internal controls. As lending outpaced deposits, banks put themselves in a dangerous position by funding their shortfall through interbank borrowing, mainly from foreign banks. As a consequence non-performing loans increased from around 2 per cent of total loans in 1990 to 9 per cent in 1994, prior to the peso crisis (McQuerry, 1999). In addition to these micro-level problems, macroeconomic policies also contributed to the build-up of the financial crisis. The use of an exchange rate anchor to control inflation led to overvaluation of the peso, large current account deficits and strong capital inflows. In the short run these flows stimulated growth of credit, but when they were reversed they set the stage for a twin crisis, as discussed earlier. Argentinas financial liberalization, which began in the early 1990s,10 had some of the characteristics of that of Mexico. In particular liberalization - which lifted most of the controls on the domestic and foreign operations of the domestic financial system that had been imposed during the period of high inflation and external constraints - took place at the same time as an exchange-rate-based stabilization programme (the Plan de Convertibilidad). The international situation in the early 1990s, which was marked by rising liquidity, declining international interest rates and increased access to the financial markets of industrial countries, led to a surge of optimism in the Argentinean markets. Simultaneously price stability and a fixed exchange rate regime abruptly reduced both inflation and exchange rate risk. These factors created fertile ground for the rapid growth of financial activity, but also led to maturity and exchange rate mismatches. The Argentinean financial sector enjoyed an impressive recovery until 1994: deposits and loans grew rapidly, while peso and dollar lending rates fell significantly, although they remained very high in comparison with those in most developed economies and a significant number of developing economies. These improvements were the result of several important events. First, a process of monetization - which normally follows price stability - led to the rapid growth of deposits in the banking sector. Second, there was an increase of foreign capital inflows, which raised confidence in the Convert­ ibility Plan, and increased banks propensity to make dollar-denominated Barbara Stallings and Rogerio Studart 307 loans and borrowers willingness to borrow in dollars, thus leading to the rapid dollarization of both liabilities and assets in the banking sector. Third, the increased competition among banks and the improvement of overall confidence reduced banks liquidity preference, resulting in a rapid expan­ sion of credit. In the case of domestic banks, this increased liquidity caused them to be less careful in their lending strategies and hence their portfolio quality deteriorated. Brazil also went through significant liberalizing bank reforms before 1994, although it started from a stronger initial position than the other countries. In this case the initial liberalization preceded stabilization. Three important regulatory shifts marked the development of Brazils financial system in the early 1990s: external liberalization and the banking reform in 1988, and acceptance of the Basel capital-adequacy ratio in 1994. The Brazilian reform had immediate consequences. From 1989 there was a sharp reduction in the number of commercial banks, investment banks and finance companies, most of which became universal banks. An important step in the process of liberalization was to allow the expansion of existing foreign financial institutions and the entry of new ones (especially commercial and invest­ ment banks). These changes should not prompt an overestimation of the importance of the reform, whose real significance was that it consolidated a trend that was already underway in the 1980s: the overwhelming dominance of universal banks that operated with a very short time horizon. The Tequila crisis and its effects on the stability o f the banking system The devaluation of the Mexican peso in December 1994 sparked a crisis that severely damaged the countrys banking system and had ramifications else­ where in the region and the world. Because Mexican regulations limited banks foreign exchange exposure, the problems caused by the devaluation were less significant than in other cases (although loopholes enabled banks to get around some of the restrictions, see ODougherty and Schwartz, 2001). Several indirect problems were also serious. These included a sharp drop in economic activity, a hike in interest rates and an increase in the demand for dollars. The consequence was a growing inability among debtors to service their obligations and therefore a further rise in the already high number of non-performing loans. Initially, however, the authorities thought the banking crisis would be limited in scope because of the restric­ tions on foreign exchange exposure. In addition the lack of an established regulatory authority meant that information was scarce. Thus the Mexican approach was incremental, with solutions being adopted as new problems appeared (McQuerry, 1999). The other country in the region that was particularly affected by the Tequila crisis was Argentina, whose banking system was also hit hard. The currency board system in Argentina meant that the domestic monetary authorities had no other way of preventing potential capital outflows than 308 Financial Regulation and Supervision allowing domestic rates to rise in 1995. This provoked an increase in arrears and defaults and reduced the confidence of depositors, leading to significant withdrawals of deposits. Even though the Convertibility Plan had been successful for almost five years, depositors showed their fear of devaluation by withdrawing their dollar deposits. Thus in addition to a liquidity problem the banks faced increased exchange rate mismatching. The combination of deteriorating asset quality and loss of deposits revealed the vulnerable side of the seemingly solid Argentinean system. In order to avoid a full banking crisis the Argentinean central bank (the BCRA) began injecting liquidity through its discount window, backed by the sale of dollar-denominated bonds (which in turn led to increased exchange-rate exposure on the part of the government) and reducing the reserve requirements for banks. Despite these steps by the BCRA, the accumulated losses amounted to 12 per cent of the banking sectors net worth by the first quarter of 1995. Unlike in Argentina, the causes of the 1995 banking crisis in Brazil preceded the Tequila crisis, although the latter exacerbated the problems. The fundamental reasons had to do with the abrupt adjustment that the banks had to make due to the success of the 1994 stabilization programme (the Plano Real). During the 1980s banks earned substantial profits from inflationary gains associated with the double intermediary role of public debt that the Brazilian banks enjoyed during the long period of high infla­ tion and indexation. The abrupt decline in these gains and the high fixed costs in Brazils banking sector led private banks to expand credit, which prompted the boom in consumer demand that followed the 1994 stabiliza­ tion programme.11 The rapid and sometimes careless expansion of credit, the high interest rate policy and rising unemployment provoked a rise in non-performing loans and arrears. The monetary authorities tried to restrict this expansion by setting very high reserve requirements, but these failed to constrain credit expansion. In addition interest rates were maintained at high levels, which created an increasingly dangerous mix of credit expansion and high lending rates. The public banks faced additional problems due to their limited capacity to restructure their portfolios (dominated by state government debt) and their high operational costs (in view of the job security of many of their employees). The Tequila crisis was the last straw in a process of increasing bank problems. Chile was much less vulnerable than the other countries for two reasons. First, its macroeconomic performance was barely affected by the Tequila crisis due to its lower external debt, strong trade balance and sound domestic fundamentals (for example high growth and fiscal balance). Second, as explained above, the Chilean banking system had already gone through major changes in supervision, regulation and structure. As a matter of fact, from 1991 onwards bank activity started expanding at a rate that was slightly higher than that of GDP, such that the ratio between loans and GDP grew from 45 per cent in 1990 to 66 per cent in 1999 - much higher than the peak Barbara Stallings and Rogerio Studart 309 achieved in 1984. Other indicators also point to an improvement in the efficiency and further consolidation of the banking sector (Ahumada and Marshall, 2001: 46-7). Regulatory changes after the 1994-95 crisis The Tequila crisis revealed the strengths and vulnerabilities of the banking systems of the four countries. The speed and depth of the changes in regulation and supervision varied with the information available to the authorities, their perception of the severity of the problems confronting them and the instruments they had at hand. In this context Chiles situation - with almost no impact on the banking sector - stands out as completely different from the other three cases and shows the importance of its earlier steps to clean up the banking sector, establish a modern regulatory and supervisory system and maintain comprehensive real macroeconomic balances. In Argentina after 1995, given the characteristics of its monetary and exchange rate regime, it became clear that (1) its banking sector was highly vulnerable to changes in domestic interest rates, exchange rates and depositor confidence; (2) domestic banks were more vulnerable than foreign-owned ones; and (3) since the capacity of the monetary authorities to intervene in periods of crisis was very limited under the Convertibility Plan, some additional mechanisms were needed to increase systemic liquidity (especially for dollar deposits). In order to overcome these weaknesses a set of measures was introduced to restructure the sector by injecting more capital, promoting mergers and acquisitions, and creating incentives for the expansion of foreign banks. Of the most important regulatory changes, five should be emphasized. First, the Fondo Fiduciario de Capitalización Bancaria was a full restructuring programme supported by BCRA funds and aimed at capitalizing and strength­ ening the banking sector by providing incentives for the acquisition of banks in trouble by those with a more solid market position. Second, the Fondo de Garantía de Depósitos, a deposit insurance scheme financed by private funds, was aimed at increasing depositors confidence and the banking safety net. Third, a new system of reserve requirements was intro­ duced in order to reduce leverage and improve safety. This new system widened the scope of the previous policy to encompass all bank liabilities, rather than just sight and saving deposits as was the case earlier. Fourth, the Programa Contigente de Pases was an innovative mechanism to increase the systemic liquidity of the banking sector by establishing contracts between the BCRA and international banks, in which the former acquired the right to sell dollar-denominated government bonds and mortgage-based securities to the latter. This meant that the participating banks provided a short-term overdraft line that gave the BCRA a lender-of-last resort facility in times of crisis.12 Finally, measures were introduced to stimulate the continuing 310 Financial Regulation and Supervision process of mergers and acquisitions and to expand the share of foreign banks in the domestic market. The results of these measures initially seemed quite positive in many respects. In the second half of the 1990s private bank provisions in relation to total credit increased substantially, liquidity within the banking sector rose, and the capital-adequacy ratio was maintained at levels far beyond those established by the Basel I guidelines. In addition foreign banks more than doubled their share of the market between 1994 and 1999. In sum the banking sector became more solid, which explains why its ability to deal with the emerging market crises that characterized the late 1990s was far superior to what had been observed after the Mexican crisis. Nonetheless macroeconomic policies - and especially the Convertibility Plan - eventually undermined these improvements and the banking sector entered a severe crisis after the devaluation of 2002. It will clearly take many years to recover. Brazil also took important steps to strengthen its banking system, but as mentioned above, these were not prompted by the Tequila crisis itself. During the first three years of the successful stabilization programme the central bank intervened in 40 banks (of the 271 that existed in July 1994): 29 were liquidated, four failed, six were placed under temporary adminis­ tration and one continued to operate. A further 32 banks went through a restructuring process that resulted in mergers and acquisitions, some of them with government support through the bank restructuring programme (PROER), which included fiscal incentives for banks to acquire other finan­ cial institutions and for the promotion of mergers (among domestic banks) and acquisitions (by foreign banks). Another programme (the PRO ES) was directed at the restructuring of the public financial institutions, which were in particular difficulty. This facility was created by the central bank to provide loans to federal and state banks to speed up their restructuring and in some cases their privatization or liquidation. In the process of restruc­ turing, foreign banks were allowed to enter the economy. The number and participation of foreign banks increased significantly after 1995, presenting a competitive challenge to the Brazilian banks. In addition to the restructuring of the banking sector, a number of com­ plementary regulatory measures were decreed in late 1995. These included the establishment of a deposit insurance fund that guaranteed up to R$20 000 per depositor, and increased capital requirements for the establishment of new banks. Separately, new central bank regulations were introduced to promote accountability and avoid bailouts by ensuring that the shareholders of institutions that were sold or transferred were liable for any previous wrongdoings. Perhaps the most significant of these additional measures was a preventative law that gave the central bank authorization to restructure financial institutions that were not meeting system requirements or were demonstrating financial problems. While a form of this law had existed previously, and the central bank was authorized to place banks under one of three forms of special regime (a temporary system of special administration, Barbara Stallings and Rogerio Studart 311 intervention, or extrajudicial liquidation), these laws had lacked a preventa­ tive character. Now the central bank was empowered to prescribe preventative remedies (for example increased capitalization, the transfer of stockholder control, or mergers and acquisitions) for faltering banks, and certain assets of failing banks could be confiscated. An indicator of the effectiveness of the changes was the lack of a serious banking crisis in the face of the devaluation of 1999. Mexico moved more slowly than Argentina and Brazil in dealing with its financial crisis. Indeed Mexico has had constant banking difficulties since 1995 and is still involved in a costly restructuring of its banking system. The government set up several programmes to help recapitalize and strengthen the banks. The best known was administered by the deposit insurance agency FOBAPROA, which involved the purchase of the banks non-performing loans to clean up their balance sheets. In addition a number of banks were intervened in and later resold, leading to a dramatic increase in foreign par­ ticipation in the banking sector (Graf, 1999). In December 1998, new financial legislation was approved by the Congress and duly implemented. Chief among the changes were: • A new deposit insurance system, which ended the de facto unlimited deposit insurance that had existed previously and increased the oversight of the deposit insurance agency. • Stricter accounting standards, which increased the transparency of credit operations for both supervisors and the public, imposed stricter stan­ dards for handling overdue loans and substantially increased loan-loss provisions. • A series of measures to improve lending practices and new laws on credit transactions to speed up the process of foreclosing on assets and allowing for a wider range of property to be used as collateral. • Stricter rules on capital quality (EIU, 2000). In addition, in order to reduce possible future exchange rate mismatching the Bank of Mexico lowered the existing ceilings on foreign currency liabil­ ities and imposed compulsory liquidity coefficients in foreign currency (Yacamán, 2001). In the aftermath of the crisis, banking activity as a percentage of GDP declined between 1994 and 1996, and only in 1996 did overall lending start to grow again. Lending to the private sector only began to rise in 2000. C onclusions: po licy lessons from th e L atin A m erican experience As we have seen through the experiences of Argentina, Brazil, Chile and Mexico, managing the financial system is an enormous challenge, especially in developing countries. The inherent fragility of the financial sector is mag­ nified by the volatility of capital flows and the macroeconomic shocks that 312 Financial Regulation and Supervision have been discussed in earlier chapters. The resulting instability mounts as the problems of individual banks quickly spread to other institutions and to the real economy as well. While such problems have always existed, new ones are continually arising with the increased integration of international capital markets. It is important to stress, as we have throughout the chapter, that financial instability is not an isolated problem but is closely related to macroeco­ nomic policy and performance. The relationship runs in both directions. On the one hand financial crises undermine attempts to maintain stable output growth rates and thereby increase employment opportunities and reduce poverty. They are also extremely expensive and can hobble government finances and private sector viability for years afterwards. On the other hand macroeconomic policy can bring about financial instability or even crises. For example raising interest rates can create problems for the financial sector, especially if it is already in a weakened condition. Likewise devaluing the local currency is very risky if the financial sector is heavily indebted in foreign currency. Among our cases, Chile provides a good example of the way in which a well-functioning financial system can be an important asset for an economy. After the significant corrections made after the deep financial crisis in the early 1980s, the financial sector became crucial in maintaining high economic growth for a long period, and it gave policy makers room to follow flexible policies when hard times emerged. At the other extreme the Argentinean crisis is an especially dramatic example of negative interactions between the two. Despite significant improvements in regulation and super­ vision during the 1990s, the banking system was kept afloat after the January 2002 devaluation only by tight capital controls and the freezing of deposits. Based on our analysis, and in the context of these new dilemmas, several policy lessons can be drawn by developing countries. First, it is clear that much remains to be done in the specific areas of regulation and supervision. Some countries are more advanced than others, but all can do more in terms of developing institutional supervision, improving the transparency of regulations and so on. However it is important to bear in mind that the tightest regulations are not necessarily found in the best-performing banking systems. This may mean that very strict regulations are necessary when the banking system is beginning to develop, but it may be possible to relax them somewhat in the longer term, if and when banks begin to take greater responsibility for their own behaviour. Second, even countries that have made substantial progress in the regu­ latory and supervisory sphere cannot assume that this is sufficient. The best regulatory and supervisory systems assume a relatively stable macroeconomic environment. The procyclical nature of the banking sector, with its implica­ tions for stability, is exacerbated in the case of Latin America due to the nature and sharpness of its recent business cycles. In a situation of strong Barbara Stallings and Rogerio Studart 313 volatility, whether domestic, international or both, the financial system will become increasingly fragile. Hence regulation of the financial sector must go hand in hand with adequate fiscal, monetary and exchange rate policies, as well as with measures to prevent external shocks from ravaging local economies. Third, because of the procyclical nature of the banking sector, some observers have recommended provisioning rules that take into consideration changes of risk throughout the cycle (see for example Ocampo, 2002). Under such a system, like that which is currently in place in Spain, risk is estimated for categories of credit according to the possible loss that a typical asset would experience over the entire cycle. Even though this method aims to provide a cushion for changes in risk throughout the cycle, Ocampo argues that it can also be used as a countercyclical instrument. Fourth, there are other problems in the financial sector that have little to do with regulation and supervision, and may even involve trade-offs with the latter. The main function of the financial sector is to support the development of the local economy, which means providing credit in such a volume that production and consumption can grow at an appropriate rate. If the regulations are too tight, banks may prefer to hold only the safest assets, whether government bonds or loans to the largest and lowest-risk customers in the private sector. Consideration must be given to these aspects of the financial system while balancing them with the obvious need to make the system a safer one. Finally, a supportive international environment must complement a sound domestic regulatory and supervisory system in developing countries. This includes adequate macroeconomic coordination in industrial countries as well as appropriate regulation of their financial systems. It also means that any new international regulations must consider the implications for developing countries. It must be recognized that the impact on the financial sectors of industrial and developing countries is not the same, and both must be taken into account. Notes 1. For discussions of these topics in Asia see Masuyama et al. (1999) and ESCAP (1999, 2000). 2. The most extensive work has been conducted by the Development Research Group and the Financial Sector Strategy and Policy Department of the World Bank. This is summarized in World Bank (2001); background papers can be found on the World Bank website. BIS annual reports and working papers are very useful, espe­ cially with respect to the issue of cycles (for example Borio et al., 2001), as are the publications of the FSF. The IMFs annual publication, International Capital Markets, contains extensive data and analysis, and the IMFs financial sector assessment papers can now be found on its website. On regulation and supervision in Latin America see Held and Szalachman (1991), Norton and Aguirre (1998), United Nations (1999) and Aguirre (2000). 314 Financial Regulation and Supervision 3. This became a common approach in the management of financial crises in both developed and (more often) developing economies in the 1990s; see Fischer (2001). 4. On financial institutions see Burki and Perry (1998) and World Bank (2002). 5. On these trends see Feeney (1994), Blommestein (1995), Fornari and Levy (1999) and BIS (2001). 6. The issue of foreign participation in the banking sector of developing countries has been extensively studied in the last few years. See for example IMF (2000), Clarke et al. (2001), Litan et al. (2001) and Chapter 4 of this book. 7. See Barth etal. (2001a) for a description of the database, which was constructed from a survey of bank regulators and supervisors in 107 countries. In a companion paper Barth et al. (2001b) present a preliminary analysis of the data and question the relevance of the regulatory and supervisory guidelines stressed in their paper. We believe that the conclusions reached by Barth et al. are due to their failure to distinguish between developing and developed countries, whose experiences have been quite different with respect to the behaviour of the financial sector. We intend to test this hypothesis in future research. 8. ECLAC has often advocated that developing countries should maintain ratios that are above the international norm, given the extremely high cost of banking crises. See for example ECLAC (2000). 9. This result is to be expected, given the differences in the structure of the banking system between countries. In particular the US banking sector is characterized by a myriad of small local banks, while the Latin American countries have a much smaller number. 10. Argentina attempted financial liberalization in the late 1970s, but the related measures were reversed as part of the overall abandonment of reforms at that time. For an analysis of the earlier attempt see Studart and Hermann (2001: 34-8). 11. In the first months o f the implementation of the Plano Real, Brazils central bank expanded the monetary base very rapidly to accommodate the increased demand for money that usually occurs after a successful price stabilization programme. This also increased the reserve base of the domestic banks, permitting them to expand credit. 12. This mechanism, which was designed to deal with liquidity problems, did not work during the recent crisis because of the magnitude o f the challenges facing the BCRA. That is, since in a currency board the central bank does not act as lender of last resort, the mechanism was a way of mimicking this role in periods when specific banks experienced reduced liquidity. However the mechanism was not meant to deal with potential solvency problems, as in the case of the recent crisis. In a solvency crisis of the magnitude faced by Argentina, if the mechanism had been used the international banks would have had to cover a very significant part of Argentinas total deposits, thus putting their own assets at unacceptable risk. Hence it was not used and the government had to freeze bank deposits in order to avoid the overall insolvency of the system. References Aguirre, E. (2000) Basic Reforms of the Banking Systems in Latin America, Washington, DC: Financial Restructuring Operations Division, World Bank (www.worldbank.org). Ahumada, A. and J. Marshall (2001) The Banking Industry in Chile: Competition, Consolidation and Systemic Stability, BIS Papers, no. 4, Basel: BIS. Bank for International Settlements (BIS) (2001) The Banking Industry in the Emerging Market Economies: Competition, Consolidation and Systemic Stability, BIS Papers, no. 4, Basel: BIS. Barbara Stallings and Rogerio Studart 315 Barth, J. R., G. Caprio Jr and R. Levine (2001a) The Regulation and Supervision of Banks around the World: A New Data Base’, Policy Research Working Paper Series no. 2588, Washington, DC: World Bank. , ------ and-------(2001b) Bank Regulation and Supervision: What Works Best, Policy Research Working Paper Series no. 2725, Washington, DC: World Bank. Blommestein, H. J. (1995) Structural Changes in Financial Markets: Overview of Trends and Prospects, in The New Financial Landscape, Paris: OECD. Borio, C., C. Furfine and P. Lowe (2001) Procyclicality of the Financial System and Financial Stability: Issues and Policy Options, BIS Papers, no. 1, Basel: BIS. Budnevich, C. (2000) El Sistema Financiero Chileno y su Institucionalidad Regulatoria: Las Políticas Bancarias en los Noventa, in O. Muñoz (ed.), El Estado y el Sector Privado: Construyendo una Nueva Economía en los Años 90, Santiago: FLACSO/ Dolmen. Burki, S. J. and G. Perry (1998) Beyond the Washington Consensus: Institutions Matter, Washington, DC: World Bank. Clarke, G., R. Cull, M. S. Martinez Peria and S. M. Sánchez (2001) Foreign Bank Entry: Experience, Implications for Developing Countries, and Agenda for Future Research, Policy Research Working Paper Series no. 2698, Washington, DC: World Bank. ECLAC (2000) Growth with Stability: Financing for Development in the New International Context, Santiago: ECLAC. Economist Intelligence Unit (EIU) (2001) Country Finance: Mexico, London: EIU, April. ESCAP (1999) Economic and Social Survey of Asia and the Pacific, 1998, Bangkok: ESCAP. (2000) Economic and Social Survey of Asia and the Pacific, 1999, Bangkok: ESCAP. Feeney, P. W. (1994) Securitization: Redefining the Bank, New York: St Martins Press. Fischer, S. (2001) Financial Crisis Management, www.imf.org. Fornari, F. and A. Levy (1999) Global Liquidity in the 1990s: Geographical and Long Run Determinants’, BIS Conference Papers, no. 8, Basel: BIS. Graf, P. (1999) Policy Responses to the Banking Crisis in Mexico, BIS Policy Papers, no. 6, Basel: BIS. Held, G. and L. F. Jiménez (2001) Liberalización Financiera, Crisis y Reforma del Sistema Bancario Chileno: 1974-1999, in R. Ffrench-Davis and B. Stallings (eds), Reformas, Crecimiento y Políticas Sociales en Chile Desde 1973, Santiago: CEPAL/LOM. and R. Szalachman (eds) (1991) Regulación y Supervisión de la Banca: Experiencias en América Latina y el Caribe, 3 vols, Santiago: ECLAC. International Monetary Fund (IMF) (2000) International Capital Markets Developments, Prospects, and Key Policy Issues, Washington, DC: IMF. (2001) International Capital Markets Developments, Prospects, and Key Policy Issues, Washington, DC: IMF. Kaminsky, G. and C. Reinhart (1999) The Twin Crises: The Causes of Banking and Balance of Payments Problems, American Economic Review, 89, 3. Litan, R., P. Masson and M. Pomerleano (eds) (2001) Open Doors: Foreign Participation in Financial Systems in Developing Countries, Washington, DC: Brookings Institution. Livacic, E. and S. Sáez (2000) La Supervisión Bancaria en América Latina en los Noventa, Serie Temas de Coyuntura, no. 10, Santiago: ECLAC. Masuyama, S., D. Vandenbrink and S. Y. Chia (eds) (1999) East Asias Financial Systems: Evolution and Crisis, Singapore: Nomura Research Institute and Institute of Southeast Asian Studies. McQuerry, E. (1999) ‘The Banking Sector Rescue in Mexico, Federal Reserve Bank of Atlanta Economic Review, Atlanta: Federal Reserve Bank, third quarter. Norton, J. and E. Aguirre (eds) (1998) Sistemas Bancarios Latinoamericanos: Reformas Recientes y Perspectivas, Caracas: SELA/Agencia Española de Cooperación Internacional. 316 Financial Regulation and Supervision Ocampo, J. A. (2002) Developing Countries’ Anti-Cyclical Policies in a Globalized World, in A. Dutt and J. Ros (eds), Developing Economics and Structuralist Macro­ economics: Essays in Honour of Lance Taylor, Aldershot: Edward Elgar. ODougherty, P. and M. Schwartz (2001) Prudential Regulation of Foreign Exchange: The Mexican Experience’, BIS Papers, no. 1, Basel: BIS. Stallings, B. and W. Peres (2000) Growth, Employment, and Equity: The Impact of the Economic Reforms in Latin America and the Caribbean, Washington, DC: Brookings Institution. Studart, R. and J. Hermann (2001) Sistemas Financeiros no Mercosul: Perspectivas a Partir das Reformas dos Anos 1990, Texto para Discussáo, no. 799, Brasilia: IPEA. United Nations (1999) World Economic and Social Survey, 1999, New York: UN. World Bank (2001) Finance for Growth: Policy Choices for a Volatile World, Washington, DC: World Bank. (2002) World Development Report, 2002, Washington, DC: World Bank. Yacamán, J. M. (2001) Competition and Consolidation in the Mexican Banking Industry after the 1995 Crisis, BIS Papers, no. 4, Basel: BIS. I n d e x accounting 78(nl3), 90, 94, 100, 106, 112, 156, 177, 235, 237, 301, 311 Africa 60, 61t, 62, 64f, 67f, 77t, 81t, 82, 83t aggregate demand 27f, 35, 192, 198f, 253, 269-71, 273-6, 279-80, 282, 283, 287, 293 Agosin, M. 40(n9), 240(nl), 241(n7) Aguirre, E. 303, 313(n2) Allemann, B. 77n Alvarez-Grijalba, N. 57n American Depository Receipts 205 American Drawing Rights (ADRs) 9, 10, 223, 227, 257 Andean Development Corporation (Corporación Andina de Fomento) 15 Andersen, P. 77n Argentina 5, 20, 24, 32-4, 54, 61, 63t, 65, 74-5, 84, 87t, 90-1, 135, 160, 168, 173, 176, 234, 245-8, 250, 25 If, 257, 263, 265(n3-4), 292-302, 311-12 bank regulation (selected indicators) 300t bank supervision (selected indicators) 302t banking sector (concentration, 1994-2000) 297t capital flows (1994-99) 254t claims of international banks (changes, 1990-2000) 69t country risk (1994-2002) 26f crisis (2001-) 6, 31, 175, 177, 178, 292 currency board 171,252-5 debt securities issued in domestic markets (1989-2000) 298t default 11 exchange rate regimes (1994-) 252f financial markets 171 financial volatility index (FVI, 1977-79) 24 7t foreign bank assets as share of total bank assets (1994-2000) 296t foreign-controlled banks 40(nl0) GDP (1971-2002) 28t liquidity requirements (1995) 238 low inflation and output volatility 252-5 money supply (M2) as share of GDP (1992-2000) 295t macroeconomic performance (1994-99) 254t national response to financial crises 305, 306-7, 307-8, 314(nl0) overall regulation index (OR1) 301f overall supervision index (OSI) 303f ratings crisis 122, 124-6, 127-8 real exchange rate (1994-99) 254t regulatory changes (post-Tequila crisis) 309-10, 314(nl2) share of foreign banks in domestic market 310 stock exchange prices (1990-2002) 23t Ariyoshi, A. 240(nl, n4, n6) Asia 20, 63, 65, 84, 89, 296, 313(nl) bank flows (1998-2001) 67f banking sector (concentration, 1994-2000) 297t banks in-country lending versus cross-border lending (1995, 2001) 88t borrowing by domestic non-banks from international banks (2002) 63t foreign bank assets as share of total bank assets (1994-2000) 296t foreign ownership of banking sector 87, 87t, 88 GDP (1950-2010) 64t involvement of international banks (1998-2000) 71t money supply (M2) as share of GDP (1992-2000) 295t net repayment of short-term loans 91 pull factor dominates’ 67 short-term debt to foreign exchange reserves (1996, 2000) 84t 317 318 Index Asia-Pacific region bank flows (1997-2001) 64f banks’ cross-border exposure (1997, 2001) 81t, 82, 83t, 83 international bank lending (1990-2000) 63t international banks exposure (June 2002) 77t international debt securities (1990-2000) 63t lending by Japanese-owned banks 60, 61t Asian (East Asian) crisis (1997-98) xi, 4-5, 19(n4), 24, 33, 56, 60-2, 69, 74, 86, 103, 141, 166, 170, 181, 194, 218, 227 aftermath 3, 7, 8, 10, 14, 34, 64t, 64n, 73, 75, 81, 83, 127, 159, 163, 171, 173, 174, 179(n9), 223, 232 Latin American exchange rate policies 245-68 lessons 122 Malaysia 224-5 performance of credit rating agencies 119 ratings crisis 120-1, 126 redirected lending to Latin America 68 repayments 83 stepping stone path 54 asset liability models (ALMs) 8 asset prices 192-3, 195, 202, 233, 240, 264 bands 201, 211(n5) booms 293 inflation/deflation 220 volatility 237-9 assets 2 4 1 (n ll) bubbles 193, 197, 199, 201, 204 classes 204, 212(n8) denominated in national currency 249 dollar-denominated 249 non-performing 236 quality 192, 193, 194, 197, 238 quantity 192-3 supply 197, 210 Auerbach, A. 272 Australia 63t, 144, 245, 247t, 248, 249, 290(n26) Austria 208t Bahrain 78(n8) balance of payments 78(n6), 89, 123, 192, 259, 308 balance sheets 37, 70, 72, 76, 85, 86, 90, 95, 104, 105, 112, 154, 166, 176, 177, 218-21, 232, 311 consolidation 83, 84, 89, 115 hedging 164t national 222 redistribution 89 balanced budget multiplier problem 275 Balassa-Samuelson effect 266(nl3) Banco Central de la República Argentina (BCRA) Argentine central bank 308, 309, 314(nl2) lender-of-last-resort 309 Banco de España 236 band of agnosticism’ (de Grauwe) 200-1 bank: definition 78(nl3) bank deposits 208-9t, 312, 314(nl2) Bank of England 189(n2), 202, 211(n4) Bank of England: Financial Industry and Regulation Division 183 Bank for International Settlements (BIS) 88, 91, 165, 179(n7), 189, 292-3, 299, 304 annual reports 313(n2) data 60, 63t, 64f, 66-71, 76-7, 77n, 78(nl2) pressreleases 166, 179(n7) survey (1995) of foreign exchange activity 52 Bank ofM exico 311 bank restructuring programme (PROER, Brazil) 310 banking/banking sector 56, 122, 124, 188, 190(n5), 308-10, 314(n9) deregulation 295, 314(n5) foreign participation 295-6, 299, 314(n6) fragility 89-90 international 9, 174, 189, 234, 309, 314(nl2) offshore 78(nl3) procyclical nature 312, 313 traditional role 94, 116(n4) banking crises 31, 260, 294, 305, 308, 311, 314(n8) Index 319 banking law 303, 305 bankruptcy 11, 15, 114, 120, 149, 153, 206 banks 12, 18, 52, 70, 89, 93, 95, 99n, 130, 146, 150, 168, 172, 176, 219, 220, 235, 292, 302, 313, 314(nl2) acquired 40(nl0) capital adequacy 30, 131-2, 210, 237, 240 commercial 126, 294 ‘creeping influence’ of regulation 55 crossing the border 6, 7, 86-91 degree of foreign ownership 71-2, 78(n8) domestic/local 76, 78(n7), 174, 309 European-owned 60, 61t, 78(n2) exposure to developing countries 77t, 181, 189(nl) external positions vis-à-vis emerging economies (1997-2001) 64f, 67f foreign 6, 70-2, 76, 78(n7-8), 87, 87t, 90-2, 92(n2), 309 German 69-70 in-country lending versus cross-border lending (1995, 2001) 88t individual 31, 188, 312 internal risk management systems 182, 186 involvement in developing countries 5t, 71t Japanese 60, 61t, 73 Korean 105 market share 73 mergers and acquisitions 296, 29 7t Mexican 105 OECD/non-OECD 129, 132, 133-4t onshore and offshore lending 87-9 procyclical 293 profits 95 purchase of local banks 62-3, 65, 77 reduction in number (Brazil) 307 Spanish 62-3, 70 subsidiaries 6, 7, 60, 70, 75, 76 universal 123, 307, 295 Barings 53 Barrera, E 240(nl) Barth, J. R. 299, 314(n7), 315 Barth, M. 141-3 Bartram, S. 164, 179(n5) Basel I (Basel Capital Adequacy Accord, 1988) 52, 55, 62, 70, 73-5, 181, 182, 189, 299, 304, 310 revisions 129-35 risk weights 129-30, 132-6, 154, 239 sovereign ratings 129-35 Basel II (New Basel Capital Accord) 12, 14, 119, 131-2, 189(n3), 304 benefits of international diversification 185-6, 188 capital requirements 181, 184-5, 186, 190(n5) cost and quantity of lending 183-6 developing countries 181-90 further research warranted 187, 188, 189 implementation postponed 189, 304 issues, implications 181-90 IRB approach 129, 182-7, 188, 189 may discourage further lending 181 net impact on developing countries and policy proposals 187-9 Pillar I 182 policy recommendations 187-9 procyclicality 186-7 proposed 13, 18, 182 removal of OECD/non-OECD distinction 182 removal of sovereign ceiling 182 risk weights 129-30, 132-6, 154, 239 trade-offs 187 Basel Committee on Banking Supervision (BCBS) 73,119-20, 135, 183-9, 207, 212(n9), 305 developing country representation 188 homogenization of standards 304 quantitative impact studies 184 risk-sensitive capital framework 187 BBVA Banco Bhif xv, 166, 265n Bekaert, G. 141, 157 Belgium 208t benchmarking 193, 201, 202 Bernanke, B. 179(nl0) Bertola, G. 290(nl7) Bhattacharya, A. 241(n9), 265n Bhinda, N. 19(n7) Blinder, A. 275 Blommestein, H. J. 314(n5) Bloomberg 51 320 Index Blum, J. 131 Blum-Hellwig model 131 Bolivia 168, 299-303 bond flows 10-11 markets 13, 119, 230 prices 145 restructurings 152, 157(n3) bonds 14, 15, 17, 18, 25, 46, 50-1, 62t, 78(n6), 93-9, 107, 120, 126, 127, 136, 136(nl), 196, 197f, 205-7, 305, 313 callable 106 Chilean 250, 265(n6) collective action clauses 151-3, 157(n3) commodity-indexed 279 corporate 208-9t dollar-denominated 308, 309 emerging market 156, 199-200 foreign currency 128 investment-grade 150-1, 197 Korean 151 Latin America (1992-2002) 25f long-term 140, 143 major currency 97, 100 public sector 238 usage 116(n5) yield spreads 199-200 bonuses 155, 200, 285-6, 290(n25-6) boom-bust cycles 22, 30, 32-3, 37, 121, 126-7, 132, 206-7, 279, 285 capital flow to emerging markets 139-58 direct source 222 macroeconomics 217-21 problems 139-45 strategic issues 145-7 see also business cycles Borio, C. 241(nl0), 313(n2), 315 borrowers 75, 7 8 (n ll) banks 130, 130t, 183 corporate 130, 130t, 132, 182, 183, 186, 188 high-rated 190(n5) low-rated 183, 188 sovereign 94, 130, 130t, 132, 183 borrowing 277, 282 cost 40(n4), 255 external 30, 230, 239 foreign-currency-denominated 229 public sector 255 short-term 30 Botswana 78(n8) Brady bonds 21, 96 Braga de Macedo, J. 265(nl0), 267 Brazil 4, 7, 31, 54, 60, 61, 63t, 63, 69, 75, 84, 86, 87t, 89, 107, 125, 128, 148, 149, 160, 168, 171, 176, 195, 240(n4), 245, 251f, 293, 295, 299-302, 311 bank regulation (selected indicators) 300t bank supervision (selected indicators) 302t banking crisis (1995) 308 banking sector (concentration, 1994-2000) 297t claims of international banks (changes, 1990-2000) 69t debt 229, 230 debt securities issued in domestic markets (1989-2000) 298t devaluation 198f, 246, 253 financial volatility index (FVI, 1977-79) 24 7t fiscal deficit and public debt (1994-99) 231f foreign bank assets as share of total bank assets (1994-2000) 296t GDP (1971-2002) 28t money supply (M2) as share of GDP (1992-2000) 295t national response to financial crises (case study) 305, 307, 308, 314 (n ll) overall regulation index (ORI) 301f overall supervision index (OSI) 303f regulatory changes (post-Tequila crisis) 310-11 stock exchange prices (1990-2002) 23t Brennan, M. J. 196 Bretton Woods: breakdown (early 1970s) 221 Buch, C. 69-70 Budnevich, C. xv, 35, 36, 284-5, 289(n3), 29 0 (n ll), 290(n23-4), 305 buffers 110, 114, 115-16, 117(nl9) Buiter, W. H. 148 Index 321 Bulgaria 84 Burki, S. J. 314(n4) business cycles 29, 36, 39, 75, 125, 187, 196, 199, 233, 235-7, 239, 255, 265, 273, 283, 312, 313, 313(n2) see also boom-bust cycles Business Council of Australia 285, 286, 290(n26) Caballero, R. J. 250, 255, 265(n5), 282, 286, 290(nl2, n27) Cailloux, J. 78(n4) Calvo, G. A. 92(nl), 139, 157(nl), 196, 212 Canada 11, 257 Cantor, R. 120-1 Cantor-Packer model 121, 121t Cao, H. H. 196 capital 190(n5), 199 serves two functions 114 short-term 179(n3) too much or too little 55 capital account 22, 24, 31, 32, 35, 271 cycles 29 full opening 38 volatility 228 capital account regulation 29-30, 33, 34, 238 complementary liability policies 228-32 developing countries 221-32 dual role 221-2 innovations (1990s) 222-8, 240(nl-4) price-based 229 capital controls 70, 110, 207, 228, 235, 312 capital flight 65, 75, 90, 91, 229 capital flows 59-60, 292 aims of book xi boom-bust cycles 139-58 cyclical 3 deregulation 9 drought 75, 106, 197, 198, 200 emerging economies 1-19 external 232 flood to drought 75 foreign 264 international 93-118 key question 1 net long-term top developing countries (1990-98) 98t official 2t, 59t, 98t policy options xi, 14-18 potential reversibility 82 pull factors 197 push factors 194-9 push and pull factors (somewhat misleading) 191, 192, 196 reverse 110, 128, 253, 255, 264 securitization 94 short-term 174, 176 structural factors 1, 7, 9, 14 supply and demand 20-9 transformation 94-7, 98t, 116(n6) unstable (direct source of boom-bust cycles’) 222, 232 volatility xi, 159, 160-1, 311 capital flows (private) 2t, 14, 96, 96t, 188 bank lending 4-7 bond flows 10-11 equity flows 7-10 FDI (‘increasingly hedged) 3-4 new pattern 3-11 portfolio flows 7-11 sharp decline 3 capital inflow 33, 89, 103, 105, 109, 117(nl2), 121, 126, 132, 223, 246, 254-60, 264-5, 279-80, 287, 289, 306 Chile (1990-2000) 258t Mexico (1992-2000) 262t transitory 266(nl8) capital markets 39, 94, 95, 96, 230, 232 international 20, 128, 227, 281, 312 capital outflow 38, 109, 110, 258, 307 major currency 105 problems 102-3 capital regulation index 299, 300t capital requirements 110, 113-14, 115, 117(nl9), 190(n5), 310 regulatory 181, 184-5, 186, 188 capital stringency index 299, 300t, 300 capital surges 22, 34, 105, 221, 225, 230, 233, 250, 255, 264, 279 capital vehicles 93, 116(nl) Cárdenas, M. 240(nl), 241 (n8) Caribbean 63t, 160 Carpenter, R. E. F. 179(nl0) 322 Index carry trade 68, 104-5 Carstens, A. 260 cash flow 103, 164, 174, 2 9 0 (n ll) corporate 173 management 159, 176, 177, 178 volatility 167 Cashin, P. 289(nl0), 29 Central Bank of Chile 168 centra] banks 34, 45, 60, 78(nl3), lO lf, 102, 105, 108-10, 173-4, 177-8, 229, 236, 252, 256-7, 259, 261, 264, 266(n21), 269-72, 280, 284, 286, 288, 289(n2), 308, 310, 311, 314(n ll-12 ) statisticians 77 Central Provident Fund (Singapore) 290(n29) CEPAL (Comisión Económica para América Latina y el Caribe, see ECLAC Cetes 229, 260 chain reactions 31, 292 Chase Manhattan 166 Chernow, R. 116(n4) Chew, D. H. 179(n5) Chiappe, M. L. 240n Chile 10, 28t, 30, 33, 34, 35, 40(n9), 63t, 65, 73, 87t, 160, 167-76, 232, 245, 246, 248, 263-4, 265(n6-7), 266(nl5), 269, 293-5, 299-302, 309, 311-12 bank regulation 300t bank supervision 302t banking crisis (1983) 31 banking sector (concentration, 1994-2000) 297t capital account regulations 225, 226f capital flows, exchange rate, macroeconomic performance (1990-2000) 258t claims of international banks (changes, 1990-2000) 69t copper stabilization fund (1985-) 265(n7), 277, 282, 283 crawling-band approach 255-9, 266(nl6-21) daily domestic interest rate (1996-2001) 172f daily foreign exchange rate (1996-2001) 172f debt securities issued in domestic markets (1989-2000) 298t exchange rate regimes since 1994 252f financial volatility index (FVI, 1977-79) 247t fiscal policy 282-4, 290(nl9-21, n24) foreign bank assets as share of total bank assets (1994-2000) 296t Foreign Investment committee 161 forward contracts 168-71 money supply (M2) as share of GDP (1992-2000) 295t national response to financial crises (case study) 305, 308-9 overall regulation index (ORI) 30If overall supervision index (OSI) 303f peso-dollar contracts (1996-2000) 168, 169t short-term instruments 170,171 stock exchange prices (1990-2002) 23t UF-dollar contracts (1996-2000) 168, 169t, 170 URR 222-4, 225, 226f, 227, 239, 240(nl, n5), 241(n7) China 7, 30, 61, 63t, 65, 69t, 70, 73 Choe, H. 141, 157 Citibank 166 Citigroup 183 Claessens, S. 78(n7), 79, 139, 140, 179(n4) Clarke, G. 314(n6) Clerc, L. 241(nl0) CNN 51 Cobb-Douglas production function 290(n20) codes of conduct 150, 156 Cohen, B. 78(n5) collapsed market 205 collateral 18, 94, 102, 104-5, 110-12, 114-16, 117(nl6, n21), 205, 238, 240, 287-8, 290(n29), 293, 311 collective action clauses 11, 40(n8), 151-3, 157(n3), 207 Colombia 30, 63t, 87t, 230, 232, 245, 295 capital account regulations 225, 226f coffee stabilization fund 36, 265(n7), 277 Index 323 exchange rate regimes since 1994 252f financial volatility index (FVI, 1977-79) 247t fiscal deficit and public debt (1994-99) 231f foreign bank assets as share of total bank assets (1994-2000) 296t GDP (1971-2002) 28t money supply (M2) as share of GDP (1992-2000) 295t stock exchange prices (1990-2002) 23t URR 222-4, 225, 226f, 227, 239, 240(nl) Committee on Global Financial System 77 Committee on Payment and Settlement Systems (CPSS) 212(n9) commodities 35, 162 prices 36, 179(n6), 249, 276-7, 288 sudden spikes 277-8, 289(n6) stabilization funds 36, 276-8, 288, 289 common action problem 206 common lender effect 69 companies 6, 10, 176 super-margined 110, 114 see also corporations; multinational corporations; SMEs Compendium of Standards (G7 FSF) 206, 212(n9) constant absolute risk aversion (CARA) 202 consumption 272, 273, 275, 276, 285, 287 contagion 22, 29, 54, 65, 105, 131, 141, 159, 176, 193, 195, 197, 199, 202, 204, 205, 217, 218, 245, 250, 255, 259, 265(n9) aggregate trends (1998-2001) 198f role of bank lending 69 Convertibility Law (Argentina) 252 copper 35, 250, 256, 277, 283, 284 Corbo, V. 255, 265(n5) corner solutions 34 corporations 112, 176, 220, 229, 234 geographical diversification, 176, 177 market orientation 176, 177 national 176 risk exposure 176 corruption 228 corto procedure 261 Costa Rica; money supply (M2) as share of GDP (1992-2000) 295t countercyclicality 30, 36, 40(n8), 178, 189, 206, 266(n22), 279, 313 fiscal policy 269-91 prudential regulation in developing countries 217-44 credibility 248, 250, 251, 258, 259, 263, 266(n20-l) credit 31, 109, 176, 194, 240, 294, 307, 308, 313, 3 1 4 (n ll) booms 294 crunches 186, 195, 220, 233 cycles 236 flows 193 instruments 106 rationing 200 supply 193 transactions 311 see also risk credit rating agencies 13, 38, 40(n8), 73, 74, 127, 129, 130, 135, 151, 195, 207, 228-9, 266(n22), 301, 302 crisis 120-6 criticism 119 regulation 17-18 weak prediction value 132 credit ratings 73-4, 100, 110, 114, 189 post-Asian crisis (1997-) 119-38 see also sovereign credit ratings credit risk measurement foundation approach 182 IRB approach 182-7, 188, 189 Spanish provisioning approach 189 standardized approach 182, 184, 187, 189 Credit Suisse Group 183 creditors 26, 52, 54, 148 crises 7, 15, 17, 21, 32, 38, 55, 61, 63, 72, 121, 174-5, 178, 202, 221, 222, 230, 233, 281, 286, 309 debt 86, 140, 149, 194, 197, 218, 266(nl8) external 279 fragility of banking system 89-90 liquidity 131, 132, 148 prevention policy 37 probability 90-1, 92 324 Index crises - continued result of poorly managed booms 221, 232 severity 89, 90 see also banking crises; currency crises; financial crises crossing the border 6, 7, 81-92 currencies 24, 65, 76, 94, 106, 140, 144, 168 general: devaluation 6, 13, 64, 75, 89, 91, 105, 108, 110, 125, 153-4, 159, 163-4, 171, 173, 192, 198f, 218-19, 246, 253, 259, 261, 266(n22), 307-8, 310-12; developing countries 113; domestic 63t, 123, 153-4, 228, 240(n3), 246, 249; emerging market 203; foreign 25, 31, 73, 76, 78(n9, n l3 ), 89, 102, 123, 163, 165, 172, 176-7, 227-9, 238-40, 257, 311, 312; loan denomination 62, 95, 153-4; local 7, 9, 71n, 73, 77, 88-9, 101-2, 104-5, 109-10, 117(nl0, nl2), 163, 174, 176-8, 264, 312; major 95, 97, 99n, 101-2, 105, 116(n7); overvalued 248, 250; petrodollars 95; probability of crashing 128; reporting 164; risk management 161-6, 179(n5); speculative attack 109, 110; strong 163; threats to stability 108-10 specific: baht 122; Deutschmark 256; dollar (USA) 102-3, 105, 117(nl4), 153, 154, 165, 171, 174, 178, 224, 252, 256, 257, 258, 265(n8), 307; dollar bond yields spreads 126-7; dollar deposits 309; dollar futures 168; dollar/yen 47, 50, 50f; dollarization 32, 123, 245, 307; euro 265(n8); euroization 123; Hong Kong dollar 144; peso 102-3, 117(nl4); peso (Argentina) 252; peso (Chile) 224, 257, 258, 265(n6); peso (Mexico) 105, 260, 261, 306, 307; ringgit (Malaysia) 224; yen 256; yen carry trade 68 see also exchange rate systems currency boards 32, 33, 144, 171, 172, 177, 245, 246, 252-5, 307, 314(nl2) currency crises 9, 13, 69, 119, 124, 147, 171, 175, 176 early warning signals 90, 126 current account 2t, 3, 24, 68, 264, 266 Argentina 254t balance (Chile, 1990-2000) 258t balance (Mexico, 1992-2000) 262t deficits 257, 258, 260, 265(nl2), 266(nl9), 287-8, 306 surpluses 63 Curtis, J. 57n Czech Republic 63t, 87t, 296t, 297t daily earnings at risk (DEAR) 12, 40(n5), 53-4, 140, 146 data problems 176 ,177 ,192-3 , 211(nl), 240(n4) Davis, E. 164, 179(n5) De Grauwe, P. 200-1 de Gregorio, J. 223, 240(nl), 242 de Lis, F. S. 220, 242 dealers 102-5, 109-10, 112-15, 117(nl2-13), 117(nl6) registration 112 debt 21, 75, 140, 164, 195, 197, 218, 225, 266(nl8), 285 corporate 30 dollar-denominated 38 emerging-market 135 ex ante rules 15 external 29, 76, 122, 123, 222, 223, 250, 262t, 290(nl3), 308 foreign currency 128, 161, 173, 175 hybrid 167t local 175 maturities 6, 148, 149 predictor of currency crisis 90 prudential limit 85 public 218-19, 230, 231f, 238, 260, 270, 279, 280, 284, 285, 290(nl3, n l8 ), 308 short-term 5-6, 60, 84, 85-6, 90, 223 debt payments/debt service 128, 147-8, 152, 290 (n ll) debt rescheduling/restructuring 96, 148, 153, 194, 207 debt securities 71n, 230 dedicated investors 8 Index 325 default 91, 102, 120, 122, 128, 136, 186, 205-7, 260, 280, 308 risk premium 126 demand 26, 39, 131, 193, 264, 308 deposit guarantee 305 deposit insurance 279, 294, 301, 310, 311 deposit insurance agency (FOBAPROA, Mexico) 311 derivatives 13, 18, 33, 39(n2), 71n, 77, 93-118, 161, 163-78, 179(n6) bid and ask (dealers buy and sell) prices 102, 112, 117(nl2) can accelerate pace of financial crisis 105, 110, 114 Chile 178 commodity prices 277, 289(n7) credit risk 5 developed countries 111-14, 179(n9) developing countries (policy options) 114-16 embedded (put options’) 106, 112, 166 examples 116(n2) fixed exchange rate regimes 108-10 foreign exchange 174f instruments 167t Latin America 167-72 maturity 179(n9) policy options 110-16 risk-shifting function 100 statistics 165-6 structural 167t terminology 116 (n2) DESA/UN headquarters seminar 39n Deutsche Bank 128-9 developed countries 111-14, 116, 179(n9) see also OECD countries developing countries 289(n7) bond market 107 derivatives (prudential regulation) 114-16 exporting their stock markets 9 foreign ownership of banking sector 87-8 international banks involvement (1998-2001) 5t net long-term flows (1990-98) 98t New Basel Capital Accord 181-90 prudential regulation 217-44 stocks 199, 211(n3) Diaz-Alejandro, C. F. 232 disclosure 57, 228, 305 Disyatat, P. 202 diversification 99t, 165, 265(n5) dividends 4, 160, 164, 175, 178, 192 Dodd, R. xv, 4, 13, 18, 117(n20) Dont Fix, Dont Float (Braga et al., 2001) 265(nl0) Drazen, A. 290(nl7) East Asia/Far East 5, 8, 21-2, 31, 35, 102, 104, 107, 107t, 139, 140-3, 153, 292, 294 bond market 96 equity markets 96 GDP (1971-2002) 28t maturation of stock markets (1990-99) 97t sharp reduction in inflow of portfolio equity (1997 crisis) 142 stock exchange prices 23t, 24 East Timor 78(n8) Eatwell, J. 117(nl9) ECLAC (Economic Commission for Latin America and the Caribbean) xi, xii, 21 In, 265n economic agents 22, 26, 201, 294 Ecuador 128, 153 Eichengreen, B. 62, 152-4 Eleventh of September (2001) 9, 198f, 203f EMBI (JP Morgan’s Emerging Markets Bond Index) 125t, 203, 211(n7), 279, 286 emerging markets 212(n8), 265(n8), 266(nl8) aims of book xi asset stocks (1994-2001) 197f capital flows 1-19 cross-border portfolio flows (1995-2002) 48f equity investment 9 financial regulation and supervision 292-316 net external financing (1996-2002) 59t 326 Index emerging-markets assets-demand schedule 191-213 effects of official intervention 205-10 formal analytical definition lacking 210 macroeconomic dimension 194-9 microeconomic dimension 199-204 employment 35, 270, 287, 271, 289(n2), 290(n26), 293, 312 energy 9, 128, 160 equity 7-10, 71n, 98t, 99t, 100, 141, 194, 195-7, 197f, 208-9t, 222 ERM crisis 194 ESCAP 313(nl) Europe 64f, 77t, 81t, 83t, 196 Central 40(nl0), 60, 61t, 67f, 87-8, 296t, 29 7t Eastern 8, 296 Western 64t European Union (EU) 71, 208t exchange controls 30, 227, 239 exchange rate policy 159,172-3 , 245-68, 313 exchange rate systems bands 32-4, 177, 224, 245-8, 251, 252f, 259-60, 263-4, 266-7(n23) crawling band 255-9, 264, 266(n 16-21) crawling ceiling (Mexico) 260 crawling peg 32, 266(nl7) dirty floating 32, 221, 246, 256 fixed 82, 84, 104, 108-9, 219, 221, 245-7, 251-2, 255, 263 flexible policy packages 265 floating 33, 34, 82, 84, 86, 173, 221, 224, 245-8, 250, 251, 252f, 259-63, 264 non-credible band 248 pegged 33, 34, 108, 109, 245, 250, 252f, 263, 264 shock amplification 255 soft peg 245, 2471, 247, 248, 250, 252f, 261 stability of financial and real sectors 246-52 exchange rates 22, 24, 25, 32-5, 36, 67n, 68, 90, 103, 122, 124t, 141, 178, 203, 210, 219, 223-4, 233, 275, 309 anchors 306 appreciation 219, 257, 258 band of agnosticism (De Grauwe) 200-1 depreciation 258, 266(nl8) fear of floating 82 fluctuations 76 foreign 174 forward 4, 102, 117(nl4) future 211(n5) instability 264, 265 (n5) nominal 2471 outlier 37 overvalued 253, 255, 259, 265(n4) real 246, 250, 253-6, 258-9, 261, 262t, 263, 265(n8, n l2), 266(nl3), 267(n23), 285 spot 102, 117(nl4) stability 246, 265 three questions 176-9 volatility (Latin America) 159-80 exit consents 153 expectations 191, 192, 193, 206, 253, 266(nl8) inflation 82 losses 235 returns 203, 204 Expert Group on Development Issues (EGDI), Ministry of Foreign Affairs, Sweden 240n export credit agencies (ECAs), 130, 130t, 136(n2) exports 40(n8), 64, 176, 255, 263, 264, 279 external booms 278 external credit assessment institutions (ECAIs) 182, 189, 239 Farrell, D. 116(n6) Fazzari, S. M. 179(nl0) FDI (foreign direct investment) 3-4, 9, 13, 21, 39(nl), 59, 89, 93, 96-9, 139-40, 159, 162, 173, 176, 195, 222, 227, 254t, 260, 278 capital flow volatility 160-1 inward 62t volatility (1980-99) 164t FDO Partners 47 Feenberg, D. 272 Feeney, P. W. 314(n5) Fender, I. 77, 173, 179 Fernández Arias, E. 160, 196 Index 327 Ffrench-Davis, R. xi, xii xv, 19n, 19(n3), 26, 32, 33, 37, 39, 40(n9), 240(nl), 241(n7), 265(n8), 266(nl6, n l9 ), 283, 289n, 290(n22) finance managers 16 7 ,1 7 1 ,1 7 4 ,1 7 7 financial crises 89, 94, 124, 147, 163, 171, 176, 179(n9), 187, 218, 237, 292, 299, 312, 314(n3) domestic policies for growth 29-36 interplay between supply and demand of funds 20-9 national policy issues 20-42 national responses 305-11 policy lessons 36-9 financial deepening 228, 294 financial institutions 18, 30, 32, 55, 104, 106, 113, 128, 144, 145-6, 232, 233, 294, 310, 314(n4) multilateral 230 financial instruments 53, 57, 71 financial integration (into rest of world) 248-9, 263 financial liberalization 194, 197, 305 importance of sequencing 232 financial markets 32, 40(n8), 62, 74, 111, 144, 145-6, 205 collapse of information costs 51-2 consolidation 52 domestic and foreign 257 forces reducing diversity of behaviour 51-3 freeze-up/meltdown 114 international volatility 11-13 local 172 policy options 110-16 risk-management systems 52-3 financial volatility index (FVI) 246, 247t, 247 financierist trap 21, 39(n3) Fiorelli, M. 77n, 78(nl) fiscal adjustment measures 280 balance 39, 120-1, 258t, 260 boards 286 deficit 23If, 280, 282, 285 incentives 286 indicators 123 surplus 285, 290(nl3) fiscal committee (suggested) 288 fiscal policy 35, 261 automatic stabilizers 272-3 concepts and measurement issues 273-6 countercyclical 269-91 literature, empirical evidence, policy proposals 269-91 macroeconomic role 270-2 political explanation 281-2 proposals 284-7, 287-9 puzzling behaviour (developing countries) 281-2 stop-go 276, 287 timing 289 Fischer, S. 265(nl), 314(n3) Fitch IBCA 119,126-7 Fite, D. 167 FitzGerald, V. xv, 191-213 Fondo Cafetero (Coffee Fund, Colombia) 36, 265(n7), 277 Fondo Fiduciàrio de Capitalización Bancaria (Argentina) 309 Fondo de Garantía de Depósitos (Argentina) 309 foreign exchange/currency 46, 144, 145, 166, 178, 223, 294 accumulation 222 BIS survey (1995) 52 interbank and stock market prices 171 liabilities ceilings 311 risk management by multinational firms 161-6 spot market 174 foreign exchange forward 13, 99t, 100-1, 102-3, 108-10 foreign exchange market 159,176, 177, 178, 299 trading guidelines 150 foreign exchange option 99t, 102, 109 foreign exchange rates 115, 165, 176 Chile (1996-2001) 172f currency risk management 173-6 foreign exchange reserves 68, 82, 84, 85, 109, 123, 132 foreign exchange swap 13, 991, 101-2, 102-3, 108-10 Fornari, F. 314(n5) forward contracts 166,168-71 France 18, 69t, 208t, 298t Frankel, A. 77 Frankel, J. A. 32, 2 6 5 (n ll) 328 Index fraud 110-14 Freeland, C. 77n Frenkel, J. A. 290(nl6) Friedman, M. 143 Froot, K. A. 47-8, 141, 157, 161, 180 fund managers 8, 11, 12, 16, 17, 56, 65, 75, 195, 201, 202 incentives 200 fundamentals 177, 191, 192, 193, 202, 207, 248, 255, 256, 308 futures markets 167t, 205 G3 countries 196 ,210 ,211 G7 66f, 188, 281 Financial Stability Forum (FSF) 206, 207, 212(n9) Market Dynamics Study Group report 143-5, 150 G10 countries 60, 152, 189 Garber, P. 105,110 García, M. G. P. 240(n4) Gavin, M. 281, 285, 291 GDP 35, 37, 61-2, 64t, 65, 66f, 120, 122-3, 132, 246, 247t, 253-4, 257, 259-61, 266(nl5), 269-75, 282-5, 290(nl5), 294, 295t, 306, 308, 311 and aggregate demand (1990-2001) 27f Chile 31 East Asia 28t Latin America 26, 28t volatility 249f, 25If GDP growth 29-36, 250, 253-6, 263, 266(nl4), 290(n24), 312 Chile (1990-2000) 258t Mexico (1992-2000) 262t Gelos, R. G. 202 Germany, 60, 63t, 69t, 164t, 167t, 208t, 298t Getler, M. 179(nl0) Gilchrist, S. 179(nl0) Glass, C. 52 Glass-Steagall Act (1933) 52 Global Depository Receipts 205 Global Drawing Rights (GDRs) 9 globalization 37, 39, 161, 270 financial volatility 255 Goldberg, L. 70, 90, 92(n2) Goldfeld, S. M. 275 Goldstein, M. 121, 178(nl) Goodhart, C. 19(n9) Gottschalk, R. xi, 19n, 39n governments 15, 39, 72-3, 108-9, 128-9, 192, 236, 272, 276-8, 280, 283, 287, 289(n7), 294, 299, 308, 311, 312, 314(nl2) macroeconomic policy (speculative attack) 109, 110 grain prices 289(n6) Gramm-Leach-Biley Act (1999) 52 Granger causality tests 127 Greenspan, A. 27 Griffith-Jones, S. xi, xii xv, 19(n4, n9), 39n, 74, 77n, 78(n4), 136(n2), 142, 178n, 265n Guay, W. W. R. 164, 179(n5) Guidotti rule 85-6 Gulf War (1991) 72 Harberger, A. 40(n4) Hausmann, R. 62, 154, 160 Hawkins, J. xv, 19n, 60, 78(n8), 289n hedge funds 136(nl), 143, 146, 147, 195 hedging 3-4, 55, 57, 62, 78(n3), 94, 101, 105, 108, 115, 161-5, 174-7, 178, 237, 240(n3), 249, 277, 279 most important subjects 164t tactics in Latin America 166-73 Held, G. 294, 305, 313(n2) Heller, P. S. 273, 291 Hellwig, M. 131 herding 9-10, 12, 13, 16-18, 22, 38, 52-5, 57, 85-6, 126, 142, 155, 157(n2), 186, 195, 199, 201, 204 observation of safety creates risk’ 54-5 Hermann, J. 314(nl0) Highly Leveraged Institutions (HLIs) 143-5, 150, 195 double play 144 Hong Kong 60, 63t, 73, 107t, 144, 245, 247t, 247-8, 252f human capital 38-9 Hungary 63t, 87t, 296t, 29 7t hyperinflation 33, 34, 160, 252, 253 IADB 265 (n6) IDB 283 IDS (Institute of Development Studies, University of Sussex) xi, 189(n3) Index 329 IMF (International Monetary Fund) I, 3, 10, 36, 59, 76, 105, 107, 111, 119, 202, 206, 207, 212(n9), 225, 273, 274, 276, 292, 293 website 313(n2) Committee on Balance of Payments Statistics 60 Financial Sector Assessment Programmes 304 IMF Survey 304 India 30, 61, 63t, 69t, 227 Indonesia 23t, 28t, 54, 61, 63t, 68, 69t, 73, 84, 97t, 107t, 245 inflation 62, 108, 120, 122, 123, 125, 160, 161, 199, 219, 248, 250, 252-9, 261, 264, 265(n4, n6), 269, 271, 275, 279, 283, 285, 286, 288, 289(n2), 290(n28), 294, 306, 308 Chile (1990-2000) 258t expectations 82 information 9, 31, 46-7, 193, 194, 199, 201, 207, 210, 248, 294, 307 cost 51-2, 200-1, 211(n5) publicly available 126 information asymmetry 22, 171, 177, 195, 196, 205, 217, 219, 293 information technology 90 insolvency 148, 280 Institute of International Finance (IIF) 59, 65, 84 insurance 279, 295, 303 insurance companies 7, 17, 93, 112, 136(nl), 143, 146, 150, 151, 305 interest arbitrage 84, 86 interest arrears 78(nl3) interest payments 229, 281 interest rate instruments 166 regulations 227 spreads 223 swaps 99t, 103 interest rates 22, 24, 31, 61, 66f, 95, 106, 109, 115, 152, 154, 167, 173, 176, 199, 210, 218, 220, 221, 229, 233, 246, 248, 249f, 256, 260-1, 270-1, 275, 290(nl3), 293, 294, 305, 307, 308, 312 Chile (1996-2001) 172f differentials 65, 68, 104, 122, 257 domestic/local 105, 171, 174, 223, 257, 280, 309 Europe 196 international 171, 174 OECD 192 short-term 68 USA 196, 198f variable 99n, 100 International Association of Insurance Supervisors (IA1S) 212(n9) international bank lending 59-80 BIS data 60, 76-7 borrowing by domestic non-banks 63t changes in bank operations 70-3 concentration 61-2 currency denomination 62 cyclical aspects 65-70 deposits from emerging economies 65, 78(n6) diversification of sources of funding 69-70 expected returns 65, 68 exposure 60-1, 61t financing of developing economies (1990-2000) 63t maturity 61 net bank funding 65 pattern 60-2 policy 73 push and pull factors 65-70 recent trends 62-5, 78(n4) specialization 60-1, 61t structural aspects 70-5 ‘international capital crunch’ 196 International Capital Markets (IMF, annual) 313(n2) International Organization of Securities Commissions (IOSCO) 212(n9) internet 51 interviews 160, 166, 167, 172-3, 179(n8) intramarginal intervention 263, 266(n21) investment 14-16, 26, 37, 39, 59t, 64, 125, 131, 266(nl8), 276 cross-border 9-10 ethical 15 foreign 108 greenfield 295 330 Index investment - continued gross fixed (Latin America, 1977-2002) 27f local 46 long-term 7, 18, 45, 55, 56 objectives 16 private 2t, 38, 279 productive 39(nl) public 38, 284 stop-go 282 systematic contrarian 146, 147, 155 investment banking 38, 47-8, 143, 149, 195, 307 investment funds 208-9t investment managers 147 investors 24-5, lO lf, 173, 240(n3), 257 cross-over 8, 10 direct 202 domestic 18, 101, 143, 196, 263 East Asian 113 foreign 97, 100, 101, 141-2, 196, 210, 222 foreign portfolio 143 institutional 7-8, 11, 16, 93, 96, 126-7, 136, 141, 211, 211(n3), 232, 258, 296, 305 overseas 47-8 procyclical 293 professional 57 retail 8, 56-7 ultimate 146-7 unconstrained 136(nl) Iran 65 IRB (internal ratings-based) approach 129, 133-4t, 134n, 135, 182-7 Ireland 289 (n4) irrational exuberance (Greenspan) 27 irrational overkill 38 ISDA Master Trading Agreement 111 Israel 63t, 84, 245 Italy 209t Jackson, R 183 Japan 49, 60, 63t, 67f, 67, 68, 69t, 196, 209t, 290(n25), 298t Jeanneau, S. 61, 67-8 Jiménez, L. F. 294, 305 Johnson, C. A. 117(n21) Jordan 78(n8) JP Morgan 202 EMBI 125t, 203, 211(n7), 279, 286 Global Risk Aversion Index 203 LCPI (Liquidity and Credit Premia Index) 203 junk bonds 153 Juttner, D. J. 121-2 Kaminsky, G. 141, 158, 202, 213, 299 Kaplan, E. 40(n9), 225 Kaufman, H. 143, 145 Keynes, J. M. 11, 200, 211(n2), 270, 280, 289(nl) Kim, W. 141-2 Kimmis, J. xi, 19(nl0) Kindleberger, C. 11,211 (n2) King, M. A. 271 Klau, M. 60, 77n Klingebiel, D. 78(n7) know thy customer rule 113 Koch, E. 77n Korea, Republic of 20, 30, 37, 54, 61, 62n, 63t, 73, 84, 87t, 97t, 107t, 140, 141-2, 148, 149, 195, 196, 245, 25 If, 290(n25) banking sector (concentration, 1994-2000) 29 7t claims of international banks (changes, 1990-2000) 69t crisis (late 1997) 143 exchange rate regimes (1994-) 252f financial volatility index (FVI, 1977-79) 247t foreign bank assets as share of total bank assets (1994-2000) 296t GDP (1971-2002) 28t money supply (M2) as share of GDP (1992-2000) 295t ratings crisis 120 stock exchange prices (1990-2002) 23t Krueger, A. 149 Krugman, P. 266(n21) Kumar, M. S. 5, 7, 202 labour market 248, 263 Lall, S. 105,110 Lamfalussy, A. 60 Larrain, F. 223, 240(nl), 242 Index 331 Larrain Rios, G. xv, 32, 33, 128, 137, 253, 266(n22), 267, 289n Larson, D. 289(n5, nlO) latent risk’ 236, 237, 239 Latin America 4, 8, 9, 20-2, 24, 31, 33, 35, 37, 39(nl), 40(nl0), 62-3, 68, 72, 78(n6), 84, 142, 165, 175, 232, 273, 281, 286, 287 bank flows (1997-2001) 64f, 67f banking sector 314(n9) banking sector (concentration, 1994-2000) 297t banks cross-border exposure (1997, 2001) 81t, 83t banks in-country lending versus cross-border lending (1995, 2001) 88t borrowing by domestic non-banks from international banks (2002) 63t capital transfer volatility (1980-99) 164t characteristics of new financial sector 294-9 cost and maturity of bonds (1992-2002) 25f debt overhang (1982-) 96 debt securities issued in domestic markets (1989-2000) 298t exchange rate policies during Asian crisis 245-68 FDI volatility (1980-99) 164t financial links with rest of world 249-50 financial regulation and supervision (1994-) 292-316 financial sector (1990s) 294-304 foreign bank assets as share of total bank assets (1994-2000) 296t foreign ownership of banking sector 87, 87t, 88 GDP 28t, 64t GDP and aggregate demand (1990-2001) 27f gross fixed investment (1977-2002) 27f hedging tactics 166-73 international bank lending (1990-2000) 63t international banks exposure (June 2002) 77t international debt securities (1990-2000) 63t involvement of international banks (1998-2000) 71t lending by Spanish-owned banks 60-1, 61t lending by US-owned banks 60, 61t, 70 liberalization, crisis and rescue 294 money supply (M2) as share of GDP (1992-2000) 295t ‘push factor dominates 67 regulation and supervision 299-303 short-term debt to foreign exchange reserves (1996, 2000) 84t stock exchange prices (1990-2002) 23t Laurens, B. 240(nl) Le Fort, G. 40(n9), 223, 240(nl), 257, 284-5, 289(n, n3), 290(n23-4) Lehmann, S. 40(n9), 223, 240(nl), 257 Leiderman, L. 266(n23) lending/loans 4-7, 14-16, 59-80, 94-9, 106-7, 112, 151, 179(n3), 193, 208-9t, 229, 233, 290(n29), 313 commercial 235 cross-border 65, 81-92, 129 cross-default clauses 95, 99t, 116(n8) currency of denomination 153-4 current approach 133-4t dollar-denominated 306-7 foreign 163, 256, 257 foreign banks 95 foreign currency 168, 236-7, 238 long-term 21, 68, 7 8 (n ll), 132, 140, 154 major currency 105 maturities 132, 133-4t, 134n medium-term 6, 21 non-performing 220, 294, 306-8, 311 offshore 60, 72, 73 onshore 40(nl0), 88, 92 percentage of total capital flows (1973-97) 96 regulatory incentives for short-term interbank 133-4t retail 235 servicing 95 332 Index lending/loans - continued short-term 5-6, 21, 61, 68, 75, 81-6, 88, 89, 91, 135, 140, 141, 149, 189, 191, 304 short-term foreign currency 103 standardized approach 133-4t, 135 syndicated 93, 95, 196-7 see also international bank lending Levy, A. 314(n5) Levy, E. 265(nl) liability policy 222 liberalization 295, 305 banking 307 capital account 31, 35, 227, 265, 294 capital flows 260 capital markets 94, 95, 96 domestic finance 31 financial 194, 197, 232, 294, 305, 306 importance of sequencing 232 trade 253 Lipsey, R. E. 140, 160 liquidity 9-10, 15, 25, 45-58, 131, 132, 148, 171, 176, 200, 202, 238 black holes 48-50, 55 coefficients 311 diversity and size not synonymous’ 50-1 drought 106 emerging equity markets (1997-2002) 47f indicators 123 international 253 ‘needs losers 56 requirements 112-13 shortages 107 solutions 56-7 systemic 309 Litan, R. 314(n6), 315 Livacic, E. 303 LIBOR (London interbank offered rate) 13, 103, 104, 133-4t, 134n, 135 loan delinquency 233, 235 losses 236 portfolios 184-5, 186 rescheduling 72 London 142, 152, 153 Long-Term Capital Management (LTCM) 9, 47, 57, 144 Lowell, B. 116(n6) Lubin, D. xv Luna, C. 77n Luttick, J. 211(nl) macroeconomic behaviour 280, 288 countercyclical policy 270-2 dimension (asset demand schedule) 194-9 effects/results 225, 227, 287 environment 161, 263, 281, 292 factors 233 imbalance 26, 258 implications 173, 183 instability/volatility 38, 235 management (irresponsible) 154 performance 308, 312 stability 188, 205, 255-6, 312 variables 276 Macroeconomic Group of the Initiative for Policy Dialogue 39n macroeconomic policy, 160, 222-4, 241 (n7), 264-5, 283, 287, 306, 310, 312 complements to 239 domestic (no space for) 252 for growth 29-36 irresponsible 40(n7) prudential 250 saving during booms, expenditure during crises 273, 289, 289(n4) macroeconomic policy committee (suggested) 288 Magendzo, I. 266(n20), 268 Mahathir bin Mohamad, Datuk Seri Dr 143 Malaysia 30, 40(n9), 54, 63t, 70, 87t, 97t, 103, 107t, 144, 228, 245 banking sector (concentration, 1994-2000) 29 7t basic lesson 227 capital account regulations 224-5, 226f, 227, 239, 241(n6) claims of international banks (changes, 1990-2000) 69t financial volatility index (FVI, 1977-79) 24 7t foreign bank assets as share of total bank assets (1994-2000) 296t Index 333 GDP (1971-2002) 28t money supply (M2) as share of GDP (1992-2000) 295t stock exchange prices (1990-2002) 23t manipulation 110, 111, 113, 145, 150, 279 margin requirements 110 market capitalization 48f, 96, 201 Market Dynamics Study Group report 143-5 market equilibrium 193, 205 failure 193, 219 integrity 145 markets imbalanced, 102-3 local credit 102-3 Martner, R. 289(n3) Massad, C. 284, 289n Masuyama, S. 313(nl), 315 maturities 223, 227-30, 234, 240(n3), 257, 260 McCarthy, J. 121-2 MERCOSUR 253 mergers and acquisitions 31, 39(nl), 40(nl0), 294, 295, 296, 297t, 309, 310 non-greenfield FDI’ 21 Merrill Lynch 166 Mexican crisis (Tequila crisis, 1994-5) 20, 21, 22, 25, 37, 68, 119, 173, 245, 250, 25 If, 257, 260, 266(n22), 293, 304 aftermath 127, 159, 163, 309-11 effect on stability of banking system (national case studies) 307-9 financial structure and changes before 305-7 Mexico 4, 7, 25-6, 31, 34, 35, 61, 63t, 65, 69, 73, 84, 86-90, 104, 122, 128, 160, 168, 195, 196, 229, 248, 265(n7), 299-302 bank regulation (selected indicators) 300t bank supervision (selected indicators) 302t banking legislation (1998) 311 banking sector (concentration, 1994-2000) 297t capital flows, real exchange rate, macroeconomic performance (1992-2000) 262t claims of international banks (changes, 1990-2000) 69t country risk (1994-2002) 26f debt securities issued in domestic markets (1989-2000) 298t devaluation (1994) 253 exchange rate regimes since 1994 252f financial volatility index (FVI, 1977-79) 24 7t fiscal deficit and public debt (1991-96) 231f floating exchange rate regime 259-63 foreign bank assets as share of total bank assets (1994-2000) 296t GDP (1971-2002) 28t money supply (M2) as share of GDP (1992-2000) 295t national response to financial crises (case study) 305, 306, 307 overall regulation index (ORI) 301f overall supervision index (OSI) 303f regulatory changes (post-Tequila crisis) 311 stock exchange prices (1990-2002) 23t micro finance 26, 27 micro-macro transmission mechanisms 159, 176 microeconomic behaviour 159 dimension (asset demand schedule) 199-204 efficiency 31 level 191, 204 training 39 Micu, M. 61, 67-8, 77n Middle East 64f, 77t, 81t, 82, 83t Mihaljek, D. 78(n8) mining 161, 162-3, 278, 2 9 0 (n ll) Minsky, H. P. 11, 218 mismatches currency 17, 56, 70, 221, 240 currency and maturity 31, 38, 62, 90, 220, 221, 230, 232, 234-5, 237, 294 334 Index mismatches - continued duration 56 exchange rate 308,311 liquidity 238 maturity 206, 219 maturity on assets and liabilities 115 Modigliani-Miller world 131 Mody, A. 152, 153, 195 Moguillansky, G. xv momentum trading 202 monetary base 3 1 4 (n ll) indicators 123 policy 178 ,221 ,287 pressures 223, 225, 226f money supply 254t, 255, 294, 295t Montiel, P. 196 Moodys Country Credit Statistical Handbook 122 Moodys Investor Services 119, 120, 121t, 122-6, 128, 134n, 135, 211(n4) Argentina, 124, 125t crisis 120-1 Mora, N. 128 moral hazard 199, 219, 233, 279 Morandé, F. 290(n22) Morgan Stanley 166 multinational corporations 4, 93, 140, 166, 178, 178n affiliates 197 Argentinean 178 diversified (regionally and geographically) 163-4 export sector 162-3 hedging tactics in Latin America 166-73 investments concentrated in one region 164 mining sector 162-3 public services 165 quarterly financial statements 179(n8) risk management 159-80 three questions 176-8 typology of financial strategies 161-5 mutual funds 7, 141, 142, 146, 155, 157(n2), 196-7, 198f, 201-2, 211(n6), 229 Myners Review 16 NAFTA 71, 260 NASDAQ 112 Neftci, S. N. 105 New York 1 1 ,1 4 2 ,1 5 2 ,1 5 3 ,1 6 8 New York Stock Exchange (NYSE) 112 New Zealand 78(n8), 144, 245, 247t, 248, 249, 252f No Single Currency Regime is Right for All Countries (Frankel, 1999) 265 (n ll) non-deliverable forwards (NDFs) 168 non-tradable sector 237, 238, 241(nl2), 248, 249-50, 253, 264, 266(nl3) Norton, J. 313(n2) OConnell, P. 47-8 ODougherty, P. 307 Ocampo, J. A. xi, xv, 22, 29, 32, 37, 39n, 178(nl), 265n, 240(nl), 265 (n8), 289n, 313 offshore centres 61, 77 offshore/onshore funds 157(n2) off-balance-sheet activities 112, 115, 166 oil 35-6, 65, 75, 82, 95, 162-3, 165, 261, 282, 289(n6) oil stabilization funds 265 (n 7), 282 Oliner, S. D. 179(nl0) OPEC 76 options 166, 167t, 168 Organisation for Economic Co-operation and Development (OECD) 59, 61-2, 70-1, 73, 129-30, 136, 191, 199, 207, 212(n8-9), 236, 249, 260, 275, 281, 284 debt securities issued in domestic markets (1989-2000) 298t capital markets 210 OECD Development Centre 136n original sin 154 Ötker-Robe, I. 241(n6) Ottawa: North-South Institute 117(nl8) output 271, 273, 289(n2), 290(n20) growth 276, 284, 290(n22) volatility 247, 252-5 over-the-counter (OTC) derivative transactions 111, 112, 113, 116, 117(n21) Index 335 over-the-counter (OTC) instruments 166, 167t, 168 overall bank activities and ownership restrictiveness index 300t, 300 overall regulation index (ORI) 300, 301f overall supervision index (OSI) 302, 303f Packer, R 120-1 Pakistan 84, 128 Palma, G. 227, 240(nl) panic 126, 132, 142, 147, 148, 151, 260 Paraguay 253 Partnoy, F. 117(n20) Peek, J. 89 pension fund contributions 287 managers 305 systems 290(n29) pension funds 7, 12, 13, 14-15, 16, 78(n6), 93, 112, 136(nl), 201-2, 207, 210, 258-9, 272, 280 Chile 141 compulsory contributions 288-9 regulation in nine OECD countries (2001) 208-9t pensions 279, 284 Peres, W. 305 Perry, G. 314(n4) Persaud, A. xv, 5, 7, 9-10, 12, 17, 40(n5), 140, 202, 265n Peru 23t, 28t, 63t, 87t, 168, 265(n9), 295, 296t, 298-303 Pétre, D. 77n Pfleiderer, P. 167 Philippines 23t, 28t, 63t, 72, 73, 84, 97t, 107t, 295t, 297t Phillips curve 271 physical capital 38-9 Plan de Convertibilidad (Argentinean Convertibility Plan) 306-7, 308, 309, 310 Plano Real (Brazil, 1994-) 308, 314 (n ll) Poland 63t, 73, 87t, 296t, 297t policy event 108, 117(nl7) policy lessons/options xi, 14-18, 36-9 capital flows to emerging markets 210-11 corporate risk management and exchange rate volatility 176-8 countercyclical fiscal policy 239-40 curbing the boom-bust cycle 156 derivatives 110-16 encouraging lending and investment 14-16 exchange rate policy 263-5 financial regulation and supervision 311-13 fiscal policy 284-9 managing macroeconomic effects of boom-bust cycles 237 New Basel Capital Accord 187-9 prudential regulation in developing countries 239-40 ratings since Asian crisis 135-6 reducing procyclicality and short-termism 16-18 Portes, R. 152 portfolio approach 161 capital 191, 223 diversification 8 equity 96t, 142, 145 flows 7-11, 222, 227, 232 investment 2t, 5, 9, 21, 59, 59t, 78(n6), 140-1, 195, 254t positive-feedback trading 142, 157(n2) Powell, A. 74 Prevost, A. K. 164, 179(n5), 180 prices 265(n4), 275, 278 domestic 278, 289(n9) flexibility 245, 263 misalignments 290(nl8) stabilization schemes 278, 3 1 4 (n ll) principal exchange-rate-linked notes (PERLs) 113 private monitoring (World Bank) 301, 302t private sector 122, 128, 194-5, 279, 283, 286, 289(n7), 311, 312, 313 privatization 63, 72, 165, 168, 194, 197, 253, 260, 266(nl3), 295-6, 305-6 probability theory 200 procyclicality 12-13, 16-18, 24, 29, 35, 40(n5, n7-8), 45, 54, 74, 121, 128, 131-2, 135, 136, 140, 142, 157(n2), 172, 186-9, 201, 206, 223, 230, 233, 235-7, 239, 279, 281, 304 product diversification 289(n 7) 336 Index productivity 253, 256, 258, 266(nl3, n l9 ), 289(n7) PROES (Brazil) 310 profits 25 maximization 193 repatriation 278 sharing 285-6 Programa Contingente de Pases (Argentina) 309 project finance 278-9, 2 9 0 (n ll) prudential regulation 20, 29, 30-2, 37-9, 86, 93-118, 127, 136, 207, 228-9, 241(nl0-13), 305 asset prices 237-9 countercyclical 232-9 currency and maturity risks 237-9 instruments to protect against credit risk 235-7 micro- and macroeconomic dimensions 232-5 public accounts 35, 269, 270 public deficit 274 public expenditure 35-6, 39, 275-6, 279, 281-2 taxpayers money 72 public sector 229, 239, 253, 260, 270 level of activity 280-2 theory and empirical evidence 280-2 public services 161 ,165 ,177 public works 279, 282 put options 106, 107, 112, 151, 156 putable debt 106-7 quality of recovery 37 Quiroz, J. 289(n8) Rajaraman, I. 241(n6) rate-spread widening 198-9 rates of return 21, 24, 105, 258 rating pressure (definition) 129 ratios actual risk-adjusted 299, 300t, 314(n8) capital adequacy 17, 232, 307, 310 capital-asset 237, 240, 299, 300t, 300 debt to capital 305 expenditure and revenue to potential and actual output 275 external debt to exports 254t external debt to GDP (Mexico, 1992-2000) 262t foreign debt and exports 120, 122 international bank lending (concentration, 2000) 62t investment to GDP (Chile, 1990-2000) 258t loan to collateral value 240 price-earnings 21, 22, 37 public spending to potential output 274 short-term debt to reserves 84-6 short-term debt to total debt 5, 85, 85t, 86 tax revenue to effective output 274 Razin, A. 290(nl6) real estate 22, 25, 37, 38, 208-9t, 220, 238, 295 property 56 recessions 22, 72, 253, 255, 256, 259, 261, 266(nl5-16), 269, 270, 272, 281, 282, 284, 290(n26) downturns 131, 286, 287 regulation 32, 53, 57, 90, 106, 107, 313 biases 189 countercyclical 29 creation of liquidity black holes 45-58 creeping influence 55 differing impact on industrial and developing countries 313 macroeconomic 37 see also prudential regulation regulation and supervision 305, 309 state of art 299-303, 314(n7) training required 299 trends 301, 302t regulatory authorities/regulators 16, 17, 30, 85 regulatory incentives 192 Reinhart, C. M. 92(nl), 196, 299 Reisen, H. xvi, 13, 17, 19(n9), 121, 126, 127, 128, 265n Remolona, E. 78(n5) remuneration practices 154-6 repurchase agreements 93, 94, 116(n3) reputation 53, 72, 91, 115, 194, 201, 263, 266(n21), 271, 289 reserve requirements 238, 256, 257, 305, 308, 309 Index 337 reserves 2t, 4, 174, 249f, 254t, 294 international 222, 225, 246, 247t, 248, 252, 260, 279 Mexico (1992-2000) 262t resource allocation/misallocation 26, 32, 33, 36, 183, 188 revulsion 83-4, 86, 92 Rincón, H. 240(nl) risk 5, 8, 9, 11, 18, 40(n7), 46, 49, 70, 74, 77, 94, 102, 104, 114-16, 183, 186, 190(n5), 205, 210, 219-20, 222, 240(n3), 279, 299, 313 actual 181, 185, 188, 299, 304 cashflow 177 commodity price 179(n6), 276 correct reporting 151 country 14, 26f, 76, 85, 91, 173, 281 credit 5, 30, 68, 73, 76, 95, 97, 99t, 100, 110, 116(n9), 117(nl6), 182, 234, 235-7, 238, 239, 293 cross-border (1997, 2001) 81t currency 84, 86, 91, 122, 153-4, 163-6, 172-8, 238 currency and maturity 237-9 default 192, 196, 199, 200, 206, 210 derivatives 97, 99, 99t devaluation 229 exchange-rate 4, 68, 95, 97, 100, 105, 106, 108, 116(n9), 249, 250, 308 financial 166, 168 fixed exchange rate systems 255 foreign debt 161 foreign exchange 73, 78(n9), 99t, 101, 104, 117(nl0), 307 global 202 interest rate 95, 97, 99t, 100, 106, 115, 116(n9), 238 liquidity 99t, 100, 115, 119, 132, 195, 293 macroeconomic 106, 239 market 97, 100, 103-4, 110, 112, 116(n9), 293 market-sensitive 17, 52-3, 56 measurement 182, 188, 189 microeconomic 235, 239 new categories 304 new market 93 not balanced (between borrower and lender) 95 perplexing paradigm 54-5 price 97, 99t, 116(n2), 192-3 redistribution 96-7 security price 117(nl0) settlement 116(n9) sovereign 74, 132, 253 structural measures 17 systemic 195, 292 transaction 163, 164, 176, 177 translation 176, 177, 178 risk appetite 199-204,211 risk underestimation 217 risk aversion 82, 163, 165, 181, 193, 199, 201, 202, 204, 211(n5) flight to quality 217 global 203f risk management 16, 40(n5), 45, 53-4, 71, 78(n9-10), 110, 115 banks 140 corporate 159-80 currency 159, 161-6, 173-6, 178n diversity of systems 55 foreign exchange 161-6 further research 160 internal models 236 methodology 159-60 multinational firms 161-6 short-term systems 56, 57 typology of financial strategies 161-5 varied 56 risk weighting 75, 238 Rodrik, D. 40(n9), 225, 265(n2), 268 rogue traders 55 Rojas-Suârez, L. 241(nl2) rollovers 175, 219, 222, 229 Romania 84 Ros, J. 260, 264 ROSCs 304 Rosengreen, E. S. 89 Rudebusch, G. D. 179(nl0) rumour 144, 150 Russia 5, 7, 54, 60, 61, 63t, 65, 84, 86, 89, 102, 128 default (August 1998) 11, 47-8, 75, 171, 173, 198f, 218, 246, 253 Sâez, S. 303 Santander Bank 166 Sarno, L. 160 Saudi Arabia 61, 65, 72-3 338 Index savings 22, 29, 46, 75, 90-1, 125, 264, 278-80, 284, 287-8, 290(n29) Schwartz, M. 307 securities 78(nl3), 93-5, 112, 116(n3, n6), 128, 136, 168, 210, 295, 296, 303 dollar-denominated 230 local currency 117(nl0) mortgage-based 309 offshore markets 249 public sector 232 structured 113, 117(n20) US Treasury 113 securitization 93, 94 shadow transactions 93-4, 97-107 shares/shareholders 5, 305, 310 shocks 32-3, 34, 36, 75, 82, 127, 131, 178, 199, 218, 220, 230, 234, 238, 246, 248-51, 260, 263, 264, 267(n23), 271, 278-9, 281-2, 285, 287-8, 293-4, 301, 311, 313 amplified by rigid exchange rate systems 245 commodity price 160 currency 159 financial 40(nl0), 159, 171 multiplier effects 272 short-termism 16-18, 20, 24, 74, 146-8, 151, 153, 155-6, 178, 229, 256 Sibert, A. C. 148 Singapore 63t, 71-2, 73, 97t, 107t, 144, 290(n29) SMEs 6, 72, 176, 183, 185-6, 188, 220, 234 social security 273, 283, 296 solvency 238, 240, 270, 273, 277, 314(nl2) Soto, M. 240(nl), 241(n7) South Africa 10, 63t, 84, 86, 142, 144, 154 South-East Asia 21, 23t, 28t, 107, 107t Southern Cone 124 sovereign credit ratings 119-38, 152 country ceiling policy 128 determinants 120-6 downgrades 136 downgrades/upgrades 127, 136(nl) market impact 126-9 Mora’s puzzling finding 128 policy conclusions 135-6 quantitative measures/indicators 122-3 revisions to Basel Accord 129-35 sovereign immunity 152 sovereign yield spreads 132 Spain 60, 159, 179(n8), 313 countercyclicality regulations (December 1999) 236,237, 239-40 investment regulation of pension funds (2001) 209t provisioning system 17 speculation 34, 39, 102, 108, 143, 144, 194, 224, 248, 260, 263, 266(n21) Spratt, S. xvi, 19(n9), 74, 136(n2) spreads 228, 234 stabilization 273, 285, 296, 306, 307, 310 Brazil 308, 3 1 4 (n ll) Stallings, B. xvi, 305 Standard Poor’s (SP) 119, 120, 121t, 124-6, 128 crisis 120-2 SP 500 49 Turkey 124, 124t, 125 State Street 47 statistics 207 Central Bank of Chile 168 daily publication 140 derivative markets 165-6 Steagall, H. 52 Steiner, R. 240(nl), 241(n8) sterilized reserve accumulation 34 Stern, J. M. 179(n5) Stiglitz, J. E. 39n, 241(n9) stock markets 10, 15, 22, 96, 97t, 141, 142, 168 stock prices 25 stock shares 96 stocks 93, 94, 95 structured notes (hybrid instruments) 106 Studart, R. xvi, 265n, 314(nl0) Stulz, R. M. 167 Sturzenneger, F. 265(nl) Sub-Saharan Africa 6, 8, 9 subsidiaries 91, 162, 166, 167, 174, 176, 177, 305 Sutherland, A. 290(nl7) Index 339 swaps 166, 167t, 168 Swaps Monitor 117 (n ll) Swensen, D. 146 Szalachman, R. 313(n2) Taiwan 23t, 28t, 61, 65, 290(n25) Talvi, E. 281 Tapia, H. xi, 39n, 265n, 283 tax base 281, 286 benefits/incentives 14-15, 18, 161, 211 deductibility 137 evasion 288 flexibility 284, 286-9, 290(n24) policy 155 revenues 274, 275, 281, 283, 284, 290(nl5) smoothing 281, 282 taxation 30, 35, 36, 39, 94, 100, 107, 257, 270, 272, 273, 279, 287 corporate 272, 273, 280, 285, 286, 288 countercyclical 282, 285 indirect 281 payroll 288, 289 personal income 269, 285, 286, 288 progressive 280, 288 provision for foreign-currency liabilities 229 trade 281 Taylor, J. 271 Taylor, L. 218 Taylor, M. P. 160, 195 technology 197, 222, 263 telecommunications 4, 9, 128, 160, 173 terms of trade 254t, 257, 258, 258t, 262t, 266(nl9), 271, 285, 286, 289 Tesobonos (1994-) 105, 229, 260 Thailand 20, 23t, 28t, 30, 54, 63t, 69t, 73, 84, 87t, 97t, 107t, 195, 245, 247t, 25If, 295t, 296t, 297t Tobin tax 222 Topix 49 total return swap (TRS) 13, 99t, 104-5, 117(nl6) Tovar, C. 240(nl) tradable sector 248, 265(n5), 266(nl3) trade 54, 70, 86, 123, 253, 256, 258, 263, 276, 308 free trade agreements 257 trade credits 78(nl4), 140, 149 transparency 18, 31, 39, 39(n2), 52, 90, 93, 100, 110-11, 114, 140, 171, 189, 261, 269, 284, 294, 311-12 Turkey 7, 54, 61, 63t, 65, 73, 75, 84, 86, 89, 90, 135, 198f, 296t, 297t ratings crisis 124-6, 127-8 Turner, P. 77n, 241(nl0) twin crises 299 Ukraine 128 unemployment 37, 123, 248, 253, 266(nl3), 273, 275, 280, 308 unemployment benefits/insurance 36, 270, 272, 273, 276, 279, 280, 286-9 United Kingdom 8, 11, 18, 52, 61t, 63t, 69t, 142, 157(n2), 159, 179(n8), 207, 209t, 210, 313(n2) United States (of America) 8, 11, 52, 63t, 66f, 68, 75, 112, 117(n21), 142, 157(n2), 164t, 166, 196, 203f, 256, 260, 261, 275, 299-302 bank regulation (selected indicators) 300t bank supervision (selected indicators) 302t banking sector 113, 314(n9) budget deficit 269 claims of banks on developing economies (1990-2000) 69t Commodity Futures Trading Commission 113 Controller of Currency 117 (n 11) current account deficit 249 debt securities issued in domestic markets (1989-2000) 298t economic slowdown 64-5 GDP (1950-2010) 64t imports from Mexico 263 investment regulation of pension funds (2001) 209t most-used instruments in derivative market 167t net inflows from emerging economies 78(n6) overall regulation index (ORI) 301f overall supervision index (OSI) 303f 340 Index United States (of America) - continued pension funds 210 Securities and Exchange Commission 51, 114, 179(n8) securities markets 113 yield spreads 196 universal debt rollover option with a penalty (UDROP) 147-9, 156 university endowments 93, 146-7 unremunerated reserve requirement (URR) 222-7, 239, 240(nl-4), 241(n7-8) UNU/WIDER Capital Flows project xi, xii, 39n, 21 In, 292, 293 Helsinki seminar (October 2001) xi, 77n, 21 In, 289n Santiago seminar (March 2001) xi, 77n, 157n, 211n Uruguay 253, 255, 265(n6, n9) Valdes-Prieto, S. 240(nl), 241(n7) Valpassos, M. V. F. 240(n4) value at risk (VaR) 5, 12, 40(n5), 53, 54, 55, 113, 131, 207 value-added tax (VAT) 36, 272, 275, 280, 282-9, 290(n23) countercyclical fiscal management 286 Van Rijckeghem, C. 69 vanilla interest rate swap 103 Varangis, P. 289(n5, nlO) Vegh, C. 281 Venezuela 23t, 28t, 36, 63t, 87t, 265(n7), 295, 296t, 297t, 299-303 Vergara, R. 290(n22) Villar, A. 77n Villar, L. 240(nl) volatility 8, 16, 21, 29, 33, 35, 54, 56, 82, 102, 108, 117(nl0), 131, 136, 139-41, 193, 198-9, 201, 211(n5), 217, 234, 238, 292, 313 exchange rate (Latin America) 159-80 financial 249f, 250-1, 251f international financial markets 11-13 securities prices 93 short-term capital flows to developing countries 45-58 von Kleist, K. 77n, 78(nl4) von Maltzan, J. 126, 127, 128 vulnerability 21, 36, 38, 40(n6), 69, 234 wages 37, 265(n4), 273, 281, 282, 286 flexibility 245, 285-6, 290(n25) Washington Consensus 116, 212(nl0) Weder, B. 69, 77n Wei, S.-J. 141-2 Werner, A. 260 Widera, R. 77n Williamson, J. xvi, 12, 240(n5) Winograd, C. 253 Wooldridge, P. 78(n5) World Bank 7, 59, 206, 211(n6), 241(n9), 283, 299, 301, 304, 313(n2), 314(n4) data 5, 31 Development Research Group 313(n2) Financial Sector Strategy and Policy Department 313(n2) website 313(n2) World Trade Organization (WTO) 71 Wyplosz, C. 264, 266(n23) Yale University 146-7 Zhang, X. 141-3