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 it a l S u rg e s t o D ro u g h t Seeking Stability for Em erging Economies Edited by Ricardo Ffrench-Davis UN Economic C om m ission for Latin Am erica and the Caribbean Santiago and Stephany Griffith-Jones Institute o f D evelopm ent Studies Brighton, Sussex i n a s s o c ia t io n w i t h t h e U n i t e d N a t i o n s U n i v e r s i t y / W o r ld 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 i c s R e s e a rc h Studies in Development Economics and Policy G e n e r a 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 I D E R ) w a s e s t a b lis h e d b y t h e U n i t e d N a t i o n s U n i v e r s i t y a s its firs t re s e a rc h a n d t r a i n i n g c e n tre a n d s ta rt e d w o r k i n H e ls in k i, F in la n d , i n 1 9 8 5 . T h e p u r p o s e o f t h e in s t it u t e is t o u n d e r t a k e a p p li e d re s e a rc h a n d p o li c y a n a ly s i s o n s t r u c t u r a l c h a n g e s a f f e c t in g d e v e lo p i n g a n d t r a n s i t io n a l e c o n o m ie s , t o p r o v id e a f o r u m f o r t h e a d v o c a c y o f p o lic ie s le a d i n g t o r o b u s t, e q u it a b le a n d e n v i r o n m e n t a l l y s u s t a in a b le g r o w t h , a n d t o p r o m o t e c a p a c it y s t r e n g t h e n i n g a n d t r a i n i n g i n t h e f ie ld o f e c o n o m i c a n d s o c ia l p o li c y - m a k i n g . It s w o r k is c a r rie d o u t b y s ta f f re se a rc h e rs a n d v i s i t i n g s c h o la r s i n H e l s i n k i a n d v i a n e t w o r k s o f c o l la b o r a t i n g s c h o la r s a n d i n s t i t u t i o n s a r o u n d t h e w o r ld . UNU World Institute for D evelopm ent Economics Research (UNU/WIDER) Katajanokanlaituri 6B, F IN -00160 Helsinki, Finland Titles include: R ic a r d o F f r e n c h - D a v i s a n d S t e p h a n y G r if f it h - 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 t a b il i t y f o r E m e r g i n g E c o n o m i e s A i g 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 , IN 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 e r t J. M c I n t y r e a n d B r u n o D a l l a 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 I T I O N A L E C O N O M I E S V l a d i m i r M i k h a l e 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. 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Library o f Congress Cataloging-in-Publication Data From capital surges to drought:seeking s ta b ility fo r emerging econom ies/edited by Ricardo Ffrench-Davis and Stephany C riffith-Jones. p. cm. — (Studies in developm ent economics and policy) Includes bibliographical references and index. ISBN 1 -4 0 3 9 -1 6 3 1 -4 I. C apital m ovem ents— Developing countries. 2. M onetary policy— Developing countries. 3. C apital m arket— Developing countries. II. G riffith-Jones, Stephany. III. Series. HG3891.F765 2003 3 3 2 .0 4 2 — dc21 10 12 9 11 8 10 7 09 6 08 5 4 3 2 1 07 06 05 04 03 Printed and bound in Great Britain by A n to n y Rowe Ltd, Chippenham and Eastbourne I. Ffrench-Davis, Ricardo. 2003049831 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 1.2 International banks involvement with all developing countries, 1998-2001 2.1 Latin America and East Asia: stock exchange prices, 1990-2002 2.2 Latin America and East Asia: GDP, 1971-2002 4.1 Emerging market economies net external financing, 1996-2002 4.2 Consolidated international claims of BIS reporting banks for developing countries, June 2002 4.3 Concentration ratios 4.4 Borrowing by domestic non-banks from international banks: percentage denominated in domestic currency, June 2002 4.5 International financing of developing economies, 1990-2000 4.6 Real GDP, actual and forecast, 1950-2010 4.7 Correlations between changes in claims of BIS-reporting banks on developing economies, June 1990-June 2000 4.8 International banks involvement in developing countries, June 1998-December 2000 A4.1 BIS reporting banks exposure to developing countries 5.1 Banks net cross-border exposure to developing countries, 1997 and 2001 5.2 Accounting for the fall in banks gross cross-border exposure to developing countries, 1997-2001 5.3 Yesterdays problem: ratio of short-term debt to foreign exchange reserves, 1996 and 2000 5.4 Foreign ownership of banking sector assets in selected emerging markets, 1994 and 1999 5.5 Banks in-country lending versus cross-border lending, i995 and 2001 6.1 Private capital flows to developing countries, 1973-81 and 1990-97 6.2 Maturation of East Asian stock markets, 1990-99 6.3 Net long-term flows to developing countries, 1990-98 6.4 Capital instruments, their associated risks and the derivatives used to manage the risks 6.5 Putable debt issued from East Asia 7.1 Explanatory power of the conventional determinants of sovereign ratings, 1995-98 vii 2 5 23 28 59 61 62 63 63 64 69 71 77 81 83 84 87 88 96 97 98 99 107 121 viii 72 7.3 9.1 9.2 9.3 9.4 11.1 13.1 13.2 13.3 13.4 15.1 15.2 15.3 15.4 15.5 15.6 L i s t o f T a b le s The new Basel Capital Accord Regulatory incentives for short-term interbank lending Latin America: FDI and net capital transfer volatility, 1980-99 Most important subjects of hedging strategies Most used instruments in the derivative market Forward contracts in Chile, 1996-2000 Investment regulation of pension funds in nine OECD countries, 2001 Volatility in selected countries during international financial turmoil, 1997-99 Argentina: capital flows, real exchange rate and macroeconomic performance, 1994-99 Chile: capital flows, exchange rate and macroeconomic performance, 1990-2000 Mexico: capital flows, real exchange rate and macroeconomic performance, 1992-2000 Money supply as share of GDP, 1992-2000 Foreign bank assets as share of total bank assets, 1994-2000 Indicators of concentration in the banking sector, 1994 and 2000 Outstanding amounts of debt securities issued in domestic markets, 1989-2000 Bank regulation: selected indicators Bank supervision: selected indicators 130 133 164 164 167 169 208 247 254 258 262 295 296 297 298 300 302 List of Figures 2.1 Latin America: cost and maturity of issues of bonds, 1992-2002 2.2 Argentina and Mexico: country risks, 1994-2002 2.3 Latin America: GDP and aggregate demand, 1990-2001 2.4 Latin America: gross fixed investment, 1977-2002 3.1 Liquidity index for emerging equity markets, 1997-2002 3.2 Cross-border portfolio flows to emerging equity markets as a proportion of market capitalization, 1995-2002 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 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 4.1 Banks external positions vis-à-vis emerging economies, 1997-2001 4.2 Bank lending to emerging market economies and policy interest rates, 1985-2001 4.3 Push influences on international bank lending, 1978-2001 4.4 Banks external positions vis-à-vis emerging economies, 1998-2001 4.5 Japanese international bank lending to Asian economies, 1985-2001 5.1 Combinations of short-term debt to reserves ratio and short-term debt to total debt ratio 6.1 Foreign exchange forward 7.1 Turkeys exchange rate and sovereign ratings, 1990-2001 7.2 Argentinas sovereign spreads and ratings, 1990-2001 9.1 Chile: total forward contracts with non-financial corporations, 1995-2001 9.2 Chile: forward contracts for more than 42 days with non-financial corporations, 1995-2001 9.3 Chile: daily foreign exchange rate and interest rate, 1996-2001 9.4 Actors in a foreign exchange derivative market 9.5 Multinational companies currency risk management and the foreign exchange market 11.1 Aggregate trends in emerging-market asset stocks, 1994-2001 ix 25 26 27 27 47 48 49 50 64 66 66 67 67 85 101 124 125 170 170 172 174 175 197 x L i s t o f F ig u r e s 11.2 11.3 11.4 12.1 12.2 13.1 13.2 13.3 15.1 15.2 Aggregate asset demand composition, 1990-2001 Aggregate trends in contagion, 1998-2001 Global risk aversion Index of expansionary monetary pressures, 1990-2000 Fiscal deficit and public debt: Brazil, Colombia and Mexico GDP volatility versus various financial volatilities Real and financial volatility in three episodes Exchange rate regimes since 1994 Overall regulation index (ORI) Overall supervision index (OSI) 198 198 203 226 231 249 251 252 301 303 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 i c a r d o F f r e n c h - D a v is S t e p h a n y G r if f it h -J o n e s xi A cknow 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 BCRA BCBS BIS CEPA CEPR CPSS DEAR ECAIs ECB ECLAC/CEPAL EMBI ESCAP EU EDI FSF HLIs IAIS IDB IDS IIF IMF IRB IOSCO LCPI LIBOR LTCM NAFTA NBER NDF OECD OPEC ORI OSI PERLs ROSC asset liabilities model The Argentine central bank Basel Committee on Banking Supervision Bank for International Settlements Center for Economic Policy Analysis Center for Economic and Policy Research Committee on Payment and Settlement Systems daily earnings at risk external credit assesment institutions European Central Bank Economic Commission for Latin America and the Caribbean/Comisión Económica para América Latina y el Caribe Emerging Markets Bond Index (JP Morgan) Economic and Social Commission for Asia and the Pacific European Union foreign direct investment Financial Stability Forum Highly leveraged institutions International Association of Insurance Supervisors Inter-American Development Bank Institute of Development Studies, University of Sussex Institute of International Finance International Monetary Fund internal ratings based (assessment) International Organisation of Securities Commissions Liquidity and Credit Premia Index London interbank offered rate Long Term Capital Management North American Free Trade Agreement National Bureau of Economic Research non-deliverable forward Organisation for Economic Co-operation and Development Organization of the Petroleum Exporting Countries Overall regulation index Overall supervision index principal exchange rate linked notes Report on the Observance of Standards and Codes (World Bank and IMF) xiii xiv L is t o f A b b r e v ia tio n s SMEs UDROP UF UNDP UNU US SEC VaR WIDER WTO small and medium-sized enterprises Universal debt rollover option with penalty Unit of Fomento (Chile) United Nations Development Programme United Nations University United States Securities and Exchange Commission value at risk World Institute for Development Economics Research World Trade Organization N otes on th e C o n trib u to rs 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. X V 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. 1 C ap ita l Flows to Em erging Econom ies: Does th e Em peror H ave 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 15 0 .9 2 1 2 .0 2 3 4 .2 11 1.9 6 5 .4 69 A 7.7 3 1 .3 5 8 .0 7 6 .8 8 0 .8 1 0 0 .1 1 1 7 .0 14 2 .7 1 5 4 .7 16 3 .8 1 5 3 .4 1 7 5 .5 15 7.1 1 6 5 .7 P r iv a te p o r t f o li o in v e s t m e n t 1 1 3 .0 4 1 .2 8 6 .9 46 .3 -4 .6 3 3 .9 -4 .3 -3 0 .2 1 4 .6 15 .8 O th e r* -4 2 .9 70.7 3 0 .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 P r iv a te c a p it a l flo w s , o f w h i c h P r iv a te d ir e c t in v e s t m e n t 3.5 26 .9 -1 .5 64 .9 6 0 .5 13 .7 5.7 3 7 .2 3 2 .7 15 .2 C h a n g e i n re se rve s -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 rre n t acc o u n t -7 2 .2 -9 2 .4 -9 6 .8 -6 9 .0 -5 2 .6 3 2 .9 12 8 .3 8 9 .4 1 6 .9 -1 6 .7 O f f ic ia l f lo w s * M ain ly b a n k le n d in g . Source: IMF (2002). S t e p h a n y G r i ffi 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 o f 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 t a l F l o w s to E m e r g i n g E c o n o m i e 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 te p h a n y G r ifp th -fo n e s T a b le 1 . 2 5 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 ts t a n d in g 924 742 -7 .0 O t h e r a sse ts* 110 157 9.1 248 434 2 3 .7 L o a n s b y s u b s id ia r ie s i n lo c a l c u r r e n c y * In c lu d e s h o ld in g o f d e b t securities, so m e d e riv a tiv e p o s itio n s a n d e q u itie s. Sources : C h a p te r 4; BIS, w w w .b is.o rg . 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 developingcountry 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 t a l F lo w s t o E m e r g i n g E c o n o m i e 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 t e p h a n y G r i ffi 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 ita 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 emergingmarket 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 te p h a n y G r iffith -] 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 t a l F l o w s to E m e r g i n g E c o n o m i e 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 developingcountry 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 te p h a n y G r ifp 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 ita 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 ffi 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 ita 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 investm ent 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 ffi 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 t a l F l o w s to E m e r g i n g E c o n o m i e 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 t e p h a n y G r i ffi 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 t a l F l o w s to E m e r g i n g E c o n o m i e 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 t e p h a n y G r i ffi th - J o n e s 19 Notes * I t h a n k R ic a r d o G o t t s c h a lk f o r u s e fu l in p u t s . I a m a ls o v e r y g r a t e fu l t o J o sé A n t o n i o O c a m p o , R ic a r d o F f r e n c h - D a v i s a n d J o h n H a w k i n s fo r t h e ir v a l u a b l e c o m m e n t s . 1. In t e r v i e w m a t e r ia l. 2. N e u m a n n a n d T u r n e r (2 0 0 1 ); in t e r v ie w m a t e ria l. 3. I t h a n k R ic a r d o F f r e n c h - D a v i s f o r t h i s p o in t . 4. F o r t h e E a s t A s i a n c risis, see G r if f it h - J o n e s et al. (2 0 0 2 ). et al. (1 9 9 9 ). 5. In t e r v i e w m a t e r ia l. 6 . In t e r v i e w m a t e r ia l; I M F (2 0 0 1 b ). 7. F o r a m o r e d e t a ile d d is c u s s i o n see B h i n d a 8 . In t e r v ie w m a t e r ia l. 9. See G r if f it h - J o n e s a n d S p r a t t (2 0 0 1 ); R e is e n (2 0 0 1 ); G o o d h a r t (2 0 0 1 ). 10. I t h a n k J e n n y K i m m i s fo r t h i s p o in t . References B h in d a , N ., S. G r iffit h -J o n e s , J. L e a p e a n d M . M a r t i n (e d s) (1 9 9 9 ) to Africa, Private Capital Flows T h e Hague: Fondad. G o o d h a r t , C . (2 0 0 1 ) T h e In t e r - T e m p o r a l N a t u r e o f R is k , L o n d o n : F i n a n c i a l M a r k 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 r iffit h - J o n e s , S. (1 9 9 8 ) Global Capital Flows: Should they be Regulated ?, B a s in g s t o k e a n d N e w Y o rk : M a c m i l l a n a n d S t M a r t i n s Press. and S. S p r a t t (2 0 0 1 ) T h e P r o - c y c lic a l E ffe c ts o f t h e N e w B a s e l A c c o r d , i n N ew Challenges o f Crisis Prevention, T h e H a g u e : F o n d a d . a n d J. C a i l l o u x (e d s) (2 0 0 2 ) International Capital Flows in Calm and J. J. T e u n is s e n (ed.), R. G o t t s c h a lk Turbulent Times, A n n A r b o r , M I : U n i v e r s i t y o f M i c h i g a n Press. In t e r n a t i o n a l M o n e t a r y Fund (IM F ) (2 0 0 1 a ) Emerging M arket Financing Quarterly, W a s h i n g t o n , D C : IM F . (2 0 0 1 b ) International Capital Markets, Developments, Prospects, and Key Policy Issues, W a s h i n g t o n , D C : IM F . (2 0 0 2 ) World Economic Outlook, W a s h i n g t o n , D C : IM F . The General Theory o f Employm ent, Interest and Money, K e y n e s , J . M . (1 9 3 6 ) London: M a c m illa n . K in d le b e r g e r , C . (1 9 7 8 ) M aniacs, Panics and Crashes: A History o f Financial Crisis, N e w Y o rk : B a s ic B o o k s . K u m a r , M . a n d A . P e r s a u d (2 0 0 1 ) P u r e C o n t a g i o n a n d In v e s t o r s S h i f t i n g R is k A p p e tit e : A n a l y t i c a l Is s u e s a n d E m p i r i c a l E v id e n c e , IMF W orking Paper 0 1 /1 3 4 , W a s h i n g t o n , D C : IM F . M i n s k y , H . (1 9 8 2 ) T h e F i n a n c i a l In s t a b i li t y H y p o t h e s is , C a p i t a li s t P r o c e s se s a n d t h e Financial Crisis, Theory, History and Policy, C a m b r id g e : C a m b r i d g e U n i v e r s i t y Press. Myners Review (2 0 0 1 ) In s t i t u t i o n a l In v e s t m e n t i n t h e U K : A R e v ie w , L o n d o n : H M B e h a v i o u r o f t h e E c o n o m y , i n C . K in d le b e r g e r a n d J. P. L a f fa r g u e (e d s), T re a su ry , (h t t p :/ /w w w . h m - t r e a s u r y . g o 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 r n e r (2 0 0 1 ) M a r k e t s , R e g u l a t i o n a n d B a n k i n g i n E m e r g i n g M a r k e t s , u n p u b l i s h e d paper. R e is e n , H . (2 0 0 1 ), W i l l B a s e l I I C o n t r i b u t e t o C o n v e r g e n c e i n In t e r n a t i o n a l C a p i t a l F lo w s ? , p a p e r p r e p a r e d fo r t h e 2 9 t h E c o n o m i c s C o n f e r e n c e o f t h e A u s t r i a n N a t i o n a l B a n k , 31 M a y - 1 J u n e , V ie n n a . W o r l d B a n k (2 0 0 1 ) Global Developm ent Finance, W a s h in g to n , D C : W o r ld B an k. F in an cial 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 i c a r d o F f r 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 i n a n c i a 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 IM 1998). F, 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 r ic a a n d E a s t A s ia : s t o c k e x c h a n g e p rice s, 1 9 9 0 - 2 0 0 2 (in d e x e s , J u ly 1 9 9 7 = 1 0 0 )* 1990 (Dec.) 1992 (Sept.) 1994 (Sept.) 1995 (March) 1997 (July) 1998 (Aug.) 2000 (March) 2001 (Sept.) 2 002 (March) 2002 (June) Latin America 2 1 .7 4 4 .6 9 2 .5 52 .3 1 0 0 .0 4 7 .2 8 8 .3 5 4 .8 71.8 A r g e n t in a 13.4 4 6 .9 78 .2 5 3 .5 1 0 0 .0 53 .4 9 0 .3 3 7 .8 23 .5 13.5 B r a z il 8 .0 2 2 .1 7 1 .8 4 2 .8 1 0 0 .0 4 4 .4 7 6 .9 3 9 .0 5 4 .6 4 4 .6 6 0 .8 C h ile 2 4 .5 5 1 .4 93.1 8 9 .4 1 0 0 .0 4 8 .0 7 8 .4 5 4 .2 6 1 .8 5 6 .4 C o lo m b ia 16.6 6 5 .0 11 3.1 96 .3 1 0 0 .0 4 9 .9 4 1 .2 2 9 .0 3 1 .2 3 3 .3 M e x ic o 3 8 .6 72 .7 13 2.1 45 .9 1 0 0 .0 4 9 .7 11 8 .5 8 3 .3 11 6 .2 9 8 .7 Peru n.a. n .a. 72 .9 5 6 .4 1 0 0 .0 5 7 .3 6 7 .7 54 .1 6 0 .2 5 7 .6 V e n e z u e la 8 4 .9 8 2 .2 5 0 .8 3 7 .9 1 0 0 .0 2 6 .2 3 6 .2 4 6 .3 3 1 .7 2 7 .3 East A sia n.a. 4 9 .9 1 1 0 .0 9 7 .9 1 0 0 .0 3 7 .0 1 0 7 .9 45 .1 77 .0 7 3 .9 In d o n e s i a n .a. 5 3 .7 8 4 .2 7 1 .6 1 0 0 .0 1 1 .1 2 7 .6 13 .7 17.3 2 2 .0 1 1 1 .9 K o re a n .a. 8 7 .6 1 8 7 .2 16 1 .9 1 0 0 .0 3 0 .2 1 2 0 .1 5 4 .9 10 9 .6 M a la y s ia n .a. 6 3 .7 1 1 9 .0 10 3 .5 1 0 0 .0 16 .8 6 1 .3 3 5 .6 46 .1 4 7 .3 P h il i p p i n e s n .a. 67.1 13 4 .6 10 8 .6 1 0 0 .0 3 0 .4 4 7 .9 2 5 .5 30 .9 2 7 .7 T a iw a n n .a. 37 .1 8 0 .9 73 .5 1 0 0 .0 4 7 .6 99 .1 3 1 .6 55 .5 4 8 .8 T h a ila n d n .a. 13 3 .9 2 7 9 .8 2 3 6 .3 1 0 0 .0 19 .0 4 8 .0 2 5 .2 3 6.1 4 2 .2 * T he averages are w e ig h te d b y a m o u n t o f tra n s a c tio n s . The values a t th e e n d o f e a c h p e rio d a re e xpressed in c u rre n t US dollars, e x c lu d in g d is trib u te d earn in g s. T h e selected d a te s c o rre s p o n d to p eak s a n d m in im u m levels for th e average o f L a tin A m erica (e x c ep t fo r S e p te m b e r 1992). So u rce: Based o n IF C /S tan d ard P oors, E m erging Stock M a r k e t R eview , several issues. N u 24 F i n a n c i a l C r is e s a n d N a t i o n a l P o l i c 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 i c a r d o F f r 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 Figure 2.1 1993 1994 1995 1996 1997 1998 1999 2000 2001 L a t in A m e r ic a : c o s t a n d m a t u r it y o f iss u e s o f b o n d s , 1 9 9 2 - 2 0 0 2 (p e rc e n ta g e s a n d y e a r s )* * T h e c o st is e q u a l to th e av erag e sp re ad 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 T reasury 10-year b o n d s. Sources: ECLAC; W o rld B ank; IMF. A n n u a l m o v in g averages. 26 F i n a n c i a l C r is e s a n d N a t i o n a l P o l i c 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 4500 4000 3500 3000 2500 2000 1500 1000 500 0 1994 Figure 2 .2 1995 1996 1997 1998 1999 2000 2001 2002 A r g e n t i n a a n d M e x ic o : c o u n t r y risk s, 1 9 9 4 - 2 0 0 2 (b a se p o i n t s ) S o u rce : JP M o rg an . C o u n try risk m e a su re d b y th e so v ereig n sp re ad o v e r th e US zero c o u p o n curve. R i c a r d o F f r e n c h - D a v is Figure 2.3 27 L a t in A m e r ic a : G D P a n d a g g r e g a te d e m a n d , 1 9 9 0 - 2 0 0 1 (a v e ra g e a n n u a l g r o w t h rates, p e r c e n t) S o u rce : ECLAC, b a se d o n official figures fo r 2 0 c o u n trie s in c o n s ta n t 1995 dollars. Latin Am erica: G ross fixed investm ent, 1977-2002 (% o f 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 i n A m e r ic a : g r o s s fix e d in v e s t m e n t , 1 9 7 7 - 2 0 0 2 ( p e r c e n t a g e o f G D P ) * * P re lim in a ry d a ta fo r 2002. Source: B ased o n ECLAC fig u res for 19 c o u n trie s, 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 i n A m e r ic a a n d E a s t A s ia : G D P , 1 9 7 1 - 2 0 0 2 ( a n n u a l g r o w t h rate s, p e rc e n t) 1 9 7 1 -8 0 1 9 8 1 -8 9 1990 1 9 9 1 -9 4 1995 1 9 9 6 -9 7 1 9 9 8 -2 0 0 2 1 1 9 9 0 -2 0 0 2 1 Latin Am erica2 5 .6 1.3 -0 .6 4.1 1.1 4.5 1.2 2 .4 A r g e n t in a -0 .7 -2 .0 6.7 -3 .3 1.7 2.3 -4 .6 8.0 2.8 -2 .9 B r a z il 2.8 8.6 4 .2 1.7 1.9 C h il e 2.5 3.0 3.3 7.5 9 .0 2.3 5 .2 C o lo m b ia 5.4 3.7 3 .2 3.9 4.9 M e x ic o 6.7 1.5 5.1 3.5 -6 .2 2.8 6.8 2.6 6.1 Pe ru 3.9 -0 .7 -5 .4 5.1 8.6 V e n e z u e la 1.8 -1 .5 5.5 3.2 5.9 1 9 7 1 -8 0 1 9 8 1 -9 0 1 9 9 1 -9 2 1 9 9 3 -9 6 2.4 3 .2 3.1 4 .6 1.6 3 .0 3.4 1997 0 .4 -1 .2 1.9 1998 1 9 9 9 -2 0 0 2 1 1 9 9 0 -2 0 0 2 1 East A sia3 8.1 7.0 7.3 7.3 4.6 -5 .4 4 .7 5.3 In d o n e s i a 7.7 5.5 8.1 7.7 4.7 -1 3 .1 3.1 4 .4 K o re a 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 i p p i n e s 5.9 1.7 -0 .1 4.2 5 .2 -0 .6 3 .6 3 .0 T a iw a n 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 N otes: 1 P ro v isio n al figures. 2 Average o f 19 c o u n trie s. 3 In e ac h p e rio d , e ac h c o u n try s GDP w as w e ig h te d b y its sh are in re g io n a l o u tp u t, ex p re sse d in c u rre n t US dollars. Sources : For L atin A m erica: ECLAC (expressed in US d o llars a t 1980 p ric e s fo r 1 9 7 1 -8 0 , a t 1990 prices fo r 1 9 8 0 -8 9 a n d a t 1995 prices fo r 1 9 8 9 -2 0 0 2 ). For East Asia: IMF, In te rn a tio n a l F in a n cia l Statistics; A sian D e v e lo p m e n t B ank; JP M o rg an . R ic a r d o F fr e n c h -D a v is 29 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 i n a n c i a l C r is e s a n d N a t i o n a l P o l i c 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-theboard 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 macroeconomic 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 i n a n c i a l C r is e s a n d N a t i o n a l P o l i c 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 i n a n c i a 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 i n a n c i a 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 i n a n c i a 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 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 g r a te fu l fo r t h e c o m m e n t s m a d e b y t h e p a r t ic ip a n t s i n t h e U N U / W I D E R p roject, p a r t ic u la r l y J o s é A n t o n i o O c a m p o a n d S t e p h a n y G r iffit h -J o n e s ; b y t h e p a r t ic ip a n t s i n a s e m i n a r a t t h e D E S A / U N h e a d q u a r te r s ; a n d b y t h e M a c r o e c o n o m i c G r o u p o f t h e In i t ia t i v e f o r P o l i c y D ia lo g u e , d ir e c t e d b y J o s e p h S t ig lit z . I a ls o a p p r e c ia t e t h e v a l u a b l e a s s is t a n c e o f a n d s u g g e s t i o n s b y R ic a r d o G o t t s c h a lk ( ID S ) a n d H e r ib e r t o T a p ia ( E C L A C ) . T h e r e s p o n s i b i li t y f o r a ll in t e r p r e t a t io n s is s o le ly m in e . 1. T h e d ir e c t p o s it iv e l i n k b e t w e e n E D I a n d p r o d u c t iv e i n v e s t m e n t ( F f r e n c h - D a v is a n d R e is e n , 1 9 9 8 : c h . 1) w a s w e a k e n e d b y t h e fa c t t h a t a s ig n if i c a n t s h a r e o f F D I c o r r e s p o n d e d t o m e r g e r s a n d a c q u i s i t i o n s i n s t e a d o f c r e a t in g n e w c a p a c it y . It is e s t im a t e d t h a t m e r g e r s a n d a c q u i s i t i o n s a c c o u n t e d f o r 4 9 p e r c e n t o f F D I t o L a t in A m e r i c a i n 1 9 9 5 - 2 0 0 0 ( U N C T A D , 2 0 0 1 ). 2. T h e a cc e le ra te d g r o w t h o f d e r iv a tiv e s m a r k e t s h e lp e d t o s o ft e n m ic r o in s t a b ility , b u t t e n d e d t o in c r e a s e m a c r o i n s t a b il i t y a n d t o re d u c e t r a n s p a r e n c y . F o r a n a n a ly s i s o f t h e c h a n n e l s b y w h i c h s t a b ilit y a n d i n s t a b il i t y a re t r a n s m it t e d , see C h a p t e 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 i c p o l i c y a p p r o a c h t h a t le a d s t o a n e x t r e m e p r e d o m i n a n c e o f o r d e p e n d e n c y o n a g e n t s w h o s p e c ia liz e i n m i c r o e c o ­ n o m i c a s p e c ts o f fin a n c e , p la c e d i n t h e s h o r t - t e r m o r l i q u i d s e g m e n t s o f c a p it a l m a rk e t s. 40 4. F i n a n c i a l C r is e s a n d N a t i o n a l P o l i c y I s s u e s T h e r e is a d if fe r e n t issu e , b u t a ls o re le v a n t, a s s o c ia t e d w i t h t h e g a p b e tw e e n a v e ra g e (p r iv a t e ) a n d m a r g i n a l (s o c ia l) c o s t s o f b o r r o w i n g b y e m e r g in g e c o n o m ie s . See H a r b e r g e r (1 9 8 5 ). 5. I n C h a p t e r 3 P e r s a u d a r g u e s t h a t m o d e r n r is k m a n a g e m e n t b y i n v e s t i n g i n s t i ­ t u t i o n s ( s u c h a s f u n d s a n d b a n k s ), b a s e d o n v a lu e - a t - r is k m e a s u r e d d a i l y a n d w i t h li m i t s se t f o r d a il y e a r n i n g s a t risk , w o r k s p r o c y c li c a l ly i n b o o m s a n d b u sts . P r o c y c lic a lit y is r e in fo r c e d b y a t r e n d t o w a r d s t h e h o m o g e n i z a t i o n o f c r e d it o r a g e n ts. 6. V u ln e r a b ilit ie s w e re s t ill s i g n if i c a n t i n e m e r g in g e c o n o m ie s w h e n n e g a t iv e s ig n a l s re ap p e are d 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 i t e d States. 7. N e it h e r o f th e s e is a s u b s t it u t e f o r t h e r is k s t h a t p r o c y c li c a l o r ir r e s p o n s ib le m a c r o e c o n o m i c p o lic ie s g e n e ra te . 8. T h e m a r k e t s h a v e m a d e s o m e p r o g r e s s t o w a r d s s t a b ilit y b y i n t r o d u c i n g c o u n t e r ­ c y c lic a l a d j u s t m e n t c la u s e s f o r lo a n s : fo r in s t a n c e t ie d t o e x p o r t p r ic e s (see C h a p t e r 14 ) a n d c o lle c t iv e a c t i o n c la u s e s (see C h a p t e r 8). O n t h e o t h e r h a n d r is k - r a t in g a g e n c ie s c o n t i n u e t o b e h a v e p r o c y c li c a l ly a n d t o f o l l o w r a t h e r t h a n le a d t h e f i n a n c i a l m a r k e t s (see C h a p t e r 7). 9. See fo r i n s t a n c e L e F o rt a n d L e h m a n n (2 0 0 0 ) a n d A g o s i n a n d F f r e n c h - D a v is (2 0 0 1 ) o n C h ile , a n d K a p l a n a n d R o d r i k (2 0 0 1 ) o n M a l a y s i a . 10. T h e r e h a v e b e e n s iz a b le a c q u i s i t i o n s o f b a n k s i n e m e r g in g e c o n o m ie s , p a r t ic u la r ly i n C e n t r a l E u r o p e a n d L a t i n A m e r ic a . F o r i n s t a n c e i n 2 0 0 0 h a l f o f A r g e n t i n a s b a n k a sse ts b e lo n g e d t o f o r e ig n c o n t r o lle d b a n k s . In t e r e s t in g ly , f o r e ig n o w n e r ­ s h i p im p li e s t h a t o f f s h o r e l e n d i n g b y th e s e b a n k s h a s b e e n c o n v e r t e d t o o n s h o r e l e n d i n g (see C h a p t e r s 4 a n d 5). T h e c o n v e n t i o n a l a r g u m e n t t h a t t h e lo c a l p re s e n c e o f f o r e ig n b a n k s w o u l d h e lp e m e r g in g e c o n o m i e s t o c o n f r o n t f i n a n c i a l s h o c k s h a s a p p a r e n t l y n o t b e e n s u p p o r t e d i n A r g e n t in a . References A g o s i n , M . (2 0 0 1 ) K o r e a a n d T a i w a n i n t h e F in a n c i a l C r is is , i n R. F f r e n c h - D a v i s (ed.), Financial Crises in Successful Emerging Economies, W a s h in g to n , DC: ECLAC/ B r o o k i n g s In s t i t u t i o n . A g o s in , M . a n d S. R. 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(2 0 0 0 ) C r is e s : T h e P ric e o f G lo b a li z a t io n ? , p a p e r p r e s e n t e d a t t h e F e d e ra l R e s e rv e B a n k o f K a n s a s C i t y S y m p o s i u m o n G l o b a l E c o n o m i c In t e g r a t io n : O p p o r ­ t u n it ie s a n d C h a l l e n g e s J a c k s o n H o le , W y o m i n g , 2 4 - 2 6 A u g u s t . L e F ort, G . a n d S. L e h m a n n (2 0 0 0 ) E l E n c a je , lo s F lu jo s d e C a p i t a le s y e l G a s t o : u n a E v a l u a c i ó n E m p ír ic a , Docum ento de Trabajo, n o . 64, S a n t ia g o : C e n t r a l B a n k o f C h ile , F e b ru ary. O c a m p o , J. A . (2 0 0 2 a ) R e c a s t in g t h e In t e r n a t i o n a l F i n a n c i a l A g e n d a , i n J. E a t w e ll a n d L. T a y lo r (e d s) International Capital Markets: System s in Transition, N e w Y o rk : O x f o r d U n i v e r s i t y Press. 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(2 0 0 1 ) W orld Investm ent Report 2001: Promoting Linkages, A n á lis is y P r o p u e s t a s , UNCTAD N e w Y o rk a n d G e n e v a : U n i t e d N a t io n s . U n i t e d N a t i o n s (2 0 0 2 ) The Monterrey Consensus, N e w Y o rk : U n i t e d N a t io n s . W i l l i a m s o n , J. (2 0 0 0 ) E x c h a n g e R a te R e g im e s f o r E m e r g i n g M a r k e t s : R e v i v i n g t h e In t e r m e d ia t e O p t i o n ’, Policy A nalyses in International Economics, W a s h i n g t o n , D C : In s t it u t e f o r In t e r n a t i o n a l E c o n o m ic s . 6 0 (S e p te m b e r), P a rt I T h e S u p p ly o f C a p ita l 3 L iq u id ity Black Holes: W h y M o d e rn Fin an cial R egulation in D eveloped C ountries is M a k in g Short-Term C ap ital Flows to D evelo p in g C ountries Even M o re 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; FfrenchDavis 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 h at 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 i q u i d i t y B l a 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. B id-ask spreads are a g o o d m easure o f liq u id ity d u rin g g o o d liq u id ity c o n d itio n s, b u t n o t d u rin g p o o r c o n d itio n s - w h ic h o f co u rse is e x a c tly w h e n a m easure is n eed ed . O n e so lu tio n to th is data p ro b lem is to u se cu sto d ia l d atabases th a t record b o th q u a n tity an d price in fo r m a tio n o n p u rch ases a n d sales b y in v esto rs. State Street is o n e o f th e w orlds largest cu sto d ia n s, w ith a p p ro x im a tely U S $6 trillio n o f assets u n d er c u sto d y or 10 per c e n t o f th e w orld s tradable securities. U sin g th is database at a n aggregate lev el, Ken Froot a n d Paul O C o n n ell o f Harvard U n iv e r sity a n d State Street A ssociates (State Street Bank a n d FDO Partners, 2 0 0 0 ) h a v e d e v e lo p e d a n in d e x o f th e price im p a ct fa ced b y overseas in v esto rs w h e n b u y in g a n d se llin g e q u itie s in 4 2 m arkets. Figure 3.1 sh o w s th e average p ercen ta g e price im p a ct fa ced b y a n overseas in v esto r w h e n b u y in g or sellin g o n e b asis p o in t o f th e c a p ita liza tio n o f a n em erg in g e q u ity m arket. T h is graph su g g ests th a t liq u id ity is retu rn in g. T h e b ad n ew s is th a t it h as ta k en a n ex traord in arily lo n g tim e to d o so 3 0 m o n th s, fo llo w in g a series o f liq u id ity d ra in in g e v e n ts in 1998: th e u n w in d in g o f th e U S $ /y e n carry trade in July, th e R ussian d efa u lt in A u gu st a n d th e co lla p se o f L on g Term C ap ital M a n a g em e n t (LTCM), a n o v e rly lev er­ aged h e d g e fu n d , in Septem ber. In 1 9 9 9 liq u id ity w as p ro b a b ly h e ld d o w n b y tw o o th e r factors. First, th ere w a s c o n ce r n a b o u t th e m ille n n iu m bu g, w h ic h w as p o te n tia lly o f greatest th reat to em erg in g m arkets. S econ d , in v e s tm e n t ban ks, h u rt b y th e e v e n ts o f 1 9 9 8 , r em o v e d th e ir trad in g infrastructure from m a n y e m erg in g m arkets. It w a s said th a t o n e large US (July) (Apr.) (Jan.) (Oct.) (July) (Apr.) (Jan.) Figure 3.1 L iq u id it y in d e x f o r e m e r g in g e q u ity m a rk e ts , 1 9 9 7 - 2 0 0 2 (p e rc e n ta g e r e t u r n p e r b a sis p o in t o f m a rk e t c a p ) Sou State Street Bank. rce: 48 Liquidity Black Holes in v e s tm e n t b an k h a d 4 0 0 e m p lo y e e s in its M o sco w o ffic e trad in g R ussian d eb t an d stocks in A u gu st 1 9 9 8 , just b efo re th e R ussian d efau lt, b u t ju st four in A ugust 1999. Figure 3.1 sh o w s a strik in g varia b ility in liq u id ity . T h e F ro o t-O C o n n e ll m e th o d o lo g y m od era tes th is to so m e e x te n t b y m ea su rin g price im p a ct over a p eriod o f 1 0 0 d ays, b u t it is clear th a t sharp d e c lin e s in liq u id ity w ere n o t just a feature o f 1 9 9 8 . O ver th e p ast fiv e years th ere h a v e b e e n tw o o c ca ­ sio n s each year w h e n th e average price im p a c t o f se llin g em e rg in g e q u ity m arkets has risen sharply. T h is is an average: so m e m arkets suffer m o re th a n oth ers. T his variab ility is p articularly tr o u b lin g for in v esto rs. In d eed th ere is e v id e n c e th a t th e rude a w a k e n in g to liq u id ity issu es in 1 9 9 8 le d to an in creased preferen ce b y in v esto rs for m arkets w ith h ig h a n d stab le liq u id ity. T his has k ep t overseas in v e sto r s o u t o f e m erg in g m arkets for a n e x te n d e d period, ev en th o u g h m a n y o f th e se m arkets h a v e offered, o n a h istorical basis, attractive in v e s tm e n t y ie ld s (Figure 3.2 ). L iq u id ity b l a c k h o le s If a m arket is c o n s is te n tly a n d m easu rab ly illiq u id , in v esto rs w ill d em a n d a liq u id ity p rem iu m b u t w ill p rob ab ly n o t a v o id th e m arket altogeth er. If a m arket appears liq u id , esp ec ia lly w h e n o n e b u y s in to it, b u t b e c o m e s illiq u id just w h e n o n e w a n ts to sell, th is gen erates a d egree o f u n c e rta in ty Figure 3.2 C ro s s -b o rd e r p o r t f o lio flo w s t o e m e rg in g e q u ity 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 r k e t c a p ita liz a tio n , 1 9 9 5 -2 0 0 2 ( c u m u la tiv e ba sis p o in ts o f m a r k e t c a p ita liz a tio n , J a n u a ry fig u re s ) S rce: State Street Bank. ou Avinash Persaud 49 th a t in v esto rs an d creditors stro n g ly dislik e, e sp e cia lly w ith th e current em p h a sis o n q u a n tita tiv e risk co n tro ls. M ea su rem en ts o f liq u id ity th a t are m e a n in g fu l to m arket p articip an ts sh o u ld in c lu d e n o t ju st th e average le v e l o f liq u id ity b u t also th e v o la tility o f liq u id ity . O f cou rse liq u id ity , esp ec ia lly w h e n d efin ed in term s o f h o w m u c h th e price m o v e s for a g iv e n flow , is a m easu re o f th e v o la tility o f price (an d so in m ea su rin g th e v o la tility o f liq u id ity w e are m ea su rin g th e v o la tility o f v o la tility - th e th ird d erivative o f price). In th is chapter, ep iso d e s w h ere liq u id ity su d d e n ly disappears w ill b e called liq u id ity b lack h o le s, partly b eca u se liq u id ity appears to b e su ck ed o u t o f m arkets th a t are in th e v ic in ity o f th e o n e at th e cen tre o f a liq u id ity ev en t. Investors are co n cern ed th a t w h ile, in general, th e le v e l o f liq u id ity has fin a lly returned to lev els last se e n in 1 9 9 6 -9 7 , th e n u m b er o f liq u id ity b lack h o le s m a y h a v e increased . O n e sim p le m easure o f th e freq u en cy o f liq u id ity black h o le s is to c o u n t th e n u m b er o f tim es th ere is a sp ik e in v o la tility . Figure 3 .3 tracks th e n u m b er o f days in a quarter th a t th e b road m arket in d ic e s for US, UK an d Jap an ese stock s (SP 5 0 0 , FTSE a n d T opix, resp ectiv ely ) m o v e d b y tw o standard d e v ia tio n s m ore th a n th e average d a ily m arket m o v e . To capture th e tren d b etter w e h a v e p lo tte d a five-year m o v in g average o f th is q u arterly tally, a n d rep laced th e ou tliers - th e th ree largest a n d th ree sm a llest read in gs - w ith th e average reading. T here appears to b e a regular cy cle to th is m easu re o f v o la tility , b u t b o th th e quarterly bars a n d th e sm o o th e d average su g g est th a t th e n u m b er o f ex trem e e v e n ts or liq u id ity b la ck h o le s h a v e risen sig n ifi­ c a n tly sin c e th e m id 1 9 9 0 s. It is rea so n a b le to q u e stio n h o w m u c h th is is 60 -. — Five-year smoothed average 50 - Figure 3.3 L iq u id it y b la c k h o le s : n u m b e r o f d a ys p e r fir s t q u a rte r t h a t th e US, Japa ne se a n d B r itis h b r o 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 tio n s m o re th a n th e av e ra g e d a ily p ric e m o v e , 1 9 7 8 -2 0 0 2 Source: State Street Bank. 50 Liquidity Black Holes a tren d an d h o w m u c h it is related to th e great rise a n d su b se q u e n t fall in e q u ity prices b e tw e e n 1 9 9 8 a n d 2 0 0 1 . It is hard to b e sure, b u t it is eq u a lly reason ab le to ask w h e th e r liq u id ity factors h e lp e d to p ro d u ce th is surge an d collap se. It is a lso in ter e stin g to o b serv e th a t th e up w ard tren d in b lack h o le s c o n tin u e d b e y o n d th e p eak a n d b o tto m in e q u ity prices in M arch a n d S eptem b er 2 0 0 0 , resp ectively. M oreo v er a sim ilar tren d in b la ck h o le s ca n b e seen o u tsid e th e e q u ity m arkets in th e U S $ /y e n fo reig n e x c h a n g e m arket (Figure 3.4). W e h a v e fo cu sed o n e v id e n c e o f liq u id ity black h o le s in th e m ajor m arkets b eca u se th eir p resen ce in large, g ro w in g m arkets is m o s t striking, h o w ev e r th ere is certain ly e v id e n c e o f liq u id ity b la ck h o le s in em e r g in g m arkets to o (Persaud, 2 0 0 1 b ). T h e q u e stio n is, w h y are liq u id ity b la ck h o le s b e c o m in g m o re freq u en t in general? L iq u id ity is a b o u t d iv e r s ity , n o t siz e , a n d t h e t w o a r e n o t synonym ous T he a ssu m p tio n th a t th e b igger a m arket th e m o re liq u id it is, is so p revalen t th a t tu rn over a n d liq u id ity are o fte n se en as sy n o n y m o u s. In fa ct th e tw o are o n ly in d irectly related. Im a g in e a m arket p lace w ith tw o assets (g o v ern ­ m e n t b o n d s an d cash ) a n d ju st tw o players (A n ish a n d Ish an ), a n d im a g in e th a t w h en e v e r A n ish w a n te d to b u y b o n d s w ith h is cash , Ish a n w a n te d cash for h is b o n d s, a n d vice versa. T h is w o u ld b e a v ery liq u id m ark et w ith th e price im p a ct o f trad in g b e in g n il for b o th A n ish a n d Ish an . N o w im a g in e th a t A n ish , b ored w ith su c h p ro v in cia l b liss, m o v e s to a b igger m arket p lace 1970 1972 1974 1976 1978 1980 1982 1984 1986 1 9 8 8 1 9 9 0 1992 1994 1996 1 9 9 8 2000 2002 Figure 3 .4 L i q u id i t y b la c k h o le s : n u m b e r o f d a y s 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 t w o s ta n d a r d d e v ia t io n s m o r e t h a n t h e a v e ra g e d a ily p r ic e m o r e , 1 9 7 0 -2 0 0 2 S rce: State Street Bank. ou Avinash Persaud 51 w ith 10 0 0 0 players, an d th a t w h e n e v e r h e w a n te d to b u y b o n d s for ca sh so d id th e o th er 9 9 9 9 , an d w h e n e v e r h e w a n te d to sell so d id th e o th e r 9 9 9 9 . W h e n b u y in g , A n ish w o u ld h a v e to b id u p th e price o f b o n d s a lo n g w a y to tu rn o n e o f th e o th e r b u yers in to a seller. T he sam e w o u ld be true w h e n h e tried to sell. T h e price im p a ct o f b u y in g or sellin g w o u ld b e h ig h . T he m arket m a y h a v e b e e n bigger in term s o f th e n u m b er o f players a n d th e a m o u n t o f b o n d s an d ca sh b e in g m a n a g ed , a n d e v e n in term s o f th e tu rnover, b u t it w o u ld h a v e b e e n less liq u id in term s o f th e price im p a c t o f trading. M arkets can b e b igger a n d y e t th in n er: liq u id ity requires diversity. O f cou rse th is is an ex trem e e x a m p le a n d it is se n sib le to a ssu m e th a t th e m o re m arket players th ere are, th e greater th e d iv ersity o f o p in io n s an d desired trades. T h e lin k b e tw e e n liq u id ity a n d size m a y b e in d irect, b u t it certa in ly exists. T h e p rob lem is th a t a lth o u g h m arkets are g en era lly g e ttin g bigger, a n u m b er o f separate forces h a v e co n sp ired to red u ce diversity. T h ese forces h a v e grow n stron gly sin ce th e m id 1990s, a p eriod in w h ic h , accord in g to th e d ata w e h a v e just co n sid ered , m a n y m arkets appeared to b e g r o w in g larger an d y e t th in n er, or at lea st m o re v o la tile . T h e th ree m a in forces red u cin g d iversity are th e co lla p se o f in fo r m a tio n costs, th e c o n so lid a tio n o f m arket players an d m o d e r n risk -m a n a g em en t a n d regu latory practices. T he fo llo w in g d iscu ssio n w ill to u c h o n th e first tw o forces a n d d w e ll lo n g er o n th e last. F o rc e s r e d u c i n g t h e d i v e r s i t y o f b e h a v i o u r i n f i n a n c i a l m a r k e ts T he co llap se o f in fo rm a tio n costs In th e past, o n e sou rce o f d iv ersity o f v ie w s w a s th e c o st o f in fo rm a tio n : th e h ig h er th e c o st o f o b ta in in g in fo r m a tio n th e greater th e d iv ersity o f v iew s, esp ecially b etw een m arket insiders a n d outsiders. A n u m b er o f factors, su ch as th e e x p o n e n tia l rise in th e c o m p u tin g p o w er o f co m p u ter c h ip s, m ass access to th e In tern et a n d d ereg u la tio n o f th e airw aves a n d te le c o m m u n ic a tio n s n etw ork s, h a v e led to th e co lla p se o f in fo r m a tio n co sts, w h ic h in tu rn h as d ram atically redu ced th e d iv ersity o f in fo r m a tio n . A rm ed w ith th e n e w te c h n o lo g y , regulators h a v e a ccelerated th is p ro cess th r o u g h in itia tiv e s su c h as th e US SECs Fair D isclo su re R egu lation , w h ic h requires c o m p a n ie s to b roadcast p rice-sen sitiv e in fo r m a tio n to e v e r y o n e at th e sam e tim e (in practice, via th e Internet) a n d n o lo n g e r g iv e preferen tial tr ea tm e n t to a sm all c o m m u n ity o f p ro fessio n a l an alysts. T h e en co u r a g e m e n t o f d e v e lo p in g co u n tries to m e e t sp ecific co d e s a n d standards is also ca u sin g in v esto rs to p o ssess a n d u se sim ilar in fo r m a tio n sets (see Archarya, 2 0 0 1 ). T h an k s to su c h reg u la tio n s a n d p o p u la r fin a n c ia l n ew s broadcasters su ch as B lo o m b erg a n d C N N , th e o u tsid ers h a v e, to a large e x te n t, step p ed in sid e . If th ere is a favou rab le p ie c e o f in fo r m a tio n a b ou t a co m p a n y s stock or a co u n try s fu n d a m e n ta ls a n d th is is m a d e 52 Liquidity Black Holes availab le to e v e r y o n e at th e sa m e tim e, e v e r y o n e w ill w a n t to b u y at th e sam e tim e a n d th e price o f th e sto ck h a s to rise a lo n g w a y to c o n v in c e so m e b u yers to b e sellers (W erm ers, 1 9 9 8 ). In th e b a d o ld d ays th e in sid ers w o u ld h a v e b o u g h t th e stock c h e a p ly from th e b lissfu lly ig n o r a n t ou tsid ers. T he m arkets are m ore eq u ita b le a n d tran sp aren t to d a y - a n d less liq u id b eca u se o f it. M ark et c o n so lid a tio n E ven b efore th e 1 9 9 9 G ra m m -L ea ch -B iley Act, w h ic h rep ea led th e 1 9 3 3 G lass-Steagall Act, th e a ttem p t b y US Senator Carter Glass a n d R epresentative H en ry Steagall to separate d ifferen t fin a n cia l a ctiv ities in to separate firm s h a d b e e n w atered d o w n . C o n so lid a tin g d ifferen t b u t related fin a n cia l activities, o fte n w ith th e sam e clie n ts, le d to su b sta n tia l sa v in g s a n d p o sitiv e syn ergies (w h ic h is w h y a n A ct h a d b e e n required to en fo rce th e earlier sep aration ), a n d served as a stro n g in c e n tiv e for c o n so lid a tio n . D iv ersity h a s b e e n red uced b y th ere b e in g fewer, m o re v ertica lly in teg ra ted players in th e m arket. T his c o n so lid a tio n ca n b e se e n clearly in th e fo reig n e x c h a n g e m arket. In th e 1995 BIS su rv ey o f fo reig n e x c h a n g e activity, so m e 2 4 1 7 b an k s from 2 6 co u n tries particip ated . By 2 0 0 1 th is n u m b e r h a d d ro p p ed b y 2 0 per c e n t to 1 9 4 5 . In th e U n ite d States in 1995, 2 0 o f th e se b an k s a c c o u n te d for 75 per c e n t o f forex tra n sa ctio n s. By 2 0 0 1 just 13 b an k s a c c o u n te d for 75 per c e n t o f forex tran saction s. T he fo reig n ex c h a n g e m arket rem a in s th e largest, w ith a d a ily tu rn ov er o f U S $ 1 .5 trillio n , b u t in 2 0 0 1 o n ly 2 0 b an k s a ro u n d th e w orld q u o te d tw o -w a y prices o n a w id e range o f cu rren cy pairs (BIS, 2 0 0 1 ). M arket-sen sitiv e risk m a n a g e m e n t system s T here is an in te r e stin g d iscrep a n cy b e tw e e n th e large degree to w h ic h fin a n cia l crises are ex tern a l a n d sy stem ic a n d relate to th e h erd b eh a v io u r o f creditors in d e v e lo p e d co u n tries, a n d th e fo cu s o f p o lic y m akers o n th e n e e d for d o m e stic reform s (Eatw ell, 1 9 9 7 ). It is argued b y m a n y d e v elo p ed c o u n tr y p o lic y m akers, a n d is cu rren tly p erh ap s m o s t stro n g ly esp o u se d b y th e U n ite d K in gd om , th a t if b an k s a n d c o u n tries w ere to a d o p t tig h ter p ru d en tial, su p ervisory a n d risk -m a n a g em en t co n tro ls, liq u id ity or s o lv e n c y crises w o u ld n o t h a p p en , a n d if th ere w as n o in itia l crisis, th ere w o u ld be n o su b seq u e n t c o n ta g io n - w h a te v er th e flaw s in th e cu rren t fin a n c ia l a rch i­ tectu re. T his m a y b e true, b u t th e real p ro b lem h a s c o m e w ith th e a ttem p t to im p ro v e th e s e co n tr o ls b y ste p p in g aw ay from th e p rev io u s sy ste m o f a fe w regulatory risk b u ck ets o u tlin e d in th e orig in a l B asel C ap ital A d eq u a cy A ccord (1988) a n d th e stride tow ard s m a rk et-sen sitiv e risk m a n a g e m e n t system s. T his has b e e n m o tiv a te d b y a n u m b er o f factors. First, th ere is c o n c er n th a t u sin g a few b road ca teg o ries o f risk w h e n reg u la tin g th e a ctiv itie s o f p articip an ts in fin a n c ia l m arkets, is p ro n e to regu latory arbitrage th r o u g h Avinash Persaud 53 th e in n o v a tio n o f fin a n c ia l in stru m e n ts th a t appear to sit in a low -risk ca teg o ry b u t h a v e th e characteristics o f a h ig h -risk in str u m en t. S eco n d , th e previous broad risk-bucket ap p roach failed to capture th e g ro w in g co m p le x ity a n d range o f n e w fin a n cia l in str u m e n ts, e v e n w h e n regu latory arbitrage w as n o t a m o tiv e for th eir in n o v a tio n . T hird, th ere is a b e lie f th a t h as sp illed over from o th er w alk s o f life th a t p u b lic o fficia ls c a n n o t p resu m e to k n o w m o re th a n th e m arket w h e n a ssessin g risk. W h ile th is m a y in d e e d b e true in gen eral, it is least a p p lica b le to th e w ork o f th e regulators o f fin a n c ia l m arkets. After all, fin a n cia l crises occu r b eca u se m arkets fail, a n d th is is w h y th e in crea sin g u se o f m ark et-sen sitiv e risk m a n a g e m e n t sy stem s h as n o t led to a m o re rob u st an d effic ie n t fin a n cia l sy stem , b u t to o n e th a t is m o re p ro n e to fin a n cia l crisis a n d in d u c es m o re c o n c e n tr a tio n o f fin a n c ia l risks (Persaud, 2 0 0 0 ). M o d e m r is k m a n a g e m e n t t h e o r y : v a l u e a t r is k a n d d a i l y e a r n i n g s a t r is k In esse n c e value-at-risk (VaR) sy stem s estim a te th e a m o u n t o f a ban k s d a ily earn in gs th a t are at risk, at a g iv e n p rob ab ility, u sin g th e d istrib u tio n o f th e v o la tility an d correlation o f th e p o r tfo lio o f assets a n d lia b ilitie s w ith w h ic h th e b a n k h as exp osu re. T h e m o re v o la tile a n asset th e greater th e lik e lih o o d o f a lo ss, u n le s s it is in v e r s e ly co rrela ted w ith a n o th e r a sset in th e p o r t­ fo lio . L ow er v o la tility o f assets, a n d co rrela tio n b e tw e e n assets, red u ce d a ily earn in gs at risk (DEAR). A rise in v o la tility a n d correla tio n d o e s th e o p p o site. M ost o fte n th e banks risk m a n a g e m e n t p rocess is to set a lim it for DEAR, an d if th e lim it is reach ed , to take a c tio n to red u ce DEAR b y se llin g th e m o st v o la tile or m o st h ig h ly correlated assets. T he in trin sic p ro b lem w ith m a rk et-sen sitiv e risk m a n a g e m e n t sy stem s a p ro b lem th a t c a n n o t b e so lv e d b y in cre a sin g ly so p h istica te d sta tistical m o d e ls an d th e u se o f stress tests - is th a t th e y a ssu m e th a t b a n k s a n d m arket p articip an ts act in d e p e n d e n tly a n d th a t th e p o sitio n s o f o n e b an k are in d e p e n d e n t o f th o s e o f an o th er. In a w o rld o f in d e p e n d e n t m arket players th ere is a stron g p ro b a b ility th a t th e se llin g o f secu rities b y o n e b a n k c o u ld b e m e t b y th e purch ases o f an oth er. T h e reality, o f cou rse, is d ifferen t. M arket p articip an ts a n d b an k s b e h a v e in strategic rela tio n w ith o n e an oth er. O ften th e y h erd in t o o n e or a sim ilar set o f m arkets or in str u m en ts. There are a n u m b er o f in d iv id u a lly ra tio n a l reason s for h e rd in g b eh a v io u r, n o t least b eca u se th ere is safety in n u m b ers, b o th fin a n c ia lly a n d in term s o f rep u ta tio n (Shiller, 1990 ). If o n e b an k m ak es a n in v e s tm e n t m ista k e th e regulators m a y let it g o u n d er, as in th e case o f B arings in th e U n ite d K in gd om . If all b an k s m a k e th e sam e m istak e, th e regulators w ill b a il th e m o u t in order to preserve th e fin a n c ia l sy stem . M o reover in a w o rld o f u n cer­ ta in ty th e ch ea p est strategy for c a tc h in g u p w ith th o s e y o u th in k are b etter in fo r m e d is to fo llo w th e m . 54 Liquidity Black Holes W h e n v o la tility rises in o n e m arket, in crea sin g DEAR a n d p ro m p tin g a b a n k to sell its risky assets, it is lik ely th a t th e DEAR lim its w ill b e reach ed b y m a n y ban ks. T h e d y n a m ics th e n g o fro m bad to w o rse. As m a n y b anks try to sell th e sam e asset at th e sa m e tim e , th ere are fe w or n o b u y ers a n d so th e price gaps narrow a n d v o la tility rises further, w h ic h in creases DEAR again an d triggers further sales. Faced w ith a g a p in g m arket, so m e b a n k s w ill try to redu ce DEAR b y sellin g a n o th e r asset th a t is h e ld b y th e h erd partly b eca u se it is u n correla ted w ith th e first. H o w ever th is n o t o n ly in creases v o la tility in th e se c o n d asset, b u t also in creases correlation . H igher vola tility , a n d n o w correla tio n to o , n o t o n ly raise DEAR at th e first set o f ban k s, b u t a lso at a se c o n d set o f b an k s th a t m a y n o t h a v e h a d th e first asset, an d so m ore banks an d m o re m arkets are su ck ed in to th e p rocess. T h e resu ltin g c o n ta g io n o f se llin g m y stifie s m o s t an a ly sts b eca u se th e m arkets th a t are h it are fu n d a m e n ta lly u n rela ted . T h e ste p p in g -sto n e p a th o f th e A sian fin a n c ia l crisis from T h a ila n d to In d o n e sia a n d M alaysia, th e n to Korea a n d o n to Russia, an d fin a lly to Brazil, w as n o t related to th e p a th o f trade flo w s, b u t to th e p ath o f sh ared cred itors a n d bankers (Persaud, 2 0 0 1 a ). A p e rp le x in g p a ra d ig m In th e c o n te x t o f u n c e r ta in ty a n d in v e sto r b eh a v io u r, th e VaR ap p ro a ch n o t o n ly leads to c o n ta g io n w h e n it c o m b in e s w ith h erd b eh a v io u r, b u t also co n trib u tes to h e r d in g in th e first p lace. VaR sy stem s h ig h lig h t th o s e sets o f m arkets w h ic h cu rren tly offer lo w v o la tility a n d lo w co rrela tio n , a n d th u s safe returns, w h ic h p ro m p ts m a n y p layers to sw itch in to th e se m arkets over tim e, u n til at so m e p o in t th ere is a large c o n so lid a tio n o f p o sitio n s a herd. T he o p p o site also occu rs. VaR sy stem s h ig h lig h t th e cu rren t set o f m arkets th a t offer h ig h v o la tility a n d co rrela tio n a n d as a c o n se q u e n c e in v esto rs stay clear o f th e se m arkets, m a k in g th e m less correlated a n d less v o la tile over tim e a n d less p ro n e to c o n ta g io n . H ere is a p e r p lex in g paradigm : th e o b serv a tio n o f safety creates risk (as th e h erd ch a ses after w h a t w as safe an d investors b e c o m e o v erly con cen trated ) a n d th e o b serv a tio n o f risk creates safety (as th e h erd a v o id s w h a t w as risky). In th is w a y m a rk et-sen sitiv e risk m a n a g e m e n t sy stem s d a n g ero u sly add to th e p ro cy c lic a lity o f cap ital flo w s (Persaud, 20 0 0 ; Turner, 2 0 0 0 ). W e are in th e latter e n v ir o n m e n t tod ay. L o o k in g th r o u g h a five-year w in d o w o f returns, v o la tilitie s a n d correction s, em erg in g m arkets still appear to b e th e last p laces o n earth a n in v e sto r w o u ld w a n t to b e, w ith th eir lo w to n eg a tiv e returns, h ig h risks a n d v o la tility , a n d h ig h co rrela tio n . C o n ­ se q u e n tly in v esto rs h a v e a b a n d o n e d th is sp ace a n d so w h e n a ccid en ts h a p p en , su ch as in Turkey in D ecem b er 2 0 0 0 a n d February 2 0 0 1 , a n d A rgentin a in D ecem b er 2 0 0 1 , th ere is n o c o n ta g io n . T h e regulators th in k th a t th is is a sign o f a m o re rob u st sy stem , b u t th e y are m ista k en . T he five-year Avinash Persaud 55 w in d o w w ill s o o n sh o w th a t em erg in g m arkets are safer, less correlated a n d m o re profitab le, an d th e h erd w ill return. A lready in 2 0 0 1 th e a d v a n ce party, co m p risin g em ergin g -m a rk et h e d g e fu n d s, p o ste d th e b est in v e s tm e n t p erform an ce o u t o f a b road ran ge o f in v e s tm e n t sectors a n d sty les. Far from b e in g robust, th e in te r n a tio n a l fin a n c ia l sy stem appears to d eliv er e ith e r to o m u c h cap ital to em erg in g m arkets or to o little (Gurria, 1995; G riffith-Jones, 1998). T his supports n eith er e c o n o m ic d e v e lo p m e n t n or th e n ecessary reform p rocess in m a n y em erg in g fin a n c ia l m arkets (W illia m so n , 1 9 9 3 ). T h e c re e p in g in flu e n c e o f b a n k r e g u la tio n T h ro u g h o u t th is ch ap ter w e h a v e lu m p e d th e b e h a v io u r o f b an k s w ith th a t o f o th er creditors an d in v e sto r s in g en eral. H o w ev er th e Basel C ap ital A d eq u acy A ccord is d esig n e d for th e r eg u la tio n o f ban k s, n o t all in v esto rs. W h y is th e h erd in g o f ban k s n o t o ffse t b y lo n g er-term in v e sto r s lo o k in g to p ick u p a b argain in th e w ak e o f th e forced sellin g triggered b y VaR m o d els? T h e p ro b lem is th a t th e v a st m a jo rity o f in v esto rs a n d cred itors n o w u se th e VaR ap proach . T his is n o t e n tir e ly o u t o f free c h o ic e . To b e g in w ith th ere is regu latory creep. R egulators are c a jo lin g o th er fin a n c ia l in stitu tio n s, e sp e ­ cia lly in su ra n ce c o m p a n ie s a n d fu n d m an agers, to a d o p t th e VaR ap p roach in th e m ista k en b e lie f th a t c o m m o n standards are g o o d . W h ere h e rd in g is p revalen t, h ig h standards are g o od ; c o m m o n standards are bad. H o w ev er e v e n w h ere regulators are n o t b r ea th in g d o w n th e n eck s o f in vestors, m a n y c h o o s e to fo llo w th e VaR a p p roach . W h y? In a w o r ld o f u n c e r ta in ty w ith a lo n g h isto r y o f fin a n c ia l crises a n d ro g u e traders, it is h ard for in v esto rs to te ll th eir tru stees th a t th e y are u sin g a risk m a n a g e m e n t sy stem th a t n o b o d y else u ses. In vestors g e n era lly a p p rove o f e x p e r im e n ­ ta tio n , b u t o n ly w ith o th e r p eo p les m o n e y . T h e iron y, o f cou rse, is th a t a d iv ersity o f risk m a n a g e m e n t sy stem s, w ith lo n g -te r m in v esto rs an d creditors fo llo w in g a risk m a n a g e m e n t ap p ro a ch th a t is m o re su itab le for th eir ob jectiv es, w o u ld n o t o n ly red u ce th e n u m b er o f liq u id ity b la ck h o le s b u t w o u ld also en a b le lo n g -ter m in v esto rs to p rofit. T h e fo llo w in g ex a m p le illu strates th is p o in t. Im a g in e a lo n g -term in v e sto r ca lled F elicity Foresight. Each year F elicity k n o w s w h ic h are th e te n b e st cu rren cy trades for th e year. She p u ts th e m o n at th e b e g in n in g o f th e year a n d u ses a state-of-th e-art, d a ily m ark-to-m arket, value-at-risk, risk m a n a g e m e n t sy stem . O ver th e p a st te n years sh e w o u ld h a v e lo s t m o n e y in a lm o st ev ery year, sto p p e d -o u t b y h er risk sy stem w h e n th e trades h a d g o n e ag a in st her. W h a tev er y o u th in k y o u r in v e s tm e n t sty le is, in rea lity it is largely d e te r m in e d b y y o u r risk m a n a g e m e n t system . In vestors p ro u d ly p ro cla im a raft o f d ifferen t styles, m o d e ls an d ap p roach es, b u t th e v a st m a jo rity a d o p t th e sa m e risk m a n ­ a g e m e n t ap p roach an d so th e y b e h a v e like e v ery b o d y else, le a d in g to little d iversity an d m a n y b lack h o le s. 56 Liquidity Black Holes W h a t a r e t h e s o lu tio n s ? H a vin g an a ly zed th e p ro b lem s, th ree so lu tio n s c o m e to m in d . First, regu­ lators n eed to h ig h lig h t as a risk th e d u ra tio n m ism a tc h b e tw e e n lo n g -term in v e s tm e n t o b jectiv es a n d sh ort-term risk m a n a g e m e n t sy stem s. T h e y ca n facilita te a n a rro w in g o f th is gap a n d in so d o in g en co u ra g e a greater d iversity o f b eh a v io u r b y g iv in g th eir co n sid e r ed sta m p o f ap p roval to a few an d varied risk m a n a g e m e n t a p p roach es. For e x a m p le in th e a tte m p t to be th e first to g et o u t o f assets b e in g dragged d o w n in a crisis, risk m a n a g e m e n t sy stem s are in crea sin g ly fo c u sin g o n v ery sh ort-term correlation s a n d v o la til­ ities, an d w h e n th e s e rise risk lim its are h it, triggerin g furth er sales. H ow ever a b an k th a t m a n a g es sh o rt-term lia b ilities m a y b e m o re in terested in a rise in th e short-run correla tio n o f assets d u rin g a crisis th a n a lo n g -te r m in vestor, w h o m a y b e c o n te n t to a ssu m e th a t th e cu rrent co rrela tion s w ill fall back to th eir lo n g -term average. A risk m a n a g e m e n t sy stem for th e lo n g -te r m in v esto r m a y th erefore b e less se n sitiv e to sh ort-term c h a n g e s in v o la tility a n d correlation a n d m o re se n sitiv e to th e u n d er ly in g , p erh ap s fu n d a m en ta l, correlation . T here is th e p o te n tia l h ere for a v irtu o u s cy c le . T h e m o re th a t short-term an d lo n g -term in v esto rs b eh a v e differently, th e shorter th e m arket d isru p tion s w ill b e an d th e m o re th is d ifferen t b e h a v io u r w ill b e p rofitab le for lo n g -term in v esto rs. G iv in g a sta m p o f ap p roval to a v a riety o f risk m a n ­ a g e m e n t sy stem s d esig n e d for d ifferen t ty p es o f in v esto r w o u ld so lv e a co o r ­ d in a tio n prob lem : it w o u ld b e c o m e easier for fu n d m a n a g ers to g o to th eir trustees an d say th a t th e y are n o t fo llo w in g a sh ort-term , m a rk et-sen sitiv e risk m a n a g e m e n t system , b u t an oth er, a lo n g th e lin e s p ro p o sed b y th e regulators sp ecifica lly for lo n g -te rm in v esto rs. Secon d , th ere n e e d s to b e less relia n ce o n m a rk et-sen sitiv e m ea su res o f risk. Regulators sh o u ld p ursue research in to co u n tercy clica l or structural m ea ­ sures o f risk, su c h as th e d egree o f d iv ersity or fra g m e n ta tio n in a fin a n c ia l m arket as w e ll as th e d egree o f d u ra tio n a n d cu rren cy m ism a tc h o f assets an d liab ilities. M arkets th a t are n o t v o la tile or h ig h ly correlated w ith o th ers b u t w h ere th ere is a h ig h co n c e n tr a tio n o f p o sitio n s b y o n e ty p e o f player in o n e in str u m e n t sh o u ld b e v ie w e d as risky a n d require m o re regu latory cap ital th a n h isto rica l v o la tilitie s a n d co rrela tio n s m ig h t su ggest. T h e large co n c e n tr a tio n o f fo reig n cu rren cy le n d in g to th e p rop erty a n d b a n k in g sy stem in A sian m arkets is a case in p o in t (Perry a n d L ederm an, 1 9 9 8 ). T hird, a lth o u g h m u c h r e g u la tio n is a b o u t lim itin g lo sses, liq u id ity n ee d s losers. If a m arket is to b e liq u id th ere n e e d s to b e a b u y er w h e n ev er y o n e else is sellin g an d th e price is fa llin g . In itia lly th e b u yer w ill lo se, b u t sh e or h e w ill h o p e to p rofit w h e n th e m arket turns a ro u n d a n d w ill b e m ore in c lin e d to take th is g a m b le if sh e or h e is n o t w orried th a t h er or h is risk m a n a g e m e n t sy stem w ill take h er or h im o u t o f th e trade just as it is g o in g to m ake m o n ey . R egulators n e e d to address th is p ro b lem b y reg u la tin g w h o th e u n reg u la ted in v esto r c a n b e. T h ey w ill w a n t to lim it th e lo sse s o f retail Avinash Persaud 57 in v esto rs for fear th a t th e y w ill b e ab u sed for th eir relative lack o f in fo rm a ­ tio n , an d to en co u ra g e th e m to save for th eir future. F in a n cia l in stru m e n ts u se d b y retail in v esto rs sh o u ld b e strictly regu lated - as th e y are - a n d th eir lo sses lim ite d th r o u g h sh ort-term risk sy stem s. F in a n cia l in str u m e n ts u se d b y p ro fessio n a l in v esto rs, h o w ev er, sh o u ld b e lig h tly regu lated a n d th eir a b ility to buck th e tren d sh o u ld b e facilitated . T h is fram ew ork provid es a d ifferen t p ersp ectiv e o n h e d g e fu n d s in v e s tm e n t v e h ic le s d esig n e d for in v e s tm e n t p r o fessio n a ls w ith w e a lth to lo se. H ed ge fu n d s so m etim e s lo se m o n ey , so m e tim e s b lo w u p an d so m e tim e s are part o f th e herd, b u t th e y are a lso b e st su ite d to th e role o f u n reg u la ted in v esto rs w h o can b u y w h e n e v e r y o n e else is sellin g , a n d in th e p rocess m ak e th e fin a n cia l m arket liq u id . T h e c o st o f m a k in g it hard for th e m to d o th is - b y regu latin g th eir leverage a n d cred it - is a re d u ctio n in m arket liq u id ity. T he reg u la tio n o f h e d g e fu n d s a n d th eir req u irem en ts o f d isclosu re to th eir cou n terp arties sh o u ld th erefo re b e g o v e r n e d b y to u g h q u e stio n s su ch as: w o u ld a fu n d w ith th is a m o u n t o f leverage e n d a n g er th e fin a n cia l system ? T h is w o u ld c a tch a n y fu tu re LTCM w ith o u t ca u sin g th e o th e r s to w ith d raw from p ro v id in g th e n ecessa ry liq u id ity . N o te 1. T h a n k s are d u e t o Jam e s C u r tis a n d N a ta lia A lv a re z -G rija lb a f o r t h e ir s ta tis tic 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 I n te r n a tio n a l S ta n d a rd s f o r F in a n c ia l S ta b ility : 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 iffith - 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. 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R e ise n (eds) (1 9 9 8 ) Capital Flows and Investm ent Performance: Lessons from Latin America, P aris: 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 ric e F o r m a tio n a n d L iq u id it y in th e US T re a s u ry M a rk e t: T h e R e sp o n se t o P u b lic I n f o r m a t io n , Journal o f Finance, 5 4 , 5: 1 9 0 1 -1 5 . G riffith -J o n e s , S. (1 9 9 8 ) Global Capital Flows, L o n d o n : M a c m illa n . G u rria , 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 iffith -J o n e s (ed s), 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 rid g e , M A : B la c k w e ll. 58 Liquidity Black Holes P e rry, 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 r a b ility , S p illo v e r E ffe c ts a n d C o n ta g io n : L e sson s f r o m th e A s ia n C rises f o r L a tin A m e ric a , W orld B ank Latin Am erican and Caribbean Studies Viewpoints, W a s h in g to n , D C : W o r ld B a n k . P ersau d, 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 d g e , W orld Economics, 1, 4 (O c to b e r-D e c e m b e r). (2 0 0 1 a ) F ads a n d F a s h io n s i n th e P o lic y R espo nse t o F in a n c ia l M a r k e t C ris e s , in L. J a cq u e 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 it h G o lia th : H o w S m a ll E x c h a n g e s w i l l S u rv iv e in th e F u tu re , W orld 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 it 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 r k 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 rid g e , M A : N B E R . T u rn e r, P. (2 0 0 0 ) P r o c y c lic a lity o f R e g u la to ry R a tio s ? ’ , 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 t u a l F u n d H e r d in g a n d th e Im p a c t o n S to c k P ric e s , Journal o f Finance, 5 4 , 2. W illia m s o n , J. (1 9 9 3 ) A C o s t- B e n e fit A n a ly s is o f C a p ita l A c c o u n t L ib e ra liz a tio n ’, in H . R e ise n a n d B. F is c h e r (ed s), Financial Opening, P aris: O E C D . 4 I n t e r n a t io n a l F lo w in g B a n k L e n d in g : W a t e r U p h ill? * John Hawkins B a n k l e n d i n g a n d o t h e r c a p i t a l flo w s In tern a tio n a l b a n k le n d in g is a v ery im p o r ta n t c o m p o n e n t o f cap ita l flo w s to em erg in g e c o n o m ie s. M o reover b a n k le n d in g h a s b e e n th e m o s t variable ty p e o f cap ital flow . Table 4 .1 sh o w s h o w fo reig n d irect in v e s tm e n t, a n d e v e n p o rtfo lio in v e stm e n t, h e ld fairly stea d y th r o u g h o u t th e A sian crisis. H ow ev er th e in te r n a tio n a l b a n k s w e n t fro m le n d in g large a m o u n ts b efore th e crisis to w ith d ra w in g large a m o u n ts after it. T h e B ank for In tern a tio n a l S e ttle m en ts (BIS) c o m p ile s a n d p u b lish es th e m o s t co m p r e h e n siv e d ata o n in te r n a tio n a l b a n k le n d in g ,1 w h ic h w ere u sed w h e n p u ttin g to g e th e r th e In stitu te o f In ter n a tio n a l F in a n ce (IIF) estim a tes u se d in Table 4.1 an d th e statistics o n ex tern a l d eb t p u b lish e d jo in tly w ith th e W orld Bank, IMF an d OECD. T h e great a d v a n ta g e o f th e se d ata is th a t th e y are c o m p ile d from th e cred itor sid e in a c o n siste n t w ay. T h e d isa d v a n ­ ta ge is th a t th e y co v er o n ly part o f cap ita l flo w s, alb eit p erh ap s th e v o la tile part. IMF data o n cap ital flo w s are b a sed o n th e b a la n ce o f p a y m e n ts reports b y th e recip ien t co u n tries an d are m o re co m p r e h e n siv e . H o w ev er it is k n o w n th a t th e rep ortin g o f cap ita l flo w s is in e v ita b ly rather in a ccu ra te (a lth o u g h 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 fin a n c in g , 1 9 9 6 -2 0 0 2 (U S$ b illio n ) 1996 D ir e c t e q u ity in v e s tm e n t P o r t fo lio e q u ity in v e s tm e n t B a n k le n d in g N o n - b a n k p r iv a te le n d e rs O ffic ia l flo w s T o ta l e x te rn a l f in a n c in g 1997 1998 1999 2000 2001 2002e 93 35 118 89 5 340 116 25 44 84 47 316 121 14 -5 5 64 52 19 5 14 9 19 -5 2 36 13 166 13 5 14 -0 38 -4 18 4 135 11 -2 6 7 14 140 11 3 11 -1 1 10 17 140 Source : In s titu te o f In te rn a tio n a l F in a n c e (2001, 2002). 59 60 International Bank Lending m ajor progress h a s b e e n m a d e in recen t years as a resu lt o f th e efforts o f th e IMF C o m m itte e o n B alan ce o f P a y m en ts Statistics). T h e BIS data (w h ic h are d escrib ed in m o re d etail in A p p e n d ix 4 .1 ) are c o m p ile d o n tw o b ases. T h e locational sta tistics report o n th e a c tiv ities o f b an k s in th e rep ortin g e c o n o m y , regardless o f th eir o w n e r sh ip , b u t n o t in c lu d in g th eir fo reig n su b sid iaries. T h e consolidated sta tistics report o n th e g lo b a l activ ities (in c lu d in g fo reig n subsidiaries) o f b a n k s w h o se h e a d o ffice is lo ca ted in th e rep ortin g e c o n o m y . W h e n ap p rop riately scaled , th e BIS data ca n b e h e lp fu l in id e n tify in g e c o n o m ie s w h ere th e a c c u m u la tio n o f b o rro w in g fro m in te r n a tio n a l b an k s is le a v in g th e m vu ln era b le to a lo ss o f c o n fid e n c e (see H aw k in s a n d Klau, 2 0 0 0 ). It has o fte n b e e n th e case th a t e x c essiv e cap ital in flo w s h a v e fu n d e d d o m e s tic sp ecu la tiv e b o o m s. T h e cen tral b a n k g o v ern o rs o f th e G 1 0 c o u n ­ tries h a v e b e e n regularly briefed over th e years o n sign s o f im p e n d in g trou b le. A recen tly p u b lish e d a c c o u n t b y an e m in e n t insider, A lexan d re L am falussy (2 0 0 0 ), w h o w as e c o n o m ic ad viser at th e BIS fro m 1 9 7 6 a n d th e n gen eral m anager, p o in ts o u t th a t in th e 1 9 7 0 s th e g o v ern o rs agreed to p u b lish co u n try -b y -co u n try data o n ex tern a l b a n k d eb t a c c u m u la tio n o n ly after so m e h e sita tio n b eca u se n a m in g co u n tries c o u ld in itse lf p recip ita te crises. Yet e v e n th o u g h th e se data w ere p u b lic ly a vailab le b efo re th e A sian crisis, at th e tim e th e y attracted rela tiv ely little a tte n tio n d e sp ite efforts b y th e BIS to draw a tte n tio n to th e w a rn in g s it w as g iv in g . H aw k in s (1 9 9 9 ) p o in ts o u t th a t in early 1 9 9 7 th e BIS data revealed th e large, rap id ly g ro w in g a n d in crea sin g ly sh ort-term d eb t in cu rred b y th e fiv e A sian e m erg in g e c o n o m ie s w h ic h s o o n after suffered m a ssiv e d ep recia tio n s. T h e p a tte r n o f in te r n a tio n a l b a n k le n d in g S p ecializatio n b y le n d in g c o u n trie s T h e BISs co n so lid a te d sta tistics are p u b lish e d b y n a tio n a lity o f rep o rtin g b an k , so, for e x a m p le, it is p o ssib le to see th e ex p o su re o f G erm a n -o w n ed b an k s to Russia, or S p a n ish -o w n e d b an k s to Brazil. T h e d istr ib u tio n o f le n d in g to em erg in g e c o n o m ie s is su m m arized in Table 4 .2 . As ca n b e seen , E u rop ean -ow n ed b an k s are th e largest len d ers to all r e g io n s,2 b u t th ere is a lso a degree o f sp ecia liz a tio n . J a p a n ese-o w n ed b an k s m a in ly le n d to th e A sia-Pacific reg io n w h ile U S -o w n ed b an k s co n c e n tr a te o n Latin A m erica. W ith in Europe, G e rm a n -o w n ed b a n k s are th e m a in len d ers to C en tral an d Eastern Europe, w h ile F ren ch -o w n ed b an k s are th e m a in len d ers to Africa a n d Sp an ish b an k s are large len d ers to L atin A m erica. T w o recen t tren d s are o f particular sig n ifica n ce. T he first is th e w ith d ra w a l o f Japanese ban k s from A sia (b o th from th e d e v e lo p in g c o u n tr ie s a n d from H o n g Kong): from its p eak in Ju n e 1 9 9 5 , b y m id 2 0 0 1 th is h a d fa lle n b y arou n d tw o third s, a d e c lin e o f a lm o st U S $ 2 0 0 b illio n , a lth o u g h so m e o f th is w as b o o k in g Jap an ese le n d in g b u sin ess w ith in Japan rather th a n o ffsh o re. John Hawkins 61 Table 4.2 C onsolidated intern atio n al claims of BIS reporting banks for developing countries, June 2002 (US$ billion) Asia-Pacific Europe Latin America M iddle-East and Africa Total E u ro p e , o f w h ic h G e rm a n y F ra n ce U n it e d K in g d o m S p a in U n it e d S tates Japan O th e r 194 47 29 64 1 76 52 73 244 88 21 11 1 21 4 28 302 34 21 27 15 7 131 10 49 10 9 22 36 27 2 15 5 25 849 191 10 7 129 161 243 71 17 5 T o ta l 395 297 492 15 4 1 338 Source: BIS (2002). T h e se c o n d is th e rapid g ro w th o f S p an ish ban k s ex p o su re in Latin A m erica. In th e five years to m id 2 0 0 1 , th is a lm o st q u ad ru p led , an in crea se o f a lm o st U S $ 4 0 b illio n . M a tu rity o f b a n k le n d in g A rou n d a th ird o f in te r n a tio n a l b a n k le n d in g to em er g in g e c o n o m ie s is sh ort term , th a t is, w ith a r e m a in in g m a tu rity o f less th a n o n e year (see Table A 4.1). T h e p ro p o rtio n rose in th e first h a lf o f th e 1 9 9 0 s - Jea n n ea u an d M icu (2 0 0 2 ) attribute th is to th e g ro w th o f trade fin a n c in g , th e liberal­ isa tio n o f fin an cial sectors, th e e sta b lish m en t o f offsh ore fin a n cia l centres and th e ad van tages offered b y sh ort-term lo a n s in th e m o n ito r in g a n d m a n a g e ­ m e n t o f in tern a tio n a l exp osu res. S h ort-term b o rro w in g is u su a lly ch eap er b u t e x p o ses th e borrow er to r e fin a n c in g risks. As b orrow ers fo u n d th a t sh ort-term cred it w as so m e tim e s cu t o ff d u rin g th e A sian a n d o th e r crises, th e y h a v e in crea sin g ly felt th a t th e h ig h er in terest rates are w o r th p a y in g an d so m atu rities h a v e le n g th e n e d again . S o m e b o rro w in g c o u n tr ies h a v e a d o p ted sp ecific g u id e lin e s to le n g th e n d eb t m atu rities. C o n c e n tra tio n o f b a n k le n d in g It is o fte n cla im ed th a t in te r n a tio n a l b a n k fin a n c e to em e r g in g e c o n o m ie s is u n d u ly co n cen tra ted . A t first sig h t th is appears to b e th e case, as o v er h a lf o f in tern a tio n a l b an k lo a n s to em erg in g e c o n o m ie s g o to ju st te n e c o n o m ie s. In order, th ese are Brazil, Korea, M ex ico , C h in a, Turkey, A rgentina, In d on esia, Russia, Saudi Arabia an d T aiw an. H o w ev er it is less c o n c e n tra te d th a n p o p u la tio n , GDP or o th e r form s o f cap ital in flo w (Table 4 .3 ). T h e list o f th e to p te n recip ien ts o f b an k le n d in g is very sim ilar to th e te n largest em erg in g e c o n o m ie s, w ith th e e x c e p tio n th a t In d ia receiv es m u c h less le n d in g th a n th e size o f its e c o n o m y w o u ld su ggest. T h e OECD m em b ers receiv e m ore 62 International Bank Lending Table 4.3 C oncentration ratios (percentage shares of em erging econom ies)1 Share o f top 5 I n te r n a tio n a l b a n k le n d in g (e n d 2 0 0 0 )2 In te r n a tio n a l b o n d is s u a n c e (e n d 2 0 0 0 ) S to c k o f in w a r d fo r e ig n d ir e c t in v e s tm e n t (2 0 0 0 ) P o p u la tio n (1 9 9 9 ) G D P (PPP ba sis) (1 9 9 9 ) Share o f top 10 40 65 53 55 53 62 83 68 66 67 N o te s: 1 D ata c o v er 126 e m e rg in g e c o n o m ie s w ith a p o p u la tio n o v e r o n e m illio n a n d p e r c a p ita G D P of b e lo w 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 n so lid a te d basis (for a n e x p la n a tio n see A p p e n d ix 4.1). Sources: W o rld B ank A tlas (2001); UNCTAD (2001); BIS (2001). (p erhap s partly b eca u se o f th eir fav o u red tre a tm en t u n d er th e Basel C ap ital A ccord - see b elo w ). At th e o th er e n d o f th e d istrib u tio n , th e 2 5 p o o r est e c o n o m ie s (m o stly African cou n tries w ith per capita in c o m e s b e lo w US$1 0 0 0 ) receive o n ly ab ou t 1 per c e n t o f in te r n a tio n a l b a n k le n d in g . W h ile th e se e c o n o m ie s a c c o u n t for 10 per c e n t o f th e p o p u la tio n o f em e r g in g e c o n o m ie s, th e y o n ly a c c o u n t for 2 per c e n t o f GDP. M oreover le n d in g to m a n y o f th e p o o r e st co u n tries is a lm o st en tirely sh ort term , crea tin g a d d itio n a l v u ln era b ilities. T h ese ch arac­ teristics su ggest th a t in te r n a tio n a l b a n k le n d in g m a y n o t b e th e id eal v e h ic le for p ro v id in g fin a n c e to th e sm a llest a n d p o o r e st co u n tries. C u rre n c y d e n o m in a tio n o f b o rro w in g b y e m e rg in g eco n o m ies M ost em erg in g e c o n o m ie s, particularly th o se w ith a h isto ry o f h ig h in fla tio n a n d d ep recia tio n , face a sig n ific a n t la cu n a in fin a n c ia l m arkets. As a result o f w h a t E ich en green a n d H a u sm a n n (1 9 9 9 ) ca ll orig in a l sin , th e y h a v e great d ifficu lty m ark etin g lo n g -te r m secu rities d e n o m in a te d in th e d o m e s tic currency. In a d d itio n fo reig n len d ers w ill n o t le n d in th e d o m e s tic cu rren cy (Table 4 .4 ) an d te n d to b e u n w illin g to sta n d o n th e o th e r sid e o f a h ed g e co n tra ct.3 In th e se circu m sta n ces firm s ca n o n ly c h o o se b e tw e e n a cu rren cy m ism a tc h a n d a m a tu rity m ism a tch . R e c e n t t r e n d s i n n e t b a n k f i n a n c e t o e m e r g i n g e c o n o m ie s B an k le n d in g T h e cutbacks in in te r n a tio n a l b a n k lo a n s to em e r g in g e c o n o m ie s after th e A sian crisis m o d era ted d u rin g 2 0 0 0 a n d 2 0 0 1 (Table 4 .5 a n d Figure 4.1 ). T here w ere c o n tin u in g , a lb eit m u c h m o re m o d e st, d e c lin e s in lo a n s to em erg in g A sian e c o n o m ie s 4 b u t so m e in crease in lo a n s to L atin A m erica, a lth o u g h th is w as partly a refle ctio n o f th e p u rch ase b y S p an ish b an k s o f John Hawkins 63 Table 4.4 B o r r o w in g b y d o m e s tic n o n -b a n k s fr o m in te r n a tio 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 tic c u rre n c y ,* J u n e 2 0 0 2 A sian emerging economies C h in a In d ia In d o n e s ia K o re a M a la y s ia P h ilip p in e s T h a ila n d 4 2 6 4 4 3 4 Latin Am erican emerging economies A r g e n tin a B ra z il C h ile C o lo m b ia M e x ic o P e ru V e n e z u e la 0 1 0 0 1 1 0 Other emerging economies A dvanced economies C z e c h R ep. H u n g a ry Is ra e l P o la n d R ussia S o u th A fr ic a T u rk e y 14 5 1 6 1 13 1 A u s tra lia G e rm a n y H ong Kong Japan S in g a p o re UK USA 27 18 17 57 11 23 84 * For so m e e m e rg in g e c o n o m ie s th e fig u res m a y b e o v e re stim ate s as it is a ssu m e d th a t all lo a n s a n d b o n d s n o t d e n o m in a te d in a m a jo r c u rre n c y are d e n o m in a te d in th e d o m e stic currency. Source: BIS (2002). Table 4.5 In te r n a tio 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 illio n s , a n n u a l ra te ) International bank lending1 International debt securities2 1 9 9 0 -9 7 A ll d e v e lo p in g e c o n o m ie s 3 A s ia -P a c ific ,3 o f w h ic h C h in a c r is is - h it A s ia 4 L a tin A m e ric a a n d C a rrib e a n 1 9 9 8 -9 9 2000 1 9 9 0 -9 7 1 9 9 8 -9 9 2000 48 -7 4 -1 3 54 37 40 39 8 27 -7 9 -1 4 -5 9 -2 9 -5 -1 7 21 2 17 -1 -1 0 2 0 3 8 -1 2 14 26 24 28 Notes: 1 E x c h a n g e ra te a d ju ste d c h a n g e in claim s o f BIS re p o rtin g b an k s. 2 N e t issuan ce. 3 E xcludes H o n g K ong a n d Sin g ap o re. 4 In d o n e s ia , Korea, M alaysia, th e P h ilip p in e s a n d T h a ila n d . p rivatized B razilian ban k s. For m o s t o f 2 0 0 0 Turkey receiv ed sig n ifica n t a m o u n ts o f n e w le n d in g , b u t th is w as sh arp ly red u ced in early 2 0 0 1 . It is strik ing th a t e v e n fiv e years after th e A sian crisis, b a n k le n d in g to e m erg in g e c o n o m ie s h as n o t recovered . Several p o ssib le reason s h a v e b e e n su g g ested .5 T here w as a n u n u su a l p erio d in re cen t years w h e n L atin A m erica a n d m u c h o f Asia grew m ore slo w ly th a n th e g lo b a l average (Table 4 .6 ). M a n y em erg in g m arket borrow ers in Asia ran current a c c o u n t surpluses, as after th e 1 9 9 7 -9 8 crises im p orts w ere h e ld d o w n b y w ea k d o m e stic c o n su m p tio n 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 itio 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 , U S$ b illio n ) Notes : 1 A n e g ativ e (p o sitiv e) v a lu e in d ic a te s a n in c re a se (decrease) in BIS re p o rtin g b a n k s lia b ilities vis-à-vis e m e rg in g e co n o m ie s. 2 C h an g e s in claim s m in u s c h a n g e s in liabilities. 3 T w o -q u arter m o v in g average. Source: BIS (2002). T a b le 4 .6 change) R eal G D P , a c tu a l a n d fo re ca st, 1 9 5 0 -2 0 1 0 (avera ge a n n u a l p e rc e n ta g e 1 9 5 0 -9 6 W e s te rn E u ro p e 1 U n it e d States E m e rg in g A s ia ,2 o f w h ic h c ris is - h it L a tin A m e ric a 3 W o r ld 4 1996-2001 2 0 0 1 -1 0 5 3 .7 3 .4 6.7 6 .2 4 .8 4 .8 2 .6 3 .4 5 .3 1.5 2 .5 3.3 2 .2 3 .1 6 .2 4 .8 3 .3 3 .6 N o tes: 1 W eig h ted average o f 15 W este rn E u ro p ea n eco n o m ies. 2 W eig h ted average o f C h in a , H o n g K ong, In d ia , Indonesia, Korea, M alaysia, Philippines, T aiw an a n d Thailand, o f w h ic h th e c o u n trie s in italics are classified as crisis-hit. 3 W eig h ted average o f A rg e n tin a , Brazil, C h ile, C o lo m b ia , M exico, P eru a n d V enezeula. 4 W eig h ted average o f 45 e c o n o m ie s w ith o v e r 85 p e r c e n t o f g lo b al GDP. 5 C o n se n su s forecasts. an d in v e s tm e n t w h ile ex p o rts b en e fite d from im p r o v e d c o m p e titiv e n e ss fo llo w in g th e large d e v a lu a tio n s. M ore rece n tly th e slo w d o w n in th e US e c o n o m y h as in d u c e d further w arin ess o n th e part o f len d ers. T h e A sian e c o n o m ie s in particular are su fferin g fro m th e w ea k n ess in US te c h n o lo g y John Hawkins 65 in d u stries. Furtherm ore, as d iscu ssed b elow , b an k s in th e in d u strial co u n tries h a v e in creasin gly so u g h t credit exp osu re in em erg in g e c o n o m ie s b y p u rch as­ in g lo ca l banks, rather th a n th r o u g h cross-border le n d in g . R ecen t p ro b lem s in A rgen tin a an d Turkey are lik ely to b e d a m p e n in g ban k s e n th u sia sm for le n d in g to em erg in g e c o n o m ie s, a lth o u g h th e ex trem es o f c o n ta g io n se e n in earlier crises h a v e n o t b e e n o b served . D eposits fro m em e rg in g eco n o m ies D ep o sits from e m erg in g e c o n o m ie s h a v e b e e n g ro w in g stron gly. In 2 0 0 0 , d e p o sits w ere eq u iv a le n t to 2 per c e n t o f em e r g in g e c o n o m ie s GDP, th e largest p ro p o rtio n sin ce 1 9 7 9 -8 0 , w h e n o il-e x p o r tin g co u n tries p la ced w in d ­ fall rev en u es w ith in tern a tio n a l ban k s. T h e m a in sources o f th e se d ep o sits w ere T aiw an, m a in la n d C h in a a n d th e o il-e x p o r tin g co u n tries (n o ta b ly Saudi Arabia, Iran, M e x ic o a n d Russia). In th e case o f C h in a , a w ea k d e m a n d for fo reig n curren cy lo a n s an d in terest rate d ifferen tia ls w ere im p o r ta n t reasons. M ore generally, a sharp rise in resid en ts d e p o sits in overseas b a n k s is o fte n regarded as sy m p to m a tic o f cap ita l flig h t, w h ile a m o re gradual rise in th e se d e p o sits m a y just reflect p o rtfo lio rea llo ca tio n s. M a n y co u n tries d iscou raged or p ro h ib ited fu n d m an agers (u n it trusts, p e n s io n a n d m u tu a l fu n d s a n d so o n ) from in v e s tin g abroad so as to retain scarce cap ital for d o m e s tic d e v e l­ o p m e n t. T his m le has b e e n grad u ally ea sed in a n u m b er o f co u n tries. For e x a m p le in C h ile th e a llo w a b le p ro p o r tio n o f assets in v e s te d abroad w as raised from 2 per c e n t in 1 9 9 2 to 16 per c e n t in 2 0 0 0 as th e a u th o rities w ish e d to reduce th eir c o n c e n tr a tio n o f risk. In m a n y cases fu n d m an agers h a v e tak en ad v a n ta g e o f th is greater freed o m to p la ce fu n d s w ith in ter ­ n a tio n a l b a n k s.6 N et b a n k fu n d in g W ith le n d in g at b est flat a n d d e p o sits rising, fu n d s flo w e d fro m em e rg in g e c o n o m ie s to th e b an k s (Figure 4 .1 ). T h e IIF e stim a tes in Table 4 .1 sh o w th a t b an k s w ith d rew m ore m o n e y from th e em e rg in g e c o n o m ie s in 2 0 0 1 an d 2 0 0 2 . In tern a tio n a l b a n k lo a n s o u tsta n d in g to A sia are e x p e c te d to c o n tin u e fa llin g . W h ile th is partly reflects less d e m a n d for credit, or m o re o f it b e in g m e t d om estically, it also reflects c o n tin u in g ca u tio n b y len d ers a b o u t p o litica l u n certa in ties a n d th e slo w p a ce o f restru ctu rin g in so m e co u n tries. C y c lic a l a s p e c ts o f i n t e r n a t i o n a l b a n k l e n d i n g In te r n a tio n a l b a n k le n d in g to e m e r g in g e c o n o m ie s is su b ject b o t h to p u sh factors (in th e so u rce c o u n tr ie s) a n d to p u ll fa cto rs (in th e u ser c o u n tr ie s). A sim p le c o m p a r iso n o f th r e e o f th e s e fo rces - th e str e n g th o f th e a d v a n c e d a n d e m e r g in g e c o n o m ie s , w h ic h m ig h t b e a sso c ia te d w ith th e ir r e sp e c tiv e e x p e c te d retu rn s, a n d in te r e st rates in th e a d v a n c e d e c o n o m ie s - are s h o w n in Figures 4 .2 , 4 .3 a n d 4 .4 . In term s o f th e a c tiv ity 66 a *n c 3 Q. 4 5 (B © 2 J. 2 Figure 4.2 B a n k le n d in g t o e m e r g in g m a r k e t e c o n o m ie s a n d p o lic y in te r e s t rates, 1 9 8 5 -2 0 0 1 N o te s: 1 L eft-h a n d scale. 2 R ig h t-h a n d scale. Sources: N a tio n a l d a ta ; BIS. Figure 4.3 P u s h in flu e n c e s o n in te r n a tio n a l b a n k le n d in g , 1 9 7 8 -2 0 0 1 Notes: 1 L e ft-h a n d scale. 2 R ig h t-h a n d scale. Sources: N a tio n a l d ata: BIS. John Hawkins Total bank flow s Figure 4.4 67 Bank flow by region3 s -4 B a n k s e x te rn a l p o s itio n s vis-à-vis e m e r g in g e c o n o m ie s ,1 1 9 9 8 -2 0 0 1 Notes : 1 E x c h a n g e ra te a d ju ste d c h a n g e s in a m o u n ts o u ts ta n d in g , in b illio n s o f US d ollars. 2 A n e g ativ e (p o sitiv e) v a lu e in d ic a tes a n in crease (decrease) in BIS re p o rtin g b a n k s liabilities vis-à-vis e m e rg in g e co n o m ies. 3 C h a n g e s in claim s m in u s c h a n g e s in liabilities. 4 T w o -q u arter m o v in g average. Source: BIS. Figure 4.5 Japa ne se in te r n a tio 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 tio n a l d a ta ; BIS. m ea su res, th e grap h s su g g e st th a t th e p u ll fa c to r is g e n e r a lly stro n g er th a n th e p u sh , th a t is, b a n k s le n d in g is m o r e r e sp o n s iv e to c o n d it io n s in th e b o r r o w in g e c o n o m ie s th a n in th e le n d in g e c o n o m ie s , b u t th e r e are so m e e x c e p tio n s . T he stark est r e c e n t e x a m p le o f th is h a s b e e n th e sh a rp c u t­ b a ck in le n d in g to A sian e c o n o m ie s b y J a p a n e se b a n k s b e c a u se o f th e ir d o m e s tic d iffic u ltie s (Figure 4 .5 ). It h a s b e e n su g g e ste d th a t th e p u sh fa cto r d o m in a te s in L atin A m erica a n d th e p u ll fa cto r in A sia. In th eir su rv ey o f th e literature, J ea n n e a u a n d M icu (2 0 0 2 ) c o m m e n t th a t s o m e o f th e m o re r ecen t stu d ie s h a v e te n d e d to e m p h a s ise th e c o m p le m e n ta r ity o f 68 International Bank Lending p u sh a n d p u ll factors, w ith th e first se t o f factors d e te r m in in g th e tim in g a n d m a g n itu d e o f flo w s a n d th e s e c o n d se t d e te r m in in g th e ir g e o g r a p h ic d istrib u tio n . J ean n eau a n d M icu p resen t em p irical e v id e n c e , u sin g BIS b a n k in g data, th a t o n e p u sh factor - real sh ort-term in terest rates in in d u stria l co u n tries is th e d o m in a n t in flu e n c e (b u t real GDP in th e le n d in g c o u n tries d o es n o t h a v e a sig n ifica n t in flu e n c e ). O f th e p u ll factors, th e y fin d a role for e c o n o m ic g ro w th in b o rr o w in g co u n tries, th eir e x c h a n g e rate va ria n ce a n d ch a n g es in fo reig n reserves a n d th e cu rren t a c co u n t. T h e resu lts are b road ly sim ilar for Asia a n d Latin A m erica. Tests u sin g a crisis d u m m y su g g est th a t th e A sian crisis h a d th e effect o f red irectin g le n d in g fro m Asia to Latin A m erica. T h ese factors e x p la in m o re o f sh ort-term th a n lo n g -te r m le n d in g . It is n o te w o r th y th a t th e p re v io u sly ob serv ed te n d e n c y for cap ita l flo w s to em erg in g e c o n o m ie s to rise w h e n a c tiv ity in th e in d u stria l w o rld w ea k en ed is n o t h a p p e n in g in th e cu rren t slo w d o w n ; all th e sig n s are th a t flo w s are d e c lin in g . Interest rates in m o s t a d v a n ce d e c o n o m ie s w ere lo w in th e early 1 9 9 0 s (in th e U n ite d States, p artly d u e to th e w ea k n ess o f th e b a n k in g sector at th a t tim e). T his e n co u r a g e d b an k s to seek h ig h e r returns fro m le n d in g to em erg in g e c o n o m ie s. In terest rates stayed v ery lo w in Japan in th e 199 0 s, g iv in g rise to y e n carry trade: b o rro w in g in y e n (at p erh ap s 0 .5 per cen t) an d le n d in g elsew h ere in Asia (perhaps at 2 0 per c e n t in In d o n e sia ). T he sh eer size o f th e in terest rate d ifferen tia l a n d c o n fid e n c e in th e A sian e c o ­ n o m ic m iracle te m p te d len d ers to ig n o re th e e x c h a n g e rate a n d cred it risks in v o lv e d . A n o th er ex a m p le w h ere in terest rates p la y ed a n im p o r ta n t role w as th e rise in US rates in early 1 9 9 4 , w h ic h a cted as a n im p o r ta n t trigger for M exicos su b seq u e n t p ro b lem s. H o w ev er th is also p ro v id es a c o u n te r e x ­ a m p le as th e in terest rate in crease se em e d to d o n o th in g to curb le n d in g to th e A sian e c o n o m ie s. Just lo o k in g at in terest rates in a d v a n ced e c o n o m ie s is, o f cou rse, very sim p listic. A m o re rele v a n t m easu re w o u ld b e th e risk-adjusted e x p e c te d return, w h ic h sh o u ld b e co m p a red w ith ex p e c te d returns in e m erg in g m arket e c o n o m ie s. Furtherm ore le n d in g m a y also resp o n d to th e d egree o f v a riation an d u n certa in ty a b o u t th e return or th e e x te n t to w h ic h returns are correlated across co u n tr ie s a n d regio n s. A d d ressin g th e se issu es em p irica lly is w e ll b e y o n d th e sc o p e o f th is chapter. T he relative im p o rta n c e o f p u sh a n d p u ll factors w ill a lso d e p e n d o n th e e x te n t to w h ic h ban k s are in fo rm e d a b o u t in d iv id u a l em e rg in g e c o n o m ie s an d d iscrim in ate b e tw e e n th e m . To test for th is, th e p ercen ta g e c h a n g e in th e o u tsta n d in g claim s o f b anks o w n e d b y th e five m a in le n d in g co u n tries o n th e te n m a in e m erg in g e c o n o m ie s w as ca lcu la ted o v er six -m o n th ly p eriod s from June 1 9 9 0 to Ju n e 2 0 0 0 . T h e co rrela tio n s are sh o w n in Table 4 .7 . There are q u ite a few n eg a tiv e correlation s, su g g e stin g th a t th e le n d in g flo w s w ere n o t u n ifo rm b u t h a d m a n y id io sy n cra tic features. It c a n also b e o b serv ed John Hawkins 69 Table 4 .7 C o r re la tio 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 rtin 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 Borrowers C h in a In d o n e s ia In d ia M a la y s ia K o re a T h a ila n d A r g e n tin a B ra z il C h ile M e x ic o S ta n d a rd d e v ia tio n s G erm any Japan UK US 0 .0 8 -0 .0 6 -0 .0 0 -0 .1 2 0 .0 3 -0 .2 0 0 .5 1 0 .4 5 0 .4 2 0 .0 3 0 .3 0 .0 1 0 .0 2 -0 .1 0 0 .1 4 -0 .2 0 -0 .3 7 0 .2 5 0 .4 6 0 .1 9 0 .0 6 0 .2 0 .1 1 -0 .0 4 0 .3 3 -0 .3 2 -0 .2 8 -0 .1 4 0 .1 0 0 .1 2 -0 .0 2 0 .1 4 0 .2 0 .1 2 -0 .1 7 -0 .0 7 0 .0 9 -0 .1 0 -0 .3 3 0 .9 0 -0 .0 3 0 .4 1 -0 .1 5 0 .4 0 .0 1 -0 .0 3 -0 .0 8 -0 .1 8 -0 .1 5 -0 .3 9 0 .1 2 0 .1 1 0 .3 9 -0 .3 0 0 .2 Standard deviations 0 .1 0 .1 0 .2 0 .2 0 .1 0.1 0 .3 0 .2 0 .2 0 .2 * C o rre la tio n b e tw e e n p e rc e n ta g e c h a n g e in le n d in g o v e r s ix -m o n th ly p e rio d s b y b a n k s o w n e d b y le n d in g c o u n try i to b o rro w e r / w ith all lo a n s to all d e v e lo p in g e c o n o m y b o rro w e rs. th a t th e correlation s te n d to b e m o re sim ilar across th e row s (borrow ers) th a n d o w n th e c o lu m n s (len d ers), ag a in su g g estin g th a t p u ll factors w ere gen era lly m ore im p ortan t. In a sim ilar stu d y th a t focu ses o n p eriod s o f currency crisis, V an R ijckeghem an d W eder (2 0 0 0 , 2 0 0 1 ) u se BIS c o n so lid a te d b a n k in g sta tistics to e x a m in e th e role o f b an k le n d in g in c o n ta g io n . N o tin g th e sp e cia liz a tio n illu strated in Table 4 .2 , th e y test for a c o m m o n len d er effect. T h e h y p o th e s is is th a t b an k s th a t m ake lo sses d u e to th eir ex p o su re to a crisis c o u n tr y resp o n d b y c u ttin g back le n d in g to o th e r em e r g in g e c o n o m ie s. As a result, em e r g in g e c o n o m ie s th a t h a v e th e sa m e len d ers as a crisis e c o n o m y suffer fro m c o n ­ ta g io n . T h ey fin d e v id e n c e for su c h a n e ffect after th e M ex ic a n a n d A sian crises b u t n o t after th e B razilian crisis. G iv e n th e p attern o f c o m m o n len d ers sh o w n in Table 4 .2 , th is fo rm o f c o n ta g io n is m o st lik e ly to a ffect o th er e c o n o m ie s in th e sam e reg io n . From a p o lic y p o in t o f view , th e se fin d in g s im p ly th a t em erg in g e c o n o m ie s c o u ld reduce th eir c o n ta g io n risk b y d iver­ sify in g th e sources o f th eir fu n d in g a n d carefu lly m o n ito r in g th eir v u ln e r ­ a b ility th r o u g h shared b a n k creditors. N o tw ith sta n d in g th e fa ct th a t p rivate b anks c h o ic e o f creditors is th e d e c isio n o f in d iv id u a l ban k s, th e a u th o rities c a n still p lay a role b y p r o v id in g in fo r m a tio n o n aggregate p o sitio n s a n d b y a d ju stin g th e c o m p o s itio n o f th eir o w n creditors. S om e recent studies o n d eterm in a n ts o f th e d estin a tio n o f b a n k le n d in g are su m m arized b y B u ch (2 0 0 0 ). For G erm an b an k s, le n d in g is h ig h ly correlated 70 International Bank Lending w ith trade lin ks, a lth o u g h th is d o es n o t appear to b e fo llo w th e cu sto m er b eh a v io u r as m u c h o f th e le n d in g stu d ied w as to banks, rather th a n c o m ­ p a n ies, in th e recip ien t co u n tries. A stu d y o f OECD b a n k s fo u n d th a t m arket g ro w th an d d iv ersifica tio n p ro sp ects w ere m o st im p o rta n t. In th e U n ite d States, sm all ban k s te n d to fo llo w th e lea d o f large b an k s in th eir overseas le n d in g . Based o n BIS data, B u ch fin d s th a t in te r n a tio n a l b a n k lo a n s are greater to co u n tries th a t h a v e trade lin k s w ith th e len d er, stro n g g r o w th in in d u strial p ro d u ctio n , m e m b e r sh ip o f th e OECD (a ssu m ed to reflect th e co rresp o n d in g lo w er cap ita l req u irem en ts u n d er th e B asel A ccord) a n d are g eo g ra p h ica lly c lo se to th e lender. C apital co n tr o ls d eter le n d in g . In ad d ­ itio n , S p an ish b an k s le n d far m o re th a n th e se variables a lo n e w o u ld pred ict to S p an ish -sp eak in g co u n trie s (th e o n ly case w h ere c o m m o n la n g u a g e appears to b e im p o rta n t). In terest rate d ifferen tia ls are n o t sig n ifica n t. T h e in te r n a tio n a l le n d in g b eh a v io u r o f in d iv id u a l US b a n k s is stu d ie d b y G old b erg (2 0 0 1 ). M u c h o f th is le n d in g is c o n c e n tr a te d in L atin A m erica, a n d G oldberg sh o w s th a t th is is esp ecia lly true o f sm aller ban k s. Sh e c o n c lu d e s th a t US banks fo reig n le n d in g to Latin A m erica ex p a n d s m o re w h e n th e US e c o n o m y is g ro w in g stron gly, b u t th is is n o t th e case for le n d in g to Asia. H ow ever in te r n a tio n a l le n d in g b y US b an k s is n o t se n sitiv e eith er to real in terest rates or to d e m a n d c o n d itio n s in th e r ecip ien t em e r g in g e c o n o m ie s. Structural aspects of international bank lending C h a n g e s i n b a n k o p e r a tio n s G lob al banks h a v e red u ced th eir le n d in g to em er g in g e c o n o m ie s in favou r o f fee-b ased a ctiv ities a n d le n d in g v ia subsidiaries (Table 4 .8 ). T h e m o v e tow ard s fee-based a ctiv itie s m a y b e d u e to b a n k s try in g to m e e t th eir aspir­ a tio n for h ig h returns o n e q u ity w ith o u t a d d in g assets to th eir b a la n ce sh eet, w h ic h w o u ld require m o re e q u ity to b e raised. It a lso m a y reflect a m ore co n serv a tiv e a ttitu d e tow ard s ta k in g risks o n to th eir o w n b a la n c e sh eets (p o ssib ly d u e to a greater a p p recia tio n o f th e e x te n t o f th e se risks) a n d a desire for m o re stab le in c o m e sources. L en d in g th r o u g h su b sid iaries m a y a llo w b etter q u a lity c o n tr o l b y le n d in g officers lo ca ted in sp ecific em e r g in g e c o n o m ie s. It m o re read ily a llo w s in ter­ n a tio n a l banks to le n d in d o m e stic currency, as a su b sid iary ca n raise d ep o sits in th e d o m e stic cu rren cy to a v o id a cu rren cy m ism a tch . In so m e c o u n tries (for ex a m p le C h in a a n d M alaysia) direct le n d in g in d o m e s tic cu rren cy from th e h ea d o ffice is p ro h ib ite d b y cap ital co n tro ls. In so m e cases, h o s t b a n k supervisors prefer in te r n a tio n a l b an k s to le n d th ro u g h su ch sub sidiaries. M a n y e m erg in g m arket e c o n o m ie s are n o w en co u ra g in g th e en try o f fo reig n b anks to m ak e u p for d efic ie n c ie s in th eir d o m e stic b a n k in g sy stem , su c h as lack o f cap ital, lack o f c o m m ercia l b a n k in g skills an d a n in e ffic ie n t b a n k in g structure. F oreign b an k s u su a lly John Hawkins 71 Table 4.8 In te rn a tio n a l b an k s in v o lv em e n t in develo p in g co un tries, Ju n e 1998-D ecem ber 2000 % change (at annual rate) June 1998 (US$ bn) Dec 2 0 0 0 (USS bn) A ll developing countries L o a n s o u ts ta n d in g O th e r assets1 L o a n s b y s u b s id ia rie s 2 924 110 248 73 9 15 5 435 -8 .8 1 4 .7 2 5 .2 Developing Asia L o a n s o u ts ta n d in g O th e r assets1 L o a n s b y s u b s id ia rie s 2 358 36 72 243 41 118 -1 4 .4 5 .3 2 1 .8 Latin America L o a n s o u ts ta n d in g O th e r assets1 L o a n s b y s u b s id ia rie s 2 278 43 134 213 74 23 1 -1 0 .1 2 4 .3 2 4 .3 I n te r n a tio n a l d e b t s e c u ritie s o n issue 345 417 7.9 N otes: 1 In c lu d e s h o ld in g s o f d e b t securities, so m e d e riv a tiv e p o s itio n s a n d e q u itie s. See BIS (2000), p a rt I.C. 2 Local c u rre n c y claim s o f BIS re p o rtin g b a n k s fo reig n affiliates w ith lo cal resid en ts. Source: BIS (2000), p a rt I.C. b rin g state-of-the-art te c h n o lo g y a n d tra in in g for d o m e stic bankers. M oreover th e y are fam iliar w ith so p h istica te d fin a n c ia l in str u m e n ts a n d te c h n iq u e s, a n d h a v e faster an d ch ea p er a ccess to in te r n a tio n a l cap ita l m arkets an d liq u id fun ds. T heir p resen ce m a y also en cou rage o th er foreign firm s to in v est in th e d o m e stic ec o n o m y . Em pirical stu d ies h a v e fo u n d th a t fo r e ig n b a n k e n try im p ro v es th e fu n c tio n in g o f n a tio n a l b a n k in g m arkets b y in crea sin g th e d egree o f c o m p e titio n , a n d b y in tr o d u c in g a v a riety o f n e w fin a n c ia l p rod u cts a n d b etter risk m a n a g e m e n t te c h n iq u e s .7 A liberal ap p ro a ch to fo reig n b a n k en try h as b e e n laid d o w n b y in te r n a tio n a l trade ag reem en ts (W TO, NAFTA), is a c o n d itio n o f m em b e rsh ip o f th e OECD a n d th e EU, or is part o f reciprocity req u irem en ts for d o m e s tic b a n k s to e x p a n d in to fo reig n m arkets. As a result, fo reig n ban k s n o w h a v e a large p resen ce in m o s t e m erg in g e c o n o m ie s. In d eed for a sm a ll e c o n o m y it m a y m ak e se n se n o t to h a v e a n y d o m e stic a lly o w n e d b an k s at all, as th e y m a y n o t b e ab le to d iversify th eir risks su fficien tly. N o n e th e le ss in practice th ere are o n ly a few e c o n o m ie s w ith fu lly fo r e ig n -o w n ed b a n k in g sy stem s, w ith th e d eg ree o f fo reig n o w n er sh ip m ore n o rm a lly ly in g so m e w h er e b e tw e e n 2 0 per c e n t a n d 5 0 per c e n t.8 W h e n a n n o u n c in g a m ajor lib era liza tio n p rogram m e, th e a u th o rities in S in gapore stated e x p lic itly th a t th e y w a n te d lo c a l b an k s to retain at least 72 International Bank Lending h a lf th e m arket. A n o th er e x a m p le is th e P h ilip p in e s, w h e r e a la w restricts fo reig n banks share o f assets to 3 0 per c e n t or less. F oreign b an ks o fte n en ter b y ta k in g over a tro u b led d o m e s tic b an k . H o w ­ ever th ere m a y b e p u b lic resista n ce to th is, esp ecia lly if taxp ayers m o n e y h a s b e e n u sed to clea n u p th e banks b a la n ce sh e e t a h ea d o f p riv a tiza tio n . G o v ern m en ts a lso face d o m e s tic pressure to lim it th e role o f fo reig n b anks b eca u se o f fears th a t fo reig n b a n k s w ill q u ick ly d o m in a te th e lo c a l m arket a n d n eg lect sm all b u sin e sses or rural cu sto m ers, or ca u se a lo w e rin g o f cred it standards b y in creasin g co m p e titio n , esp ecia lly if th e y u se th eir d eep p o ck ets to su b sid ize early lo sses. E v id en ce o n w h e th e r th e b u sin e ss fo cu s o f fo reig n a n d d o m e stic ban k s d iverges is rather m ix e d . In m o s t em er g in g m arket ec o n o m ie s, h ow ever, fo reig n b an k s appear to b e very c a u tio u s a b o u t le n d in g to sm aller firm s b eca u se o f th e ir lim ite d k n o w le d g e o f lo c a l industry. A n im p o rta n t issu e h a s b e e n fo reig n ban k s b e h a v io u r d u rin g recessio n s in h o s t co u n tries a n d th e fo reig n ban k s h o m e base. O n e o p in io n is th a t d o m e s tic b an k s are m o re c o m m itte d to th e d o m e stic e c o n o m y , in th e sen se o f h a v in g b o th lo n g er-term b u sin e ss rela tio n s w ith c u sto m ers a n d a p a trio tic a ffin ity w ith th e n a tio n a l in terest. F oreign ban k s, b y con trast, are said to lo o k at le n d in g o p p o r tu n itie s a ro u n d th e w o rld a n d m a y n e g le c t th e h o s t co u n tr y e c o n o m y if its p ro sp ects deteriorate or if p ro sp ects im p ro v e in o th e r cou n tries. F oreign b an k s m a y also b e less lik ely th a n d o m e stic a lly o w n e d b an k s to h e e d ex h o r ta tio n s b y th e d o m e stic a u th o rities to m a in ta in le n d in g d u rin g recession s. In so m e cases fo reig n b an k s h a v e b e e n less co o p er a tiv e in resch ed u lin g lo a n s in tim e s o f crisis. It is d ifficu lt to assess th e tru th o f th e se criticism s. T h ey m a y w e ll a p p ly m o re to fo reig n b a n k s w ith o n ly a sm all an d recen t p resen ce in th e d o m e s tic b a n k in g sy stem . H ow ever, larger, lo n g er-esta b lish ed fo reig n b an k s m a y b e less in c lin e d to risk th eir rep u ta tio n a n d b eh a v e m o re lik e th e d o m e s tic ban k s. T here is also e v id e n c e th a t lo ca l m a n a g e m e n ts are u su a lly stro n g ly c o m m itte d to th e lo c a l o p era tio n s, a n d th a t th e y id e n tify m o re w ith d o m e stic in terests over tim e . T he con trary o p in io n is th a t fo reig n b an k s are b etter p la ced to ride o u t d o m e stic recessio n s b eca u se th e y ca n m o re read ily a ccess in te r n a tio n a l fin a n cia l m arkets or draw o n cred it lin e s from th eir p aren ts. F urtherm ore th e y h a v e m ore d iversified b a la n ce sh eets. T h e em p irica l e v id e n c e from Latin A m erica su ggests th a t fo reig n b anks h a v e g en era lly had low er v o la tility o f le n d in g th a n d o m e s tic b an k s a n d n o ta b le cred it g ro w th d u rin g crisis periods, an d th a t o n ly o ffsh o re le n d in g te n d s to co n tra ct in b a d tim es. Foreign bank op eration s m a y also keep in tern a tio n a l m arkets b etter in fo rm ed a b o u t d o m e stic c o n d itio n s a n d so h e lp d a m p en p a n ic w ith d ra w a ls o f in te r n a tio n a l fu n d in g (as in Saudi Arabia d u rin g th e G u lf War in 1 9 9 1 ), or ca n h elp reduce resid en t cap ita l o u tflo w s d u rin g crises b eca u se th e y are u su a lly p erceived as safer. G o v e rn m en ts m a y a lso b e relu cta n t to h a v e th eir d o m e s tic b a n k in g sy stem s d o m in a te d b y b an k s from a sin g le c o u n tr y lest th e y su d d e n ly cu t John Hawkins 73 th eir a ctiv ities w h e n faced w ith p ro b lem s at h o m e (for e x a m p le J ap an ese ban k s in Asia) or exert p o litica l pressure for favou rab le trea tm en t. For th is reason em erg in g e c o n o m ie s m a y seek to diversify fo reig n o w n ers. For ex a m p le th e Saudi au th orities h a v e b e e n selectiv e an d lic e n se d fo reig n banks from d ifferen t parts o f th e w orld , w ith d ifferen t m a n a g e m e n t cultures, sy stem s an d te c h n o lo g ie s. Sim ilarly th e a u th o rities in C h in a h a v e b e en c o n c e r n e d a b ou t th e im p a ct o f fo reig n b an k s o n th e c o m p e titiv e n e ss o f d o m e s tic banks, an d h a v e s o u g h t to lim it th eir m arket share b y lic e n sin g b an k s from d ifferen t cou n tries, restrictin g th eir a ctiv ities to b u sin e ss in fo reig n currencies o n ly , or restrictin g th eir b u sin ess in lo c a l cu rren cy to tw o cities. T h ey h a v e also en su red th a t b an k s are fam iliar w ith th e lo ca l m arket b y requ iring th e m to h a v e a rep resen ta tiv e o ffice for tw o years before c o m m e n c in g b a n k in g o p era tio n s. P o lic y to w a r d s in t e r n a t io n a l b a n k le n d in g S in ce th e A sian crisis th ere h as b e e n greater aw aren ess a m o n g p o lic y m akers o f th e risks in v o lv e d in e x c e ssiv e ex tern a l b o rro w in g . Supervisors m a y th er e ­ fore d iscou rage b an k s from b o rro w in g o ffsh o re a n d restrict th eir fo reig n e x c h a n g e e x p o su re.9 S o m etim es, h o w ev er, b a n k s try to restrict th eir o w n fo reig n e x c h a n g e exp osu re b y le n d in g in fo reig n cu rren cy to d o m e s tic c u sto m ers w h o se ca sh flo w s are in th e d o m e s tic currency. H o w ev er th e y th e n face a large cred it risk if th ere is a sharp d ep recia tio n . T h is w as a m ajor p ro b lem d u rin g th e M ex ic a n a n d A sian crises in th e 199 0 s. In so m e co u n tries restriction s h a v e b e e n p la ce d o n in ter n a tio n a l b an k fin a n c in g , su ch as th e recen t tig h te n in g o f lim its o n n o n -re sid e n ts ab ility to b orrow d o m e s tic curren cy in In d o n esia , th e P h ilip p in e s a n d T h ailan d . O ften th e se h a v e b e e n d irected at su ch a c tiv ities as n o n -r e sid e n ts shortse llin g th e currency as part o f a sp ecu la tiv e attack, b u t th e restriction s m a y redu ce le n d in g for other, m o re in n o c e n t, p u rp o ses as w ell. I n t e r n a tio n a l b a n k le n d i n g a n d t h e B a se l C a p ita l A c c o r d T h e Basel C o m m itte e o n B an k in g S u p erv isio n is cu rren tly in th e process o f a d a p tin g th e Basel C apital A ccord to n e w m arket realities (it issu ed c o n s u l­ ta tio n drafts in Ju n e 1 9 9 9 a n d January 2 0 0 1 ). T h is c o u ld h a v e im p lic a tio n s for th e q u a n tity or d istrib u tio n o f b an k le n d in g to em e r g in g e c o n o m ie s. S o m e argue th a t b an k s are already rea ctin g to th e p rop osals. A prim ary goal o f th e p rop osals is to a lig n m ore c lo se ly th e cap ital required to su p p ort a lo a n an d th e risk o f th e lo a n . In particular it rep laces th e O E C D / n on -O E C D d is tin c tio n w ith a n ap p ro a ch b a sed o n ban k s in tern a l cred it ratings or th o s e set b y cred it a sse ssm e n t a g en cies. T h is m e a n s th a t lo a n s to low er-rated OECD e c o n o m ie s su ch as Korea, M ex ic o , P o la n d a n d Turkey w o u ld require m ore capital w h ile lo a n s to higher-rated n on -O E C D e c o n o m ie s su ch as C h ile, H o n g K on g a n d Sin gap ore w o u ld require less. 74 International Bank Lending Risk w e ig h ts for ban k s a n d corp orates w o u ld also b e d e p e n d e n t o n th eir cred it ratings. T h is sh o u ld red u ce th e fu n d in g co sts o f so m e o f th e so u n d est b an ks an d c o m p a n ie s in em er g in g e c o n o m ie s. T h e lo w er risk w eig h ts a ssig n ed to corp o ra tio n s rated A m in u s or a b o v e c o u ld lea d to m o re le n d in g to th e m at th e e x p e n se o f w eaker credits. As w eaker cred its te n d to b e m o re p rev a len t in em erg in g e c o n o m ie s, th is c o u ld red u ce th e o v era ll flo w o f b a n k le n d in g to e m erg in g e c o n o m ie s. It m ig h t w e ll b e in e m er g in g e c o n o m ie s in terests if th e riskiest b orrow ers w ere to fin d cred it m o re ex p e n siv e , b u t c o n c e r n has b e e n ex p ressed - for e x a m p le b y G riffith-Jones a n d Spratt (C hapter 10) - th a t th e m a p p in g b e tw e e n credit a ssessm en ts a n d cap ital required m a y b e so steep th a t th e lo w est-ra ted b orrow ers w o u ld fin d lo a n s from b an ks p r o h ib itiv e ly e x p en siv e . A particular p r o b le m for corp orate borrow ers in m a n y e m er g in g e c o n o m ie s is th a t fe w o f th e m h a v e a credit rating; for ex a m p le P ow ell (2 0 0 1 ) reports th a t in A rgentina o n ly 1 5 0 o f 8 0 0 0 0 corp orate borrow ers are rated. T h e n e w A ccord en v isa g e s th a t th e m o re so p h istic a ted b an k s w ill u se a n a d v a n ced in tern a l ratin gs-b ased a p p roach . T h is m a y red u ce th e e x te n t o f h erd in g if it cau ses ban k s to b ase th eir lo a n s o n in d iv id u a l a ssessm en ts o f co u n tr ie s.10 H ow ever th e p r o p o se d role for ex tern a l cred it a sse ssm e n t a g e n ­ cies (n o t just ratings a g e n c ie s b u t also n a tio n a l ex p o rt cred it a g en cies) h as led to so m e c o n cern . S o v ereig n ratings h a v e te n d e d to la g b e h in d e c o n o m ic d e v e lo p m e n ts as ratin g a g e n c ies h a v e b e e n slo w to d o w n g ra d e c o u n tr ie s in th e ru n-up to crises, w h e n u n d e r ly in g im b a la n ce s are b u ild in g u p a n d w a rn ­ in g s w o u ld b e u sefu l b o th to b orrow ers a n d to len d ers, a n d th e n p u t th e c o u n tries th r o u g h several d o w n g ra d es o n c e th e crises h a v e b ro k en o u t. T his m a y m ak e th e m a p ro cy clica l e le m e n t (as th e y w ere d u rin g th e A sian crisis), en co u ra g in g b an k s to w ith d ra w e v e n furth er fro m em er g in g e c o n o m ie s just w h e n th eir su p p ort is m o s t n e e d e d . H o w ev er it is n o t clear w h a t w o u ld b e a b etter altern ative. S o v ereig n cred it spreads te n d to b e e v e n m o re v o la tile th a n ratings. O n e ap p ro a ch w o u ld b e to adjust regu latory risk w e ig h ts o n ly gradu ally in resp o n se to c h a n g e s in cred it ratings. F in an cial m arkets are lik ely to b e p rocyclical regardless o f h o w regu lation s are structured. It is to b e h o p e d th a t a greater fo cu s o n m ea su rin g risk b y b an k s a n d th eir supervisors w ill m e a n a m o re careful a n d less sh ort-term focu s. U nder th e presen t accord, in tern a tio n a l interbank le n d in g o f u p to o n e year to n on-O E C D e c o n o m ie s h as a 2 0 per c e n t risk w e ig h t w h ile lo n g er-term le n d in g carries a 1 0 0 per c e n t risk w e ig h t. O n e p o ssib le c o n se q u e n c e o f th is d is tin c tio n is th a t b a n k le n d in g to e m erg in g m arkets is to o sh ort term , an d th u s m ore su b ject to c y clica l fo rces.11 W h ile a lo w er risk w e ig h t for sh o rt­ term le n d in g th a n for lo n g -ter m le n d in g m a y m ak e se n se for th e le n d in g o f a n in d iv id u a l b a n k (w h ic h is th e fo cu s o f th e supervisors), it m ak es less sen se if all banks le n d sh o rt term so th a t th e b orrow er is v u ln era b le to a su d d en lo ss in liq u id ity. In o th e r w o rd s th e sy ste m ic (or m acro) c o n sid e r a tio n s m a y to so m e e x te n t ru n co u n te r to su p erv iso ry (or m icro) co n sid e r a tio n s. John Hawkins 75 T h e co n su lta tiv e d o c u m e n t issu ed b y th e Basel C o m m itte e (2 0 0 1 ) reco g ­ n iz e d th e p o te n tia l for u n in te n d e d c o n se q u e n c e s o n le n d in g m arkets from se ttin g low er cap ital req u irem en ts for sh o rt-m a tu rity lo a n s a n d so u g h t c o m m e n ts o n th is q u e stio n . It su g g ested lo w e rin g th e th r e sh o ld for pre­ ferable trea tm en t o f sh ort-term d eb t to th ree m o n th s, th e u p p er m a tu rity b a n d in th e in terb a n k m o n e y m arket. W h ile th e p r o p o sed risk w e ig h ts for sh ort-term le n d in g to b a n k s rated b e tw e e n A p lu s a n d B m in u s are low er th a n th o s e a p p lied to lo n g -te rm lo a n s to th o s e b a n k s, th e d ifferen ce is 3 0 - 5 0 p ercen tag e p o in ts rather th a n th e cu rren t 8 0 p ercen ta g e p o in ts. Conclusions S in ce th e A sian crisis fu n d s h a v e c o n siste n tly flo w e d to in te r n a tio n a l b an k s from em e rg in g e c o n o m ie s. P rev io u sly th is w o u ld h a v e se em e d as lik ely as w ater flo w in g u p h ill. A n u m b er o f factors are resp o n sib le for th is surprising ev en t, b o th cy clica l a n d structural: • • • • • T h e A sian crisis ca m e as a sh o ck to c o m p la c e n t b an k s th a t h a d a ssu m ed th e g o o d tim es in A sia w o u ld g o o n in d e fin ite ly a n d th erefo re ig n o red th e m o u n tin g d eb t in th e reg io n . S u b seq u en tly th e R ussian crisis w ea k e n e d th e c o n v ic tio n th a t len d ers to im p o rta n t co u n tries w o u ld alw ays b e b a iled o u t. T his h as led to red u ced le n d in g . S o m e c o m p la c e n c y w as a lso r e m o v ed fro m borrow ers in e m erg in g e c o n o m ie s. M a n y borrow ers b e c a m e k e e n to repay d eb t. In Asia, cu rren cy d e v a lu a tio n s an d stro n g d e m a n d (u n til recen tly ) for th eir e lec tro n ic exp orts a llo w ed th e m to repay e x c e ssiv e d eb t. C yclical factors p la y ed so m e role; u n til r e c e n tly g r o w th p ro sp ects in th e U n ite d States w ere seen as e x c e p tio n a lly stron g. G row th p ro sp ects lo o k e d poorer in d a m a g ed A sian e c o n o m ie s, as w e ll as in A rgen tin a, Brazil a n d Turkey. M an y A sian e c o n o m ie s h a v e a le g a c y o f o v e r in v e s tm e n t so are n o t k een to borrow . D ep o sits in in te r n a tio n a l b a n k s b y em e r g in g m arket e c o n o m ie s h a v e b e e n grow in g, reflectin g th e d ereg u la tio n o f fa st-g ro w in g fu n d m anagers, cap ital flig h t a n d th e sa v in g s fro m h ig h o il reven u es. A structural c h a n g e ex a g g era tin g th e p h e n o m e n o n is th a t ban k s, e n c o u r ­ aged b y p o lic y m akers, are in crea sin g ly d o in g th eir le n d in g in e m erg in g e c o n o m ie s th r o u g h sub sid iaries th ere, u sin g d ep o sits raised th ere, rather th a n from h ea d office. It is hard to a p p o rtio n th e tu rn a ro u n d in in te r n a tio n a l b a n k le n d in g b e tw e e n th e se factors. But th ere is a risk th a t in ste a d o f e x c e ssiv e cap ita l in flo w s th e em erg in g e c o n o m ie s w ill face in a d e q u a te in flo w s. T h e w ater flo w in g u p h ill w ill m o v e th e m from flo o d to d ro u g h t. 76 International Bank Lending Appendix 4.1 BIS in t e r n a t io n a l b a n k in g sta tis tic s D ata are gath ered q u arterly fro m n a tio n a l a u th o rities, u su a lly cen tral banks, in 3 2 e c o n o m ie s, in c lu d in g th e w orlds m a in b a n k in g ce n tr e s.12 T here are tw o m a in q uarterly c o lle c tio n s, k n o w n as th e lo c a tio n a l a n d c o n so lid a te d c o lle c tio n s. T he lo c a tio n a l data, w h ic h c o m m e n c e d in 1 9 6 4 , are c o n siste n t w ith b a la n ce o f p a y m e n ts p rin cip les a n d co v er ban k s, b o th d o m e s tic a n d fo reig n o w n ed , lo ca ted in th e 3 2 e c o n o m ie s (but n o t th eir overseas subsidiaries). T h e data relate to ban k s in te r n a tio n a l b a n k in g b u sin ess, d e fin e d as gross fin an cial claim s or liab ilities vis-à-vis n o n -resid en ts as w ell as foreign currency p o sitio n s vis-à-vis resid en ts. To m in im iz e rep o rtin g b u rd en s th e c o lle c tio n is b u ilt o n e x is tin g n a tio n a l data c o lle c tio n s. A lth o u g h th e data u su a lly co v er w e ll over 9 0 per c e n t o f in te r n a tio n a l le n d in g , th ere is so m e v a ria tio n in th e coverage o f in s titu tio n s a n d so m e d e fin itio n a l in c o n s is te n c ie s .13 T h e assets a n d lia b ilities (an d a narrow er c o n c e p t o f lo a n s a n d d ep o sits) are b rok en d o w n by: • • • currency, in to d o m e s tic currency, US dollar, eu ro, y e n , sterlin g, Sw iss franc an d oth er. O n e rea so n for th is is to m easu re th e e x te n t to w h ic h ch a n g es in sto ck ex p ressed in US dollars are attrib u tab le to v a lu a tio n effects arisin g from e x c h a n g e rate flu c tu a tio n s rather th a n b e in g d u e to tran sactions; sector, in to b an k s a n d n o n -b a n k s; e c o n o m y (in tern a tio n a l o r g a n iza tio n s su ch as th e IMF, OPEC a n d so o n are in c lu d e d as sp ecia l co u n tries rather th a n b e in g a llo c a te d to th e c o u n try in w h ic h th e y are head q u artered ). A sn a p sh o t su m m a ry o f th e se data, w h ic h are p u b lish e d for over 1 6 0 in d i­ v id u a l em erg in g e c o n o m ie s, as o f m id 2 0 0 2 is p ro v id ed in th e u p p er part o f Table A 4.1. For so m e c o u n tr ie s th ere are sig n ific a n t d iscrep a n cies b e tw e e n th e data p u b lish ed b y th e BIS (based o n in fo r m a tio n fro m len d ers) a n d th e extern al d eb t statistics p u b lish e d b y n a tio n a l statistical a g en cies (b ased o n in fo r m a tio n fro m borrow ers). In so m e cases th is is k n o w n to b e d u e to d e fin itio n a l d ifferen ces rather th a n m isr ep o r tin g .14 T h e co n so lid a te d c o lle c tio n , la u n c h e d in 1 9 7 7 b u t rep orted o n ly se m i­ a n n u a lly u n til 2 0 0 0 , fo cu ses o n banks w o rld w id e cred it a n d c o u n tr y risk exp osu re. It g iv es in fo r m a tio n o n banks in te r n a tio n a l le n d in g a c tiv ities brok en d o w n b y m aturity, sector a n d b o rro w in g c o u n tr y o n a w o rld -w id e c o n so lid a te d basis. B anks w ith h e a d o ffices in th e rep o rtin g c o u n tr y p ro v id e in fo r m a tio n o n all th eir o ffices at h o m e a n d abroad (in c lu d in g a n y o p er­ a tio n s in w h ic h th e y o w n m o re th a n 5 0 per c e n t o f th e cap ital), w ith th e p o sitio n s b e tw e e n d ifferen t o ffices o f th e sam e b a n k n e tte d o u t. E xam p les o f John Hawkins Table A4.1 77 BIS reporting banks exposure to developing countries (US$ billion, June 2002) Asia-Pacific Assets o f which lo a n s t o n o n - b a n k s e c to r L ia b ilitie s o f which d e p o s its t o n o n - b a n k s e c to r C o n s o lid a te d c la im s o f which s h o r t- te r m o n p u b lic s e c to r o n n o n -b a n k p r iv a te s e c to r U n u s e d lin e s A ffilia 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 Europe Latin America M iddle East and Africa Total 277 173 281 156 887 231 112 371 135 79 15 0 215 147 233 14 7 78 343 72 8 416 1097 370 140 39 5 15 0 41 296 229 131 492 339 14 4 15 4 1 088 456 1 337 12 8 40 80 33 112 40 62 20 382 133 121 54 10 8 50 164 32 58 44 451 180 14 1 10 4 247 34 526 Source : BIS (2002). th e se data are p ro v id ed in th e lo w e r part o f Table A 4.1. T h e c o lle c tio n s also in c lu d e separate rep ortin g o f fo r e ig n ban k s lo ca l b u sin e ss in lo c a l currency, a g ro w in g item d u e to in ter n a tio n a l b a n k s’ p u rch ase o f d o m e s tic b an k s in em erg in g e c o n o m ie s. Im p r o v e m e n ts T he BIS data c o llectio n s are c o n tin u o u sly b e in g im p ro v ed in term s o f accuracy, coverage a n d tim e lin e ss. L ikely im p r o v e m e n ts w ith in th e n e x t tw o years in c lu d e a d d in g m ore d e v e lo p in g c o u n tries a n d o ffsh o re cen tres to th e in ter­ n a tio n a l b a n k in g statistics, a c o u n tr y b rea k d o w n for th e d eriv a tiv es b u sin e ss o f b an ks an d m ore d eta iled d ata o n a n u ltim a te risk basis. T h e im p r o v e­ m en ts are ov erseen b y th e C o m m itte e o n th e G lo b a l F in a n cia l S ystem a n d an exp ert group o f cen tral b a n k sta tisticia n s (see Fender a n d Frankel, 2 0 0 1 ). N o te s * A n y o p in io n s e x p re ss e d in th is c h a p te r are 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 rily s h 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 iv e d fr 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 iffith -J o n e s , M a rc K la u , E lm a r K o c h , C h r is tin a L u n a , M a r ia n M ic u , P h ilip T u rn e r, A g u s tin V illa r, K a rs te n v o n K le is t, B e a tric e W e d e r, R a in e r W id e ra a n d p a r tic 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 r u n o A lle m a n n , M e lis s a F io r e lli, M a rc K la u a n d D e n is P etre a s siste d w i t h th e d a ta . 78 International Bank Lending 1. F o r f u r th e r d e ta ils see BIS, 2 0 0 0 ; BIS, 2 0 0 2 ; F io re lli, 2 0 0 0 . 2. I t h a s b e e n s u g g e s te d t h a t th e m o re re a d y g r a n tin 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 rt a g e n c ie s is e n c o u ra g in g in te r n a tio 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 tic a g e n ts is lik e p la y in g pass th e p a rc e l a n d d o e s 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 ile d a n a ly s is o f flo w s t o A s ia , in c lu d in g a n a n a ly s is ba se d o n in d iv id u a l b a n k d a ta , see C a illo u x a n d G riffith -J o n e s (2 0 0 0 ). 5 . See W o o ld rid 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 U S b a la n c e o f p a y m e n ts d a ta , n e t in flo w s t o th e U n it e d States fr o m e m e rg in g e c o n o m ie s a v e ra g e d a r o u n d U S $ 7 0 b i lli 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 it h a n e t a ve ra g e o u t f lo w o f a r o u n d U S $ 4 0 b i lli o n d u r in g th e th re e p re c e d in g y e a rs . W h ile 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 r n m e n t b o n d s o r p o r t f o lio 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 riv a te p e n s io n fu n d s i n L a tin A m e ric a are n o w e s tim a te d t o h a v e a r o u n d U S $ 1 7 0 b i lli 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 lae ssen s a n d K lin g e b ie l (1 9 9 9 ). C lae ssen s et al. (2 0 0 1 ) s h o w th a t s ig n ific a n t fo r e ig n b a n k e n t r y is as so cia te d w it h a r e d u c tio n in o p e r a tin g expe nses a n d th e p r o f it a b i lit y o f d o m e s tic b a n k s . 8 . V e ry h ig h ra te s o f fo r e ig n b a n k p e n e tr a tio 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 (9 5 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 issu e b e in g a d d re ss e d fr o m s c ra tc h w a s 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 rte d ly th e e c o n o m ic s m in is te r p re fe rre 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 lit ic ia n f o u n d i t h a r d t o im a g in e a n a t io n w it 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 share s o f fo r e 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 lje k (2 0 0 1 , ta b le 9 ). 9. T h e F in a n c ia l S ta b ility F o ru m ’s (2 0 0 0 ) r e p o r t o n c a p ita l flo 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 resou rce s are scarce, s im p le re s tric tio n s o n b a n k s fo r e ig n e x c h a n g e e x p o s u 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 tic a te d ris 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 e se re s tr ic tio n s c o u ld in c lu d e lim it s o n lo n g o r s h o r t p o s itio n s re la tiv e t o c a p ita l, m in im u m h o ld in g s o f liq u id assets, a n d reserve re q u ire m e n ts . F o re ig n c u r r e n c y lo a n s c o u ld b e re s tric te d to a fix 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 b e r e 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 u c h in d e p e n d e n c e b e c o m e s less lik e ly i f b a n k s use th e s a m e c re d it r is k m o d e ls a n d re ly o n th e sa m e d a ta b a s e t o q u a n t if y c re d it losses. 11. W h ile i t is re a s o n a b le f o r b o rro w e rs t o p a y m o re f o r lo n g e r - te r m lo a n s , th e p r e 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 ir e m e n ts are in a p p r o 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 tria , B ah a m a s, 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 ra n ce , G e rm a n y , G u e rn s e y , H o n g K o n g , In d ia , Ire la n d , Is le o f M a n , Ita ly , J a p a n , Jersey, L u x e m b o u rg , N e th e rla n d s , N e th e rla n d s A n tille 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 e d e n , S w itz e rla n d , T a iw a n , T u rk e y , th e U n it e d K in g d o m a n d th e U n it e d States. 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 tio n s o f t h e ir c e n tra l b a n k a n d s o m e o n ly p r o v id e d a ta o n b a n k s o p e r a tin g in t h e ir o ffs 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 r o v id e a r e s tr ic te d fo r e ig n c u rr e 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 it 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 ba sis o n w h ic h th e v a lu e o f s e c u ritie s are re p o rte d a n d th e tr e a tm e n t o f in t e r ­ est arrears. 14 . T h e tr 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 ility F o ru m (2 0 0 0 ) f o r a fu r th e r d is c u s s io n o f th e d iffe 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 . John Hawkins 79 R e fe re n c e s B a n k f o r I n te r n a tio n a l S e ttle m e n ts (BIS) (2 0 0 0 ) Guide to the International B anking Statistics, J u ly , w w w .b is .o r g . (2 0 0 2 ) I n t r o d u c t io n t o th e BIS lo c a tio n a l a n d c o n s o lid a te d in te r n a tio n a l b a n k in g s ta tis tic s , BIS Quarterly Review, D e c e m b e r: A 4 - A 5 s ta tis tic a l a n n e x . B asel C o m m itte 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 f o r m a t io n o r R e g u la tio n : W h a t is D r iv in g th e I n te r n a tio n a l A c tiv itie s o f C o m m e rc ia l B a n ks ? , Kiel Institute o f World Economics W orking Paper n o . 1 0 1 1 , K ie l: K ie l I n s titu 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 illo u x , J. a n d S. G r iffith -J o n e s (2 0 0 0 ) I n t e 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 ris is , B r ig h to n : ID S , U n iv e r s ity o f Sussex. C lae ssen s, S., A . D e m ir g iif - 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 tr y 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 B anking and Finance, 2 5 , 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 tiv e F ra m e w o rk s fo r P r o v id in g F in a n c ia l S ervices, World B ank Policy Research W orking 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 e p te m b e 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 r v 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 R ates a n d F in a n c ia l F r a g ility ’, i n N ew Challenges for M onetary Policy, F e d e ra l R eserve B a n k o f K ansas C ity , w w w .k c .fr b .o r g , p p . 3 2 9 -6 8 . F e n d e r, I. a n d A . F ra n k e l (2 0 0 1 ) A N e w F o cus f o r th e BIS C o n s o lid a te d B a n k in g S ta tis tic s , BIS Quarterly Review, M a rc h : 2 3 . F in a n c ia l S ta b ility F o ru m (2 0 0 0 ) Report o f the W orking Group on Capital Flows, w w w .fs fo r u m .o r g , A p r il. F io r e lli, 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 tio n a l a n d C o n s o lid a te d I n te r n a tio n a l B a n k in g S ta tis tic 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 tile ? , NBER Working Paper n o . 8 2 0 9 , C a m b rid g e , M A : N B E R , A p r il. G r e n v ille , S. (2 0 0 0 ) C a p ita l F lo w s a n d C ris e s , in G . N o b le a n d J. R a v e n h ill (ed s), The A sian Financial Crisis and the Architecture o f Global Finance, C a m b rid g e : C a m b rid g e U n iv e r s ity Press: 3 6 - 5 6 . A ls o i n Reserve B ank o f A ustralia Bulletin, D e c e m b e r 1 9 9 8 : 1 6 -3 1 . G riffith - 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 B asel 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 trie s ? ’, B r ig h to n : ID S , U n iv e r s ity 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 it o r in g , A ustralian Economic Indicators n o . 1 3 5 0 .0 (J a n u a ry ): 3 - 1 2 , C a n b e rra : A u s tr a 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 rin g P o te n tia l V u ln e r a b ilitie s i n E m e rg in g M a rk e t E c o n o m ie s , BIS W orking Paper 9 1 , Basel: BIS, O c to b e r. a n d D . M ih a lje k (2 0 0 1 ) T h e B a n k in g In d u s tr 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 itio n , C o n s o lid a tio n a n d S y s te m ic S ta b ility - a n O v e rv ie w , BIS P apers, n o . 4, B asel: BIS, 1 -4 4 . In s titu te o f I n te r n a tio 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 r k e t E c o n o m ie s , w w w . iif. c o m , 2 4 J a n u a ry . (2 0 0 2 ) C a p ita l F lo w s t o E m e rg in g M a r k e t E c o n o m ie s , w w w .iif.c o m , 18 S ep te m b e r. J e a n n e a u , S. a n d M . M ic u (2 0 0 2 ) D e te r m in a n ts o f I n te r n a tio n a l B a n k L e n d in g , BIS W orking Paper 1 1 2 , B asel: BIS, J u n e . L a m fa lu s s y , A . (2 0 0 0 ) Financial Crises in Emerging Markets, N e w H a v e n , C T : Y ale U n iv e r s ity Press. 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 p e r, S e p te m b e 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 tio 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 p e 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 illo 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 W orking 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 o u rc e s o f C o n ta g io n : Is i t F in a n c e o r T ra d e ? , Journal o f International Economics, 5 4 , 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 r e 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 P apers 13, B asel: BIS, D e c e m b e r. W o o ld rid g e , P. (2 0 0 1 ) T h e I n te r n a tio n a l B a n k in g M a r k e t, BIS Quarterly Review, J u n e : 12-20. 5 B a n k L e n d in g C r o s s in g t h e t o E m e r g in g M a r k e ts : B o r d e r David Lubin Reflections on the collapse of short-term lending W ith o u t q u e stio n th e w orld s b an k s h a v e b e e n th e largest n e t taker o f fu n d s from em erg in g m arkets sin c e th e 1 9 9 7 A sian crisis. From Table 5 .1 it is clear th a t b e tw e e n th e e n d o f 1 9 9 7 - w h e n banks e x p o su re p ea k ed - to th e e n d o f 2 0 0 0 , banks n e t cla im s o n d e v e lo p in g c o u n tries fe ll b y a m a ssiv e U S $ 2 9 2 .8 b illio n . M oreover it is clear from th e sa m e tab le th a t b an k s a ctu a lly b e ca m e n e t d ebtors to th e d e v e lo p in g w o rld d u rin g th e sam e p eriod . W h ereas in 1 9 9 7 th e banks h a d a n e t cred it p o sitio n o f U S $ 1 4 7 b illio n , b y D ecem b er 2 0 0 0 th is h a d tu rn ed in to a n e t d eb to r p o sitio n o f U S $ 1 4 5 b illio n . 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 trie s , 1 9 9 7 a n d 2 0 0 1 (U S $ b illio n ) 1997 B a n k s in te r n a tio n a l A fr ic a a n d M id d le A s ia a n d P a c ific E u ro p e L a tin A m e ric a B a n k s in te r n a tio n a l A fric a a n d M id d le A s ia a n d P a c ific E u ro p e L a tin A m e ric a B a n k s n e t e x p o s u re A fric a a n d M id d le A s ia a n d P a c ific E u ro p e L a tin A m e ric a assets E ast lia b ilit ie s East East 1 051 206 141 0 2 6 449 913 156 237 304 030 903 934 267 088 285 476 106 053 245 317 147 27 2 -1 2 6 062 164 43 7 50184 5 8 71 3 Source: BIS. 81 2001 (0 3 ) 874 141 273 165 294 1 090 329 369 131 259 -2 1 5 -1 8 8 -9 5 34 34 512 151 308 985 068 001 932 10 4 551 414 489 781 796 434 654 Change - 1 7 6 694 125 - 1 7 6 605 9 748 - 9 962 186 067 62 844 83 628 25 49 8 14 09 7 - 3 6 2 761 - 6 2 719 - 2 6 0 233 - 1 5 750 - 2 4 059 82 Bank Lending to Emerging Markets c o m m o n e n o u g h for th e w orld s b anks to b e n e t d eb to rs to th e M id d le East a n d A frican reg io n s, p rim arily d u e to th e assets o w n e d b y o il-e x p o r tin g cou n tries. Yet for d e v e lo p in g co u n tries overall it is q u ite u n u su a l for th e w orld s b an k s to b e n e t d eb to rs to th e d e v e lo p in g w o rld . O n th e face o f it, th e se data m ake a m o c k e ry o f th e id ea th a t b an k s o u g h t to b e u se d as a w a y o f c h a n n e llin g fo reig n sa v in g s to d e v e lo p in g co u n tries. T hree p o in ts are w o r th m a k in g in order to h e lp u s u n d ersta n d w h y th e banks n e t ex p o su r e to d e v e lo p in g co u n tries c o lla p sed so th o r o u g h ly b e tw e e n th e se years. First, th e fall in n e t c la im s o n d e v e lo p in g c o u n tr ies is h a lf ex p la in e d b y a rise in d e v e lo p in g co u n tries fo reig n e x c h a n g e reserves. Table 5.1 sh o w s th a t th ere w as a U S $ 1 4 7 b illio n in crea se in ban k s lia b ilities to d e v e lo p in g co u n trie s b e tw e e n 1 9 9 7 a n d 2 0 0 0 , a n d th is a c c o u n ts for ro u g h ly h a lf o f th e U S $ 2 9 2 b illio n fall in n e t cla im s. T h e rea so n w h y th is is in terestin g is th a t it casts a slig h tly d ifferen t lig h t o n th e rea so n w h y n e t exp osu re fell. If ban k s w ere red u cin g th eir gross ex p o su r e to em er g in g m arkets - w h ic h o f cou rse th e y w ere d o in g - th is su ggests a n in crease in risk a v ersio n o n th e part o f th e b an k s. Yet at th e sam e tim e , if d e v e lo p in g c o u n ­ tries th e m se lv e s w ere in crea sin g th eir h o ld in g s o f fo reig n e x c h a n g e reserves, th is su ggests th a t th ere w as an in crease in risk a v ersio n in th e d e v e lo p in g w orld . In o th er w ord s, it w a s n o t ju st b a n k s th a t w ere m o r e risk-averse, b u t a lso cou n tries. In m a n y w a y s th is is iro n ic , g iv e n th e w id esp rea d sw itc h th a t h a s tak en p la ce in em erg in g m arkets fro m fix e d e x c h a n g e rate reg im es to flo a tin g regim es. In p rin cip le o n e w o u ld ex p e c t a c o u n tr y th a t a d o p ts a flo a tin g rate regim e to w a n t to h o ld few er fo re ig n e x c h a n g e reserves, n o t m ore, sin ce sh o ck s can b e ab sorb ed b y c h a n g es in th e e x c h a n g e rate rather th a n ch a n g e s in th e q u a n tity o f reserves. T h e fact th a t reserve h o ld in g s h a v e risen so sh arp ly seem s o n th e face o f it to su g g est th a t d e v e lo p in g c o u n tries are n o t en tirely h a p p y w ith th e c o m fo r t o f h a v in g flex ib le e x c h a n g e rates as a m ea n s o f ab sorb in g in te r n a tio n a l sh o ck s. T h is c o u ld m e a n o n e o f tw o th in g s: eith er co u n tries h a v e a fear o f flo a tin g ,1 in o th er w ord s, th e y w a n t to m in im iz e e x c h a n g e rate v o la tility in order, for ex a m p le , to im p r o v e c o n tro l o v er in fla ­ tio n a ry ex p ecta tio n s; or th e y are c o n c e rn e d a b o u t th e p o te n tia l reversib ility o f cap ital flow s, w h ic h requires th e m to h o ld a greater c u sh io n o f reserves o n th e realistic a ssu m p tio n th a t th e e x c h a n g e rate c a n n o t b e e x p e c te d to absorb th e en tire sh o c k o f a su sta in ed n e t cap ita l o u tflo w . S econ d , th e fall in ex p o su re w as m a ssiv e ly c o n c en tr a te d in Asia. Table 5.1 sh o w s th a t th e fall in n e t cla im s to d e v e lo p in g c o u n tries b e tw e e n 1 9 9 7 a n d O ctob er 2 0 0 1 w as so m e U S $ 3 6 3 b illio n , b u t th a t over 7 0 per c e n t o f th is fall w as e x p la in e d b y a fall in n e t c la im s to Asia. In d eed gross c la im s to n o n A sian d e v e lo p in g co u n tr ie s w ere rather stab le d u rin g th e 1 9 9 7 -2 0 0 1 p eriod , rem a in in g c lo se to U S $ 6 0 0 b illio n th r o u g h o u t. T hird, th e fall in ban k s ex p o su re is largely e x p la in e d b y a fall in sh o rt­ term exp osu re. Table 5 .2 sh o w s th a t gross cross-border b a n k ex p o su re to David Lubin 83 Table 5.2 A ccounting for th e 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 A fric a a n d M id d le East A s ia a n d P a c ific E u ro p e L a tin A m e ric a C h a n g e in s h o r t- te r m e x p o s u re A fr ic a a n d M id d le East A s ia a n d P a c ific E u ro p e L a tin A m e ric a -1 4 6 .4 5 .0 -1 6 7 .4 6 .9 9.1 -1 2 7 .9 -0 .9 -1 1 0 .1 -1 .6 -1 5 2 .5 Source: BIS. d e v e lo p in g co u n tries fell b y U S $ 1 4 6 b illio n b e tw e e n 1 9 9 7 a n d th e th ird quarter o f 2 0 0 1 ; y e t th e fall in sh ort-term e x p o su re w as U S $ 1 2 8 b illio n . In o th er w ord s th e co lla p se in cross-border le n d in g b y b a n k s to d e v e lo p in g c o u n tries w as v ery largely a fall in sh ort-term exp osu re. So in m a n y w a y s th is is a sto ry a b o u t a sharp fall in sh ort-term lo a n s to A sian borrow ers. Yet th is to o sh o u ld b e p u t in to c o n te x t, sin c e th e u n w in d in g o f th e se p o sitio n s in 1 9 9 7 -2 0 0 0 w as sim p ly th e cou n terp art to th e very sharp in crease in sh o rt-term le n d in g to Asia th a t to o k p la ce d u rin g th e la te 1 9 8 0 s an d early 1 9 9 0 s. For e x a m p le sh ort-term lo a n s as a share o f to ta l le n d in g to th e A sian r eg io n rose from 4 7 per c e n t in th e la te 1 9 8 0 s to 6 3 per c e n t in 1 9 9 7 . T h e rep a y m en ts th a t b anks h a v e receiv ed sin c e th e A sian crisis is b est d escrib ed as a p rocess o f b a la n ce sh e et c o n so lid a tio n th a t h a s red u ced th e banks sh ort-term lo a n s to a m o re a ccep ta b le lev el. W h a t h as h a p p e n e d sin c e th e A sian crisis, in effect, is th a t b an k s h a v e red u ced th eir sh ort-term cla im s tow ard s th e n orm al le v e l o f 4 7 per c e n t o f to ta l lo a n s. In o th er w ord s th e ban k s r e d u c tio n o f th eir gross sh ort-term e x p o s­ ure sin c e 1 9 9 7 lo o k s lik e th e rev u lsio n th a t o fte n ch aracterizes creditor b eh a v io u r in th e afterm ath o f a d eb t crisis. R ev u lsio n , o f cou rse, is th e flip sid e o f exu b eran ce - th e p erio d o f e x c essiv e o p tim ism th a t p reced es a crisis. In th is c o n te x t it is w o r th b ea rin g in m in d th a t th e gross rep a y m en ts th a t w ere m a d e to b an k s over th e fou r years in q u e stio n w ere in m a n y w ays sim p ly th e u n w in d in g o f a n in crease in ex p o su re th a t to o k p lace in th e ru n -u p to th e crisis. G ross cross-border b a n k e x p o su re to Asia reach ed U S $ 4 2 3 b illio n in D ecem b er 1 9 9 7 , b u t h a d fa lle n to U S $ 2 7 0 b illio n b y M arch 2 0 0 1 . Yet e v e n th is le v e l o f ex p o su re w as m a ssiv e ly h ig h e r th a n it h a d b e e n in th e early 1990s: in D ecem b er 1 9 9 3 ban k s ex p o su re to A sia h a d b e e n U S $ 1 9 0 b illio n . 84 Bank Lending to Emerging Markets O n e o f th e m a in c o n se q u e n c e s o f th is rev u lsio n is th a t th e p ro b lem o f sh ort-term d eb t - w h ic h h a s b e e n a p rin cip a l th e m e in e a c h o f th e e m erg in g m arket crises in th e p ast d eca d e - is largely n o lo n g e r a p ro b lem for d e v e lo p ­ in g co u n tries as a w h o le . T here h as b e e n su c h a h u g e re p a y m e n t o f sh o rt­ term d eb t to th e w orld s b a n k s th a t th e se days sh ort-term d eb t p o se s little threat to th e h ea lth o f d ev e lo p in g cou n tries b alan ce sh eets. A u sefu l in d icator o f th is is th e ratio o f sh ort-term d eb t to fo reig n e x c h a n g e reserves, w h ic h has c o lla p sed d u rin g recen t years as b o th d eb tors an d cred itors h a v e m o v e d to c o n so lid a te th eir b a la n ce sh eets. A cco rd in g to data fro m th e In stitu te o f In tern a tio n a l F inance, in 1 9 9 6 th ere w ere 14 large d e v e lo p in g co u n tries w h o se stocks o f sh ort-term ex tern a l d eb t w ere greater th a n th eir fo reig n e x c h a n g e reserves: A rgen tin a, Brazil, Bulgaria, In d o n e sia , Israel, Korea, M ex ic o , P akistan, P h ilip p in e s, R om an ia, Russia, S o u th Africa, T h a ila n d an d Turkey. By th e e n d o f 2 0 0 0 th a t n u m b er h a d fa lle n to just six: A rgen tin a, Brazil, M exico, P akistan, S o u th Africa a n d Turkey. Table 5 .3 sh o w s th e b ig im p r o v e m e n t in d e v e lo p in g co u n tries b a la n ce sh e ets o n a reg io n a l basis: th e ratio o f sh ort-term d e b t to fo reig n e x c h a n g e reserves co lla p sed b e tw e e n 1 9 9 6 a n d 2 0 0 0 b o th in L atin A m erica - w h ere it fe ll fro m 8 3 per c e n t to 5 4 per ce n t - an d , m o re spectacularly, in Asia, w h ere it fell fro m 8 3 per c e n t to 33 per cen t. T h e process o f u n w in d in g th e sh ort-term d eb t o v e rh a n g o f th e m id 1 9 9 0 s has b e e n rein forced b y th e sw itc h fro m fix e d to flo a tin g e x c h a n g e rate regim es in m a n y co u n tr ie s o v er th e p a st fe w years. T h e p o in t is th a t th e a ccu m u la tio n o f sh ort-term d eb t in th e 1 9 9 0 s w as at lea st partly a b y ­ p rod u ct o f th e p erv a siv en ess o f fix e d e x c h a n g e rates. T h is en co u ra g e d b o th b orrow ers an d len d ers to im a g in e th a t cu rren cy risk h a d disap p eared . T h is in tu rn m a d e ro o m for th e a c c u m u la tio n o f large sto ck s o f sh ort-term extern al d eb t in order to fin a n c e lo c a l cu rren cy assets to tak e a d v a n ta g e o f w h a t w as p erceived to b e a risk-free in terest arbitrage. N o w th a t m a n y large em erg in g e c o n o m ie s h a v e a b a n d o n e d fix e d e x c h a n g e rates for flo a tin g o n e s th ere are few er in c e n tiv e s for in s titu tio n s to create sh o rt-term lia b ilities in fo reig n e x c h a n g e . In o th e r w ord s th e sw itc h to flo a tin g e x c h a n g e rate regim es has g o n e h a n d in h a n d w ith th e co lla p se in o v era ll lev e ls o f sh o rt­ term debt. Table 5.3 Y e s te rd a y s p r o b le m : r a t io o f s h o r t- te r m d e b t t o fo r e 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 A s ia L a tin A m e ric a 2000e 83 83 33 54 S rce: Derived from Institute of International Finance databases. ou David Lubin 85 In v ie w o f all th is, o n e q u e stio n th a t m ig h t b e w o rth a sk in g is w h e th e r th ere are a n y w a y s in w h ic h th e w orlds fin a n c ia l regulators m ig h t try to a v o id th e e x cessiv e b u ild -u p o f sh ort-term le n d in g in th e future. S h o u ld th ere b e a p ru d en tial lim it o n th e a m o u n t o f b a n k le n d in g for less th a n o n e year? P ru dential lim its o n sh ort-term d eb t are n o r m a lly ex p ressed in rela tio n to a cou n trys le v e l o f fo reig n e x c h a n g e reserves. T h e b est k n o w n e x p ressio n o f th is is th e G u id o tti rule, w h ic h su ggests th a t a p ru d en tly m a n a g ed e c o n o m y w ill h a v e a sh o rt-term ex tern a l d eb t th a t is n o greater th a n its stock o f fo reig n e x c h a n g e reserves. In o th e r w ord s th e G u id o tti rule fo cu ses o n th e m a tu rity structure o f a d e v e lo p in g co u n try s b a la n ce sh eet. T his is all very sen sib le. Yet at th e sam e tim e it m ig h t a lso b e w o r th w h ile fo c u s in g o n th e m a tu rity structure o f th e ban k s c o lle c tiv e b a la n c e sh eet. T h e reason for th is is th a t it m ak es sen se to th in k th a t th e in c e n tiv e for h erd -lik e b eh a v io u r o n th e part o f b a n k s w ill b e c o m e greater as th e ratio o f sh ort-term lo a n s to to ta l lo a n s b e c o m e s larger. T h e in tu itio n h ere is sim p le. If creditor A is th e o n ly sh ort-term len d er to co u n tr y 1, w h ile th e rest are lo n ger-term len d ers, th e n th e in c e n tiv e for th a t cred itor to roll o v e r its sh ort-term lo a n w ill b e rela tiv ely h ig h sin c e th ere w ill n o t b e so m a n y b anks scra m b lin g for access to co u n tr y ls reserves in th e e v e n t o f a d eterio ra tio n in co u n tr y risk. T h is w ill rem a in true regardless o f th e c o u n tr y ’s G u id o tti rule ratio. All o th er th in g s b e in g eq u al, it is b etter to h a v e a lo w ratio o f sh ort-term d eb t to to ta l d eb t th a n a h ig h o n e . T h is situ a tio n is su m m a rized in Figure 5 .1 , w h ic h sh o w s c o m b in a tio n s o f tw o ratios: th e sh ort-term d eb t to reserves ratio (w h ic h is e sse n tia lly a m easu re o f th e q u a lity o f a cou n trys liq u id ity in fo reig n currencies), a n d th e sh o rt-term d eb t to to ta l d eb t ratio. T h e im p o rta n t asp ect o f th e latter ratio is th a t it h e lp s u s to see th in g s from th e p o in t o f v ie w o f th e creditors b a la n c e sh e e t as o p p o se d to th e debtors Ratio of short-term debt to foreign exchange reserves of country X Low High Best Low Ratio of short-term loans to total loans to country X High Worst Figure 5.1 C o m b in a tio n s o f s h o r t- te r m d e b t t o reserves r a t io a n d s h o r t- te r m d e b t t o t o t a l d e b t r a tio 86 Bank Lending to Emerging Markets b a la n ce sh eet. B ecause o f th e p o ssib ility o f h erd b e h a v io u r b y c o m m ercia l creditors, a co u n tr y sh o u ld n o t o n ly try to m in im iz e its sh ort-term d eb t to reserves ratio, b u t sh o u ld a lso try to m in im iz e its sh o rt-term d eb t to to ta l d eb t ratio for a n y g iv e n le v e l o f reserves. It m a y e v e n m ak e sen se to set a p ru d en tia l lim it o n sh ort-term d eb t as a share o f to ta l d eb t. At w h a t le v e l sh o u ld it b e set? O n e w a y o f th in k in g a b o u t th is is to lo o k at th e e x p e rie n c e o f A sian co u n tries d u rin g th e 199 0 s. At th e start o f th e 1 9 9 0 s th e ratio o f sh ort-term d eb t to to ta l ex tern a l d eb t for th e reg io n w a s 5 0 per c e n t. T h is grew d u rin g th e cou rse o f th e early 1 9 9 0 s to p eak at 65 per c e n t in 1 9 9 5 . S in ce th e crisis, len d ers re v u lsio n h as p u sh e d th e ratio d o w n to le v e ls w e ll b e lo w 5 0 per c e n t (it is cu rren tly at 4 7 per cen t). A rguably, th erefore, a c o n v e n ie n t p ru d en tia l m easu re for th e ratio m ig h t b e set at 5 0 per c e n t. T h is w o u ld be n o m o re th a n a rule o f th u m b to c o e x is t w ith th e G u id o tti rule o n th e ratio o f sh ort-term d eb t to fo reig n e x c h a n g e reserves. If sh ort-term d eb t is a cen tral in d ica to r o f risk in e m e rg in g m arkets, it is w o rth p o in tin g o u t th a t it is far from b e in g a n in fa llib le in d icator, p articu ­ larly if a cou n trys sto ck o f sh ort-term d eb t fu lfils certain q u a lita tiv e criteria. P ut flip p an tly, th ere is sh ort-term d eb t a n d th ere is sh ort-term debt. C on sid er S o u th Africa, w h ic h h a s c o n siste n tly b e e n th e e c o n o m y w ith th e h ig h e s t ratio o f sh ort-term d eb t to fo reig n e x c h a n g e reserves. T he im p o r ta n t q u e stio n is h o w S o u th Africa m a n a g e d to su rv iv e th e 1 9 9 0 s w ith o u t a d eb t crisis w h e n th e e x is te n c e o f large stock s o f sh ort-term d eb t appears to h a v e b e e n su ch a reliable in d ica to r o f th e crises in M e x ic o , Asia, Russia, Brazil an d , m ore recently, Turkey. T w o features o f th e S o u th A frican e x p erien c e h elp e x p la in w h y th e c o u n ­ try m a n aged to a v o id a crisis. T he first is th e e x iste n c e o f a flo a tin g ex c h a n g e rate regim e, w h ic h h e lp e d to m in im iz e th e a cc u m u la tio n o f a b ig sto ck o f sh ort-term liab ilities to fin a n c e a cross-border in terest arbitrage, or carry trade. T he se c o n d (related) feature is th a t S o u th Africas sh ort-term d eb t stock is w id e ly regarded to b e related to trade fin a n ce. T h is ty p e o f le n d in g , o f course, bears n o curren cy risk (for len d er or borrow er), a n d is related to a n u n d erly in g tra n sa ctio n o f real e c o n o m ic resources. All in all, th e n , S o u th Africas exp erien ce suggests th a t early w a rn in g in d icators o f crisis in em erg ­ in g e c o n o m ie s are lik ely to b e m o re u sefu l if th e y capture q u a lita tiv e aspects o f short-term d eb t stocks rather th a n sim p ly assessin g th e size o f th o s e stocks. Trade-related d eb t stocks are lik e ly to b e m ore stable th a n stocks o f debt, w h ic h are b e in g u sed to fin a n c e cross-border in terest arbitrage. A rguably M exicos stock o f short-term extern al d eb t is o f a sim ilar n atu re th e se days. Banks crossing the border W h ile it is clear th a t b an k s h a v e b e e n n e t takers o f cross-border fu n d s from em erg in g m arkets in rec e n t years, it is n o t tru e to say th a t th is b eh a v io u r n ecessarily sh o w s th a t b an k s h a v e w ith d r a w n fro m em er g in g m arkets. David Lubin 87 W h ile cross-border exp osu re h a s fa llen , in -c o u n tr y ex p o su re h a s risen . In o th er w ord s, w h a t w e h a v e se e n is b etter d escrib ed as a r ed istrib u tio n o f b a n k s’ overall em ergin g-m a rk et p o rtfo lio s, in w h ic h b anks h a v e su b stitu ted o n sh o r e for o ffsh o re le n d in g . T h e q u e stio n th a t arises fro m th is is w h e th e r th is p o r tfo lio sh ift h a s b ro u g h t a n y b e n e fits to d e v e lo p in g c o u n tries, a n d in particular w h e th e r it w ill e n d u p red u c in g th eir v u ln e ra b ility to crisis. W h a t is b e y o n d d o u b t is th a t fo reig n b a n k s h a v e m a ssiv e ly in crea sed th eir o w n ersh ip o f d e v e lo p in g co u n tries b a n k in g sectors, a n d th a t th is h a p p e n e d p recisely d u rin g th e crisis p erio d o f th e la te 199 0 s. T h e in crease in fo reig n p en etra tio n o f em e r g in g m arkets fin a n cia l sy stem s is clear from Table 5 .4 , w h ic h sh o w s th e p ercen ta g e o f b a n k in g sector assets o w n e d b y Table 5.4 F o re ig n o w n e r s 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 sector assets Central Europe C z e c h R e p u b lic H u n g a ry P o la n d T o ta l C e n tr a l E u ro p e Latin America A r g e n tin a B ra z il C h ile C o lo m b ia M e x ic o P e ru V e n e z u e la T o ta l L a tin A m e ric a T o ta l e x c lu d in g M e x ic o a n d B ra z il A sia K o re a M a la y s ia T h a ila n d T o ta l A s ia Share owned by foreigncontrolled banks 4 6 .6 2 6 .8 3 9 .4 8 .3 2 3 .8 2 .3 6 3 .4 3 2 .6 9 1 .1 4 9 .3 5 6 .6 5 2 .8 1 1 2 .8 9 .9 1 8 7 .1 5 2 .3 7 3 .2 4 8 6 .9 4 1 .4 2 8 .3 2 1 0 .2 12 .3 1 6 .4 16 .5 1 2 .2 1 7 .6 5 .4 0 .9 2 .9 1 0 .4 1 5 7 .0 7 3 2 .3 1 1 2 .3 4 5 .3 2 0 4 .5 2 6 .3 2 4 .7 4 8 .6 1 6 .8 5 3 .6 1 7 .8 1 8 .8 3 3 .4 4 1 .9 8 6 8 .7 9 .7 1 3 0 2 .4 2 5 .0 1 7 1 .5 1 3 .3 3 6 5 .6 4 4 .8 6 0 1 .1 1 4 8 .1 1 9 2 .8 9 4 2 .0 0 .8 6 .8 0 .5 1.7 6 4 2 .4 2 2 0 .6 1 9 8 .8 1 0 6 1 .8 4 .3 11 .5 5 .6 6 .0 Source: Mathieson and Roídos (2001). Total banking sector assets Share owned by foreigncontrolled banks 88 Bank Lending to Emerging Markets fo r eig n -co n tro lled ban k s (d e fin e d h ere as b a n k s th a t are at lea st 5 0 per c e n t fo reig n -o w n ed ). S in ce 1 9 9 9 th ere h a v e b e e n further large in creases in for­ e ig n o w n ersh ip , for ex a m p le in M ex ic o . T h e m o s t dram atic in crease in fo reig n p en etra tio n h a s b e e n in C entral Europe, w h ere th e share o f b a n k in g assets c o n tr o lle d b y fo r e ig n -o w n e d in s titu tio n s rose fro m 9 .9 per c e n t in 1 9 9 4 to 5 2 .3 per c e n t in 1 9 9 9 . D u rin g th e sa m e p erio d th e fo reig n p e n etra ­ tio n o f th e L atin A m erican b a n k in g sy ste m rose fro m 9 per c e n t to 2 5 per c en t. Foreign e n try to Asia w as m o re lim ited , w ith ex tern a l o w n e rsh ip risin g from o n ly 1 per c e n t o f assets in 1 9 9 4 to 6 per c e n t in 1 9 9 9 . T h e relatively sm a ll in crea se in fo reig n o w n e r sh ip o f th e A sian b a n k in g sy stem su ggests th a t it w o u ld b e d a n g ero u s to o v e r e m p h a siz e th e id e a th a t ban k s h ave sim p ly su b stitu ted lo ca l ex p o su re for cross-border exp osu re. Clearly, b an k s ta k in g r ep a y m en ts o f sh ort-term lo a n s to A sian borrow ers h a v e n o t sim p ly c h a n n e lle d th o s e p a y m e n ts in to th e p u rch ase o f A sian banks, so th e id ea th a t b a n k s h a v e b e e n e n g a g in g in so m e red istrib u tio n o f th eir p o rtfo lio s m u s t b e u n d e r sto o d in an aggregate sen se. Foreign o w n ersh ip o f d e v e lo p in g co u n tries b a n k in g sy stem s is e v id e n t n o t just from th e p ersp ectiv e o f th e share o f assets o w n e d b y fo reig n in s titu tio n s b u t also from th e p ersp ectiv e o f th e len d ers th e m se lv e s. Table 5 .5 lo o k s at th e c h a n g e in b an k s cross-border le n d in g b e tw e e n 1 9 9 5 a n d S ep tem b er 2 0 0 1 a n d com p ares th is w ith th e c h a n g e in fo reig n ban k s o n sh o r e le n d in g in lo ca l curren cy d u rin g th e sam e p eriod . It sh o w s th a t B IS-reporting banks o n sh o r e lo ca l cu rren cy le n d in g rose from a to ta l o f U S $ 1 2 3 .9 b illio n in 1 9 9 5 to U S $ 4 9 0 .7 b illio n in S ep tem b er 2 0 0 1 . N o t o n ly d id b an k s lo ca l le n d in g in crease in a b so lu te term s, b u t it also in creased su b sta n tia lly as a share o f bank s overall em erg in g -m a rk et p o rtfo lio s. In to ta l, fo reig n b an k s lo c a l Table 5.5 B a n k s in - c o u n t r y le n d in g v e rs u 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 illio 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 19 9 5 S e p te m b e r 2 0 0 1 8 6 8 .7 8 7 4 .5 1 2 3 .9 4 9 0 .7 9 9 2 .6 1 3 6 5 .2 12 36 A sia D e c e m b e r 19 9 5 S e p te m b e r 2 0 0 1 3 7 3 .3 2 7 3 .3 5 6 .5 1 1 8 .9 4 2 9 .8 3 9 2 .2 13 30 Latin America D e c e m b e r 19 9 5 S e p te m b e r 2 0 0 1 2 4 7 .1 2 9 4 .0 3 3 .9 2 6 9 .0 2 8 1 .0 5 6 3 .1 12 48 Source: BIS. David Lubin 89 le n d in g in lo ca l currencies in d e v e lo p in g co u n tries rose fro m 1 2 per c e n t o f th eir to ta l ex p o su re in 1 9 9 5 to 3 6 per c e n t in S ep tem b er 2 0 0 1 . This p h e n o m e n o n co n firm s a p o in t m a d e b y Peek a n d R o sen g reen (2000: 57): As fo reig n ban k s g et esta b lish ed w ith brick a n d m ortar o p era tio n s, a n in crea sin g share o f th e le n d in g m o v e s from o ffsh o re to o n sh o r e . O f cou rse o n e m u st bear in m in d th a t w h e n an in te r n a tio n a l b a n k takes o w n ersh ip o f a sto ck o f o n sh o r e lo a n s in a d e v e lo p in g cou n try, th is is n o t eq u iv a le n t to a flo w th ro u g h th e b a la n c e o f p a y m en ts. In o th e r w ord s th e in crease in a banks c o n so lid a te d b a la n c e sh e e t th a t resu lts fro m a n a c q u isitio n o f a lo a n b o o k m a y or m a y n o t resu lt in a cap ita l in flo w . T h is d e p e n d s e n tirely o n th e co st to th e b a n k o f a cq u irin g th e e q u ity in th e lo c a l in stitu tio n . T his p o in t is crucial to a n y d iscu ssio n o f th e b e n efits th a t a foreign b a n k b rin gs to a d e v e lo p in g co u n try s fin a n c ia l sy stem , sin c e ban k s FDI flo w s in to d e v e lo p in g co u n tries clearly are n o t rep la cin g th eir cross-border flo w s o f le n d in g . T h e b est w a y to th in k a b o u t th e id ea o f rep la cem en t is as a sto ck o f o n sh o r e lo a n s rep la cin g a sto ck o f cross-border lo a n s. It is also w o rth b ea rin g in m in d th a t th ere is so m e c o n n e c tio n b e tw e e n ban ks w ith d raw al from sh ort-term cross-border le n d in g in th e la te 1 9 9 0 s a n d th eir in crea sin g p en e tr a tio n o f d e v e lo p in g co u n tries fin a n c ia l sy stem s. T h e c o n n e c tio n arises, o f cou rse, b eca u se th e crises a sso cia ted w ith th e failure to roll over sh ort-term cross-border lo a n s - th o s e in M ex ic o , Asia, Russia, Brazil a n d Turkey - h a v e h a d th e effect o f su b sta n tia lly red u cin g th e en try co st for fo reig n ban k s. T h is r ed u ctio n h a s b e e n a c h ie v e d n o t o n ly th r o u g h th e effects o f cu rren cy d ev a lu a tio n , b u t also b e c a u se th e crises h a v e led to an ero sio n o f th e n e t w o r th o f d e v e lo p in g co u n tries fin a n cia l sy stem s. T h e r ed u ctio n in e n try c o st m a y p artially e x p la in th e rea so n for th e red istrib u tion o f banks em erg in g -m a rk et p o rtfo lio s tow ard s lo c a l cu rren cy le n d in g an d aw ay from cross-border sh ort-term le n d in g . A n o th er in c e n tiv e for crossin g th e border is th a t th e cap ita l required to su p p ort a g iv e n sto ck o f o n sh o r e le n d in g in a d e v e lo p in g c o u n tr y m a y b e sm aller th a n th a t required to su p p ort cross-border le n d in g . T h e rea so n for th is is th e p r o v isio n in g reg im e th a t b an k s face in th eir cross-border le n d in g (or th eir in -c o u n tr y le n d in g in fo reig n cu rren cies). If cross-border le n d in g to a particular co u n tr y requires p r o v isio n s to c o m p e n sa te for th e risk o f e x c h a n g e co n tro ls, th is ta x ’ o n cross-border le n d in g is a v o id a b le if b anks b o o k assets in lo ca l curren cies o n sh o re . T h e q u e stio n th a t arises fro m all th is is w h e th e r th e p rocess o f b a la n ce sh e e t red istrib u tion th a t seem s to h a v e ta k en p la ce over th e p ast fe w years h as h a d a n y id en tifia b le im p a c t o n (1) d e v e lo p in g co u n tries v u ln er a b ility to fin a n cia l crisis, or (2) th e sev erity o f fin a n c ia l crises in d e v e lo p in g co u n tries w h e n th e y d o occur. T his q u e stio n is im p o r ta n t sin c e b o th th e p r o b a b ility o f a crisis an d th e severity o f a crisis in a particular d e v e lo p in g c o u n tr y are u n iv ersa lly th o u g h t to b e p o sitiv e ly correlated w ith th e fragility o f t h e d o m e s tic b a n k in g sy stem in th a t cou n try. In d eed w h ile a n o v e r h a n g o f 90 Bank Lending to Emerging Markets sh ort-term d eb t m ig h t h a v e b e e n th e b est sin g le p red ictor o f cu rren cy crisis in d e v e lo p in g co u n tries o v er th e p ast fe w years, fin a n c ia l sy stem w ea k n ess is u su a lly h ig h o n th e list o f in d ica to rs o f v u ln e r a b ility to crisis. T h is is true to th e e x te n t th a t a p o o r ly regu lated a n d p o o r ly m a n a g e d fin a n cia l sy stem w ill h a v e rela tiv ely fe w w a y s o f ex ercisin g d isc ip lin e o v er th e structure o f banks b a la n ce sh eets, w h ic h ca n in tu rn lea v e th e m b u rd en ed b y th e tw o b a la n ce sh e e t m ism a tc h e s th a t h a v e p ro v ed so p a in fu l in rece n t crises, n a m e ly a curren cy m ism a tc h (fo reig n cu rren cy lia b ilities u se d to fin a n ce lo ca l currency assets) a n d a m a tu rity m ism a tc h (sh ort-term lia b ilities u sed to fin a n ce lon ger-term assets). T h e latter m ism a tc h w as p articu larly e v id e n t in th e recent Turkish crisis, a n d certa in ly co n trib u ted to th e u n su sta in a b ility o f th e e x c h a n g e rate regim e. In a d d itio n to th is, fragile b a n k in g sy stem s are a lso th o u g h t to bear resp o n sib ility for p erp etu a tin g crises sin c e (1) th e w eak er th e fin a n c ia l sy stem th e greater th e p u b lic sector resources n e e d e d to recap italize th e sy stem in th e afterm a th o f th e crisis, a n d (2) th e w eaker th e fin a n c ia l sy stem th e less able it w ill b e to h e lp th e p ost-crisis recovery, sin c e cap ita l flig h t w ill b e m a x im ize d a n d in te r m e d ia tio n m in im iz e d . So if it can b e sh o w n th a t fo reig n o w n e r sh ip h elp s to m a k e fin a n cia l crises e ith er less p rob ab le or less severe, th e p ro cess o f cro ssin g th e border o u g h t to brin g lo n g -term b en efits to d e v e lo p in g cou n tries. H ow , th e n , c a n w e sh o w th a t foreign o w n e r sh ip ca n h elp ? First co n sid er th e case th a t fo reig n o w n e r sh ip m ak es crises less sev ere.2 F oreign o w n ersh ip ca n h e lp to d iversify th e cap ital b a se o f a cou n trys b a n k in g system , im p r o v e th e p ricin g o f risk, a n d im p r o v e reg u la tio n , a cco u n tin g , in fo r m a tio n te c h n o lo g y a n d th e le v e l o f transparency. T he v a lu e o f th e se b e n e fits in m a k in g a crisis less severe is th a t th e y c a n h elp t o create a situ a tio n in w h ic h fo r e ig n -o w n e d b a n k s c o n tin u e to le n d in a n e c o n o m ic d o w n tu r n , p rim arily b eca u se fo r e ig n -o w n e d in s titu tio n s h a v e a m ore d iversified fu n d in g b ase. As G old b erg e t a l. (2 0 0 0 : 6) p u t it: If d o m e stic a lly -o w n e d b an k s rely m o re h e a v ily o n lo ca l d e m a n d d e p o sits a n d cy clica lly -sen sitiv e sou rces o f fu n d s, b a sic aggregate d e m a n d sh o ck s sh o u ld g en era lly lead to m o re v o la tile le n d in g b y private d o m e s tic b an k s th a n from their fo r e ig n -o w n e d cou n terp arts. In d eed G old b erg e t a l. s h o w th a t in th e m id 1 9 9 0 s fo r e ig n -o w n e d b an k s in A rgen tin a a n d M ex ic o h a d h ig h er rates o f lo a n g ro w th w ith lo w er v o la tility th a n d o m e stic a lly o w n e d banks, b o th private an d sta te -o w n e d . At th e lea st th is su ggests th a t th e p resen ce o f fo reig n -o w n ed b an k s ca n m ak e d e v e lo p in g co u n tries fin a n c ia l crises less severe th a n th e y w o u ld o th er w ise be. C o u ld fo reig n o w n e r sh ip o f a d e v e lo p in g cou n trys b a n k in g sy stem m ak e a crisis less probable? T here are tw o w ays in w h ic h th is m ig h t h a p p e n . T he first is th a t a b etter ca p ita lized a n d b etter regarded b a n k in g sy stem c o u ld lead to an in crease in th e a m o u n t o f a cou n trys sa v in g s h e ld in th e fin a n cia l system , rather th a n u n d er th e m attress. If fo reig n o w n e r sh ip o f a b a n k in g David Lubin 91 sy stem reduces th e p ro p o r tio n o f sa v in g s h e ld as m attress cash , th e n for­ e ig n o w n ersh ip c o u ld b e th o u g h t o f as r ed u cin g th e p ro b a b ility o f crisis sin ce th e eco n o m y s relian ce o n fo reig n sa v in g s w ill h a v e b e e n red u ced . A se c o n d w a y in w h ic h fo reig n o w n e r sh ip m ig h t red u ce th e p r o b a b ility o f cri­ sis is b y p ro v id in g a m e c h a n ism for d ep o sito rs to en g a g e in w h a t m ig h t b e ca lled in tern al cap ital flig h t. In a fin a n c ia l sy ste m w h ere th ere is n o fo reig n o w n ersh ip , d ep o sito rs w h o fear b o th cu rren cy risk a n d co u n tr y risk h a v e n o c h o ic e b u t to liq u id a te th eir d ep o sits a n d rem it dollars offsh ore: pure cap ital flig h t. By con trast in a fin a n cia l sy stem w h ere fo reig n o w n e r sh ip ex ists, a fo r e ig n -o w n ed b a n k is lik ely to su p p o rt its d ep o sito rs e v e n d u rin g a co u n try risk ev en t. T his is a v e r sio n o f th e d eep p o ck et arg u m en t, w h ic h su ggests th a t subsidiaries are cap ab le o f b e in g recap italized e v e n at a tim e o f serious d eterioration in co u n tr y risk, o n th e g ro u n d s th a t a fo r e ig n -o w n ed in s titu tio n risks its rep u ta tio n if it lets a fo reig n su b sid iary fail. W h a t th is m ea n s is th a t th e lia b ilities o f a fo r eig n -o w n e d b a n k in a d e v e lo p in g c o u n ­ try ca n b e th o u g h t to bear less co u n tr y risk th a n th e c o u n tr y itself. If th is is th e case, cap ital flig h t w ill b e m in im iz e d in a n e c o n o m y w ith fo r e ig n -o w n e d b an k s. T his in tu rn o u g h t to red u ce th e p ro b a b ility o f crises in e m erg in g m arkets. Yet all th is clearly fails to d escrib e w h a t h a p p e n e d in A rgen tin a, w h ere a p ersisten t flig h t o f d ep o sito rs fro m th e su b sta n tia lly fo r e ig n -o w n e d b a n k in g sy stem u ltim a te ly forced th e g o v e r n m e n t to d ev a lu e th e e x c h a n g e rate, d efa u lt o n its p u b lic d eb t a n d im p o se d ra co n ia n restriction s o n th e publics access to d ep o sits in a n effort to preserve w h a t rem a in ed o f th e cen tral banks fo reig n e x c h a n g e reserves. O n th e face o f it th e failure o f th e A rg en tin ea n fin a n c ia l sy stem to p rev en t th e crisis su ggests th a t d e v e lo p in g c o u n tries m a y g a in little from e n c o u ra g in g a fo reig n p resen ce in th eir d o m e s tic fin a n c ia l sy stem s. It m a y also m e a n th a t th e a ttra ctiv en ess o f cro ssin g th e border w ill d im in ish for bank s, sin ce A rgen tin a h a s sh o w n th a t th ere m a y b e little to g a in from su b stitu tin g cross-border ex p o su re for o n sh o r e ex p o su re. It is still far to o early to draw c o n c lu s io n s fro m th e A rg en tin ea n e x p erie n c e. T h e tw o critical b u t u n an sw erab le q u e stio n s are (1) w o u ld A rgentinas fin a n c ia l crisis h a v e h a p p e n e d m o re q u ick ly if th e fin a n c ia l sy stem h a d n o t b e e n su b sta n ­ tia lly fo reig n -o w n ed , an d (2) w o u ld th e crisis h a v e b e e n m o re severe? Conclusion A lth o u g h ban k s h a v e w ith o u t q u e stio n b e e n th e largest n e t taker o f crossborder fu n d s from d e v e lo p in g c o u n tries sin ce 1 9 9 7 , th is h a s p rim arily b e e n d u e to th e n e t rep a y m en t o f sh ort-term lo a n s b y A sian borrow ers, w h o h a v e a lso su b sta n tia lly in creased th eir asset p o sitio n s in B IS-reporting b an k s. Yet th e fall in bank s n e t cross-border e x p o su re h a s to b e e x p la in e d a lo n g sid e a n o th e r p h e n o m e n o n : th e v ery large in crease in fo reig n p e n e tr a tio n o f e m erg in g m arkets b a n k in g sy stem s. T h is ch a p ter h a s argued th a t th e se tw o 92 Bank Lending to Emerging Markets p h e n o m e n a - cross-border rev u lsio n a n d th e large g r o w th in o n sh o r e exp osu re - are c o n n e c te d to e a c h other. In effect th e p rocess o f cro ssin g th e border co n stitu te s a red istrib u tio n o f ban k s em ergin g -m a rk et p o rtfo lio s. M oreover th e v ery p rocess o f cro ssin g th e b order m a y b e th o u g h t o f as red u cin g th e risk o f fin a n c ia l crises in d e v e lo p in g c o u n tries, a lth o u g h th e case o f A rgen tin a stro n g ly su ggests th a t h a v in g a fo r e ig n -o w n e d b a n k in g sy stem p rovid es n o gu aran tees ag a in st 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 r e ig n o w n e r s h ip i n a d e v e l­ o p in g c o u n tr y b a n k in g s y s te m is t h 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 e feren ces C a lv o , G . A . a n d C . M . R e in h a r t (2 0 0 0 ) F e a r o f F lo a tin g , m im e o , C a m b rid g e , M A : NBER, M ay. 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 rti­ c ip a tio n in E m e rg in g M a rk e ts : Le sson s fr o m M e x ic o a n d A r g e n tin a ’ , C a m b rid g e , M A : NBER, M a y. H a w k in s , J. a n d D . M ih a lje k (2 0 0 1 ) T h e B a n k in g In d u s tr 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 itio n , C o n s o lid a tio n a n d S y s te m ic S ta b ility - A n O v e rv ie w , BIS P apers n o . 4, B asel: 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 a n ks in E m e rg in g M a rk e ts , IM F p r e s e n ta tio n m a te ria l, W a s h in g to n , D C : IM F , A p r il. Peek, J. a n d E. S. R o s e n g re e n (2 0 0 0 ) Im p lic a tio n s o f G lo b a lis a tio n o f th e B a n k in g S e c to r: T h e L a tin A m e r ic a n E x p e rie n c e , N ew England Economic Review, S e p te m b e r/ O c to b e r. P o m e rle 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 k s 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 it 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 il, N e w Y o rk . 6 D e r iv a t iv e s , t h e I n t e r n a t io n a l V ir t u e s o f S h a p e C a p it a l P r u d e n t ia l o f F lo w s R a n d t h e e g u la t io n Randall Dodd Introduction As m atter o f policy, capital m arkets in m a n y parts o f th e d e v e lo p in g w orld w ere liberalized d u rin g th e 1 9 9 0 s in order to o p e n u p th e m arkets to greater flo w s an d a w id er array o f cap ita l v e h ic le s .1 T h is p o lic y su cceed ed , a n d pri­ v a te cap ital flo w s to d e v e lo p in g co u n tries b o th in creased a n d in crea sin g ly to o k th e form o f securities su c h as stock s a n d b o n d s (Tables 6.1 a n d 6 .2 ). E ven part o f th e gro w th in d irect fo reig n in v e s tm e n t to o k th e fo rm o f p u rch ases o f e q u ity securities. T his tra n sfo rm a tio n in d e v e lo p in g c o u n tr y cap ita l m arkets h a d th e effect o f b ro a d e n in g th e class o f g lo b a l in v esto rs. W h ereas in v esto rs in th e prior p erio d w ere prim arily ban k s (th r o u g h sy n d ic a te d lo a n s) a n d m u ltin a tio n a l corp o ra tio n s (direct in v e stm e n t), th e secu ritiz a tio n b r o u g h t in in d iv id u a l in v esto rs an d p ro fessio n a lly m a n a g e d fu n d s b y in s titu tio n a l in v esto rs, p e n ­ sio n fu n d s, in su ran ce co m p a n ie s, u n iv e r sity e n d o w m e n ts a n d fo u n d a tio n s. T h is co n trib u ted to th e in crease in th e overall flo w o f cap ita l to d e v e lo p in g cou n tries. T h e in creased flo w s o f secu ritized cap ita l b r o u g h t fo rth th e n e w th rea t o f th eir rapid reversal; th e y also in tr o d u ce d or in crea sed th e e x p o su re o f d e v e l­ o p in g co u n tries fin a n cia l m arkets to greater v o la tility o f secu rities prices in o th er d e v e lo p in g co u n tries as w e ll as th o s e in a d v a n ced cap ita l m arket cou n tries. A lo n g w ith th is tra n sfo rm a tio n o f cap ita l flo w s to d e v e lo p in g co u n tries an d th e asso cia ted n e w m arket risks c a m e a n e w set o f parallel fin a n c ia l tran saction s. T h ese fin a n c ia l tra n sa ctio n s, th o u g h less w e ll u n d er sto o d , are in tegral to m o d e r n fin a n c ia l m arkets a n d are just as im p o r ta n t in th eir p o te n tia l to co n trib u te to fin a n c ia l sector in sta b ility . T h ese sh a d o w tran s­ a c tio n s in c lu d e d eriv a tiv es,2 rep u rch ase a g reem en ts a n d secu rities le n d in g . T h e term sh ad ow sh o u ld n o t n ecessa rily b e in terp reted as n efa rio u s or 93 94 Derivatives, Capital Flows and Prudential Regulation d ev io u s. Rather it reflects th e fact th a t th e se tra n sa ctio n s are o fte n b u ilt u p o n , or are cast lik e a sh ad ow , b y cap ital flo w s. M oreover su c h tr a n sa ctio n s are far less transparent. S h a d o w tra n sa ctio n s o fte n fu n c tio n to h e d g e or m a n a g e th e risks a sso c i­ ated w ith cap ital flow s. H o w ev er in so m e cases th e y a lso serve to fa cilita te u n p ro d u ctiv e a ctiv ities, in c lu d in g ta x a v o id a n ce, th e m a n ip u la tio n o f a cco u n tin g an d reportin g rules a n d th e o u tfla n k in g o f p m d e n tia l regu lation s. W h e n u sed to d o d g e fin a n c ia l m arket r eg u la tio n s d e sig n e d to add safety a n d so u n d n ess to th e m ark ets a n d assure th eir tran sp aren cy, th e n th e se u n p ro d u ctiv e a ctiv ities are a sou rce o f m arket in sta b ility a n d red u ce th e effic ie n c y o f m arket p ricin g. In a d d itio n th e u se o f d erivatives, e v e n w h e n th e y are u sed b y fo reig n a n d d o m e stic enterp rises for h e d g in g , ca n c o n ­ tribute to d o w n w a rd pressure o n e m erg in g m arket cu rren cies as in v esto rs rush to h ed g e th eir cu rren cy ex p o su re in a n tic ip a tio n o f a fin a n cia l crisis or to m e e t collateral req u irem en ts o n c e cu rren cy a n d a sset prices b e g in to fall. A lth o u g h th ere are n o p recise figures o n th e m a g n itu d e o f th e se tran s­ a ctio n s, th is d o es n o t m e a n th a t th e su b ject is n o t im p o rta n t, an d it sh o u ld b e ex p lo red in order to u n d ersta n d h o w su ch tr a n sa ctio n s ca n c o n trib u te to a fin a n cia l crisis. T h e n e w d e v e lo p m e n ts in fin a n c ia l tr a n sa ctio n s in d e v e lo p in g co u n tries require n e w regu latory a n d su p ervisory efforts to en su re th a t th e y w ill co n trib u te to th e im p r o v e m e n t o f liv in g standards a n d w ill n o t result in less stab le fin a n cia l sy stem s a n d greater e c o n o m ic vu ln era b ility . T h is ch ap ter fo cu ses o n derivatives a n d lea v es repurchase a g reem en ts a n d secu rities le n d in g tra n sa ctio n s for a n o th e r tim e .3 It an aly zes h o w d eriv a tiv es are related to cap ital flo w s a n d h o w th e y in tr o d u ce a d d itio n a l c o n c e rn s for m arket stability. T his in c lu d e s a n an a ly sis o f p o lic ie s d e sig n e d to stab ilize d e v e lo p in g co u n tries fin a n cia l m arkets, a n d o f fin a n cia l r eg u la tio n s in in d u s­ trialized co u n tries an d h o w th e y m ig h t b e a d ap ted to th e circu m sta n ces in d e v e lo p in g co u n tries a n d a p p lied to red u ce v o la tility a n d m itig a te th e im p a c t o f fin a n cia l secto r d isru p tio n s o n th e overa ll ec o n o m y . Transforming capital flows T h e trad ition al statu s o f b a n k in g as th e fo u n t for n e w c a p ita l w as so m e w h a t d im in ish e d b y cap ital m arket lib eralization , w h ic h resu lted in th e em erg en ce o f m o d ern cap ital m arkets in d e v e lo p in g c o u n tr ie s.4 W h ereas n e w cap ital w a s o n c e raised w ith in th e firm or fro m th e b a n k in g sector, th e n e w arrange­ m e n t a llo w ed cap ital to b e raised th r o u g h th e issu e o f sto ck s a n d b o n d s .5 T h is secu ritiza tio n o f n e w cap ita l p ro v ed to b e m o re effic ie n t in several im p o rta n t w ays an d s o o n surpassed b an k le n d in g as th e p r e d o m in a n t source for n e w capital fo r m a tio n a n d so v ereig n b o r r o w in g .6 In th e tra d itio n a l m o d e l o f raisin g n e w cap ital fro m le n d in g , b an k s m o b iliz e d savin gs a n d c o lle c te d p o o ls o f id le liq u id ity in th e p a y m e n ts an d Randall Dodd 95 se ttle m e n ts sy stem a n d tu rn ed th e m in to lo a n a b le fu n d s for n e w in v e s t­ m e n ts. Banks tra d itio n a lly h e ld lo a n s o n th eir b a la n ce sh e e t as assets, a n d th is form ed th e b asis for o n g o in g rela tio n sh ip s th a t p r o m o te d greater in fo r m a tio n sh arin g an d trust. A n o th er b e n e fic ia l feature o f b a n k le n d in g w as th a t b an k s c o u ld m ore ea sily restructure th e d eb t o f a b orrow er b eca u se th e b a n k - or a n u m b er o f b a n k s in a sy n d ica te - h e ld all o f th e debt. T raditionally, b an k p rofits w ere earn ed th r o u g h m a tu rity c o n v e r sio n . B anks accep ted sh ort-term d ep o sits, o n w h ic h th e y p aid sh o rt-term in terest rates, an d th e n tran sform ed th e fu n d s in to lo n g er-term lo a n s o n w h ic h th e y earn ed h igh er, lo n g -term in terest rates. T h ese ea rn in g s d e p e n d e d o n th e steep n ess o f th e y ie ld cu rve a n d h o w far th e b a n k w as w illin g a n d able to m o v e a lo n g th e curve. Banks o fte n a v o id e d th is in terest rate risk b y issu in g lo a n s o f m ed iu m - to lo n g -te r m m a tu rity w h o s e in terest rate w as freq u en tly a d ju sted acco rd in g to a sh ort-term in terest rate o v er th e life o f th e lo a n . T h is e n a b led th e m to m a tc h th e co sts o f th eir d ep o sits to th e ea rn in g s o n th eir lo a n s w h ile a v o id in g th e m arket risk o f in ter e st rate flu c tu a tio n s. T raditional b a n k in g h a d so m e sig n ific a n t sh o r tc o m in g s. T h e lo a n s o n th e p o rtfo lio w ere illiq u id , an d all b u t th e very largest b a n k s fo u n d it d ifficu lt to in tro d u ce g eo g ra p h ic a n d sectoral d iv ersifica tio n in to th eir lo a n p o r tfo lio . O n a m a c r o e c o n o m ic lev el, cap ita l fo rm a tio n in th e fo rm o f b a n k le n d in g m e a n t th a t in v e s tm e n t d e c isio n s w ere c o n tr o lle d b y a sm a ll n u m b e r o f b a n k e x ecu tiv es an d m an agers a n d n o t th r o u g h th e in te r a c tio n o f a large n u m b e r o f a n o n y m o u s m arket p articip an ts, as in secu rities m arkets. A n o th er sh o rt­ c o m in g o n th e m a c r o e c o n o m ic le v e l w as th a t b a n k lo a n s d id n o t g en era te m arket prices for th e in v e s tm e n t assets - th a t is, th ere w as n o price d isco v ery p rocess, as fo u n d in stock a n d b o n d m arkets. In n o v a tio n an d te c h n o lo g ic a l d e v e lo p m e n ts in a d v a n ce d cap ita l m arkets e sta b lish ed a p reced en t a n d h e lp e d to p r o m o te cap ita l m arket lib era liza tio n in d e v e lo p in g co u n tries. T h e m o d e r n iz a tio n o f th e a d v a n c e d fin a n c ia l m arkets h a d a p r o fo u n d effect o n th e sh a p e o f cap ita l flo w s to th e d e v e lo p ­ in g w orld d u rin g th e 1 9 9 0 s. D u rin g th e 1 9 7 0 s a n d 1 9 8 0 s th e se flo w s w ere p rim arily in th e form o f sy n d ica ted , variab le rate, fo reig n b a n k lo a n s. Large m o n e y -c e n tr e b an k s recy cled p etrod ollars b y u n d erw ritin g sy n d ic a ted b a n k lo a n s to d e v e lo p in g co u n tries th a t w ere s tm g g lin g to p a y for o il im p o rts an d w ere eager for n e w n e t cap ital in flo w s. T h e lo a n s w ere m o s tly ad ju stab le rate an d d e n o m in a te d in US dollars or so m e o th e r m ajor cu rren cy.7 T h is created a d istrib u tio n o f risk th a t w as n o t b a la n ced b e tw e e n b orrow er an d lender. T he borrow er carried b o th th e e x c h a n g e rate risk an d th e in terest rate risk. T h e len d er faced cred it risk, b u t th is w as m in im iz e d b y restrictin g credit to so v ereig n en titie s a n d th r o u g h th e u se o f cross-d efau lt cla u ses.8 T h e len d er also red u ced credit risk th r o u g h d iv ersifica tio n a n d th e lo a n sy n ­ d ica tio n p rocess. W h e n in terest rate a n d e x c h a n g e rate m o v e m e n ts w e n t again st th e borrow er its d eb t p o s itio n d eteriorated so b a d ly th a t it w as u n a b le p roperly to service its fo reig n cu rren cy b a n k lo a n s. T h is failure w as 96 Derivatives, Capital Flows and Prudential Regulation tran sform ed in to in crea sed cred it ex p o su re to th e lender. P ain fu l d eb t n e g o ­ tia tio n s fo llo w e d an d le d to d eb t re sch ed u lin g c o m b in e d w ith n e w le n d in g . T h is ap proach w as a c k n o w le d g e d to b e a failure at th e e n d o f th e 1 9 8 0 s a n d a n e w rou n d o f d eb t r e sc h e d u lin g c o m m e n c e d . T his c o m b in e d so m e d eb t forgiven ess w ith n e w co lla tera lized le n d in g k n o w n as Brady b o n d s. In th e en d , b o th th e in te r n a tio n a l len d ers a n d th e d e v e lo p in g c o u n tr y borrow ers suffered; th e 10 years o f d eb t o v e r h a n g in Latin A m erica, b e g in n in g in 1 9 82 , h as c o m e to b e ca lled th e lo s t decad e. C apital flo w s b eg a n to c h a n g e in th e la te 1 9 8 0 s a n d early 1 9 9 0 s. Table 6.1 sh o w s th e great tra n sfo rm a tio n th a t occu rred in cap ital flo w s to d e v e lo p in g c o u n tries. As a p ercen ta g e o f to ta l c a p ita l flo w s, b a n k le n d in g fell from n ea rly 64 per c e n t in 1 9 7 3 -8 1 to a lm o st 12 per c e n t in 1 9 9 0 -9 7 , w h ile cap ital flo w s in th e fo rm o f stock s rose from 0 .3 per c e n t to 1 6 .4 p ercen t. T he u se o f b o n d s as a d e v e lo p m e n t fin a n c e v e h ic le rose fro m 3 .5 p ercen t to 1 5 .2 per c e n t over th e sa m e p erio d . T h is n o t o n ly e lev a ted th e statu s o f th e East A sian b o n d m ark et b u t a lso esta b lish e d East A sian e q u ity m arkets as p la t­ form s o n w h ic h to raise cap ita l a n d d e stin a tio n s in w h ic h to lo c a te th e p o rt­ fo lio in v e stm e n ts o f h ig h n e t w e a lth in d iv id u a ls as w e ll as in s titu tio n a l in v e stm e n ts (D alla a n d K hatkate, 1996). T w o o f th e k ey in d ica to rs o f fin a n c ia l m arket d e e p e n in g a n d so p h istic a tio n is th e n u m b er o f firm s listed o n th e sto ck m arkets a n d th e size o f m arket ca p ita liza tio n . As ca n b e se e n in Table 6 .2 , th e se k ey in d ica to rs grew rap id ly b e tw e e n 1 9 9 0 an d 1999 . In Table 6.1 th e percen tages m easu re th e p ro p o rtio n o f to ta l capital flow s, a n d th e su m o f th e p ercen ta g es eq u a ls th e share o f p rivate flow s. Private cap ita l flo w s a c c o u n te d for 8 4 .5 p er c e n t o f flo w s in t h e earlier p eriod , w h ile th e cap ital m arket lib era liza tio n p o lic ie s o f th e 1 9 9 0 s resu lted in 9 3 .6 per c e n t o f cap ital flo w s b e in g fro m private sou rces in th e later period. Table 6 .3 sh o w s th e flo w s to d e v e lo p in g c o u n tries d u rin g th e 1990s. T h e result o f th e tra n sfo rm a tio n w as n o t just greater flo w s a n d greater v o la tility o f flo w s a n d asset prices; it w as a lso a red istrib u tio n o f risk b e tw e e n Table 6.1 P riv a te c a p ita l flo w s t o d e v e lo p in g c o u n trie 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 t o t a l o f f ic ia l a n d p riv a te flo w s ) * Type o f flo w Bonds B a n k le n d in g F o re ig n d ir e c t in v e s tm e n t P o r t fo lio e q u ity 1973-81 1 9 9 0 -9 7 3 .5 6 3 .9 1 6 .8 0 .3 1 5 .2 1 1 .7 5 0 .3 1 6 .4 * Figures are c alc u la te d as p e rc e n ta g e o f to ta l flow s a n d th e re fo re p riv a te flow s d o n o t a d d u p t o 100 p e r c e n t. Source: W o rld B an k (2000: 126). Randall Dodd Table 6.2 97 M aturation of East Asian stock markets, 1990-99 N um ber o f listed companies 1990 In d o n e s ia K o re a M a la y s ia P h ilip p in e s S in g a p o re T h a ila n d T o ta l 12 5 669 282 15 3 150 214 1 593 1999 277 72 5 75 7 226 355 392 2 732 (+ 7 2 % ) Capitalization (US$ million) 1990 8 081 110 594 4 8 61 1 5 927 34 308 23 896 231417 1999 64 067 308 534 145 445 4 8 10 5 198 407 58 365 822 923 (+ 2 5 6 % ) Source: W o rld B ank (2001). in v esto rs in a d v a n ced cap ita l m arkets a n d cap ita l recip ien ts in d e v e lo p in g co u n tries. T his m ore d iversified flo w o f fo reig n cap ital (d iversified in th e se n se th a t variou s cap ita l v e h ic le s w ere u se d to c h a n n e l th e cap ita l flow s) g en erated a d ifferen t d istrib u tio n o f m arket a n d cred it risks. C o m p a red w ith th e b a n k lo a n s o f th e 1 9 7 0 s a n d early 1 9 8 0 s, th is m o re d iversified flo w o f cap ital te n d e d to d istrib u te risk tow ard s in v esto rs in th e a d v a n ced cap ital m arket e c o n o m ie s. Stocks or e q u ity shares sh ifted price risk, e x c h a n g e rate risk an d cred it risk to fo reig n in v esto rs. Local cu rren cy b o n d s sh ifte d price, in terest rate risk, e x c h a n g e rate risk a n d cred it risk to fo reig n in v esto rs. E ven m ajor-cu rren cy-d en om in a ted b o n d s issu ed b y d e v e lo p in g -c o u n tr y borrow ers sh ifted in terest rate risk, as w e ll as credit risk, to fo reig n in v esto rs. D irect fo reig n in v e s tm e n t in p h y sic a l cap ita l - w h e th e r eq u ip m e n t, p la n t or real estate - sim ilarly sh ifted price a n d e x c h a n g e rate risks a n d cred it risk to fo reig n in vestors. T he c o m b in e d effect w as p o te n tia lly to red u ce th e d e v e l­ o p in g e c o n o m ie s exp osu re to th e m arket risk.9 Growth of shadow transactions O v e r v ie w D erivative trading grew u p a lo n g sid e th e se n e w form s o f cap ita l flo w as part o f an effort to im p ro v e th e m a n a g e m e n t o f th e risks o f g lo b a l in v e stin g . D erivatives a llo w ed risk to b e sh ifte d aw ay fro m in v esto rs w h o d id n o t w a n t it an d tow ards th o s e w h o w ere m o re w illin g a n d able to b ear it. At th e sam e tim e, h ow ever, derivatives created n e w risks th a t w ere p o te n tia lly d estab iliz­ in g for d e v e lo p in g e c o n o m ie s. T h e fo llo w in g is a n an alysis o f h o w derivatives p la y ed a co n stru ctiv e role in c h a n n e llin g cap ita l from a d v a n ced cap ital m arkets to d e v e lo p in g e c o n o m ie s, a n d h o w at th e sam e tim e th e y p la y ed a p o te n tia lly d estru ctive role in la y in g th e fo u n d a tio n s o f th e su b se q u e n t \o 00 Table 6,3 N e t lo n g - te r m flo w s to d e v e lo p in g c o u n trie s , 1 9 9 0 -9 8 (U S$ b illio n ) 1990 O ffic ia l P riv a te ( to ta l) B a n k lo a n s Bond O th e r d e b t E q u ity - p o r tfo lio DFI T o ta l P riv a te (% ) B a n k lo a n s Bond O th e r d e b t E q u ity - p o r tfo lio DFI Source: W o rld B an k (2001). 1991 1992 1993 1994 1995 1996 1997 1998 1999 5 5 .9 4 2 .6 3 .2 1 .2 1 1 .3 2 .8 2 4 .1 9 8 .5 6 2 .3 6 1 .6 5 .0 1 0 .9 2 .8 7 .6 3 5 .3 1 2 3 .9 5 4 .0 9 9 .8 16.4 11.1 10.7 14.1 47 .5 1 5 3 .8 5 3 .4 1 6 5 .8 3 .5 3 6 .6 8 .7 5 1 .0 6 6 .0 2 1 9 .2 4 5 .9 1 7 4 .5 8 .8 3 8 .2 3 .5 3 5 .2 8 8 .8 2 2 0 .4 5 3 .9 2 0 3 .3 3 0 .4 3 0 .8 1.0 36 .1 1 0 5 .0 2 5 7 .2 3 1 .0 2 8 2 .1 3 7 .5 6 2 .4 2 .2 4 9 .2 1 3 0 .8 3 1 3 .1 3 9 .9 3 0 4 .0 5 1 .6 4 8 .9 3 .0 3 0 .2 1 7 0 .3 3 4 3 .9 5 0 .6 2 6 7 .7 4 4 .6 3 9 .7 -3 .1 1 5 .6 1 7 0 .9 3 1 8 .3 5 2 .0 2 3 8 .7 -1 1 .4 2 5 .0 5 .5 2 7 .6 1 9 2 .0 2 9 0 .7 7.5 2 .8 2 6 .5 6 .6 5 6 .6 8.1 1 7 .7 4 .5 12 .3 5 7 .3 16.4 11.1 10.7 14.1 4 7 .6 2 .1 2 2 .1 5 .2 3 0 .8 3 9 .8 5 .0 2 1 .9 2 .0 2 0 .2 5 0 .9 1 5 .0 1 5 .2 0 .5 17 .8 5 1 .6 13 .3 2 2 .1 0 .8 1 7 .4 4 6 .4 1 7 .0 1 6 .1 1 .0 9 .9 5 6 .0 1 6 .7 1 4 .8 -1 .2 5 .8 6 3 .8 -4 .8 10 .5 2 .3 1 1 .6 8 0 .4 Randall Dodd 99 crisis. T h ese capital in stru m en ts, th eir a sso cia ted risks an d th e a sso cia ted d erivatives u sed to m a n a g e th e risks are listed in Table 6.4. D erivatives fa cilita te cap ital flo w s b y u n b u n d lin g risk in t o its c o m p o n e n t parts an d th e n m o re e ffic ie n tly red istrib u tin g th e variou s sou rces o f risk associated w ith each capital in stru m en t, in c lu d in g ban k lo a n s, eq u ities, b o n d s an d direct foreign in v e s tm e n t. Foreign cu rren cy lo a n s e x p o se th e fo reig n in v esto r to credit risk an d th e d o m e s tic b orrow er to e x c h a n g e rate risk; a fix ed in terest rate lo a n e x p o ses th e fo reig n len d er to in terest rate risk an d Table 6.4 C a p ita l in s tr u m e n ts , t h e ir a s s o c ia te d ris k s a n d th e d e riv a tiv e s u s e d to m a n a g e th e risks Capital instrum ent B ank loans1 In v e s to r D e v e lo p in g c o u n tr y C a r ry tra d e Bonds2 M a jo r c u rre n c y b o n d In v e s to r D e v e lo p in g c o u n tr y Lo ca l c u rre n c y b o n d In v e s to r D e v e lo p in g c o u n tr y E quity P o r t fo lio /D F I In v e s to r D e v e lo p in g c o u n tr y F D I (n o n -s e c u ritiz e d ) In v e s to r D e v e lo p in g c o u n tr y Risk exposure C re d itw o rth in e s s In te re s t ra te F o re ig n e x c h a n g e L iq u id it y F o re ig n e x c h a n g e Derivative, or risk m anagem ent C r e d it d e riv a tiv e s , c ro s s -d e fa u lt cla u s e o r d iv e r s ific a tio n In te r e s t ra te s w a p F o re ig n e x c h a n g e fo r w a r d , s w a p o r o p t io n L in e o f c r e d it (e m b e d d e d o p tio n ) TRS ( to ta l r e t u r n s w a p ) In te re s t ra te C r e d itw o r th in e s s P rice F o re ig n e x c h a n g e In te re s t ra te s w a p o r fu tu r e D iv e r s ific a tio n TRS F o re ig n e x c h a n g e fo r w a r d , s w a p o r o p t io n F o re ig n e x c h a n g e In te r e s t ra te n .a . F o re ig n e x c h a n g e fo r w a r d o r s w a p In te re s t ra te s w a p 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 r w a r d , s w a p o r o p t io n TRS, e q u ity fu tu re s a n d o p tio n s P ric e n .a . 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 r w a r d , s w a p o r o p t io n n .a . Notes: 1 B ank lo a n s are p re su m ed to b e d e n o m in a te d in a m a jo r cu rre n c y (for e x am p le US dollars), a t v a ria b le (flo atin g ) in te re s t ra te s a n d u n d e rw ritte n b y a sy n d ic a te o f ban ks. 2 B o n d refers to c o n v e n tio n a l n o te s a n d b o n d s , flo a tin g ra te n o te s a n d s tru c tu re d n o te s. Source: A u th o rs o w n analysis. 100 Derivatives, Capital Flows and Prudential Regulation a variable rate lo a n e x p o se s th e d o m e stic borrow er t o in te r e st rate risk; an d a lo n g -term lo a n e x p o se s th e fo reig n len d er to greater cred it risk a n d a sh o rt­ term lo a n ex p o ses th e d o m e stic borrow er to r efu n d in g risk (so m e tim e s called liq u id ity risk). E quities e x p o se th e fo reig n in v esto r to cred it risk a lo n g w ith th e m arket risk fro m ch a n g e s in th e e x c h a n g e rate, m ark et price o f th e sto ck a n d th e u n certa in d iv id e n d p a y m e n ts. N o te s an d b o n d s e x p o se th e fo reig n in v esto r to cred it risk a n d m ark et in terest rate risk, a n d hard cu rren cy b o n d s e x p o se th e d o m e s tic b orrow er to e x c h a n g e rate risk. T h e fin a n cia l in n o v ­ a tio n o f in tr o d u c in g d eriv a tiv es to cap ital m arkets a llo w s th e se tra d itio n a l arran gem en ts o f risk to b e red esig n ed in order b etter to m e e t th e d esired risk profiles o f th e issuers a n d h o ld ers o f th e se cap ital in stru m e n ts. W h ile th e risk -sh iftin g fu n c tio n o f d erivatives serves th e u sefu l role o f h e d g in g an d th ereb y fa c ilita tin g cap ital flo w s, th e in crea sed u se o f deriva­ tiv es raises c o n c e r n a b o u t th e sta b ility o f th e e c o n o m y as a w h o le . T h e u se o f d erivatives ca n lea d to less tran sp aren cy b e tw e e n cou n terp a rties an d b e tw e e n regulators an d m ark et p articip an ts. T h ey ca n b e u se d for u n p ro ­ d u ctiv e a ctiv ities su ch as a v o id in g p ru d en tia l reg u la tio n s, m a n ip u la tin g a c c o u n tin g rules an d cred it ratings, a n d e v a d in g tax. T h e y ca n a lso b e u se d to raise th e le v e l o f m arket risk ex p o su re relative to cap ita l in th e p u rsu it o f h ig h er y ie ld in g - a n d h ig h e r risk - in v e s tm e n t strategies. T he greater th e m arket e x p o su re - p o ssib ly created b y o p e n p o sitio n s in d erivative co n tra cts - th e greater th e im p a c t o f a c h a n g e in th e e x c h a n g e rate or o th er m arket price o n th e fin a n cia l sector a n d e c o n o m y as a w h o le . In th is c o n te x t th e u se o f d erivatives to reduce th e a m o u n t o f cap ital relative to th e a m o u n t o f risk-taking a ctiv ities red u ces th e a b ility o f cap ita l to serve as a buffer ag a in st m arket tu rb u len ce a n d to serve as a g o v ern o r o n to ta l risk tak ing. T h is in crea ses th e lik e lih o o d o f sy ste m ic failu re a n d h e ig h te n s d ou b ts ab ou t th e stability o f th e fin a n cia l sector an d th e e c o n o m y as a w h o le . A n a ly s is o f tr a n s a c tio n s T h e rem ain d er o f th is se c tio n is o rg a n ized as fo llo w s. T h e risk characteristics o f ea ch ty p e o f cap ita l in str u m e n t is a n a ly zed , to g e th e r w ith th e ty p es o f d erivative th a t are lik ely to b e u sed in c o n ju n c tio n w ith th a t in str u m e n t. N ex t, ea ch o f th e relev a n t d erivatives is b riefly d escrib ed b efore jo in in g th e tw o d iscu ssio n s to sh o w h o w th e cap ita l in stru m e n ts a n d d eriv a tiv es are u sed to g eth er or as su b stitu tes. Foreign exchange fo rw ard A fo reig n e x c h a n g e forw ard is a co n tra ct in w h ic h co u n terp a rties agree to ex ch a n g e sp ecified a m o u n ts o f foreign currencies at a sp ecified e x c h a n g e rate o n a sp ecified future d a te (Figure 6.1 ). T h e forw ard e x c h a n g e rate is th e price at w h ic h th e cou n terp a rties w ill e x c h a n g e cu rren cy o n th e fu tu re e x p ira tio n date. T he forw ard rate is n e g o tia te d so th a t th e p resen t v a lu e o f th e forw ard co n tra ct is zero at th e tim e it is traded; th is is referred to as tra d in g at par or Randall Dodd Figure 6.1 101 F o re ig n e x c h a n g e fo r w a r d at th e m arket. As a result n o m o n e y n e e d b e p a id at th e c o m m e n c e m e n t o f th e con tract, a lth o u g h th e co u n terp a rties m a y agree to p o st colla tera l in order to en su re ea ch others a d h eren ce to th e con tract. Foreign exchange swap A fo reig n e x c h a n g e sw ap is sim p ly th e c o m b in in g o f a sp o t a n d a forw ard tra n sa ctio n (or p o ssib ly tw o forw ards). T h e startin g leg o f th e sw ap u su a lly c o n sists o f a sp o t fo reig n e x c h a n g e tra n sa ctio n at th e cu rren t sp o t e x c h a n g e rate, an d th e c lo s in g leg c o n sists o f a se c o n d fo reig n e x c h a n g e tra n sa ctio n at th e co n tra cted forw ard rate. For ex a m p le , a lo c a l in v e sto r en ters a fo reig n e x c h a n g e sw ap o f p eso s a g a in st d ollars in w h ic h th e in v e sto r b u y s U S $ 1 0 0 0 0 0 to d a y at a n e x c h a n g e rate o f U S $ 0 .0 5 per p e so (th u s p a y in g 2 0 0 0 0 0 0 p esos), a n d co n tra cts to sell U S $ 1 0 0 0 0 0 (th a t is, b u y p eso s) at U S $ 0 .0 4 7 5 in 1 8 0 days. T h e lo ca l in v esto r receives U S $ 1 0 0 0 0 0 in th e startin g leg, an d th e n u p o n th e sw ap ex p ir a tio n d a te p ays U S $ 1 0 0 0 0 0 in e x c h a n g e for receiv in g 2 105 2 6 3 p e so s in th e c lo s in g leg. T h is 1 0 .8 per c e n t a n n u a l rate o f return in p eso s is d u e to th e d ep r e cia tio n o f th e p eso a g a in st th e dollar (or a p p recia tio n o f th e dollar a g a in st th e p eso ), a n d it reflects th e p resu m ed fact th a t th e p e so rate o f return from in v e s tin g in p eso d e n o m in a te d assets is h ig h e r th a n th e US d ollar rate o f return. F oreign e x c h a n g e forw ards a n d sw aps are u se d b y b o th fo reig n a n d d o m e s tic in v esto rs to h e d g e fo reig n e x c h a n g e risk. F oreign in v esto rs from a d v a n ced cap ital m arkets w h o p u rch ase secu rities d e n o m in a te d in lo c a l curren cies u se fo reig n e x c h a n g e forw ards a n d sw aps to h e d g e th eir lo n g lo c a l currency exp osu re. S im ilarly fo reig n direct in v e s tm e n ts in p h y sic a l real estate, p la n t or eq u ip m e n t are e x p o se d to th e risk o f lo c a l cu rren cy d ep reci­ a tio n . L ocal d e v e lo p in g -c o u n tr y in v esto rs w h o b orrow in m ajor cu rren cies 102 Derivatives, Capital Flows and Prudential Regulation in order to in v est in loca l currency assets are also ex p o se d to foreign e x c h a n g e risk, an d th e y to o u se fo reig n e x c h a n g e forw ards a n d sw ap s - as w e ll as futures an d o p tio n s w h e n a vailab le - to m a n a g e th eir risks. O f course fo reig n e x c h a n g e forw ards a n d sw aps are a lso u se d for sp ecu la ­ tio n in th ese lo c a l curren cies. D erivatives en a b le sp ecu lators to leverage th eir capital in order to tak e larger p o sitio n s in th e v a lu e o f lo c a l currencies. T h is in turn m e a n s th a t d ev e lo p in g -c o u n tr y cen tral b a n k s m u st w a tc h th e e x c h a n g e rate in tw o m arkets, th e sp o t a n d forw ard, in order to m a in ta in th eir fix ed e x c h a n g e rates. Forwards a n d fo reig n e x c h a n g e sw aps are n o t alw ays h ig h ly co lla tera lized (m arket exp osu re m easu red as a p ercen ta g e o f th e p rin cip al). C ollateral is less lik ely to b e u sed for trad in g b e tw e e n th e m ajor m arket dealers, an d collateral is u su a lly lo w er for less v o la tile fin a n cia l in str u m e n ts su ch as foreign cu rren cy.10 T h is en a b le s fo r e ig n -e x ch a n g e d eriv a tiv e users to o b ta in greater a m o u n ts o f curren cy ex p o su re relative to cap ital, a n d th erefo re it can lea v e fo r eig n -ex ch a n g e d erivative cou n terp a rties e x p o se d to greater cred it risk. T h e largest cred it lo sse s in th e d erivatives m arkets in rec en t years w ere d u e to defau lts o n fo reig n cu rren cy forw ards in East Asia a n d R ussia.11 Foreign exchange forw ards a n d swaps - c a p ita l o u tflo w problem s In a d d itio n to th e a b o v e d angers o f u sin g foreign ex c h a n g e d erivatives, th ere is an a d d itio n a l p ro b lem w ith reverse cap ital flo w s. T h is arises from th e n e ed o f d erivative dealers to create b o th lo n g a n d sh o rt p o sitio n s in d e v e lo p in g co u n try currencies in order to m a k e a m arket in derivatives. Every d erivative co n tr a c t in v o lv e s a sh o rt a n d a lo n g p o sitio n . T h e party b u y in g p eso s in e x c h a n g e for US dollars in th e forw ard m arket is lo n g in p eso s (and sh o rt in d ollars), w h ile th e cou n terp a rty is sh o rt in p eso s. In th e m arket for p e so forw ards a n d sw aps th ere is lik e ly to b e o n e or m o re dealers. A dealer m akes a m arket b y q u o tin g b id a n d offer (ask)12 prices a n d th e n sta n d in g b e h in d th e m . Id ea lly th e d ealer faces a m arket th a t is fu ll o f p articip an ts w h o are w illin g to b u y a n d sell in eq u a l a m o u n ts. In th is case th e d ealer reacts to in v e sto rs h ittin g h is b id (se llin g p e so s for dollars forw ard to th e dealer) b y try in g to la y o ff th e lo n g p e so ex p o su re b y se llin g p e so s to o th e r p articip an ts in th e m ark et (th o se w h o are liftin g th e dealers offer). H ow ever it is lik e ly th a t a dealer in d e v e lo p in g -c o u n tr y fo r eig n -ex c h a n g e d erivatives w ill o fte n face a o n e -sid e d or im b a la n c e d m arket in w h ic h m o st p articip an ts w a n t to b e sh o rt in th e lo c a l cu rren cy.13 T h is m e a n s th a t it is o fte n d ifficu lt or e x p e n siv e for dealers to la y o ff th e ir lo n g p o sitio n s b y sellin g sh ort to oth ers in th e forw ard or o th e r d eriv a tiv es m arkets. As a result, eith er th e forw ard rate m u st rise (or fall) su ffic ie n tly to c o m p e n sa te th e dealer a n d o th e r risk takers for h o ld in g greater a m o u n ts o f risk, or th e dealer m u st fin d oth er, ch ea p er m e a n s to la y o ff th e risk. O n e altern ative m e th o d u se d b y dealers in th e face o f a n im b a la n ced m arket is to create a s y n th e tic forw ard or sw ap co n tra ct th r o u g h th e u se o f t h e lo ca l credit m arkets. In order to create a sy n th e tic sh o rt forw ard p e so Randall Dodd 103 p o sitio n again st th e dollar, th e dealer borrow s in th e lo ca l p e so cred it m arket (th u s creatin g a p e so liab ility ), u se s th e lo a n p ro ceed s to b u y d ollars sp o t a n d th e n in v ests th e dollars (th u s o b ta in in g a d ollar asset). Id ea lly th e m a tu rity o f th e forw ard, p e so lo a n a n d d ollar in v e s tm e n t w ill m a tc h . T h e p ro d u ct o f th e se th ree tra n sa ctio n s g iv es th e dealer a sp ecified a m o u n t o f d ollars in futures (th e lo a n rep aym en t) th a t ca n b e so ld for p eso s at a sp ecified e x c h a n g e rate in se ttlin g th e forw ard con tract, th e p ro ceed s fro m w h ic h w ill repay th e p e so lo a n a n d le a v e th e dealer w ith a p rofit. In th is m a n n er th e dealer can c o n tin u e to q u o te b id a n d offer prices w ith o u t h o ld in g m ar­ ket risk. N o te th a t in th e p rocess o f crea tin g a sy n th e tic sh ort forw ard p o s itio n to m ake a m arket in foreig n e x c h a n g e d erivatives, th e dealer h a s g en era ted a cap ital o u tflo w b y b o rro w in g at h o m e a n d le n d in g abroad in th e dollar m arket. T h us in th e c o n te x t o f im b a la n ced m arkets, w h ere m o re p articip an ts are w illin g to h o ld sh ort rather th a n lo n g p o sitio n s, h e d g in g ca n g en era te cap ital o u tflo w s. If a fo reig n in v e sto r trades a fo reig n e x c h a n g e forw ard or sw ap in order to h e d g e an in v e s tm e n t in a lo ca l-cu rren cy secu rity or direct in v e s tm e n t, th e n th e d erivatives m arket w ill p o te n tia lly g en era te a cap ital o u tflo w eq u al to th e size o f th e h e d g e. If th e fo reig n in v e sto r w ish e s to h e d g e th e fu ll v a lu e o f th e in v e s te d p rin cip le, th e n th e h e d g in g p rocess ca n p o te n tia lly n eu tralize or n e t-o u t th e cap ita l in flo w . O f co u rse th e flo w is again reversed an d returns to th e d e v e lo p in g c o u n tr y w h e n th e dealers lo a n m atures a n d h e or sh e u ses th e dollar p ro ceed s to u n w in d h is or her sy n th e tic forw ard p o s itio n .14 T here is an a d d itio n a l c o n c e r n w ith fo reig n e x c h a n g e sw ap s a n d th eir e ffect o n capital flo w s. N o te th a t th e ca sh flo w s fro m su c h a sw ap resem b le th e cash flo w from a sh ort-term fo reig n cu rren cy lo a n (see e x a m p le ab o v e). D ollars are received to d a y a n d are repaid in th e future, a n d th e lo a n co st is p a id in p eso s b ased o n th e dollar a n d p e so in terest rates. In r e c o g n itio n o f th is, M alaysia p ro h ib ite d fo reig n e x c h a n g e sw aps as part o f its effort to im p e d e capital in flo w s prior to th e 1 9 9 7 fin a n cia l crisis. Interest rate swap T h e b asic in terest rate sw ap, ca lled th e v a n illa in terest rate sw ap, is a n agree­ m e n t b e tw e e n tw o parties to e x c h a n g e th e n e t o f tw o series o f p a y m en ts. O n e series o f p a y m e n ts is b a sed o n a fix ed in terest rate a p p lied to a n o tio n a l p rin cip al, su ch as 6 per c e n t o n U S$1 m illio n , a n d th e o th er series o f p a y m e n ts is b ased o n a flo a tin g rate, su c h as a 3 -m o n th LIBOR (L o n d o n in terb a n k offered rate), a p p lied to th e sa m e n o tio n a l p rin cip a l. In order to sim p lify p a y m e n ts a n d o th er clea rin g issu es, m o s t sw ap co n tra cts a llo w th e tw o parties to p a y (or receive) o n ly th e n e t or th e d ifferen ce b e tw e e n th e se tw o series o n ea ch p a y m e n t or drop date. Borrowers w ith variable in terest rate lo a n s ca n h e d g e th eir in terest rate risk w ith a sw ap in w h ic h th e y receive th e flo a tin g rate a n d p a y th e fix e d rate (th a t is, b u y a sw ap), a n d th ereb y sw ap th eir flo a tin g rate p a y m en ts for fix e d rate p a y m en ts. 104 Derivatives, Capital Flows and Prudential Regulation T o ta l return swap A total return sw ap (TRS) is a con tract in w h ic h at least o n e series o f p a y m en ts is b ased o n th e to ta l rate o f return (th e c h a n g e in m arket price p lu s in terest or d iv id e n d p a y m en ts) o n so m e u n d e r ly in g asset, secu rity or secu rity in d e x . T h e o th er leg o f th e sw ap is ty p ic a lly b a sed o n a variab le in terest rate su c h as th e LIBOR, b u t m a y b e a fix e d rate or th e to ta l rate o f return o n so m e o th er fin a n cia l in stru m e n t. Based o n w h a t is k n o w n a b o u t th e precrisis situ a tio n s in M ex ic o an d East Asia, TRSs in th o s e situ a tio n s u su a lly c o n siste d o f sw a p p in g th e LIBOR ag a in st th e to ta l rate o f return o n a g o v e r n m e n t security. A TRS replicates th e p o sitio n o f b o rro w in g at th e LIBOR in order to fin a n c e th e h o ld in g o f a security. T h e returns are th e sam e, b u t u n lik e a n actu al ca sh m arket tra n sa ctio n , it d o e s n o t in v o lv e o w n e r sh ip or d eb t. In stead th e o n ly capital in v o lv e d in a TRS is th e p o stin g o f co llateral. In a d d itio n to th e red u ctio n in th e n e e d to c o m m it capital to th e tran saction , a TRS also h a s n o im p a ct o n a firm s b a la n c e sh e e t a n d is n o t lik ely to b e su b ject to regu latory restriction s o n fo reig n e x c h a n g e e x p o su r e .15 In sh ort, TRSs a llo w fin a n cia l in s titu tio n s an d in v esto r s to raise th eir risks a n d p o te n tia l returns, relative to capital. O n e o f th e tr o u b leso m e u ses o f TRSs is to capture th e g a in s from th e carry trade or carry b u sin ess. A p ro fita b le carry trade e x ists w h e n e x c h a n g e rates are fix ed an d in terest rate d ifferen tia ls persist b e tw e e n tw o e c o n o m ie s. T h en it is p o ssib le to b orrow in th e lo w in terest rate cu rren cy a n d le n d in th e h ig h in terest rate cu rren cy w ith n o risk o th er th a n th a t o f a failu re in th e fix e d e x c h a n g e rate regim e. T h e u se o f a TRS alters th e form , b u t n o t n ecessa rily th e q u a n tity, o f ca p ­ ital flow s to d e v e lo p in g co u n tries. A lternatively, w h e n d e v e lo p in g -c o u n tr y fin a n cia l in s titu tio n s en g a g e in th e carry b u sin ess, th e cap ita l flo w s are in th e form o f m ajor-cu rren cy (u su a lly sh ort-term ) b a n k lo a n s. W h e n th e y pu rsue th e sam e p rofit o p p o r tu n itie s b y u sin g a TRS, th is gen erates in d irect capital flow s as th e TRS counterparties, u su a lly dealers from ad v a n ced capital m arkets, b u y th e u n d e r ly in g asset as a h e d g e ag a in st th eir sid e o f th e TRS. C on sid er th e dealers sid e o f th e tra n sa ctio n . T h e dealer co n tra cts to receive th e LIBOR p lu s a spread in e x c h a n g e for p a y in g th e to ta l return o n a lo ca l currency security. T h e dealer d o es n o t in te n d to p ro fit b y in v e s tin g in th e e x p e c ta tio n th a t th e LIBOR w ill rise or th a t th e to ta l return o n th e secu rity w ill fall. In stead th e d ealer lays o ff th e risk b y b o rr o w in g at th e LIBOR an d u sin g th e p ro ceed s to b u y th e lo ca l cu rren cy security. T h e dealer th e n p asses-th rou gh in th e regular sw ap p a y m e n t th e p ro ceed s from h o ld in g th e lo ca l security, w h ile th e dealers c o st o f b o rro w in g to b u y th e secu rity is covered b y th e receip t o f LIBOR p a y m e n ts. T h e spread a b o v e th e LIBOR p aid to th e dealer is th e dealers profit, a n d th e dealer e n d s u p h o ld in g n o m arket risk.16 Randall Dodd 105 N o te th a t in th e process o f h e d g in g th e dealers p o sitio n in th e TRS th ere is a cap ita l in flo w to th e d e v e lo p in g co u n tr y b eca u se th e a d v a n c e d cap ital m arket dealer has p u rch a sed lo ca l cu rren cy security. N o r m a lly a flo w o f cap ital in th e form o f lo c a l cu rren cy secu rities w ill sh ift th e e x c h a n g e rate risk to th e ad v a n ced capital m arkets, b u t n o t in th is case. In stead it fu n c tio n s in c o n ju n c tio n w ith th e TRS to lea v e th e lo c a l d e v e lo p in g -c o u n tr y in v esto r h o ld in g th e fo reig n e x c h a n g e risk (th e sh o rt d ollar p o sitio n ), m u c h lik e a m ajor curren cy b an k lo a n . O n th e o n e h a n d th e u se o f a TRS resu lts in a sim ilar fo reig n e x c h a n g e e x p o su re to th a t d escribed b efore. H o w ev er in so m e w a y s it is far w orse. In co m p a riso n w ith u sin g fo reig n b a n k lo a n s to capture p rofit fro m th e carry trade, th e u se o f a TRS cau ses an e v e n greater surge in cross-border flo w s th a n d o sh ort-term b a n k lo a n s. T h e surge o rig in a tes fro m th e colla tera l req u irem en ts for th e sw ap. If th e p resen t v a lu e o f th e sw ap su d d e n ly drops as a result o f a rise in lo c a l in terest rates or a drop in th e v a lu e o f th e currency, or b o th , th e n th e lo c a l sw ap h o ld e r is required to p o st a d d itio n a l collateral w ith th e sw ap cou n terp arty. G en era lly th is m e a n s se llin g o th er assets, o fte n o th er d ev e lo p in g -c o u n tr y assets, in order to o b ta in dollars to m e e t th e req u irem en t to p o st a d d itio n a l collateral b y th e n e x t d a y - if n o t later th e sam e day. T hus TRSs ca n resu lt in large a n d im m e d ia te m ajor cu rren cy o u tflo w s. If sh ort-term b a n k lo a n s are co n sid e re d h o t m o n ey , th e n p a y m e n ts to m e e t m a rg in a n d collateral req u irem en ts are m icro w a v e m o n e y - th e y b e c o m e h o t m o re quickly. As a n in d ic a tio n o f th e p o te n tia l m a g n itu d e o f th e se co llateral o u tflo w s, Garber a n d Lall (1 9 9 6 ) cite th e IMF a n d in d u stry sources, w h ic h rep orted th a t M ex ica n b an ks h e ld U S $16 b illio n in te so b o n o s to ta l return sw aps at th e tim e o f th e d e v a lu a tio n o f th e M ex ic a n p eso . T h e a u th o rs ca lcu la ted th a t th e in itia l p eso d e v a lu a tio n d ep ressed th e v a lu e o f te s o b o n o s b y 15 per c en t, a n d th a t th is w o u ld h a v e required th e d eliv ery o f U S $ 2 .4 b illio n in co llateral th e n e x t day. T h is w o u ld e x p la in a b o u t h a lf o f th e U S$5 b illio n o f fo reig n reserves lo st b y th e M ex ic a n cen tral b a n k th e d a y after d e v a lu a tio n . In th is w ay, collateral or m argin calls o n d erivatives ca n accelerate th e p a ce o f a fin a n cia l crisis, an d th e greater leverage th a t d erivatives p r o v id e c a n also m u ltip ly th e size o f th e lo sses a n d th ereb y d e e p e n th e crisis. T h e u se o f TRSs also in crea ses th e lik e lih o o d o f c o n ta g io n . T h ey o fte n in v o lv e cross-currency assets a n d p a y m e n ts a n d are th erefore m o re lik e ly to transfer d isru p tio n s from o n e m arket to an oth er. N e ftc i (1 9 9 8 ) c la im s th a t o n e reason w h y K orean b an k s e n g a g e d in so m a n y In d o n e sia n TRSs w a s th a t th e y w ere seek in g h ig h er rates o f return in resp o n se to a rise in th eir fu n d in g c o sts. But, n o te th a t at th e e n d o f th is p rocess, K orean b a n k s are b e in g e x p o se d to In d o n e sia n credit. T his, h o w ev er, is n o t v isib le o n th eir b a la n ce sh eets. T his situ a tio n n o t o n ly creates th e p o ssib ility for c o n ta g io n , b u t m a y a lso m ak e th e c o n ta g io n u n p red icta b le a n d severe (ibid.). 106 Derivatives, Capital Flows and Prudential Regulation Structured notes Structured n o te s , a lso k n o w n as h y b rid in stru m e n ts, are a c o m b in a tio n o f a cred it m arket in stru m e n t, su c h as a b o n d or n o te , w ith a d erivative, su c h as an o p tio n or futures-lik e co n tra ct. H ybrid in str u m en ts in c lu d e su ch c o n ­ v e n tio n a l secu rities as c o n v e r tib le stock s, co n v e r tib le b o n d s a n d callab le b o n d s. T h ese h a v e lo n g b e e n a m o n g th e set o f tra d itio n a l secu rities regularly issu ed an d traded in US fin a n cia l m arkets. Structured n o te s w ere part o f th e n e w w a v e o f in n o v a tio n in c a p ita l flo w s to d e v e lo p in g co u n tr ie s in th e 1 9 9 0 s. T h ey offered issuers a n d in v esto rs eith er b etter y ie ld s th a n sim ila rly rated secu rities, or b etter c o m b in a tio n s or b u n d le s o f risk ch aracteristics. In so m e cases structured n o te s w ere d e sig n e d to circ u m v en t a c c o u n tin g rules or g o v e r n m e n t r eg u la tio n s a n d th u s a llo w low er cap ital charges, greater fo reig n e x c h a n g e e x p o su re or greater overa ll risk to cap ital. T he n o te s u se d in d e v e lo p in g co u n tries w ere u su a lly structured so th a t th eir y ie ld w as lin k ed to th e v a lu e o f o n e or m o re o f th e cu rren cies or sto ck in d ice s in th e d e v e lo p in g e c o n o m ie s in q u e stio n . T h e issuers o f th e se structured n o te s w ere fin a n c ia l in s titu tio n s from a d v a n ce d cap ita l m arket e c o n o m ie s, an d th e in v esto rs w ere o fte n d e v e lo p in g -c o u n tr y fin a n c ia l in s ti­ tu tio n s an d in v esto rs w h o w ere m o re w illin g to h o ld th eir o w n e x c h a n g e rate risk or th a t o f th e ir n e ig h b o u r in g d e v e lo p in g co u n tries. P u tab le debt T h e largest th rea t to fin a n c ia l m arket sta b ility th a t d id n o t d irectly in v o lv e fo reig n e x c h a n g e ex p o su re w as th e u se o f em b e d d e d d erivatives, ca lled put o p tio n s, in lo a n a n d b o n d d eb t con tracts. T h ese p u t o p tio n s o n th e d eb t prin cip al en a b le d len d ers to recall th eir p rin cip a l in th e e v e n t o f e c o n o m ic trou b le. T h e effect w as to d rain th e d e v e lo p in g c o u n tr y fin a n c ia l m arkets o f liq u id ity at just th e tim e it w a s m o s t u rg e n tly n e ed ed . It is n o t u n u su a l for cred it in str u m en ts to h a v e a tta ch ed o p tio n s. C allable b o n d s are fam iliar fin a n c ia l in str u m e n ts in a d v a n ced c a p ita l m arkets. T h ey are a c o m b in a tio n o f a c o n v e n tio n a l b o n d a n d a ca ll o p tio n th a t a llo w s th e issuer (th a t is, th e borrow er) to recall th e p rin cip a l o n th e b o n d at a sp ecified v a lu e (u su ally par) after so m e fu tu re date. C allab le b o n d s are u sed b y borrow ers to redu ce th e risk o f b e in g lo c k e d in to h ig h e r th a n m arket rates o f in terest o n th eir o u tsta n d in g debt. In th e case o f d e v e lo p in g c o u n tr y d eb t, th e a tta ch ed o p tio n s w ere u su a lly p u ts rather th a n calls. T h is gra n ted th e len d ers, n o t th e borrow ers, th e righ t to reclaim th eir p rin cip a l. L enders in a d v a n ced cap ita l m ark ets a tta ch ed p u t p ro v isio n s to lo a n s a n d b o n d s in order to red u ce th e risk th a t adverse m acroe c o n o m ic c o n d itio n s or o th er circu m stan ces w o u ld red u ce th e ab ility o f th eir borrow ers to repay th eir d eb ts. It also red u ced th eir e x p o su re to in creases in dollar or o th e r hard cu rren cy in terest rates. Yet a n o th er m o tiv a tio n Randall Dodd 107 in v o lv e d o u tfla n k in g ta x a n d regu latory req u irem en ts b eca u se th e p u tab le lo a n s c o u ld b e treated lik e lo n g -ter m d eb ts e v e n th o u g h th e y fu n c tio n e d like sh ort-term o n es. T h ese p u t o p tio n s w ere in th e fo rm o f hard a n d soft p u ts. Hard puts, u su a lly a tta ch ed to a n o te or b o n d , g a v e th e len d er th e rig h t to d e m a n d p rin cip al rep a y m en t after a certain date, for e x a m p le a five-year n o te m ig h t b e p u ta b le after o n e year. Soft p u ts, u su a lly a tta ch ed to lo a n s, g ave len d ers th e righ t to resch ed u le th e term s o f th eir cred it if certain adverse e v en ts occurred. Table 6.5 sh o w s th e b rea k d o w n b e tw e e n lo a n s a n d b o n d s in East Asia. M o st o f th e hard p u t o p tio n s w ere clo ser to th e E uropean- th a n to th e A m erican-style o p tio n . In th e se cases o p tio n h o ld ers h ad th e righ t to exercise th e o p tio n o n ly o n sp ecific days, or p erh ap s sem ia n n u a lly ; in v ery few cases w ere th e o p tio n s exercisable o n a c o n tin u o u s basis, as w ith A m erican o p tio n s. A ttached pu t o p tio n s facilitated le n d in g b y lo w erin g th e co sts to borrow ers an d en su rin g th a t len d ers w o u ld h a v e le n d in g altern a tives in th e e v e n t o f adverse m arket d isru p tio n s. T h is p u ta b le d eb t in str u m e n t w as u se d w id e ly in th e rapidly g ro w in g d e v e lo p in g -c o u n tr y b o n d m arket. T h e IMF estim a ted in 1999, u sin g p u b lic databases, th a t th ere w ere U S $ 3 2 b illio n in d eb ts p u ta b le th ro u g h th e e n d o f 2 0 0 0 for all em e r g in g co u n tries. O f th e to ta l, U S $23 b illio n w as from East A sian issuers a n d U S$8 b illio n w as from Brazil. T h e p resen ce o f p u tab le d eb t in le n d in g to d e v e lo p in g e c o n o m ie s raises several p o licy con cern s. First, th e a tta ch ed p u t low ers th e b o rro w in g co sts an d th is in tu rn en co u ra g es m o re b o rro w in g a n d le n d in g . S eco n d , th e ta x an d regu latory trea tm en t o f p u ta b le d eb t o fte n in co rre ctly treats it as lo n g -term d eb t ev e n th o u g h it fu n c tio n s lik e sh ort-term d eb t. Third, it creates liq u id ity sh ortages in the: e v e n t o f a fin a n c ia l d isru p tio n , an d it d o e s so just at th e tim e w h e n liq u id ity is crucial for th e su ccessfu l fu n c tio n in g o f th e fin a n c ia l sector. In su m , p u ta b le d eb t te n d s to in crease in d e b te d n e ss a n d d o es so in a m a n n er th a t exacerbates fin a n cia l d isru p tio n s. Table 6 .5 P u ta b le d e b t is s u e d fr o m E ast A s ia (U S$ m illio n , d u e in 1 9 9 9 o r 2 0 0 0 ) Loans H ong Kong In d o n e s ia K o re a M a la y s ia P h ilip p in e s S in g a p o re T h a ila n d T o ta l S u IMF (1999). o rce-. Bonds 1 549 2 876 3 263 54 7 75 532 1 680 10 52 2 2 642 963 3 986 1 730 1 313 10 634 108 Derivatives, Capital Flows and Prudential Regulation Threats to c u r r e n c y stability: derivatives a n d fixed e x c h a n g e rate r e gimes T h e presen ce o f d eriv a tiv es m arkets p o ses a sp ecia l set o f c h a lle n g e s for g o v e r n m e n ts w ith a fix ed e x c h a n g e rate regim e. T h is is true w h e th e r it is a so ft peg, a cra w lin g p e g or a hard p eg. D e v e lo p in g -c o u n tr y g o v e r n m e n ts p ursu e a fix ed e x c h a n g e rate p o lic y in order to en co u ra g e trade a n d in v e s t­ m e n t b y lo w e r in g e x c h a n g e rate risk. A fix e d e x c h a n g e rate ca n p r o m o te g ro w th th r o u g h th e e x p a n sio n o f trade a n d fo reig n in v e s tm e n t b y m a k in g th o s e e c o n o m ic d e c is io n s less u n certa in a n d m o re d ep en d a b le. T h is red u ces th e co sts o f th e fo reig n e x c h a n g e risk in v o lv e d in im p o r tin g cap ita l a n d raw m aterial, ex p o r tin g g o o d s a n d rep a y in g fo reig n d eb ts. A n o th er w a y is to sto p th e accelera tio n o f in fla tio n b y a n c h o r in g to ex tern a l price lev els. A gainst th is backdrop , th e p resen ce o f exch a n g e-ra te-rela ted d erivatives raises several im p o rta n t p ro b lem s th a t are ex p ressed in th e fo llo w in g qu estion s: • • • O f w h a t u se are fo reig n e x c h a n g e forw ards or sw aps w h e n th e fix e d e x c h a n g e rate regim e e lim in a te s n o rm a l m arket price v o la tility ? In o th er w ord s, h o w a n d w h y ca n th e y b e u se d if th ere is n o m arket v o la tility to hedge? W h at purpose is served b y th e price d iscovery o f th e forw ard rate (d isco u n t or p rem iu m ) a n d w h a t sig n a ls d o es it send? H o w d o es it affect th e a b ility o f th e cen tral b a n k to m a in ta in th e fix ed e x c h a n g e rate? T he first p rob lem is th a t in th e a b sen ce o f n o rm a l m arket price flu ctu ation s, e x c h a n g e rate d erivativ es fu n c tio n as a sp ecu la tiv e or h e d g in g in str u m en t again st th e su ccess o f th e g o v e r n m e n ts p o licy . In a fix e d e x c h a n g e rate c o n ­ tex t, th e o n ly e x c h a n g e rate m o v e m e n t th a t in v esto rs n e e d to h e d g e again st is a failure o f th e fix e d rate regim e th a t results in eith er a d e v a lu a tio n o f th e p eg g ed e x c h a n g e rate or c o m p le te a b a n d o n m e n t o f th e regim e. T here is a m u c h sm aller risk th a t a d e v e lo p in g cou n trys cu rren cy w ill appreciate, a n d so th e m ore relev a n t risk is a d e c lin e in its v a lu e. U sin g a forw ard, sw ap or o p tio n to take a p o te n tia lly p ro fita b le p o s itio n o n a p o ssib le fall in th e currencys v a lu e is p ra ctica lly a o n e -w a y b et. T h e future e x c h a n g e rate d eter­ m in e d in a forw ard or sw ap d erivative m arket is n o t a n ex p ressio n o f e c o n o m ic v a lu e b u t reflects th e lik e lih o o d o f g o v e r n m e n t failure, or is a m easu re o f th e lack o f c o n fid e n c e in th e g o v e r n m en ts a b ility to m a in ta in a fix ed e x c h a n g e rate. In sh o rt it is a p o litic a l price or th e price o f a p o lic y e v e n t.17 D erivative m arkets a lso p ro v id e leverage to sp ecu lators a n d players w h o m ig h t m o u n t an attack o n th e fix e d e x c h a n g e rate. T h is leverage in ta k in g a p o sitio n o n th e currencys v a lu e, w h e th er u sin g fo reig n ex c h a n g e forw ards, R a n d a ll D o d d 109 s w a p s o r o p tio n s , lo w e rs th e c o s t o f a n d th e r e f o r e ra is e s th e p o te n tia l g a in fro m su ch an u n d e r ta k in g . D e riv a tiv e s p ro v id e lo w e r c o s t p ric e e x p o su re b e c a u s e o f th e ir h ig h e r le v e ra g e ( w h ic h s a v e s o n th e c o s t o f c a p ita l), h ig h e r le v e ls o f liq u id it y ( s o m e tim e s ) a n d lo w e r t r a n s a c tio n c o s ts . T h u s t h e p r e s e n c e o f d e riv a tiv e m a rk e ts e m p o w e rs th o s e w h o a re b e ttin g o r p lo ttin g a g a in 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 lic y . M o r e o v e r , b e c a u s e i t is a p o li tic a l p r ic e a n d p r a c t ic a lly a o n e - w a y b e t , t h e r e a re lik e ly to b e f a r m o r e in v e s to r s w h o w a n t to b e s h o r t - r a t h e r t h a n - in th e lo c a l c u rre n c y . In o rd e r to d e riv a tiv e s d e a le rs w ill h a v e to ab o v e ) in o rd e r to lo n g c o m p le te th e m a rk e t, fo re ig n e x c h a n g e c re a te s y n th e tic s h o rt p o s itio n s (d e s c rib e d la y o f f t h e i r lo n g - s id e ris k . T h e r e s u lt o f t h i s is a c a p ita l o u tflo w , a n d a s th e s h o r t in te r e s t g ro w s in th e d e riv a tiv e s m a r k e t th e c a p ita l o u tf lo w w ill in c r e a s e a n d th u s c o n tr ib u te t o s e lf-fu lfillin g s p e c u la tio n a g a in s t th e c u rre n c y . T h e s e c o n d p ro b le m is 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 rd a n d s w a p m a r k e t w ill c r e a te a m a r k e t p r ic e (a p ro c e s s k n o w n a s p ric e d is c o v e ry ) th a t w ill re fle c t th e la c k of c o n fid e n c e in th e g o v e r n m e n t s e x c h a n g e r a te p o lic y . T h a t p r ic e w ill a lm o s t c e r ta in ly in d ic a te t h a t th e f u tu r e v a lu e o f t h e c u r r e n c y w ill b e b e lo w th e p r e s e n t p e g g e d s p o t r a te . If t h a t p r ic e is m i s u n d e r s t o o d , t h e n it w ill re g u la rly sen d s ig n a ls t h a t t h e c u rre n c y is g o in g to m o v e o ff o f th e p e g . T he th ird p ro b le m co n c ern s how th e p resen ce of fo rw a rd an d sw ap m a r k e t s a f f e c ts 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 re g im e a g a in s t d o w n w a rd p re ssu re cau sed by a s h o rt-te rm im b a la n c e or a la r g e s p e c u la tiv e a t ta c k . If t h e r e is 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 , th e n th e d ire c tly by in c e n tra l th e tig h te n in g e ffe c tiv e , b an k can d e fe n d sp o t m a rk e t to th e even d o m e s tic th o u g h th e buy its exchange c re d it c o n d itio n s . fo re ig n ra te its c u rre n c y w ith cu rren c y peg by in te rv e n in g fo re ig n re se rv e s, a n d D ire c t in t e r v e n t io n m a r k e t is can la rg e , b e c a u s e be th 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 is b o t h a la 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 and b ecau se it s e n d s a s ig n a l. T ig h te n in g c re d it c o n s is ts o f e ith e r ra isin g in te r e s t ra te s - w h ic h w ill a ttr a c t f o re ig n c a p ita l in flo w s , d is c o u r a g e o u tf lo w s a n d in c re a s e th e c o s t o f c a rr y in g s y n th e tic s h o r t p o s itio n s - o r r e s tr ic tin g th e s u p p ly o f c r e d i t ( t h a t is , i m p o s i n g c a p ita l c o n tro ls ) to c e rta in b o rro w e rs, s u c h a s f o r e ig n e r s o r n o n - c o m m e r c ia l firm s . T he p resen ce of one o r m o re fo re ig n -e x c h a n g e p o lic y ta rg e ts fo r th e c e n tra l b a n k . M o re o v e r th e d e riv a tiv e m a rk e ts adds d e riv a tiv e m a rk e ts a re in s o m e w a y s m o re p r o b le m a tic a s ta rg e ts th a n th e s p o t m a rk e t. W h ile th e s p o t m a r k e t is la r g e , t h e p o t e n t i a l s iz 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 is i n f i n i t e . If th e c e n tr a l b a n k ra ise s lo c a l in te r e s t ra te s , t h e n th e in te r e s t r a te d if f e re n ­ tia l in c re a s e s a n d s e rv e s a s a la rg e r b a s is fo r d is c o u n tin g t h e s w a p ra te s . If th e c e n tr a l b a n k in te r v e n e s d ire c tly , p e r h a p s i n fo rw a rd an and e ffo rt to a v o id th e f o rw a rd m a r k e t s ig n a llin g a la c k o f c o n f id e n c e in th e re g im e , t h e n t h e r e is p o t e n t i a l l y n o e n d to 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 D e riv a tiv e s , C a p ita l F lo w s a n d P ru d e n tia l R e g u la tio n 110 s u c c e e d s in s u p p o r tin g th e fo rw a r d o r s w a p ra te , th is o ffe rs a tta c k e rs a b e tte r p ric e a t w h ic h to s e ll t h e d o e s n o t in te rv e n e , th e n and fu rth e r g ro w th in lo c a l c u rre n c y in th e fo rw a rd c a n in te re s t in th e th e fu tu re . If th e c o n tin u e to fo rw a rd or c e n tra l b a n k s ig n a l a d e v a lu a tio n sw ap m a r k e t w ill spur c a p ita l o u tflo w s a s d e riv a tiv e d e a le rs c o n s tm c t s y n th e tic s h o r t p o s itio n s . T h i s is n o t t o say th a t th e s itu a tio n b e c o m e s h o p e le s s. In th e face o f a c u rre n c y a tta c k , th e c e n tr a l b a n k c a n ta k e th e e x tra s te p o f im p o s in g c a p ita l c o n tro ls th a t p r o h ib it b a n k s fro m d e liv e rin g th e e n titie s . T h is p r e v e n ts fo re ig n s p e c u la to rs fro m c o n tra c ts . T h is m e a s u re , ta k e n to g e th e r w ith lo c a l c u rre n c y to fo re ig n d e liv e rin g o n th e ir fo rw a rd an in c re a s e in in te r e s t ra te s , a m o u n ts to a b e a r s q u e e z e . T h is s tra te g y , a s u s e d in t h e c a s e o f T h a ila n d in t h e s p r i n g o f 1 9 9 7 , is d e s c r i b e d i n L a ll ( 1 9 9 7 ) a n d G a r b e r a n d L a ll ( 1 9 9 6 ) . P o lic y s o lu t io n s T h e fo llo w in g p o lic y p r o p o s a ls c o n s is t o f a s e t o f fin a n c ia l m a r k e t r e g u la tio n s th a t a re d e s ig n e d c e p tib le to to m ake d is ru p tio n s f in a n c ia l m a rk e ts an d m o re d i s t o r t i o n s . 18 T h e y e ffic ie n t a n d s h o u ld le s s sus­ th e use e n c o u ra g e o f d e riv a tiv e s fo r ris k m a n a g e m e n t p u rp o s e s w h ile d is c o u ra g in g th e ir u s e in u n p ro d u c tiv e p u rs u its th a t m ig h t c re a te d a n g e ro u s le v e ls o f e x p o su re to m a r k e t ris k , a s w e ll a s c r e d i t ris k , o r le a d t o r e v e r s e c a p ita l flo w s . T h ese p r u d e n tia l re g u la to ry p ro p o s a ls a re fu n d a m e n ta lly o f tw o ty p e s . T h e f ir s t r e l a te 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 is d e s ig n e d to im p ro v e th e tra n s p a re n c y m a rk e ts . R e p o rtin g - an d re q u ire m e n ts th u s a lso th e m akes p ric in g th e m a rk e t s u rv e illa n c e a u th o ritie s , b e tte r a b le to e ffic ie n c y g o v e rn m e n t, d e te c t a n d - an d o f th e o th e r d e te r fra u d and m a n ip u la tio n . R e g is tra tio n r e q u ir e m e n ts a re e s p e c ia lly u s e fu l in p r e v e n tin g fra u d . T he and second ty p e c o lla te ra l (a ls o of p ru d e n tia l know n re g u la to ry m e a su re s c o n s is ts of c a p ita l a s m a rg in ) r e q u ir e m e n ts . C a p ita l r e q u ir e m e n ts f u n c tio n to p ro v id e b o th a b u ffe r a g a in s t th e v ic is s itu d e s o f th e m a r k e t a n d a g o v e rn o r to o n seek h ig h b a s ic a lly th e th e te n d e n c y re tu rn s a n d sam e o f m a rk e t c o m p e titio n to d riv e p a rtic ip a n ts 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 e ffe c t, a lth o u g h th e y a p p ly to tr a n s a c tio n s an d n o t in s titu tio n s . H e n c e n o n - f in a n c ia l in s titu tio n s th a t w o u ld n o t o th e rw is e b e s u b je c t to c a p ita l r e q u ir e m e n ts w o u ld b e s u b je c t to c o lla te ra l re q u ir e m e n ts o n th e ir d e riv a tiv e tr a n s a c tio n s . M o re o v e r th e c u r r e n t m a r k e t p ra c tic e fo r m a n a g in g c o lla te ra l, in s o fa r as t h e r e is o n e , is 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 if its c r e d it r a tin g d r o p s s u b s ta n tia lly (e s p e c ia lly if it d r o p s b e lo w in v e s tm e n t g ra d e ). T h is re q u ire s a d e riv a tiv e c o u n te r p a r ty to p o s t a s u b s ta n tia l a m o u n t o f a d d itio n a l c o lla te r a l, a n d a m o u n ts to a la rg e d e m a n d f o r f r e s h c a p ita l a t ju s t th e tim e w h e n th e firm is e x p e r i e n c i n g p r o b l e m s w i t h 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 . in a d e q u a te c a p ita l. R a n d a ll D o d d 111 T h e p ro p o s a ls o ffe re d h e r e a re d iv id e d in to tw o g ro u p s . T h e firs t a p p ly to f in a n c ia l in s titu tio n s a n d m a rk e ts in in d u s tria liz e d o r d e v e lo p e d c o u n trie s . D e v e lo p in g c o u n tr ie s f in a n c ia l m a rk e ts a re n o t is o la te d fro m th e ir c o u n te r­ p a rts in th e a d v a n c e d c a p ita l m a rk e ts o f d e v e lo p e d c o u n trie s , a n d th is in te r ­ c o n n e c te d n e s s - e s p e c ia lly t h r o u g h d e r i v a ti v e m a r k e ts - is v e r y i m p o r t a n t . A s o n e s e n io r IM F o f f ic ia l o n c e r e m a r k e d t o n ev er seen one s in in d e v e lo p in g -c o u n try h a v e a s its c o u n t e r p a r ty s o m e o n e f r o m th e a u th o r in p r i v a t e , I h a v e f in a n c ia l m a rk e ts th a t d id n o t N e w Y o r k o r F o n d o n . T h e s e c o n d se t in c lu d e s a ll th e e le m e n ts o f th e firs t p lu s s o m e a d d itio n a l p ro v is io n s fo r f in a n c ia l in s titu tio n s an d m a rk e ts in d e v e lo p e d c o u n trie 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 is t h a t e a c h d e v e l ­ o p in g c o u n t r y c a n a d o p t th e s e p r u d e n t ia l r e g u la tio n s o n its o w n in itia tiv e . A n o t h e r m e r i t is 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 im ila r to o n e s u s e d in in d u s tria liz e d c o u n trie s a n d th e re fo re s h o u ld n o t b e c o n s id e re d o b je c tio n a b le b y t h e IM F o r o th e r a c to r s in t h e in t e r n a t io n a l c a p ita l m a rk e ts . D eveloped countries: registration, reporting, transparency and liquidity Reporting and registration requirements • R e q u ire p a r tic ip a n ts (c o u n te rp a rtie s ) in d e riv a tiv e c o n tr a c ts to re p o r t th e ir tr a n s a c tio n s to th e d e s ig n a te d re g u la to ry a u th o rity . A ll 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 its c le a r in g h o u s e . T h e e x c h a n g e h o u s e c o lle c ts th i s in f o r m a ti o n a n d e ith e r re p o rts it to fo r in th e th e r e g u la to r o r k e e p s th e re c o rd s so th a t th e y can b e c a lle d f u tu re . M o s t o v e r - th e - c o u n te r (O T C ) d e riv a tiv e tr a n s a c tio n s a re tra d e d th ro u g h t h e IS 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 ic h re q u ire s th e c o u n te r p a r tie s to d e riv a tiv e s tr a d e to e x c h a n g e c o n f ir m ­ a tio n m e ssa g e s to e n s u re th a t a ll th e k e y te rm s a re u n d e r s to o d . T h e r e p o rtin g re q u ire m e n t w o u ld e n ta il th e m s e n d in g a c o p y o f th e e m a il m e ss a g e o r fa x to th e re g u la to ry a u th o rity . • R e q u ire d e riv a tiv e d e a le rs to r e p o r t th e ir d e riv a tiv e tr a n s a c tio n s to th e d e s ig n a te d r e g u la to r y a u th o r ity . T h e d a ta s h o u ld in c lu d e p ric e , v o lu m e , open in te re s t, ly in g ite m , a m o u n ts tr a d e d p u t-c a ll v o lu m e an d ra tio s , m a tu r ity , in s tr u m e n t, u n d e r ­ b e tw e e n o th e r d e a le rs and w ith en d -u se rs, a n d c o lla te ra l a rra n g e m e n ts . T h is in f o r m a tio n w o u ld b e c o m p ile d , a n d b e m a d e a v a ila b le to th e o v e ra ll m a rk e t in th e n o n - p r o p r ie ta r y d a ta w o u ld o rd e r to im p ro v e tra n s p a re n c y . O n c e a g g re g a te d , th is d a ta w o u ld re v e a l th e c h a ra c te r o f t h e m a r k e t w h ile p r o te c tin g th e d e ta ils o f d e a le rs m a r k e t p o s itio n s (a s s u m in g th e r e a re s e v e ra l d e a le rs ). D a ta o f a p r o p r ie ta r y n a t u r e w o u ld b e r e ta in e d b y t h e r e g u la to r in o rd e r to d e te c t a n d d e te r fra u d , m a n ip u la tio n a n d p o te n tia l s y ste m ic b re a k s in th e m a rk e ts . 112 • D e riv a tiv e s , C a p ita l F lo w s a n d P ru d e n tia l R e g u la tio n R e q u ire p u b lic ly tra d e d c o rp o ra tio n s to m ake an e x p lic it s ta te m e n t o f th e ir d e riv a tiv e a c tiv itie s . A m e n d th e f in a n c ia l r e p o r tin g ru le s to re q u ire t h a t a ll r e g u la r f in a n c ia l r e p o r tin g s ta te m e n ts in c lu d e th e a c tu a l, u n d e r ­ ly in g e c o n o m ic p ro p e rtie s an d b u s in e s s p u rp o s e s o f m in o r ity in te re s ts , s p e c ia l p u r p o s e e n titie s a n d d e riv a tiv e tra n s a c tio n s . In o rd e r to b r in g o ff-b a la n c e s h e e t a c tiv itie s in to th e s a m e lig h t a s b a la n c e s h e e ts , d e riv a tiv e s w o u ld be re p o rte d by n o tio n a l v a lu e (lo n g and s h o rt), m a tu r ity , in s tr u m e n t a n d c o lla te r a l a r r a n g e m e n ts . T h is w o u ld e n a b le in v e s to rs to d e te rm in e w h e th e r a firm w as u n d e r- o r o v e rh e d g e d , a n d w h e th e r it w as p r im a r ily a c tin g a s a p r o d u c e r o r a w h o le s a le r. • R e g iste r a ll d e riv a tiv e d e a le rs a n d b ro k e rs . I n t h e U n ite d S ta te s , b a n k s , t h r i f t a n d o th e r d e p o s ito r y in s titu ti o n s , s e c u ritie s b r o k e r s , s e c u r itie s d e a le rs , f u tu r e s a n d o p tio n s b r o k e r s a n d in s u r a n c e s a le s ­ p e rs o n s a re r e q u ir e d to re g is te r w ith th e ir r e le v a n t r e g u la to ry a u th o r ity . T h is e s ta b lis h e s a m in im u m c o m p e te n c e checks an d to b u s in e s s d e te c t fra u d o rg a n iz a tio n fo r th e ft th e le v e l fo r th e c o n v ic tio n s in s titu tio n s . fo r E ven in d iv id u a ls , b a c k g ro u n d s a le s p e o p le th o u g h an d p ro p e r o v e r-th e -c o u n te r d e riv a tiv e m a r k e ts a re g e n e ra lly d e a le r m a r k e ts , th e r e g u la tio n s s h o u ld a lso a p p l y t o b r o k e r s . S o m e e le c tr o n i c d e r iv a tiv e tr a d in g p la tf o r m s f u n c t i o n lik e b ro k e rs, a n d u n fo re s e e a b le c h a n g e s in th e m a rk e ts m a y a g a in e le v a te th e ro le o f b ro k e rs . • M o d e rn iz e a c c o u n tin g ru le s an d o th e r f in a n c ia l m a rk e t re g u la tio n s in o r d e r p r o p e r ly to a c c o u n t fo r e m b e d d e d d e riv a tiv e s . A la rg e a n d g r o w in g a m o u n t o f s e c u r itie s a n d lo a n s h a v e d e r iv a tiv e s a t ta c h e d to o r e m b e d d e d in th e m . T h is h a s f u n d a m e n ta lly a lte r e d th e e ffe c tiv e n e s s o f t h e e x is tin g m le s f o r m a k in g c a p ita l c h a r g e s a g a in s t t h e ris k s a s s o c ia te d w ith h o ld i n g o r is s u in g th e s e s e c u ritie s , f o r f in a n c ia l r e p o r ts o n in v e s tm e n ts in th e s e s e c u ritie s a n d even fo r re g u la tio n s th a t m ig h t o th e rw is e p r o h ib it c e rta in fin a n c ia l in s titu tio n s , s u c h as p e n s io n fu n d s o r in s u ra n c e c o m p a n ie s , fro m in v e s tin g in th e s e s e c u ritie s . U p - d a te d ru le s s h o u ld re fle c t th e m a r k e t ris k a s s o c ia te d w ith th e a tta c h e d o r e m b e d d e d d e riv a tiv e a n d n o t m e r e ly th e c r e d it ris k o f t h e p r in c ip a l o f t h e s e c u rity . Liquidity requirements • In o rd e r to a ssu re m a r k e t liq u id ity , re q u ire O T C d e riv a tiv e d e a le rs to a c t as m a rk e t m a k e rs a n d m a in ta in b id /a s k q u o te s th r o u g h o u t th e tra d in g d ay . D e a le rs b e n e fit fro m th e ir p riv ile g e d ro le in th e m a rk e t. In a d d itio n to e a r n in g th e ir b id /a s k s p r e a d , d e a le rs a re a ls o p r iv y to th e m o s t r e c e n t c h a n g e s in th e m a rk e t. A lo n g w ith h e lp in g to m a in ta in th is p riv ile g e s h o u ld c o m e th e r e s p o n s ib ility o f liq u id ity a n d an o rd e rly m a rk e t. U S s to 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 le r s R a n d a ll D o d d o r m a rk e t m a k e rs th ro u g h o u t th e tra d in g d a y . L ik e w is e i n th e O TC 113 cash m a r k e t f o r U S T re a s u ry s e c u ritie s , p r im a r y d e a le r s a r e r e q u ir e d to a c t a s m a r k e t m a k e rs th r o u g h o u t th e tr a d in g d a y . T h o s e m a rk e ts h a v e p r o v e n to b e s o m e o f th e m o s t e ffic ie n t a n d m o s t liq u id in th e w o rld , a n d so th is s u p p o rtin g m a r k e t r u le h a s a lr e a d y p r o v e n its m e r it. Antifraud and antimanipulation authority • S tric tly p r o h ib it fr a u d o n th e m a r k e t an d th e m a n ip u la tio n o f m a rk e t p r ic e s a n d m a k e tr a n s g r e s s io n s s u b je c t to c iv il a n d c r im in a l p e n a ltie s . I n o r d e r to p r o te c t th e in te g r ity o f m a r k e t p ric e s so t h a t th e y w ill e n c o u ra g e th e w id e s t p o s s ib le m a r k e t p a r tic ip a tio n a n d w ill n o t s e n d d is to r tin g s ig n a ls th ro u g h o u t th e e c o n o m y , fra u d an d m a n ip u la tio n s h o u ld be s tric tly p ro ­ e n tity th a t 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 il a n d c r i m i n a l la w . • R e q u ir e r e p o r t s o f la rg e tr a d e r s p o s itio n s . D e riv a tiv e d e a le rs an d exchanges w o u ld have to re p o rt each 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 iz e i n t h e m a r k e t. T h is i n f o r m a t i o n w o u l d b e c o m p ile d a c ro ss m a rk e ts in o r d e r to d e te c t a n d d e te r m a rk e t m a n ip u la tio n . S u c h la r g e tr a d e r r e p o r t in 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 ity F u tu re s T ra d in g C o m m is s io n in te r m s o f m a r k e t s u rv e illa n c e . • E x te n d th e know th y c u s to m e r ru le to a ll f in a n c ia l in s titu tio n s th a t e n g a g e in le n d in g , u n d e rw ritin g , re p u rc h a s e a g re e m e n t tr a n s a c tio n s a n d s e c u ritie s le n d in g tra n s a c tio n s , an d to a ll d e riv a tiv e tr a n s a c tio n s w ith e n titie s in d e v e lo p in g c o u n trie s . T h is p r o v is io n w o u ld d is c o u ra g e f in a n c ia l s h a rp s te rs fro m b l o w i n g u p t h e i r c u s to m e rs . F o r e x a m p le , c e rta in s tr u c tu r e d s e c u ritie s (fo r in s ta n c e p r in c ip a l e x c h a n g e -ra te -lin k e d n o te s , o r P E R L s) s e rv e d n o p o s itiv e p u rp o s e fo r E ast A sia n in v e s to rs a n d w e re p rim a rily a s te a lth v e h ic le fo r f in a n c ia l in s titu tio n s in d e v e lo p e d c o u n trie s to a c q u ire lo n g -d a te d s h o r t p o s itio n s in d e v e lo p in 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 an d a c o m p a ra b le m e a su re to th e d iffe re n c e s b e tw e e n la rg e d e riv a tiv e e x ists e x te n d e d fo r US m a rk e ts , w h e re b a n k in g th e re m a rk e ts . is e v e n m a rk e t p a rtic ip a n ts in It s h o u ld g re a te r c o n c e rn be w ith re sp e c t o f d e g re e of f in a n c ia l s o p h is tic a tio n . D eveloped countries: capital and collateral requirem ents Capital requirements • U p d a te th e c a p ita l r e q u ir e m e n ts fo r a ll fin a n c ia l in s titu tio n s , in c lu d in g d e r iv a tiv e d e a le rs t h a t m i g h t n o t o th e r w is e b e r e g is te r e d a s f in a n c ia l in s ti­ tu tio n s , so th a t th e c a p i t a l is h e l d i n n o t o n ly w ith th e e x p o s u re to e x p o s u r e a n d t h e v a l u e a t ris k . an a m o u n t t h a t is c o m m e n s u r a t e c r e d i t lo s s , b u t a ls o w i t h p o t e n t i a l f u t u r e D e riv a tiv e s , C a p ita l F lo w s a n d P ru d e n tia l R e g u la tio n 114 T h is p r o v i s i o n is 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 oped c o u n trie s , fo r e x a m p le th e U S S e c u ritie s a n d E x c h a n g e C o m m is s io 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 ita l s e rv e s tw o f u n c tio n s : it a c ts a s a b u f f e r w h e n a firm su ffers fro 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 ita l r e q u i r e m e n t is 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 is k e x p o s u r e . C a p i ta l re q u ir e m e n ts a re e s s e n tia l in p r e v e n tin g p ro b le m s a t o n e firm fro m b e c o m in 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 is 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 rk e ts b e c a u s e th e ir fa ilu re c a n le a d to m a r k e t p ro b le m s s u c h a s illiq u id ity (m a rk e t fre e z e -u p ) o r m e ltd o w n . Collateral requirements • R e q u ire a d e q u a te a n d a p p r o p r ia te c o lla te ra l o r m a r g in to b e p o s te 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 lla te ra l (m a rg in ) o n tra n s a c tio n s fu n c tio n s d o e s fo r f in a n c ia l in s titu tio n s . It h e lp s to w ith o n e tra n s a c tio n a c tio n s an d fro m o th e r firm s . o r o th e r c re d it-re la te d in th e sam e w ay as c a p ita l p r e v e n t p r o b le m s a t o n e firm or c a u s in g p e rfo rm a n c e p ro b le m s fo r o th e r tr a n s ­ In d o in g so lo s s e s , a n d it re d u c e s th e it re d u c e s th e lik e lih o o d o f d e fa u lt m a r k e t s v u l n e r a b i l i t y to a fre e z e -u p o r m e ltd o w n . T h e c u r r e n t m a r k e t p ra c tic e s in re s p e c t o f c o lla te ra l a re fa r fro m O ne p a rtic u la rly le v e l, b u t t h e n d a n g e ro u s to re q u ire p ra c tic e a firm to is t o re q u ire becom e a a d e q u a te . s m a ll in itia l c o lla te ra l s u p e r - m a r g i n e d i f it s c re d it r a tin g d r o p s . T h is c a u s e s a la rg e in c r e a s e i n t h e n e e d f o r c o lla te r a l p r e c is e ly w h e n th e firm is 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 ita 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 . D eveloping countries: registration, reporting, transparency and liquidity Additional registration and reporting requirements • R e p o r tin g a n d r e g is tr a tio n r e q u ir e m e n ts f o r d e r iv a tiv e d e a le rs a n d d e r iv a ­ tiv e p a rtic ip a n ts in d e v e lo p in g c o u n trie s s h o u ld b e th e s a m e a s th o s e in d e v e lo p e d c o u n trie s . P re v e n tin g n o fra u d an d le s s i m p o r t a n t i n n e e d to m a in ta in m a in ta in in g d e v e lo p in g re p o rtin g a n d a tra n s p a re n t m a rk e t e n v iro n m e n t are e c o n o m ie s th a n re g is tra tio n in d e v e lo p e d ones. T he r e q u i r e m e n t s is t h e r e f o r e ju 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 is n o t s u b s ta n tia l. T he a b ility s tip u la tin g to th a t e n fo rc e any re p o rtin g d e riv a tiv e re q u ire m e n ts tra n s a c tio n th a t c o u ld w as be n o t enhanced re p o rte d by c o u ld n o t b e p u t b e fo re t h e c o u r t fo r le g a l e n f o r c e a b ility o r a b a n k r u p tc y c la im . R a n d a ll D o d d T h is p ro v is io n w o u ld e n c o u ra g e d e riv a tiv e c o u n te r p a r tie s to 115 c o m p ly w ith r e p o r tin g r e q u ir e m e n ts in o r d e r to p r o te c t th e ir c o n tr a c tu a l in te re s ts . O th e r ­ w is e it w o u ld a m o u n t to g iv in g a c o u n te r p a r ty a n o p ti o n le g a lly to a b r o g a te th e o b lig a tio n s o f th e c o n tra c t. D eveloping countries: capital and collateral requirem ents Capital requirements in addition to those for developed countries listed above • L im it e x p o s u r e to f o re ig n e x c h a n g e ra te s , in te r e s t ra te s a n d o th e r m a r k e t p ric e f lu c tu a tio n s to a p e r c e n ta g e o f c a p ita l. T h e se lim ita tio n s c o u ld b e fig u re d as p e rc e n ta g e o f c a p ita l a n d b e a u g m e n te d b y a n a b s o lu te lim it. T h e li m it a ti o n s h o u ld a p p ly to a c o n s o lid a te d b a la n c e s h e e t a n d o ff-b a la n c e s h e e t m e a s u re o f e x p o s u re . T h e lim its c o u ld b e m a d e tig h te r fo r h ig h e r d e g re e s o f e x c h a n g e ra te m a n a g e m e n t. E x a m p le s o f p o s itio n o r e x p o su re lim its a lre a d y e x ist o n US d e riv a tiv e e x c h a n g e s . T h e s e r e s tr ic tio n s a m o u n t to e x p lic it lim ita tio n s o n ris k ta k in 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 tiv e i n l i m i t i n g t h e a m o u n t o f c a rry exchange tra d e ra te or h o t m o n e y re la te d e x p o su re an d m e a s u r e d is e n c o u r a g e s le v e r a g e d a n d e n c o u ra g e s; lo n g - te r m • tr a n s a c tio n s s o m e tim e s b ecau se in te re s t ra te e x p o su re to th e y e x p o su re . d e v a lu a tio n re s u lt in H ence th e o r d e p re c ia tio n , o r m o re d iv e rs ifie d in v e s tm e n t. L im it t h e m i s m a tc h in g o f m a tu r it y o n a s s e ts a n d lia b ilitie s . A n o th e r so u rc e o f f in a n c ia l v u ln e ra b ility th a t c a n p la g u e d e v e lo p in g c o u n ­ trie s m o r e t h a n w ith t h e i r w e a l t h i e r d e v e lo p e d n e i g h b o u r s is t h e r is k a s s o c ia te d m is m a tc h in g th e m a tu rity a n in te r e s t r a te ris k f r o m o f a s s e ts a n d lia b ilitie s . N o t o n ly b u t t h e r e is 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 ro ll-o v e r o r re n e w is t h e r e c h a n g e s in th e le v e l a n d s lo p e o f t h e y ie ld c u rv e , n o t b e in g a b le to lo a n s . Collateral requirements • T h e c o lla te ra l r e q u ir e m e n ts fo r d e riv a tiv e d e a le rs an d o th e r d e riv a tiv e p a r tic ip a n ts in d e v e lo p in g c o u n tr ie s s h o u ld b e th e s a m e a s th o s e in d e v e l­ o p e d c o u n trie s . C o ll a te r a l r e q u i r e m e n t s a r e n o le s s i m p o r t a n t f o r f i n a n c ia l m a r k e ts i n d e v e l­ o p in g e c o n o m ie s th a n fo r th o s e in le v e l o f c o lla te ra l s h o u ld b e fo u n d a tio n fo r d e v e lo p e d e c o n o m ie s . T h e a p p ro p ria te s u ffic ie n tly h ig h to m a rk e t tra n s a c tio n s , b u t n o t so p ro v id e h ig h a safe a n d th a t th e use sound o f ris k m a n a g e m e n t to o ls w o u ld b e d is c o u r a g e d b y th e ir la c k o f a ffo rd a b ility . D e v e lo p in g c o u n trie s h a v e a d d itio n a l re a s o n s to m a in ta in e v e n s tro n g e r c o lla te ra l re q u ir e m e n ts . T h e y n e e d to e s ta b lis h a r e p u ta tio n fo r m a r k e t s a fe ty and s o u n d n e ss. B ecau se th e y te n d to su ffer m o re th a n w e a lth y c o u n trie s w h e n f in a n c ia l s e c to r d is r u p tio n s o c c u r, th e y re q u ire a g re a te r b u ffe r a g a in s t 116 D e riv a tiv e s , C a p ita l F lo w s a n d P ru d e n tia l R e g u la tio n such d is ru p tio n s . In a d d itio n , b y ra isin g th e c o s t o f ris k ta k in g , r e la tiv e ly h ig h e r c o lla te r a l r e q u ir e m e n ts w ill s e rv e to d is c o u r a g e e x c e s s iv e ris k ta k in g . T h e a b o v e p r u d e n tia l re g u la tio n s s h o u ld a p p ly to d e v e lo p e d a n d d e v e lo p in g c o u n tr ie s a lik e a n d th e r e s p o n s ib ility o f m a k in g t h e c h a n g e s h o u ld b e s h a r e d . B u rd e n s h a r in g w o u ld a p p ly n o t ju s t to d e b t fo rg iv e n e s s o r d e b t w o rk -o u ts , b u t a lso to th e s h a rin g o f ris k s . T h is fo llo w s fro m th e b a s ic in s ig h t th a t d e v e lo p e d c o u n trie s h a v e h a d m o re y e a rs o f e x p e rie n c e in re g u la tin g th e ir f in a n c ia l m a rk e ts , a n d th e b e n e fic ia l w is d o m o f th is e x p e rie n c e s h o u ld b e sh a re d . It w o u ld n o t b e a o n e -w a y p ro c e ss b e c a u se a m irro r c o u ld b e h e ld u p to d e v e lo p e d c o u n tr ie s if th e y p u s h e d f o r c h a n g e s i n d e v e lo p in g c o u n trie s t h a t w e r e in c o n s i s t e n t w ith w h a t w a s a c tu a lly p r a c tis e d a t h o m e . A fte r a ll th e U S f in a n c ia l m a rk e ts - w ith th e e x c e p tio n o f O T C d e riv a tiv e m a rk e ts a r e c lo s e ly r e g u la te d an d so th e W a s h i n g t o n C o n s e n s u s fo r a lib e ra liz e d , fre e -m a rk e t a p p r o a c h to d e v e lo p in g c o u n trie s f in a n c ia l m a rk e ts a m o u n ts to 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 re g u la tio n s w o u ld h o ld b o t h s id e s a c c o u n ta b le in th e ir o w n w a y . N otes 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 th at 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 n ot generally require the transfer of title or principal. Examples of derivatives are futures, options, forwards, swaps and the derivative com ponent 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 m atching 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 instm m ents th at 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 denom inate 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 117 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 M onitor (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 w hen the dealer purchases pesos in settlem ent 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 N orth-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 TheDeath of the B anker- TheD ecline and F of the G F all reat inancial Dynasties and the Trium of the Sm Investor, New York: Vintage Books. ph all Dalla, I. and D. Khatkate (1996) The Emerging East Asian Bond Market, F inance D evelopm March, Washington, DC: IMF/World Bank. ent, Chernow, R. (1997) Dodd, R. (2002) The Role of Derivatives in the East Asian Financial Crisis, in L. Taylor and J. Eatwell (eds), International Capital M arkets: System in Transition, Oxford: s 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, N E W B R orking Paper no. 6623 (June), Cambridge, MA: NBER. and S. Lall (1996) ‘Derivative Products in Exchange Rate Crises, in R. Glick (ed.), M anaging 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) O ver-The-Counter Derivatives: Docum entation, New York: Bowne. Lall, S. (1997) Speculative Attacks, Forward Market Intervention and the Classic Bear Squeeze, IM W F orkingPaper, June, Washington, DC: IMF. Lowell, B. and D. Farrell (1996) M arket U nbound - U nleashing G lobal Capitalism , New York: John Wiley and Sons. 118 D e riv a tiv e s , C a p ita l F lo w s a n d P ru d e n tia l R e g u la tio n Neftci, S. N. (1998) FX Short Positions, Balance Sheets and Financial Turbulence: An Interpretation of the Asian Financial Crisis, C P W E A orking Paper no. 11, New York: CEPA, October. Partnoy, F. (1999) F .S.C .: The Inside Story of a W Street T .I.A .O all rader, New York: Penguin. Spraus, Paul (ed.) (1999) Swaps M onitor, www.swapsmonitor.com. World Bank (2000) G lobal Developm F ent inance, Washington, DC: World Bank. (2001) W Developm Report 2000/2001, Oxford: Oxford University Press. orld ent 7 Ratings since the Asian Crisis* H e lm u t Reisen I n tr o d u c tio n I n te r m s o f fo re ig n f in a n c e , th e s in g le m o s t im p o r ta n t v is ito r to a d e v e lo p in g c o u n tr y in th e 1 9 6 0 s w a s a re p re s e n ta tiv e fro m 1 9 7 0 s it w a s a c o m m e rc ia l b a n k e r e a g e r to th e 1 9 8 0 s i t w a s a n IM F o ffic ia l. S in c e t h e n a W e s te rn a id a g e n c y ; in th e re c y c le O P E C s u rp lu s e s ; a n d in it h a s b e e n a s o v e re ig n a n a ly 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 itc h . T h e ris e i n p r iv a te c a p ita l flo w s a n d t h e s t a g n a tio n o f c o n c e s s i o n a l f i n a n ­ c ia l a s s is ta n c e h a s s ig n ific a n tly in c re a s e d th e in f lu e n c e o f c r e d it ra tin g s o n th e te rm s (a n d m a g n itu d e ) o n w h ic h d e v e lo p in g c o u n trie s c a n ta p w o rld b o n d m a r k e ts . S in c e b o n d m a r k e ts a r e e f f e c tiv e ly u n r e g u la te d , c r e d it r a tin g a g e n c ie s have becom e th e de facto m a rk e ts re g u la to rs . In d e e d , u n lik e in 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 is 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 re ig n ra tin g s a re v ita l to d e v e lo p in g c o u n trie s as th e ir a c c e ss to c a p ita l m a r k e t s is 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 in g S u p e rv is io n fo r a n e w B asel C a p ita l A c c o rd m a y m e a n e v e n g re a te r im p o r ta n c e fo r c r e d it r a tin g s i n t h e f u tu r e (R e ise n , 2 0 0 0 , 2 0 0 1 ). T h e in c r e a s e d im p o r ta n c e o f r a tin g a g e n c ie s fo r e m e r g in g - m a r k e t f in a n c e h a s b r o u g h t th e ir w o rk to th e a tte n tio n o f a w id e r g ro u p o f o b s e rv e rs - a n d s u b je c te d th e m ra tin g th a n t o c ritic is m . T h e M e x ic a n c risis o f 1 9 9 4 - 9 5 r e v e a le d t h a t c r e d it a g e n c ie s , lik e a lm o s t e v e r y b o d y e lse , w e r e r e a c tin g t o a n tic ip a tin g th e m , a n b e fo re a n d o b s e rv a tio n d u r in g th e A s ia n c ris is (R e ise n a n d v o n a g e n c ie s w e re a c c u s e d (fo r e x a m p le b y t h e IM F i n o u td a te d ra tin g m o d e ls an d o f ig n o rin g e v e n ts ra th e r re in fo rc e d b y ra tin g p e rfo rm a n c e s M a ltz a n , 1 9 9 9 ). R a tin g 1 9 9 9 ) o f b e in g g u id e d b y l i q u id it y ris k s a n d cu rren c y c risis v u ln e ra b ilitie s . T h e y e v e n a c k n o w le d g e d th is th e m s e lv e s ( H u h n e , 1 9 9 8 ). T h is c h a p te r a sse sse s w h e th e r th e im p o rta n c e o f ra tin g s fo r d e v e lo p in g - c o u n tr y f in a n c e h a s c h a n g e d a n d w h e th e r r a tin g a g e n c ie s h a v e c h a n g e d th e d e te r m in a n ts o f th e ir r a tin g d e c is io n s . It a ls o p ro v id e s a n a n a ly s is o f r e c e n t s u g g e s tio n s b y th e B asel C o m m itte e o n 119 B a n k in g S u p e rv is io n , a s th e s e are R a tin g s since the A s ia n C risis 120 v e ry im p o r ta n t fo r g a u g in g th e d e b t fin a n c e in fu tu r e ro le o f s o v e re ig n r a tin g s fo r fo re ig n d e v e lo p in g c o u n trie s . It th e n lo o k s a t r a t in g d e te r m in a n ts b e fo re a n d a fte r t h e A s ia n c risis to s e e w h a t h a s c h a n g e d a n d w h e th e r r a tin g m o d e ls have lite ra tu re o n m oved to w a rd s id e n tific a tio n c risis v u ln e r a b ility , b e fo re o f th e fa c to rs c o n s id e rin g th e s tre s s e d in th e m a rk e t im p a c t o f r a t in g e v e n ts , lo o k in g a g a in a t c h a n g e s a f te r th e o u tb r e a k o f th e A s ia n c risis. It t h e n e v a lu a te s w h e th e r r e c e n t re g u la to r y e n d e a v o u rs to s tr e n g th e n th e ro le o f s o v e re ig n r a tin g s in s e ttin g b a n k s c a p ita l r e q u ir e m e n ts c a n b e ju s tifie d in l i g h t o f t h e i r r o le i n b o o m - b u s t c y c le s i n d e v e lo p in g -c o u n try le n d in g . T h e c h a p te r e n d s w ith s o m e p o lic y p ro p o s a ls . S o v e r e ig n r a tin g d e te r m in a n ts : w h a t h a s c h a n g e d ? O n e o f t h e s tr ik i n g f e a tu r e s o f t h e A s ia n c ris is w a s t h e s o - c a lle d r a t i n g c risis ( J iittn e r a n d M c C a rth y , 2 0 0 0 ), in w h ic h th e r a tin g s o f th e a ffe c te d c o u n trie 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 th r e e le tte r g ra d e s a n d n in e ra tin g n o tc h e s ; s o v e re ig n r a tin g c h a n g e s o f th a t m a g n itu d e h a d n e v e r b e e n o b s e rv e d b e fo re , a n d th e y h a d o b se rv e d in th e etal., (B o n te lo n g h is to ry o f ra tin g tra n s itio n s ra re ly b e e n fo r U S c o rp o ra te 1 9 9 9 ). T h e r a tin g in s ta b ility re fle c te d m o r e t h a n bonds c h a n g e s in 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 in a n ts u n d e r ly in g s o v e re ig n ra tin g s fo r e m e rg in g m a rk e ts . S o v e re ig n ris k re fle c ts t h e a b ility a n d w illin g n e s s o f a g o v e r n m e n t is s u e r to m e e t its f u tu r e d e b t o b lig a tio n s . I n th e a b s e n c e o f b in d i n g in t e r n a t io n a l b a n k ru p tc y le g is la tio n , c re d ito rs have o n ly lim ite d le g a l re d re ss a g a in s t s o v e re ig n b o rro w e rs , w h o m a y a lso d e fa u lt fo r p o litic a l re a s o n s . B o th q u a li­ ta tiv e an d q u a n tita tiv e fa c to rs are e x a m in e d to fo rm a v ie w of o v e ra ll c re d itw o rth in e s s . M e a s u re s o f e c o n o m ic a n d fin a n c ia l p e rfo rm a n c e a re u s e d in th e q u a n tita tiv e a s s e s s m e n t w h ile p o litic a l d e v e lo p m e n ts , e s p e c ia lly th o s e w h ic h b e a r o n fis c a l fle x ib ility , f o r m th e c o re o f th e q u a lita tiv e e v a lu a tio n . W h ile r a tin g a g e n c ie s p e rio d ic a lly u p d a te th e lis t o f th e n u m e r o u s e c o n o m ic , s o c ia l a n d p o litic a l f a c to r s t h a t u n d e r lie th e ir s o v e r e ig n c r e d it r a tin g s , s o m e o f th 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 is 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 ti v e w e ig h ts . T he locus classicus f o r q u a n tita tiv e e v id e n c e o n s o v e re ig n ra tin g d e te r m in ­ a n t s is 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 te m b e r w e ig h e d 1 9 9 5 ), m ost th e h e a v ily a u th o rs in th e e s tim a te d w h ic h d e te rm in a tio n q u a n tita tiv e o f s o v e re ig n ris k in d ic a to rs ra tin g s by 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 ro w th (+ ), consum er p ric e in fla tio n (-), fo re ig n debt as a p e r c e n ta g e o f e x p o r ts ( - ) , a d u m m y fo r le v e l o f e c o n o m ic d e v e lo p m e n t (+ ) and a dum m y fo r d e fa u lt h is to ry (-) w ere g e n e ra lly s ig n ific a n t a n d had t h e e x p e c te d s ig n , w h ile fis c a l b a l a n c e ( + ) a n d e x te r n a l b a l a n c e ( + ) w e r e n o t s ig n ific a n t in th e a u th o r s m u ltip le re g re s s io n e s tim a te s . T h e a d ju s te d R 2 w a s H e lm u t R eisen above 0 .9 0 fo r a v e ra g e ra tin g s . T h e re s u lts ra tin g s c o n firm a s w e l l a s M o o d y s th a t to a la r g e an d S ta n d a rd e x te n t s o v e re ig n 121 P o o r s ra tin g s w ere e x p la in e d b y a lim ite d n u m b e r o f k e y m a c r o e c o n o m ic v a ria b le s b e fo re th e A s ia n c risis. S o m e o f th e an d To ra tin g d e te r m in a n ts id e n tifie d fis c a l b a la n c e s , a r e t o ig n o re th e a c e rta in e n d o g e n e ity a p ro c y c lic a l e le m e n t in to of such th e above, such as G D P g ro w th d e g re e e n d o g e n o u s to c a p ita l in flo w s . ra tin g ra tin g d e te rm in a n ts p ro cess a n d ris k s in tro d u c in g in te n s ify in g b o o m - b u s t c y c le s i n e m e r g in 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 il d - u p o f u n s u s ­ ta in a b le in flo w s w ith im p r o v e d s o v e re ig n ra tin g s . F u r th e r m o r e th e r e s e e m s li 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 flo w s : t h e d e b t c y c le h y p o t h e s i s r e q u i r e s in f lo w s to b e in v e s te d in tra d e -re la te d a re a s a n d m a r g in a l s a v in g s ra te s to e x c e e d th e a v e ra g e s a v in g s r a te u p o n r e c e ip t o f c a p ita l in f lo w s (F fre n c h -D a v is a n d R e ise n , 1 9 9 8 ). D u rin g th e an d 1 9 9 0 s th e P acker h a d little in p re c risis r a tin g d e te r m in a n ts id e n tifie d b y co m m o n C a n to r w ith th e d o m e s tic ro o ts o f th e f in a n c ia l c rise s ( b a n k in g , c u r r e n c y a n d d e b t) in d e v e lo p in g c o u n tr ie s (s e e f o r e x a m p le R e ise n , 1 9 9 8 ; G o ld s te in , 1 9 9 9 ): w e a k n a t io n a l b a n k in g a n d f in a n c ia l s y s te m s , p re m a tu re an d p o o rly s u p e rv is e d f in a n c ia l lib e ra liz a tio n , p o o r p u b lic and p riv a te d e b t m a n a g e m e n t, w ith in a d e q u a te liq u id ity d e fe n c e s a g a in s t sh o c k s, a n d v u ln e ra b le e x c h a n g e ra te re g im e s . In o th e r w o rd s it se e m s th a t s o v e re ig n ra tin g s in th e p e r io d le a d in g u p to th e A s ia n c risis w e re d r iv e n b y a n o u t­ d a te d r a tin g m o d e l. T a b le 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 te rio ra te d in th is p e rio d , p a rtic u la rly in 1998 (o n e y e a r a fte r th e c risis b r o k e o u t), w ith th e a d ju s te d R 2 d r o p p in g f r o m A s ia n o v e r 0 .9 0 to 0 .8 6 fo 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 to a s tr u c tu r a l b re a k ( J iittn e r a n d M c C a rth y , 2 0 0 0 ), b u t th e a d d itio n o f new ra tin g d e te r m in a n ts h a s h e lp e d to im p ro v e th e e x p la n a to ry p o w e r. In a d d itio n to th e e ig h t d e te r m in a n ts u s e d in th e C a n to r-P a c k e r m o d e l, J iittn e r an d M c C a rth y h a v e a d d e d fiv e r a t i n g d e t e r m i n a n ts f r o m th e lite ra tu re o n c risis v u ln e r a b ility : Table 7.1 Explanatory power of the conventional determinants of sovereign ratings, 1995-98 (adjusted R2 of Cantor-Packer model) A verage rating 1995 1996 1997 1998 Sources : M oodys rating Standard P rating oors 0.924 0.902 0.913 0.856 0.905 0.884 0.909 0.863 0.926 0.902 0.893 0.834 C a n t o r a n d P a c k e r ( 1 9 9 6 ) ; J i it t n e r a n d M c C a r t h y ( 2 0 0 0 ) . R atin g s since th e A s ia n C risis 122 • vis-à-vis t h e S h o rt-te rm in te r e s t ra te d iffe re n tia ls U S as a p ro x y o f c u rre n c y ris k . • A ra n g e (1 -5 ) o f p ro b le m a tic a s s e ts as a p e rc e n ta g e of G D P (S ta n d a rd 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 tim a te d c o n tin g e n t lia b ility o f th e f in a n c ia l s e c to r as a p e rc e n ta g e • T he o f GDP. ro llin g , fo u r-y e a r g ro w th ra te o f c re d it to th e p riv a te s e c to r as a p e rc e n ta g e o f G D P . • T h e p e rc e n ta g e d e v ia tio n o f th e re a l e x c h a n g e ra te f ro m th e 1 9 9 0 s a v e ra g e s. F o r e m e rg in g m a rk e ts , J iittn e r a n d M c C a rth y u s e a v a ria b le -s e le c tio n p r o ­ c e ss to id e n tif y w h ic h o f th e tw e lv e v a ria b le s h a v e th e h ig h e s t e x p la n a to r y p o w e r fo r s o v e re ig n ra tin g s . F o r m id 1 9 9 8 , c o n s u m e r p ric e in fla tio n (-), e x te rn a l d e b t as a p e rc e n ta g e o f e x p o rts ( - ) , a d u m m y d e fa u lt h is to r y ( - ) , an d tw o o f th e new v a ria b le s - th e in te re s t ra te d iffe re n tia l a n d th e real e x c h a n g e ra te - e n te r s ig n ific a n tly in to th e re g re s s io n a s r a tin g d e te r m in a n ts , w ith a n a d ju s te d R 2 o f 9 1 .2 p e r c e n t. N e ith e r t h e in te r e s t r a te d if f e re n tia l n o r th e e x c h a n g e ra te v a ria b le w e re s ig n ific a n t d e te r m in a n ts o f th e m id ra tin g s in 1 9 9 7 , in d ic a tin g th a t th e s e v a ria b le s w e re o v e rlo o k e d b y th e a g e n c ie s b e f o r e th e c risis. M o r e o v e r th e f in a n c ia l- s e c to r v a r ia b le s w e r e n o t r e f le c te d in th e ra tin g b e tw e e n th e w ere d iffe re n tia ls s till n o t e m p h a s iz e d p lu n g e d . J iittn e r m odel or in 1997 or 1 9 9 8 . T h is in d ic a te s s tr e n g th /f r a g ility o f th e f in a n c ia l s e c to rs in an d fra m e w o rk in ra tin g M c C a rth y fo r d e c is io n s ( ib id .: ju d g e m e n t 22) a year c o n c lu d e w h ic h is t h a t d iffe re n c e s e m e rg in g m a rk e ts a fte r th e th a t th e re c a p a b le of T hai b ah t is n o e x p la in in g set th 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 im p re s s io n th a t - d e s p ite th e le s s o n s fro m re la tin g to fin a n c ia l-s e c to r s tre n g th do n o t th e A s ia n c risis - v a ria b le s seem to fig u re la rg e ly in th 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 is 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 is g e n e r a l l y c o n s i d e r e d t o su ffer fro m a w e a k d o m e s tic b a n k in g s e c to r, m o v e d u p to th e in v e s tm 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 is 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 its d o m e s tic f in a n c ia l s e c to r, h a s y e a rs . T h e a g e n c ie s ju s tifie d su ffe re d sev eral d o w n g ra d e s in rece n t th e s e d iv e rg e n t r a tin g tr e n d s b y e m p h a s iz in g r a t h e r c o n v e n tio n a l in d i c a t o r s s u c h a s fis c a l f le x ib ility a n d e x t e r n a l s o lv e n c y (G ra n d e s, 2 0 0 1 ). T h e firs t e d itio n o f th e q u a n tita tiv e Moodys Country Credit Statistical Handbook ( 2 0 0 1 a ) m e a su re s in c lu d e d in its s o v e re ig n ra tin g lis ts d e c is io n s . T h e a g e n c y a c k n o w le d g e s th a t T he re le v a n c e of s p e c ific e c o n o m ic an d f in a n c ia l v a ria b le s a c c o r d in g to th e b r o a d le v e l o f d e v e lo p m e n t o f c o u n t r ie s can v a ry F o r e x a m p le , 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 is 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 trie s , w h ile a la rg e r r a n g e o f in d ic a to rs in th e e x te rn a l debt and H e lm u t R eisen b a la n c e -o f-p a y m e n ts a re a s is p ro v id e d fo r th e d e v e lo p in g 123 [e m e rg in g - m a r k e t] c o u n t r ie s ( ib id .: 3 ). T h e q u a n t ita tiv e in d ic a to r s fa ll in t o f o u r b r o a d c a te g o rie s : • E c o n o m ic s tru c tu re a n d p e rfo rm a n c e : in c lu d e s v a rio u s m e a s u re 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 th e s e G D P g ro w th (+ ) a n d e x p o rt g ro w th (+ ) in th e h a n d b o o k . • F is c a l in d ic a to rs : b a la n c e , to p rim a ry M o o d y s , T h e g e n e ra l g o v e rn m e n t b a la n c e an d fis c a l b a la n c e s o f g o v e rn m e n t are a m o n g s o v e re ig n fro m ris k th e a n a ly s ts . T h e th e p o p u la tio n re v e n u e , e x p e n d itu re , d e b t as a p e rc e n ta g e an d debt s to c k s o f th e v a rio u s m o s t im p o r ta n t in d ic a to rs a b ility o f g o v e rn m e n t to o f ta x p a y e rs a n d fin a n c ia l o f G D P . A c c o rd in g le v e ls e x a m in e d by e x tra c t re v e n u e s u s e r s o f s e rv ic e s , t h e e l a s tic ity o f r e v e n u e w ith re s p e c t to th e g r o w th o r d e c lin e o f n a tio n a l in c o m e , a n d th e rig id ity o f th e c o m p o s itio n th a t d e te rm in e o f g o v e r n m e n t e x p e n d itu r e s a re k e y fa c to rs w h e th e r c e n tra l a n d lo c a l g o v e r n m e n ts w ill b e a b le to m a k e fu ll a n d tim e ly p a y m e n ts o f in te r e s t a n d p rin c ip a l o n o u ts ta n d in g d e b t ( ib id .: 6 ). • E x te rn a l p a y m e n ts a n d d e b t: m e a s u r e s fo r th e r e a l e ffe c tiv e e x c h a n g e ra te ( p e r c e n ta g e c h a n g e ) , re la tiv e u n i t la b o u r c o s ts ( p e r c e n ta g e c h a n g e ) , c u r r e n t a c c o u n t b a la n c e (U S d o lla rs a n d p e rc e n ta g e o f G D P ), f o re ig n cu rren c y d e b t (U S d o lla 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 rv ic e r a tio (p e rc e n ta g e o f e x p o rts). N o te w o rth y h e re 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 in d ic a to r c a te g o ry of in s o v e re ig n ris k d e v e lo p e d c re d ib ility , a n d deep a n a ly s is ...b u t c o u n trie s w ith th a t...is lo w n o t in fla tio n , a is M o o d y s th e c e n tra l m e a n in g fu l h ig h m o n e ta ry c a p ita l m a r k e ts a n d / o r u n iv e r s a l b a n k s t h a t a llo w g o v e r n m e n ts a n d c o r p o r a tio n s to b o r r o w lo n g te r m a t fix e d r a te s in 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 is 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 tr ie s th a t a re e ffe c tiv e ly o p e r a tin g w ith o u t a d o m e s tic c u rre n c y , th e b o rd e rlin e b e tw e e n d o m e s tic a n d fo re ig n d e b t b e c o m e s q u ite fu z z y ( ib id .: 8 ). • M o n e ta ry (p er an d c e n t), liq u id ity d o m e s tic M 2 /fo re ig n exchange s h o rt-te rm e x te rn a l d e b t/fo re ig n in d ic a to rs : c re d it re se rv e s, debt in c lu d e (p e rc e n ta g e an d fo re ig n exchange c u rre n tly e x c h a n g e re se rv e s, a n d s h o rt-te rm c h a n g e ), in te re s t d o m e s tic re serv es m a tu rin g a liq u id ity ra tio ra te s c re d it/G D P , (U S lo n g -te rm d o lla rs ), e x te rn a l ( e x te r n a l lia b ilitie 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 arm a b o u t th e im p o r ta n c e o f th e s e in d ic a to rs as it p re s e n ts th 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 ( ib id .: 9 ). I t r e f e r s t o e c o n o m e tr i c m o d e ls a s o n l y p a r t ia l ly s u c c e s s f u l, w i t h th e b e s t o f th e m o d e ls b e in g a b le to a c c o u n t fo r o n ly s o m e o f th e a c tu a l c r is e s t h a t o c c u r r e d a n d p r e d i c ti n g t o o m a n y t h a t d id n o t ( ib id .: 1 0 ). 124 R a tin g s since th e A s ia n C risis I t is f a ir t o arg u e th a t th e se t o f in d ic a to rs e m p h a s iz e d b y M o o d y s b e t t e r p r e p a r e s it to g iv e a d v a n c e w a r n in g o f f ir s t- g e n e r a tio n c u r r e n c y c ris e s (w h e r e d o m e s tic m a c ro fu n d a m e n ta ls trig g e r a f in a n c ia l c risis) th a n of second- g e n e ra tio n (w h e re in c o n s is te n c ie s b e tw e e n e x te r n a l a n d in te r n a l im b a la n c e s m a tte r) o r th ir d - g e n e r a tio n w e a k n e s s e s p la y seem s to c ris e s , in w h ic h illiq u id ity a n d a c e n tr a l ro le . S ta n d a r d p u t m o re w e ig h t o n fin a n c ia l-s e c to r P o o r (fo r e x a m p le liq u id ity a n d S P, 2 0 0 1 ) fin a n c ia l-s e c to r v a ria b le s in its a s s e s s m e n ts ; i t e x p l ic itly lis ts t h e i m p o r ta n c e o f b a n k s a s c o n t i n g e n t lia b i­ litie s in s o v e r e ig n r a tin g s i n its r a tin g s - m e th o d o lo g y p r o f ile . T h e d if f e re n c e in e m p h a s is M o o d y s h a s o b serv ed a h e re c o m p a ra tiv e - w h ic h can a d v a n ta g e in o n ly be casu al - d e te c tin g s u g g e s ts th a t c risis v u ln e r a b ility in 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 is 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 le m s . T h is is s u p p o r t e d ( F i g u r e s 7 .1 a n d by th e r e c e n t c rise s in T u rk e y a n d A rg e n tin a 7 .2 ). I n F e b ru a ry 2 0 0 1 a n o t h e r e x c h a n g e - r a te - b a s e d s ta b iliz a tio n s c h e m e fa ile d in T u rk e y w h e n th e lira p lu n g e d b y m o re t h a n 3 0 p e r c e n t. A w e a k b a n k in g s y ste m , in h o t a c u te m oney c risis s in c e la te N o v e m b e r 2 0 0 0 , a n d in flo w s h ad m ade (O E C D , 2 0 0 1 ). T h e c risis w a s e x p e rie n c e d S o u th e rn F 7.1 igure in th e th e c o u n try a v a rie ty C one o f th e o f L a tin an v u ln e ra b le o v e rre lia n c e to n o w -c la s s ic A m e ric a f in a n c ia l t a b l i t a f a ilu r e tw e n ty Turkeys exchange rate and sovereign ratings, 1990-2001 on c risis y e a rs e a rlie r. H e lm u t R eisen F 7.2 igure 125 Argentinas sovereign spreads and ratings, 1990-2001 * E m e r g in g M a rk e ts B o n d I n d e x (A rg e n tin a ) A s se e n in 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 ith b o a rd re g a rd to fa ile d to ris k . T h e r e A rg e n tin a , fro m w ere c u rre n c y b o a rd th re e h ad o n w a rd s . T h is h a d m a jo r c a u se s ceased to re c e ip ts an d in o f th is d e v a lu a tio n (B ra g a etal., an d tu rn s o v e re ig n 2 0 0 1 ) . F irs t, t h e c o n f e r s u f f ic ie n t fis c a l d is c i p lin e se t in m o tio n d e p re s s e d g ro w th , w h ic h in lo w e r ta x 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 d e liv e r a s u s ta in e d r e d u c tio n fro m 1995 a v ic io u s c irc le o f r is in g c o u n t r y ris k a n d h a d w o rse n e d th e h ig h e r d e b t s e rv ic e p u b lic d e fic it th r o u g h c o s ts . S e c o n d , in itia l in fla tio n in e r tia , w a g e r ig id ity a n d a n in a p p r o p r ia te a n c h o r c u r r e n c y im p lie d e ffe c tiv e o v e rv a lu a tio n o f th e p e s o . B u s in e s s c y c le s i n th e U n ite d S ta te s ( to w h ic 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 ad c o m p e titiv e n e s s . T h ird , h ig h liq u id ity 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 s tro n g ly w eakened A r g e n t i n a s (to m a k e u p f o r t h e la c k o f t h e le n d e r-o f-la s t r e s o rt f u n c tio n in a c u r r e n c y b o a rd ). J u s t lik e a n y re s e rv e r e q u ir e m e n t, h ig h liq u id ity n e e d s h a d w e d g e b e tw e e n s a v in g an d le n d in g ra te s a n d d r iv e n a s ig n ific a n t ra te s , d is c o u ra g in g b o th in v e s tm e n t. T h is a g a in , b y c o n s tr a in in g g r o w th a n d fo r fo re ig n s a v in g s , h a d le d to a g ra d u a l d e te rio ra tio n d y n a m ic s . A g a in , r a t in g a g e n c ie s w e r e f a ir ly la te t o s a v in g s fu e llin g th e need o f A r g e n t i n a s d e b t g iv e w a r n in g o f d e te r i­ o r a tin g fu n d a m e n ta ls , b u t th e y a rg u a b ly p e rfo rm e d b e tte r th a n th e y d id in R a tin g s since th e A s ia n C risis 126 th e c a se o f T u rk e y a s th e y d o w n g r a d e d A rg e n tin a b e fo re th e b o n d c ra s h (th e p e s o r e m a in e d fix e d ) in 2 0 0 1 ( F ig u r e 7 .2 ) . T h e m a r k e t im p a c t o f s o v e r e ig n r a tin g s 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 is i m p o r t a n t t o e x p l o r e th e m a rk e t im p a c t o f s o v e re ig n r a tin g e v e n ts b e c a u s e ra tin g s m a y h a v e a n im p a c t o n b o o m - b u s t c y c le s in le n d in g t o d e v e lo p in g c o u n t r ie s . I n p r in c ip le , s o v e re ig n m a rk et ra tin g s c o u ld h e lp D u rin g le n d in g . th e to a tte n u a te boom , e a rly b o o m - b u s t c y c le s ra tin g in d o w n g rad e s d a m p e n e u p h o ric e x p e c ta tio n s a n d re d u c e p riv a te s h o rt-te rm w h ic h h a v e re p e a te d ly fu e lle d c re d it b o o m s a n d e m e rg in g - w o u ld h e lp c a p ita l flo w s , f in a n c ia l v u ln e ra b ility in c a p ita l-im p o rtin g c o u n trie s . If s o v e re ig n ra tin g s h a d n o m a rk e t im p a c t th e y w o u ld 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 le s . W o rs e , if t h e y la g g e d b e h i n d r a th e r th a n le d fin a n c ia l m a rk e ts a n d h a d a m a r k e t im p a c t, im p r o v e d ra tin g s w o u ld re in f o rc e e u p h o r ic e x p e c ta tio n s a n d s tim u la te e x c e s s iv e c a p ita l in flo w s d u r in g th e b o o m . D u rin g th e b u s t, d o w n g r a d in g m ig h t a d d to p a n ic a m o n g in v e s to rs , y ie ld d riv in g m on ey o u t s p re a d s. F o r e x a m p le of th e th e c o u n try an d fo rc in g d o w n g r a d in g o f A s ia n u p s o v e re ig n s o v e re ig n ra tin g s to 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 ld n o lo n g e r is s u e in t e r n a t io n a l le tte r s o f c r e d it fo r lo c a l e x p o r te r s a n d im p o rte rs ; in s titu tio n a l in v e s to rs re q u ire d to m a in ta in p o rtfo lio s h ad to o n ly in o fflo a d A s ia n a s s e ts a s th e y in v e s tm e n t-g ra d e s e c u ritie s ; w ere and f o r e ig n c r e d ito r s w e r e e n t itl e d to c a ll in lo a n s u p o n t h e d o w n g r a d e s . If g u id e d b y o u td a te d c risis m o d e ls , s o v e r e ig n r a tin g s w o u ld fa il t o p r o v id e e a rly w a r n in g s ig n a ls o f a lik e ly c u r r e n c y c risis, w h ic h a g a in m i g h t c a u s e h e r d b e h a v io u r b y in v e s to rs . H o w e v e r, a s fa r a s s o v e re ig n r a tin g s a re c o n c e r n e d th e r e a re s e v e ra l r e a s o n s w h y a s ig n if ic a n t m a r k e t im p a c t c a n n o t b e e a s ily e s ta b lis h e d . F irs t, s o v e re ig n a v a ila b le in f o r m a tio n (L a rra in ris k ra tin g s et al., are p rim a rily based o n p u b lic ly 1 9 9 7 ), s u c h a s le v e ls o f f o r e ig n d e b t a n d f o r e ig n e x c h a n g e re s e rv e s , o r p o litic a l a n d fis c a l c o n s tr a in ts . C o n s e q u e n tly a n y s o v e r e ig n r a t i n g a n n o u n c e m e n t w ill 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 ­ lic ly a v a ila b le n e w s . R a tin g a n n o u n c e m e n ts m a y b e la rg e ly a n tic ip a te d b y th e m a rk e t. T h is d o e s n o t e x c lu d e , h o w e v e r, th e fa c t th a t th e in te r p r e ta tio n o f s u c h n e w s b y th e r a tin g a g e n c ie s m a y b e c o n s id e r e d a n im p o r ta n t s ig n a l of c re d itw o rth in e s s . m e c h a n is m S econd, in th e absence of a c re d ib le s u p ra n a tio n a l to s a n c tio n s o v e re ig n d e fa u lt, th e d e f a u lt ris k p r e m iu m - u n lik 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 - is 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 ess ra th e r th a n a b ility to p a y (E a to n et ah, 1 9 8 6 ) . A g a i n , i t is n o t e a s y f o r r a tin g a g e n c ie s to a c q u ir e p riv ile g e d in f o r m a tio n in th is a re a t h a t c o u ld b e c o n v e y e d to th e m a r k e t th r o u g h ra tin g s . B y e x a m in in g th e lin k s b e tw e e n s o v e re ig n c re d it ra tin g s a n d d o lla r b o n d y ie ld s p re a d s , R e is e n a n d v o n th e th re e le a d in g ra tin g M a ltz a n (1 9 9 9 ) a im e d to d e te r m in e w h e th e r a g e n c ie s - M o o d y s , S ta n d a rd Poor and F itc h H e lm u t R eisen IB C A - c o u l d in t e n s if y o r a t t e n u a t e b o o m - b u s t c y c le s i n le n d in g . T h e o b s e rv a tio n p e rio d w as fro m ra tin g s s ta rte d to g a in m o m e n tu m - to 1989 - 127 e m e rg in g -m a rk e t w hen e m e rg in g -m a rk e t 1 9 9 7 , t h e y e a r w h e n t h e A s ia n c risis e ru p te d . T h e a u th o rs p ro d u c e d a n e v e n t s tu d y e x p lo rin g th e m a rk e t re s p o n s e (c h a n g e s in d o lla r b o n d y ie ld sp re a d s) fo r 3 0 tr a d in g d a y s b e fo re a n d a fte r th e r a tin g a n n o u n c e m e n ts . T h r e e o f th e re s u lts t h a t e m e rg e d f r o m th e e v e n t s tu d y d e s e rv e s p e c ia l e m p h a s is : • W h i le 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 le a d in g a g e n c ie s d id n o t p ro d u ce sp re a d s, th e ir a s ta tis tic a lly a g g re g a te d s ig n ific a n t re s p o n s e ra tin g a n n o u n c e m e n ts in s o v e re ig n p ro d u c e d y ie ld s ig n ific a n t e ffe c ts o n y ie ld s p r e a d s in t h e e x p e c te d d ir e c tio n , n o ta b ly o n e m e r g in g m a rk et b o n d s. • R a tin g d o w n g rad e s b o n d s . W h ile th e w id e n e n e d ris e in y ie ld th e y ie ld sp read s o n sp re a d s p re c e d e d th e e m e rg in g -m a rk e t d o w n g ra d e s , it w a s s u s ta in e d fo r a n o th e r 2 0 tr a d in g d a y s a fte r th e ra tin g e v e n t. • I m m in e n t r a tin g u p g ra d e s o f e m e rg in g -m a rk e t b o n d s w e re p re c e d e d b y s ig n ific a n t y ie ld c o n v e rg e n c e . S u b s e q u e n t to th e r a tin g e v e n t, h o w e v e r, th e r e w a s n o s ig n ific a n t m a r k e t re s p o n s e . H o w e v e r, b o th d e te rm in e d by th e ra tin g exogenous e v e n ts shocks; an d th is th e y ie ld c a lle d fo r sp re a d s an m ay a n a ly s is have th a t been w o u ld c o rre c t th e y ie ld d e te r m in a n ts fo r f u n d a m e n ta l fa c to rs . R e is e n an d c o rre c tin g v o n M a ltz a n fo r th e jo in t (1 9 9 9 ) th e re fo re d e te rm in a n ts ra n a G ra n g e r c a u s a lity te s t - o f ra tin g s an d y ie ld sp re a d s - and f o u n d th a t c h a n g e s in s o v e re ig n ra tin g s w e re in te r d e p e n d e n t w ith c h a n g e s in b o n d y ie ld s . T h e G ra n g e r te s t s u g g e s te d th a t th e s o v e re ig n ra tin g s by t h e th r e e le a d in g a g e n c ie s d id n o t in d e p e n d e n tly le a d th e m a rk e t, b u t th a t th e y w e re in te r d e p e n d e n t w ith b o n d y ie ld s p re a d s o n c e th e ra tin g s a n d th e sp re a d s w ere c o rre c te d fo r fu n d a m e n ta l d e te rm in a n ts . W h ile th e re s u lts s u g g e s t t h a t r a tin g a n n o u n c e m e n ts a re s e e n a s a s ig n if ic a n t s ig n a l o f c r e d it­ w o rth in e s s , th e ir im p a c t in te r n a l g u id e lin e s to d e b a r th e m fro m m ay w h ic h be due to th e p ru d e n tia l re g u la tio n in s titu tio n a l in v e s to rs a re s u b je c t a n d h o ld in g s e c u ritie s b e lo w and w h ic h c e r ta in r a tin g c a te g o r ie s .1 T h e tw o -w a y c a u s a lity b e tw e e n ra tin g s a n d s p re a d s o b s e rv e d o v e r th e p a s t d e c a d e m a y a ls o s u g g e s t th a t th e c ritic is m a d v a n c e d a g a in s t th e a g e n c ie s in 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 is based o n m o re o b s e rv a tio n s th a n ju s t th o s e s u r r o u n d in g th e s e p r o m in e n t c ris is e p is o d e s . W h ile t h e e v e n t s tu d y s u g g e s ts t h a t r a tin g a g e n c ie s d o s e e m to h a v e th e p o te n tia l to m o d e r a te 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 rise s, th e G r a n g e r te s ts m a y ju s tify th e c o n c e r n th a t th is p o te n tia l h a s n o t y e t b e e n p r o d u c tiv e ly e x p lo ite d b y th e a g e n c ie s b y in d e p e n d e n tly le a d in g th e m a rk e ts w ith tim e ly ra tin g ch an g es. As seen in th e la te s t c rise s in A rg e n tin a and T u rk e y , a n d a s c o n f ir m e d b y m o r e r e c e n t s tu d ie s th a t s tr e tc h th e o b s e r v a tio n 128 R a tin g s since th e A s ia n C risis p e rio d b e y o n d 1 9 9 7 to 2 0 0 0 (K a m in sk y a n d S c h m u k le r, 2 0 0 1 ), r a tin g a g e n ­ c ie s c a n s till b e s e e n a s la te r a t h e r t h a n e a rly w a r n in g s y s te 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 in g t o M o r a ( 2 0 0 1 ) , th e a n s w e r is n o . H e r f in d i n g s c o n f i r m th a t ra tin g s m o v e in a p ro c y c lic a l w ay , b u t th a t th e c a u s a l e ffe c t o f s o v e re ig n ra tin g s o n b o th th e h ig h e r c o s t o f b o r r o w in g a n d c a p ita l-flo w re v e rs a ls r e m a in a m b ig u o u s a fte r c o n tr o llin g f o r m a c r o e c o n o m ic v a r ia b le s a n d la g g e d s p r e a d s (a v a r ia b le t h a t s ta n d s f o r t h e p a s s iv e r e s p o n s e o f s o v e r e ig n r a tin g s to c h a n g e s in m a rk e t s e n tim 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 lin g f in d in g : h ig h e r r a t in g le v e ls m e a n a h ig h e r p r o b a b ility fin d in g o f cu rre n c y is e x p l a i n e d b e tte r ra tin g s can c rash es o n c e by th e o b ta in o th e r fa c to rs a re a m o u n t o f c a p ita l flo w s an d th a t m a k e th e m c o n tro lle d th a t fo r. T h is c o u n trie s m o re v u ln e ra b le to w ith c a p ita l f lo w re v e rs a ls. W h a t a b o u t th e re v is io n to fu tu re its c o u n t r y w o u ld a llo w o b ta in b e tte r ra tin g s in c e rta in m a r k e t im p a c t o f s o v e re ig n ra tin g s ? c e i l i n g p o l i c y , M o o d y s b o rro w e rs th a n th e to a re c e n t anno u n ced c o u n try p i e r c e t h e fo re ig n In (2 0 0 1 b ) c e ilin g , cu rren c y b o n d s o f th e th a t it t h a t is , t o g o v e rn m e n t th e ir re s p e c tiv e d o m ic ile s . T h e tr a d itio n a l r a tio n a le fo r c o u n tr y c e ilin g s h a s b e e n t h a t g o v e r n m e n ts c o n f r o n te d b y a n e x te r n a l p a y m e n ts c ris is h a v e th e p o w e r a n d m o tiv a tio n to lim it fo re ig n c u rre n c y o u tflo w s , in c lu d in g d e b t p a y m e n ts . A s s o v e re ig n ra tin g s se rv e as a c e ilin g fo r th e p riv a te s e c to r ra tin g s o f a n y g iv e n c o u n tr y , th e ir in f lu e n c e s tr e tc h e s fa r b e y o n d g o v e r n m e n t s e c u r­ itie s . S e v e ra l m o n t h s e a rlie r S P (2 0 0 0 ) h a d f o r p r iv a te s e c to r is s u e rs f r o m an n o u n ced enhanced ra tin g s s u b in v e s tm e n t g ra d e c o u n trie s if tra n s fe r a n d c o n v e rtib ility in s u r a n c e w a s u tiliz e d . P o in tin g to r e c e n t e x a m p le s o f d e fa u lt o n g o v e rn m e n t d e b t - n o ta b ly 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 rg e , in te r n a tio n a lly access to re c o g n iz e d in te rn a tio n a l s u b s ta n tia l d a m a g e o n cu rren c y d e b t. c o m p a n ie s , c a p ita l c h a n g e in th e c o u n try d im in is h in June in s titu tio n s e m e rg in g m a rk e ts , m a n y in o f p riv a te an d w h o se s ig n ific a n tly d e fa u lt th e e c o n o m y w e re b e in g a llo w e d to C o n s e q u e n tly f in a n c ia l e n titie s t h a t h a v e re lie d m a rk e ts 2001 an d agency B ra z il a n d M e x ic o , o n r e v ie w exceed s h o u ld th e m a rk e t im p a c t o f s o v e re ig n 38 e n e rg y c o m p a n ie s in fo r u p g ra d e . T h e n o t o n ly a llo w th e ir c o u n try on in flic t s e rv ic e f o r e ig n p la c e d te le c o m m u n ic a tio n s c e ilin g a p p r o a c h s e c to r d e b to rs to th e w o u ld th e ra tin g s c e ilin g s , b u t s h o u ld a lso r a tin g e v e n ts as fe w e r b o rro w e rs w ill b e im m e d ia te ly c o n c e r n e d b y th e m . In d ic a to rs o f c re d it r a tin g p re s s u re as in s tr u m e n ts fo r tr a d in g e m e rg in g m a rk e t b o n d s, in c r e a s e su ch a n tic ip a tio n as th o s e an d d e v e lo p e d h ence re d u c e by D e u ts c h e th e m e a su re d B ank (2 0 0 0 ), m a rk e t m ay im p a c t of r a tin g e v e n ts . R a tin g a c tio n s a re d e liv e re d in a d is c re te a n d , a s d o c u m e n te d above, la te fa s h io n w h ile c re d it fu n d a m e n ta ls m ove c o n tin u o u s ly . Y et r a tin g e v e n ts h a v e a n im p a c t o n s p re a d s a n d th is c a n b e e x p lo ite d b y b o n d tra d e rs . R e fe rrin g to L a rra in et al. (1 9 9 7 ) a n d R e is e n a n d v o n M a ltz a n (1 9 9 9 ), H e lm u t R eisen D e u ts c h e B a n k h a s b u ilt a re g re s s io n m o d e l to e x p la in 129 c re d it ra tin g s a n d c a lib r a te d tw e lv e - m o n th fo re c a s ts to a rriv e a t a c u r r e n t f itte d r a tin g . R a tin g p r e s s u r e is d e f i n e d a s t h e d if 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 fo r a g iv e n c o u n try . L o n g a n d s h o r t p o s itio n s c a n th e n b e e n g a g e d a c c o rd in g to w h e th e r th e r a t i n g p r e s s u r e i n d i c a t o r is p o s iti v e o r n e g a tiv e . W h e n th e r a tin g a c tio n f in a lly h its t h e m a r k e t, th e s e in v e s t m e n t b e ts c a n b e d is s o lv e d ( s e l l t h e to n e w s ) , w h ic h can trig g e r p e rv e rs e , m e a su red r a tin g c h a n g e s . A s D e u ts c h e B a n k (2 0 0 0 ) c la im s to in d ic a to rs o f r a tin g p re s s u re fo r its tr a d in g m a rk e t re sp o n ses h a v e p ro fita b ly u s e d s tra te g ie s , o th e r in v e s to r s m a y h a v e s ta rte d to p la y r a tin g e v e n ts in th e s a m e w ay . R e v isio n s to t h e B a sel A c c o r d a n d s o v e r e ig n r a tin g s T h e B a se l C o m m itte e o n B a n k in g S u p e rv is io n h a s re le a s e d tw o c o n s u lta tiv e p a p e rs o n a N e w B a se l C a p ita l A c c o rd (B a se l C o m m itte e , 1 9 9 9 , 2 0 0 1 ), w h ic 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 is i n t e n d e d t o g r a n t r a tin g a g e n c ie s a n e x p lic it r o le in th e d e t e r m i n a tio n o f t h e ris k w e ig h ts a p p lie d to m in im u m c a p ita l c h a rg e s a g a in s t d iffe re n t c a te g o rie s o f b o rro w e r. R is k w e ig 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 ts , a s t h e y h a v e to a c q u ir e a c o r r e s p o n d in g a m o u n t o f c a p ita l re la tiv e to th e ir ris k -w e ig h te d a s s e ts . I t is 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 th e 1 9 8 8 B asel A c c o rd . M o st im p o rta n tly , s h o rt-te rm b a n k le n d in g to e m e rg in g m a rk e ts h a s b e e n e n c o u ra g e d b y a re la tiv e ly lo w 2 0 p e r c e n t ris k w e ig h t, w h ile b a n k c re d it to n o n -O E C D b a n k s w ith a re s id u a l m a tu r ity of o v e r o n e y e a r h a s b e e n d is c o u r a g e d b y a 1 0 0 p e r c e n t ris k w e ig h t. T h is h a s s tim u la te d c ro s s -b o rd e r in te r b a n k le n d in g , w h ic h h a s b e e n d e s c rib e d as th 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 ts h a v e re c e iv e d m o r e le n ie n t tr e a tm e n t, e v e n if th e ir s o v e r e ig n ris 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 H en ce a re fo rm W h ile th e p ro p o se d w ill m a in ta in e m e rg in g m a rk e ts . o f th e B a se l A c c o rd s h o u ld b e w e lc o m e . th e re v isio n s o f th e B asel A c c o rd 8 p e r c e n t ris k -w e ig h te d C o m m itte e in itia lly p ro p o s e d a re v isio n on c a p ita l a d e q u a c y c a p ita l re q u ire m e n t, th e o f th e c a lc u la tio n B asel o f ris k w e ig h t­ in g s th a t w o u ld s u b s titu te c re d it ra tin g s fo r a s p lit b e tw e e n th e O E C D n o n -O E C D now a as th e p ro p o s in g s t a n d a r d i z e d Jones and m a in tw o an d d e te rm in a n t m a in an a p p ro a c h e s i n t e r n a l (R e ise n , to th e 2 0 0 0 ). c a lc u la tio n ra tin g s -b a s e d (IR B ) S p ra tt, 2 0 0 1 ; R e ise n , 2 0 0 1 ). O n e o f th e c o m m i t t e e s 1999 c o n s u lta tiv e T he o f ris k a p p ro a c h m a in p a p e r (B a se l C o m m itte e , and c o m m itte e is w e ig h ts : (G riffith - c h a n g e s fro m 1 9 9 9 ) is t h e th e c le 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 IR 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 is t h a t i n th e c a se o f s o v e re ig n e x p o s u re , m e m b e rs h ip p r o v id e th e b e n c h m a r k fo r ris k w e ig h ts . o f th e O ECD w ill n o lo n g e r 130 R a tin g s since the A s ia n C risis T a b le 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 is 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 ill 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 te r n a l c re d it a s s e s s m e n t in s titu tio n s ( n o t ju s t r a tin g a g e n c ie 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 ls o e x p o r t c r e d it a g e n c ie s , E C A s)2 f o r a s p lit 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 is k w e i g h t s w ill c o n t i n u e to b e d e te r m in e d b y c a te g o ry o f b o rro w e r b u t changes p ro p o sa l a have been s o v e re ig n m ade w ith an w ith in so v e re ig n , b a n k o r c o rp o ra te - each A A A ra tin g o f th e s e (o r c a te g o rie s . U n d e r th e 1 ECA ris k sc o re u n d e r th e O E C D 1 9 9 9 m e th o d o lo g y ) w ill r e c e iv e a 0 p e r c e n t ris k w e ig h t; lo w e r r a tin g s tra n s la te in to a ju m p in s o v e re ig n s w e ig h te d o p tio n s fo r th e ris k w e ig h ts v ia 2 0 , 5 0 , 1 0 0 a n d b e lo w B m in u s (o r E C A tr e a tm e n t o f c la im s o n ris k sco re 1 5 0 p e r c e n t fo r 7 ). T h e r e a re tw o b a n k s . T h e f ir s t is f o r b a n k s t o be a s s ig n e d a r is k w e i g h t t h a t is o n e c a te g o r y le s s f a v o u r a b l e t h a n t h a t a s s ig n e d t o t h e s o v e re ig n o f in c o r p o r a tio n . N a tio n a l s u p e rv is o rs in lo w -ra te d d e v e l­ o p in g c o u n tr ie s m a y o p t fo r t h e s e c o n d o p tio n , w h ic h b a s e s th e ris k w e ig 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 la im s o n c o r p o r a t e s , a m o r e ris k s e n s itiv e f r a m e w o r k is 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 c e n t ris k w e ig h t f o r a ll c o r p o r a te c r e d its u n d e r t h e th e u n ifo rm 100 per 1 9 8 8 A c c o rd . B o th th e o r y a n d e v id e n c e s u g g e s t t h a t t h e B a s e l II A c c o rd w ill d e s ta b iliz e p r iv a te c a p ita l flo w s t o t h e d e v e lo p in g c o u n tr ie s if th e c u r r e n t p r o p o s a l to 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 is 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 tw o e l e m e n t s . F irs t, t h e o r y r e g u la to ry c a p ita l th r o u g h m a c ro e c o n o m ic s u g g e s ts t h a t lin k in g b a n k le n d in g to a rig id m in im u m flu c tu a tio n s . S econd, th e c a p ita l ra tio e v id e n c e se rv e s to s u m m a riz e d a m p lify in th e Table 7.2 The new Basel Capital Accord (risk weight under the standardized approach, per cent) Agency rating Sovereign ECA risk score Sovereigns Banks - option l 1 Banks - option 22 Corporates AAA to AA- A+ to A- B to BB+ BBB- 1 2 3 0 20 20 20 20 50 100 503 100 50 503 50 BB+ to B B— 4-6 100 100 1003 100 B+ to B4-6 100 100 100 150 B elow B7 150 150 150 150 Notes: 1 R isk w e ig h t in g b a s e d o n ris k w e ig h t in g o f s o v e re ig n i n w h ic h t h e b a n k is in c o r p o r a te d . T h e r a t in g s h o w n t h u s re fe rs t o t h e s o v e r e ig n r a tin g . 2 R isk w e ig h t in g b a s e d o n t h e r a t in g o f t h e in d i v id u a l b a n k . 3 C la im s o n b a n k s w i t h a n o r ig i n a l m a t u r i t y o f le ss t h a n t h r e e m o n t h s w o u ld r e c e iv e a w e i g h t i n g o n e c a te g o r y m o r e f a v o u r a b le t h a n t h e r is k w e i g h t i n 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. B asel c o m m it te e o n b a n k i n g s u p e r v is io n , T h e N e w B asel C a p i ta l A c c o rd : a n e x p l a n a to r y n o t e ’, s e c o n d c o n s u lt a ti v e p a p e r, B asel, J a n u a r y 2 0 0 1 (w w w .b is .o rg ). Source: H e lm u t R eisen p re c e d in g s e c tio n s u g g e s ts le a d th e m a rk e ts , a n d th a t s o v e re ig n ra tin g s la g b e h in d ra th e r 131 th a n i t s e e m s t h a t t h e r e is 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 ig n in g fix e d m in im u m c a p ita l to b an k a s s e ts w h o s e ris k w e ig h ts a r e in t u r n d e te r m in e d b y m a r k e t- la g g in g r a tin g s w ill r e in f o rc e th e te n d e n c y o f th e c a p ita l ra tio to w o rk in a p r o c y c l ic a l w a y . T h e B a s e l II p r o p o s a ls w ill r e in f o rc e t h a t te n d e n c y a s a s tr o n g d is c o n t in u it y in tr e a tin g A and b e lo w -ra te d a s s e ts w ill m a k e b a n k s lo a n p o rtfo lio s m o re liq u id ity - h u n g ry , th u s in c re a s in g th e v u ln e ra b ility o f th e fin a n c ia l s y s te m to liq u id ity ris k . W ith re g a rd to th e th e o ry , a s s u m in g a n o n - M o d ig lia n i- M ille r w o r ld w h e re in v e s tm e n t d e m a n d o b ta in ban k lo a n s , depends B lu m o n an d th e a b ility H e llw ig o f firm s to (1 9 9 5 ) show re ta in how e a rn in g s or c a p ita l a d e q u a c y re g u la tio n fo r b a n k s m a y re in fo rc e m a c ro e c o n o m ic flu c tu a tio n s . If n e g a tiv e sh o c k s to a g g re g a te d em and re d u c e th e a b ility o f d e b to rs to s e rv ic e th e ir d e b ts to b a n k s , t h e r e d u c tio n in d e b t s e rv ic e w ill lo w e r b a n k e q u ity , w h ic h w ill in tu r n r e d u c e b a n k le n d in g a n d in v e s tm e n t b e c a u s e o f c a p ita l a d e q u a c y r e q u ir e m e n ts . L in k in g b a n k le n d in g to b a n k e q u ity th u s a c ts a s a n a u to m a tic a m p lifie r fo r m a c ro e c o n o m ic flu c tu a tio n s : b a n k s le n d m o re w h e n tim e s a re g o o d a n d le s s w h e n tim 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 a ls o b e s h o w n to c a p ita l ra tio c a n ra ise th e s e n s itiv ity o f in v e s tm e n t d e m a n d to c h a n g e s in o u t p u t a n d p ric e s . A n im p o rta n t a s s u m p tio n u n d e rly in g th e B lu m -H e llw ig m odel is th 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 is 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, an a d d itio n a l d o lla r o f b a n k p ro fits le n d in g . A s b a n k s m in im u m ra tio s in d u c e s have 1 /c a d d itio n a l u n it s c o n tin u e d to of bank h o v er a ro u n d th e r e q u ir e d 8 p e r c e n t in th e m a jo r a d v a n c e d c o u n trie s , th e y c a n g e n e ra lly b e c o n s id e r e d a s b i n d i n g ; h e n c e t h e lo g ic o f t h e B lu m - H e llw ig m o d e l is o f m o r e t h a n p u re ly a c a d e m ic in te re s t. It m a y be a rg u e d th a t a s p e c ific p ro p o sa l in re in fo rc in g th e p ro c y c lic a l im p a c t o f m in im u m th e B a s e l II A c c o r d ris k s c a p ita l r e q u i r e m e n ts . A la r g e d i s c o n t i n u i t y is 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 te d A a n d b e lo w . T o th e e x te n t th a t a h ig h s h a re o f b a n k s lo a n p o rtfo lio s is i n v e s t e d i n A - r a te d b o r r o w e r s , t h e fin a n c ia l s y ste m m a y b e c o m e v u ln e r­ a b le to a liq u id ity c risis in a d o w n tu r n in w h ic h b o rro w e rs a re d o w n g r a d e d . B a n k s w o u ld c o n f r o n t h ig h e r c a p ita l r e q u ir e m e n ts f o r th is c la s s o f b o r r o w e r s . O n e re s p o n s e w o u ld b e to c u t b a c k o n le n d in g to lo w e r r a te d c re d ito rs . L in k in g re g u la to ry b a n k c a p ita l to a g e n c y r a tin g s m ig h t m o v e b a n k s lo a n p o rtfo lio b e h a v io u r c lo se r to by th e been m a r k - to - m a r k e t ru le s sh o w n th e ir s h o rt-te rm o f th e v a lu e t h a t b a n k s firs t e n c o u ra g e d in te n s if ie d th e g lo b a l c o n ta g io n o f t h e at tr a d in g b e h a v io u r. G o v e rn e d ris k (V aR ) e x c e ss iv e b a n k a p p ro a c h , le n d in g and it has th e n 1 9 9 8 f in a n c ia l c ris is (R e ise 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 is 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 to m a tic a lly g e n e r a te s a n u p w a r d r e - e s tim a te o f c r e d it a n d m a r k e t ris k in a c o rre la te d c o u n try . T h e B a s e l II p r o p o s a l s w ill r e in f o rc e th e p ro c y c lic a l R atin g s since the A s ia n C risis 132 te n d e n c y a s a s tr o n g d is c o n t in u it y b e tw e e n ris k w e ig h ts o n d if f e r e n tly r a te d a s s e ts w ill m a k e b a n k s lo a n p o r tf o lio s m o r e liq u id ity - h u n g r y , th u s in c r e a s in g th e v u ln e ra b ility o f th e fin a n c ia l s y s te m a la r g e p ro p o rtio n s o v e re ig n s a n d of banks c o rp o ra te s lo a n (w ith to liq u id ity ris k . T o t h e e x t e n t t h a t p o rtfo lio s is in v e s te d in trip le -B -ra te d a 5 0 p e r c e n t r is k w e ig h t, T a b le 7 .2 ) , t h e d o w n g r a d in g o f s u c h a s s e ts ( im p ly in g a 1 0 0 p e r c e n t ris k w e ig h t a c c o r d in g to th e s t a n d a r d i z e d a p p r o a c h ) w ill f o r c e b a n k s t o o r to c u t b a c k le n d in g s y s te m W ith ra tin g s to th e m o re liq u id ity b o rro w e rs. H e n c e th e d o w n g ra d e d reserv e fin a n c ia l w o u ld b e c o m e m o r e v u ln e r a b le to a liq u id ity c risis. re g a rd to ris k th e e v id e n c e , th e in te n s ify in g re q u ire m e n ts u n d e r th e th e d e te rm in a n ts p ro c y c lic a l and im p a c t of n a tu re th e B a s e l II p r o p o s a ls . F irs t, t h e o f s o v e re ig n c a p ita l re a l ra te adequacy o f (a n n u a l) G D P g ro w th h a s r e p e a te d ly b e e n f o u n d to b e a n im p o r ta n t d e te r m in a n t o f r a tin g s , w ith a p o s itiv e s ig n . T h is im p lie s t h a t s o v e r e ig n r a tin g s w ill im p r o v e d u rin g boom p e rio d s an d d e c lin e d u rin g bust p e rio d s, th u s re in fo rc in g b o o m - b u s t c y c le s . S e c o n d , a s i t is h a r d f o r r a t i n g a g e n c ie s t o a c q u ir 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 ris k , t h e y t e n d t o la g b e h i n d r a t h e r t h a n le a d f in a n c ia l m a rk e ts (R e ise n a n d v o n M a ltz a n , 1 9 9 9 ). M o re o v e r th e ir ra tin g s o n lo w -ra te d b o rro w e rs a re a t tim e s c h a ra c te riz e d b y a lo w d e g re e o f d u r a b ility (IM 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 II A c c o r d w o u l d s tr e n g th e n th e m a r k e t im p a c t o f s o v e re ig n ra tin g s , b u t a s lo n g a s s o v e re ig n ra tin g s fa il to convey p riv ile g e d in fo rm a tio n to r a tin g s w ill r e in f o r c e e u p h o r ic e x p e c ta tio n s a n d th e m a rk e ts , im p ro v in g s tim u la te e x c e s s iv e c a p ita l in flo w s to e m e rg in g m a rk e ts ; d u r in g a b u s t, d o w n g r a d in g m ig h t c a u se c re d ­ ito rs a n d in v e s to rs to p a n ic , d riv in g m o n e y o u t o f th e a ffe c te d c o u n tr ie s a n d fo rc in g u p s o v e re ig n y ie ld s p re a d s. M o re o v e r th e N e w to e m e rg in g c o u n trie s an d th e B a se l A c c o rd d is c o u r a g e s lo n g - te r m d e v e lo p in g re g u la to ry c o u n trie s . in c e n tiv e s fo r For in te rb a n k le n d in g s p e c u la tiv e -g ra d e s h o rt-te rm in te rb a n k d e v e lo p in g le n d in g th e r e f o r e ti lt th e s tr u c tu r e o f th e ir c a p ita l im p o r ts to w a rd s s h o r t- te r m w ill d e b t. S h o r t- te r m f o r e ig n d e b t, in r e la tio n to o ffic ia l f o r e ig n e x c h a n g e re s e rv e s , h a s been id e n tifie d as th e s in g le m o s t im p o r ta n t p r e c u r s o r o f f in a n c ia l c rise s trig g e r e d b y c a p ita l flo w re v e rs a ls . T a b le 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 is k w e i g h t s f o r s h o r t - t e r m th a n th re e m o n th s ) b a n k -to -b a n k le n d in g . L et us (1 9 8 8 ) B asel A c c o rd h a s d is c o u ra g e d lo n g -te rm fro m d e v e lo p in g fo r le n d in g to trip le -B -ra te d m a tu ritie s a re 50 c o u n trie s , as o p p o s e d th e 6 2 .5 banks is c a lc u la te d 250 at how ( le s s th e n e u tr a l in c e n tiv e s p ro v id e d as re tu rn 1 2 .5 p e r c e n t fo r s h o r t m a tu ritie s ; th e per cent an d lo o k in te r b a n k le n d in g to b a n k s O E C D -b a s e d b a n k s . T h e ris k -a d ju s te d n o n -O E C D an d to firs t p e r c e n t fo r d o u b le -B -ra te d per fo r le n d in g to cent re s p e c tiv e banks, and fo r lo n g n u m b e rs 8 7 .5 per c e n t a n d 4 3 7 p e r c e n t f o r s in g le -B -ra te d b a n k s . T h e s ta n d a r d iz e d a p p r o a c h s u g g e s te d in to B a s e l II w o u ld trip le -B -ra te d an d a tte n u a te th e d o u b le -B -ra te d b ia s to w a rd s s h o r t- te r m b o rro w ers, b u t w o u ld n o t le n d in g e n tire ly T a b le 7 .3 R e g u la to r y in c e n t iv e s fo r s h o r t-te r m in te r b a n k le n d in g Long-term option 2 , Short-term option 2 , Assumed Risk1 Capital R isk-adj. B reak-even Assumed Risk Capital Risk-adj. B reak-even L O weight required return, IB R spread L O IB R weight1 required return spread spread per $100 (% )2 change (bp)3 spread per $100 (% )2 change (bp)3 D ouble-A (O C -based) ED Current Standardized IRB approach 10 - - 1.6 1.6 - 0.6 6.3 6.3 16.7 -6 - 100 50 40 8.0 4.0 3.2 12.5 25.0 31.3 -5 0 -6 0 100 100 100 379 8.0 8.0 30.3 50.0 50.0 13.2 - 400 + 1 115 - 20 20 7 10 - - 20 20 0 1.6 1.6 0.0 6.3 6.3 n.a. 20 20 10 1.6 1.6 0.8 62.5 62.5 125.0 20 50 60 1.6 4.0 4.8 250.0 100.0 83.3 - n.a. Triple-B(non-O C ) ED Current Standardized IRB approach 100 - - - - - -5 0 D ouble-B (non-O C ) ED Current Standardized IRB approach 400 - - - + 600 +800 T a b le 7 .3 (C o n tin u e d ) Short-term option 2 , Long-term option 2 , reak-even Assum ed R Assum ed Risk1 Capital R isk-adj. B isk Capital R isk-adj. B reak-even L O weight required return, IB R spread spread L O weight required return IB R spread per $100 (% )2 change (bp)2 spread per $100 (% )2 change (bp)1 Single-B(non-O C ) ED Current Standardized IRB approach 700 - 100 100 630 8.0 8.0 50.4 87.5 87.5 13.9 700 - - +3 709 - 20 100 400 1.6 8.0 32.0 437.5 87.5 21.9 +2 800 + 13 300 N otes: 1 F o r t h e IRB a p p r o a c h , lo n g - t e r m ( th r e e - y e a r) ris k w e ig h ts a r e o b t a i n e d f r o m t h e c u b ic r e g r e s s io n e s ti m a t e i n F ig u re 7 .1 . T h e u n d e r l y i n g d e f a u l t ra te s f o r s h o r t- te r m e x p o s u r e s h a v e b e e n o b t a i n e d f r o m M o o d y s - t h e y a re 0 p e r c e n t f o r d o u b le - A b o r r o w e r s , 0 .1 p e r c e n t f o r trip le -B , 0 .6 p e r c e n t fo r d o u b le -B a n d 6 .8 p e r c e n t f o r sin g le -B (M o o d y s , 2 0 0 1 : e x h i b it 1 6 ). F o r t h e s ta n d a r d iz e d a p p r o a c h , c la im s o n b a n k s r a t e d b e t w e e n A + a n d B B - w ith a n o r ig in a l m a t u r i t y o f le ss t h a n t h r e e m o n t h s w o u ld re c e iv e a r a t i n g t h a t w a s o n e c a te g o r y m o r e f a v o u r a b l e t h a n t h e ris k w e i g h t o n lo n g e r m a tu r itie s . 2 A s s u m e s LIBO R f la t f u n d in g . T h e r is k - a d ju s te d r e t u r n o n c a p ita l is 1 0 0 d iv i d e d b y t h e r e g u l a to r y c a p ita l r e q u i r e d p e r $ 1 0 0 m u l tip l ie d b y t h e s p r e a d o v e r LIBO R; q u o t e d a s r e t u r n i n e x c e ss o v e r LIBOR. 3 I n d ic a te s t h e a m o u n t o f s p r e 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 ) t o p r o d u c e t h e r is k - a d ju s te d r e t u 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 re a k -e v e n s p r e a d c h a n g e is t h e d iffe re n c e i n r is k - a d ju s te d r e t u r n b e t w e e n c u r r e n t a n d s t a n d a r d iz e d ; IRB a p p r o a c h m u l tip l ie d b y c a p ita l r e q u ir e d p e r $ 1 0 0 i n s t a n d a r d iz e d r e s p e c tiv e IRB a p p r o a c h . A u th o r s c a lc u la tio n b a s e d o n t h e p r o c e d u r e d e v e lo p e d b y D e u ts c h e B a n k (2 0 0 1 ). Source: H e lm u t R eisen rem o v e it. By c o n tra s t, b a n k -to -b a n k le n d in g to s in g le -B -ra te d 135 b o rro w e rs w o u ld n o lo n g e r b e d is to r te d b y h ig h e r ris k -a d ju s te d r e tu r n s o n s h o r t- te 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 tro n g in c e n tiv e s w o u ld c o n tin u e to ra tin g s -b a s e d a p p r o a c h fo r s h o r t- te r m banks. T he p o in ts o n re q u ire d b re a k -e v e n s h o rt-te rm sp re a d to p ro v id e d change le n d in g u n d e r th e c u rre n t B asel re q u ire m e n ts , as th e be u n d er th e in te rn a l- b a n k le n d in g , p a r tic u l a r ly t o trip le -B w o u ld IR B a p p r o a c h c o rre s p o n d in g be m in u s 50 b a s is c o m p a re d w ith ris k w e ig h t w o u ld th e d ro p 1 0 p e r c e n t ( a s s u m in g a 0 .1 p e r c e n t p r o b a b i li t y o f d e f a u l t o n s h o r t - te r m e x p o s u re ), a c c o rd in g to 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 ile fo r e x p o s u re s w ith a re s id u a l m a tu r ity o f th r e e y e a rs th e c o r r e s p o n d in 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 ld tr a n s la te in to a ris k w e ig h t o f 4 0 p e r c e n t a n d a r is k - a d ju s te 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 IB O R o f 1 0 0 b a s is p o in ts ) , t h e e q u i v a le n t r is k - a d ju s te d r e t u r n w o u ld b e m u c h h ig h e r - 1 2 5 p e r c e n t - fo r s h o r t- te r m e x p o s u r e s to trip le -B -ra te 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 is u s u a l l y t a k e n fo r g ra n te d , s o v e re ig n ra tin g s p la y a v ita l ro le in d e v e lo p in g c o u n trie s as t h e i r a c c e s s t o c a p ita l m a r k e ts is p r e c a r io u s a n d v a r i a b le . T h e r e c e n t p r o p o s a l b y th e C o m m itte e o n B a n k in g S u p e rv is io n fo r a n e w B asel C a p ita l A c c o rd im p lie s t h a t c r e d it r a tin g s w ill b e o f e v e n g r e a te r r e g u la to r y im p o r ta n c e in fu tu re d e c a d e s. R a tin g b e h a v io u r in th e r e c e n t e m e r g in g - m a r k e t c rise s in A rg e n tin a a n d T u rk e y s u g g e s ts t h a t r a t in g d e t e r m i n a n ts h a v e n o t b e e n s u f f ic ie n tly m o d if ie d to p u t th e a g e n c ie s a h e a d d e te rm in a n ts w eaknesses have an d o f m a r k e t e v e n ts , a n d lo s t s o m e illiq u id ity o f th e ir have n o t th a t c o n v e n tio n a l ra tin g e x p la n a to ry yet been p o w e r. F in a n c ia l-s e c to r g iv e n th e w e ig h tin g th e y d e s e rv e . P ro c y c lic a l r a tin g d e te r m in a n ts r e m a in a n im p o r ta n t in g r e d ie n t in a g e n c ie s n o te s , a n d it h a s b e e n s u g g e s te d th a t a g e n c ie s s h o u ld c o rre c t th e m f o r t h e e n d o g e n o u s e ffe c ts o f ( s h o r t- te r m ) c a p ita l in f lo w s . B ut even w ith such im p ro v e m e n ts , s o v e re ig n b e h i n d t h e m a r k e ts . F irs t, c r e d i t r a t in g s a n d ra tin g s a re b o u n d to la g r a tin g a c tio n s a re d e liv e re d in a d is c re te fa s h io n , w ith a c tio n b e in g ta k e n w h e n s u ffic ie n t u p w a r d o r d o w n ­ w a rd p re s s u re h a s b e e n p u t o n th e c re d it f u n d a m e n ta ls , w h ic h th e m s e lv e s m o v e in a c o n tin u o u s fa s h io n . S e c o n d , s o v e re ig n ris k r a tin g s a re p r im a r ily b a s e d o n p u b lic ly a v a ila b le in f o r m a tio n . C o n s e q u e n tly a n y s o v e re ig n ra tin g a n n o u n c e m e n t w ill b e T h ird , ra tin g (a lth o u g h th e c o n t a m i n a t e d b y a n n o u n c e m e n ts in te rp re ta tio n m ay be of such o th e r la rg e ly new s by p u b lic ly a v a ila b le a n tic ip a te d th e ra tin g by th e n ew s. m a rk e t a g e n c ie s m a y be s e e n a s a n im p o r ta n t s ig n a l o f c re d itw o r th in e s s ) . W h ile s o v e r e ig n r a tin g s o f te n la g b e h i n d th e m a r k e ts , jo i n t d o w n g r a d e s o f e m e rg in g -m a rk e t d e b t b y th e le a d in g a g e n c ie s can have a la s tin g m a rk et 136 R a tin g s since th e A s ia n C risis im p a c t; u p g ra d e s , in c o n tr a s t, a re la rg e ly a n tic ip a te d . T h e im p a c t o f d o w n ­ g ra d e s m a y b e d u e to th e p r u d e n tia l r e g u la tio n a n d in te r n a l in d u s tr y g u id e ­ lin e s to w h ic h in s titu tio n a l in v e s to rs a re s u b je c t a n d w h ic h d e b a r th e m h o ld in g s e c u ritie s th a t a llo w a c e rta in b e lo w c re d ito rs to th re s h o ld . c e rta in w ith d ra w B ut u n le s s ra tin g c a te g o rie s , lo a n s w h e n p ru d e n tia l an d to debt b o rro w e r ra tin g s d ro p re g u la tio n , th a t is , fro m c o n tra c ts b e lo w th e B asel A c c o rd , re in fo rc e s t h e m a r k e t im p a c t o f s o v e re ig n ra tin g s , th e ir im p a c t m ig h t d im in is h s o m e w h a t in th e f u tu re . T h e r a tin g a g e n c ie s h a v e s ta r te d to lo o s e n th e ir c o u n tr y c e ilin g p o lic y , a llo w in g c e r ta in p r iv a te s e c to r b o r r o w e r s b e tte r r a tin g s t h a n th e ir s o v e re ig n s . A n d e m e r g in g - m a r k e t b o n d tr a d in g s tra te g ie s seem to have in c re a s in g ly e x p lo ite d th e la te n a tu re o f ra tin g a c tio n s by a n tic ip a tin g th e m . F in a lly , 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 w ill d e s ta b iliz e p r iv a te c a p ita l flo w s to p ro p o s a l to A s s ig n in g lin k fix e d d e te rm in e d by c a p ita l ra tio to re g u la to ry m in im u m b an k w o rk in c a p ita l to c a p ita l m a rk e t-la g g in g c o n c e rn to ra tin g s th a t th e B a s e l II A c c o rd d e v e lo p in g c o u n trie s if th e c u r r e n t ban k w ill s o v e re ig n a s s e ts ra tin g s w h o se re in fo rc e th e ris k is a d o p te d . w e ig h ts te n d e n c y are o f th e a p r o c y c lic a l w a y . C r e d it s p r e a d s w ill m o r e c lo s e ly re f le c t c r e d it r a tin g s a s a p r o x y o f d e f a u lt p r o b a b ility . W h ile th i s is e x a c tly w h at s u p e rv is o rs th a t th e c h a sm a re a im in g a t, th e c a lc u la tio n s p ro v id e d h e re in d ic a te b e tw e e n in v e s tm e n t-g ra d e b o rro w e rs - b a s e d m o s tly in th e O E C D c o u n trie s a n d in s o m e o f th e m o re su c c e ssfu l e m e rg in g m a rk e ts - a n d s p e c u la tiv e - g r a d e b o r r o w e r s , m o s tly f r o m t h e d e v e lo p in g w o r ld , w ill d e e p e n . T h is w o u ld c le a rly ru n a g a in s t th e e n d e a v o u r o f th e g lo b a l d e v e lo p m e n t c o m m u n ity to b r o a d e n th e ra n g e o f d e v e lo p in g c o u n trie s th a t b e n e fit fro m p riv a te c a p ita l in flo w s . T he B asel II p ro p o s a ls n o t o n ly ris k ra is in g th e c a p ita l c o s ts f o r s p e c u la tiv e - g r a d e d e v e lo p in g c o u n tr ie s , th e y m a y a ls o s e rv e to in c re a s e th e v o la tility o f b a n k c r e d it s u p p ly to th is g r o u p o f c o u n tr ie s . N o te 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 dem and for a developing countrys bonds, as the dem and 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 R eisen 137 References 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, E uropean E conom R , 39, 3. ic eview 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 F ix, Dont F Paris: OECD Development Centre Studies. loat, Cantor, R. and F. Packer (1996) Determinants and Impact of Sovereign Credit Ratings, Federal Reserve Bank of New York, E conom Policy R , 20, 2. ic eview Deutsche Bank (2000) E erging M m arkets W eekly, 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, E uropeanE conom Review, 30, 3: 481-513. ic Ffrench-Davis, R. and H. Reisen (1998) Capital Flows and Investment Performance: An Overview, in Capital F s and Investm Perform low ent ance: Lessons from Latin A erica, Santiago: ECLAC/OECD. m Goldstein, M. (1999) Safeguarding Prosperity in a G lobal F inancial System The F : uture International F inancial A rchitecture R eport, New York: Council on Foreign Relations (www.cfr.org). Grandes, M. (2001) ‘External Solvency, Dollarisation and Investment Grade: Towards a Vicious Circle?, O C Developm C ED ent entre 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 E conom May/June. y, International Monetary Fund (IMF) (1999) Capital M arkets R eport, 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, O C Developm C ED ent entre T echnical Paper, no. 124, Paris: OECD, April. Moodys Investor Services (2001a) M oodys Country Credit Statistical H andbook, 1st edn, New York: Moodys, January, www.moodys.com. (2001b) Revised Country Ceiling Policy, June, w w w .moodys.com. Mora, N. (2001) Sovereign Credit Ratings: Guilty Beyond Reasonable Doubt?, mimeo, Cambridge, MA: Massachusetts Institute of Technology. OECD (2001) E conom Survey of T ic urkey, Paris: OECD, February. Reisen, H. (1998) ‘Domestic Causes of Currency Crises: Policy Lessons for Crisis Avoidance, O C Developm C ED ent entre Technical Papers, no. 136, Paris: OECD. 138 R atin g s since th e A s ia n C risis (1999) After the Great Asian Slump: Towards a Coherent Approach to Global Capital Flows, O C Developm C ED ent entre Policy B no. 16, Paris: OECD. rief, (2000) Revisions to the Basel Accord and Sovereign Ratings, in R. Hausmann and U. Hiemenz (eds), G lobal F inance from a Latin Am erican Viewpoint, Paris: InterAmerican Development Bank and OECD Development Centre. (2001) Will Basel II Contribute to Convergence in International Capital Flows?, B ankarchiv, Jg. 49, Vienna: Oesterreichische Bankwissenschaftliche Gesellschaft, August. and J. von Maltzan (1999), Boom and Bust and Sovereign Ratings, International F inance, 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 I n tr o d u c tio n T h e p ro b le m w e ll o f b o o m - b u s t c y c le s in re c o g n iz e d . T h is c h a p te r c a p ita l flo w s to e x a m in e s w h ic h e m e rg in g fo rm s m a r k e t s is o f c a p ita l flo w are p a r tic u la r ly p r o b le m a tic in th is re s p e c t a n d w h ic h a re m o r e s ta b le , a n d th e n c o n s id e rs w h a t m ig h t b e d o n e to s ta b iliz e t h e o v e ra ll flo w o f p r iv a te c a p ita l. T h e p o s s ib ilitie s h e r e in v o lv e a lte r in g e ith e r th e v o lu m e o r th e b e h a v io u r o f th e v a rio u s ty p e s s u p p ly s id e to o f f lo w . T h e r e a lte r th e is n o t m u c h re la tiv e v o lu m e th a t c a n be done fro m th e o f d if f e r e n t f o r m s o f c a p ita l flo w ; s u c h p o lic ie s a s a re a v a ila b le in th is re s p e c t c o n c e r n th e c a p ita l c o n tr o ls t h a t c a n b e e x e r c is 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 ie s , a s u b je c t t h a t is d e a l t w i t h in C h a p te r 1 2 . H e n c e th is c h a p te r fo c u s e s o n th e w a y s in w h ic h s u p p ly -s id 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 ty p e s o f c a p i t a l f lo w . D ia g n o s is o f w h e r e t h e p r o b le m s lie C o n v e n tio n a l w is d o m has lo n g h e ld th a t so m e fo r m s o f c a p ita l flo w are m u c h m o r e p r o n e to ra p id re v e rs a l t h a n o th e r s . T h is v ie w w a s c h a lle n g e d b y C la e s s e n s et al. (1 9 9 4 ), w h o fa ile d to f in d s ta tis tic a lly s ig n if ic a n t d iffe re n c e s i n t h e t i m e s e rie s p r o p e r t ie s o f d if f e r e n t f o r m s o f c a p ita l f lo w (F D I, p o r tf o l io e q u ity , lo n g - te r m , s h o r t- te r m , b a n k s , g o v e r n m e n t a n d p riv a te ). B u t in h is d is c u s s io n o f th is p a p e r, C a lv o (1 9 9 8 ) p re s c ie n tly p o in ts o u t th a t th e a u th o r s e s tim a te s o f v o la tility (w h ic h e s s e n tia lly fo c u s o n th e s e c o n d m o m e n t o f th e t i m e s e rie s ) m i g h t f a il t o g iv e d u e w e ig h t t o w h a t is o f m o s t im p o r t a n c e : t h e p o s s ib ility m o m e n ts o f o c c a s io n a l m a jo r d is ru p tio n s (w h ic h in th e tim e s e r ie s ) .1 T o ju d g e by w h at a re m e a s u re d b y h ig h e r happened in E a s t A sia d u r in g its r e c e n t c risis, w h e n F D I w a s la rg e ly m a in ta in e d w h ile b a n k c a p ita l r e v e r s e d o n a g r a n d s c a le , it is 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 la tility o f s o m e fo rm s o f c a p ita l flo w t h a n o f o th e r s . A m o r e r e c e n t s tu d y 139 C u rb in g th e B o o m -B u s t C ycle 140 by L ip se y (2 0 0 1 ) c o n firm e d th e c o n v e n tio n a l w is d o m a b o u t th e re la tiv e s ta b i lit y o f F D I f lo w s . T h is is 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 ill r e f r a i n f r o m s h if tin g w o rk in g b a la n c e s a m o n g c u rre n c ie s d e p e n d in g o n th e ir v ie w o f th e m a c r o e c o n o m ic p r o s p e c ts , b u t ju s t t h a t s u c h s h if ts a re u n lik e ly to b e la rg 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 le r e v e r s a l is i n m o s t c a se s p h y s ic a lly im p o s s ib le . B ank le n d in g , w h ic h w as th e p rin c ip a l c o m p o n e n t o f th e c a p ita l flo w r e v e r s a l i n E a s t A sia , 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 risis. C o m m o n te rm bank lo a n s e x p e c ta tio n a re s e n s e ( a n d r e c e iv e d w is d o m ) s u g g e s ts t h a t s h o r t­ m o re th a t a g a in p ro n e seem s to to in s ta b ility have been in te r b a n k c re d it lin e s e x p e rie n c e d b y K o re a in C la e s s e n s etal. (1 9 9 4 ) fa ile d to f in d an y th a n lo n g -te rm v e rifie d b y th e la te d is tin c tio n lo a n s , an e v a p o ra tio n of 1 9 9 7 . O n e re a so n w h y in v o la tility b a s e d m a tu r ity m a y b e t h a t th e y lu m p e d tra d e c re d its w ith o th e r s h o r t- te r m on c re d its 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 ie f is t h a t t r a d e c r e d i ts a r e o n e o f t h e le s s v o la tile so u rc e s o f fin a n c e s h o rt te rm d e s p ite th e fact th a t e a c h n e e d t o b e f i n a n c e d . I t is t h e r e s id u a l it e m te rm i n d i v i d u a l c r e d i t is - b e c a u s e th e y a re c o n s ta n tly re n e w e d as n e w tra d e tra n s a c tio n s - b a n k c la im s t h a t h a v e a s h o r t to m a tu r ity a n d a re n o t tra d e -re la te d - th a t c o n v e n tio n a l w is d o m h o ld s to b e p a rtic u la rly v o la tile . It h a s b e e n a rg u e d b y P e rsa u d (2 0 0 0 ) th a t th e re c e n t m o v e s to s tre n g th e n b a n k ris k m a n a g e m e n t, s tr e n g t h e n p r u d e n tia l s ta n d a r d s a n d in c r e a s e tr a n s ­ p a re n c y m a y e v e n in te n s ify th e p ro b le m H e p o in ts to a to o l fro m of th e ris k o f p ro c y c lic a l b e h a v io u r b y b a n k s . in c re a s in g u s e o f D E A R m an ag em en t th a t seem s (d a ily e a rn in g s p e rfe c tly a t ris k ) li m it s ra tio n a l w hen as v ie w e d th e s ta n d p o in t o f th e in d iv id u a l b a n k , b u t w h ic h c a n se rv e to in c re a s e v o la tility . T h e D E A R s e ts a lim it o n h o w m u c h t h e b a n k is p r e p a r e d t o ris k lo s in g d u r in g th e fo llo w in g d a y w ith , say, 1 p e r c e n t p ro b a b ility : I t is 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 is tr ib u tio n o f d a ily re tu r n s b a s e d o n p a s t m e a s u re s o f m a rk e t c o rre la tio n a n d v o la tility . B o th r is in g v o la tility a n d r is in g c o r r e la tio n w ill in c r e a s e th e p o t e n t i a l lo s s o f t h e p o r tf o l io , in c r e a s in g D E A R W hen DEAR exceeds t h e lim it, t h e b a n k r e d u c e s e x p o s u r e , o f te n b y s w i tc h i n g i n t o le s s v o la tile a n d le s s c o r r e l a t e d a s s e ts . T h e d a ily p u b lic a tio n o f s ta tis tic s c a n a c c e le ra te a n d in te n s if y th e s p re a d o f a n y b a d n e w s th a t m a y b re a k , w ith d e c lin in g a s se t v a lu e s a n d in c re a s in g v o la tility s e rv in g a s s o p h is tic a te d p o s itiv e fe e d b a c k m e c h a n is m s . S o m u c h fo r th e e a sy ca ses. T h e in te re s tin g q u e s tio n c o n c e rn s th e v o la til­ ity o f o th e r c la im s t h a t c a n b e lo n g -te rm b o n d s. T h e re w as i n v e s t m e n t t o E a s t A sia i n s o ld in d e e d q u ic k ly , n o ta b ly p o r tf o lio a re d u c tio n in th e flo w e q u ity and o f p o rtfo lio 1 9 9 7 - 9 8 , a l th o u g h n o t h i n g lik e t h e re 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 is 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 illia m s o n 141 e x p e c t le s s v o la til ity i n t h e c a s e o f p o r tf o l io e q u i ty t h a n i n t h e c a s e o f s h o r t ­ te rm lo a n s : th e a ll th e p ric e o f th e a d ju s tm e n t ta k in g re le v a n t a sse t (sh a re s) c a n p la c e in th e a d ju s t, r a th e r th a n v o lu m e . In d e e d if a s h o c k h a s th e s a m e im p a c t o n th e fu tu r e e x p e c ta tio n s o f d o m e s tic a n d fo re ig n in v e s to rs in sh a re s, th e n o n e w o u ld e x p e c t th a t a ll th e r e s u ltin g a d ju s tm e n t w o u ld s h o w up in a c h a n g e in s h a r e p ric e s , w ith e x c h a n g e ra te s . (L a rg e a n d p ro b le m s , e s p e c ia lly w h e n ra th e r th a n n o c o n s e q u e n c e s f o r c a p ita l flo w s o r a b r u p t d e c lin e s in s h a re p ric e s c a n e x p e c ta tio n s a re e n d o g e n o u s a n d exogenous an d re g re s s iv e . I w o u ld a lso c re a te e x tra p o la tiv e n o n e th e le s s a rg u e th a t th e s to c k m a r k e t is a r a t h e r g o o d p la c e t o a b s o r b t h e im p a c t o f c h a n g e s i n e x p e c t­ a tio n s , b e c a u s e th e lin k s f ro m th e s to c k m a rk e t to th e re a l e c o n o m y te n d to b e w e a k i n t h e s h o r t t e r m .) I t is o n l y w h e n f o r e i g n i n v e s t o r s lo s e t h e i r n e r v e a b o u t th e p ro s p e c ts fo r a c o u n tr y o r r e g io n in a w a y th a t d o m e s tic in v e s to rs d o n o t , a s i n E a s t A sia i n 1 9 9 7 , th a t o n e s h o u ld e x p e c t a n im p a c t o n c a p ita l flo w s . T h e e m p i r i c a l e v i d e n c e is 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 ig h t h a v e le d o n e to e x p e c t. F ro o t etal. (1 9 9 8 ) h a v e fo u n d e v id e n c e th a t e q u ity flo w s a r e p e r s is te n t o v e r tim e a n d th a t in v e s to rs o f te n b u y r e s p o n s e t o a p r ic e ris e (d e c lin e ) . K a m in s k y etal. fu n d s have a d e s ta b iliz in g L a tin A m e ric a . It a ls o im p a c t an d have se e m s th a t C h ile a n (s e ll) i n (1 9 9 9 ) c o n c lu d e th a t m u tu a l h e lp e d p e n s io n sp rea d c o n ta g io n fu n d s m a d e u se o f th e ir 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 b u t th e n p la c in g began fu n d s a b ro a d o n a la rg e s c a le w h e n in a lm o s t n o su rg e , c a p ita l flo w r e v e r s a l o c c u r r e d a f te r t h e E a s t A s ia n c ris is ( F f r e n c h - D a v is a n d T a p ia , 2 0 0 1 ) . B e k a e rt etal. (1 9 9 9 ) h a v e fo u n d th a t w h e n e q u ity c a p ita l le a v e s it d o e s so f a s te 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 tin g t h a t it is n o t s o d if f i c u lt to fin d d o m e s tic p u rc h a se rs. O n ly B a rth an d Z hang (1 9 9 9 ) can fin d no e v id e n c e t h a t f o r e ig n in v e s to r s h a v e p la y e d a d e s ta b iliz in g ro le : in d e e d th e y c la im th a t it w as o n ly in o n e m o n th (D e c e m b e r 1 9 9 7 ) th a t m u tu a l fu n d s w e r e n e t s e lle rs i n t h e f o u r m a i n c ris is c o u n t r ie s o f E a s t A s ia ( ib id .: 2 0 1 ) . A n d w h ile th e y re fe r to m a rk e ts w ith a lso a rg u e s lo w to s o m e in v e s to r s a s h a v i n g b e e n a t tr a c t e d i n t o t h e A s ia n a s h o rt-te rm th a t th e h o riz o n fig u re s e x it a fte r th e show s e e k in g h ig h th a t fo re ig n r e t u r n s ( ib id .: 1 9 9 ), th e y in s titu tio n a l in v e s to rs w e re c risis s ta r te d , a s a r e s u lt o f w h ic h th e y lo s t a lo t o f m o n e y ( ib id .: 2 0 2 - 5 ) . K o re a h a s a p a rtic u la rly ric h d a ta se t (a lth o u g h th e re a re d o u b ts about its r e lia b ility ), a n d th i s h a s e n a b le d r e s e a r c h e r s t o tr a c e t h e s tr a te g y o f in d i­ v id u a l in v e s to rs in a w a y t h a t is n o t p o s s ib le e ls e w h e r e . T h e f ir s t s t u d y t o e x p lo it th is so u rc e , th a t b y C h o e by fo re ig n a c te d in v e s to rs w as etal. d e s ta b iliz in g a s a s ta b iliz in g fo rc e d u r in g th e (1 9 9 9 ), s u g g e s ts t h a t w h ile t h e tr a d e fo re ig n in v e s to rs c risis. H o w e v e r th e ir d a ta b efo re th e c risis, e x te n d e d o n l y b r ie f ly i n t o t h e c ris is p e r io d , a n d t h e s u b s e q u e n t s tu d y b y K im a n d W e i (1 9 9 9 a) in v e s to rs c o n c lu d e s w ere th a t fo re ig n p o s itiv e -fe e d b a c k in s titu tio n a l tra d e rs an d (th a t is , (e v e n m o re ) b o u g h t in in d iv id u a l re sp o n se to C u rb in g the B o o m -B u s t C ycle 142 a p r ic e ris e a n d s o ld i n r e s p o n s e t o a p r ic e f a ll) b o t h b e f o r e a n d d u r i n g t h e c risis. T h e o n ly e x c e p tio n to th is p r o c y c lic a l b e h a v io u r w a s p r io r to th e c risis b y fo re ig n in s titu tio n s w ith a K o r e a n o ffic e : th e s e w e r e c o n t r a r ia n ( t h a t is , t e n d e d t o b u y r e c e n t lo s e r s a n d a ls o c a lc u la te th a t a c o n tr a r ia n th a n a p o s itiv e -fe e d b a c k been fo llo w in g s u c h feed b a ck th a n s tra te g y w o u ld s tra te g y , w h ic h a s tr a te g y (a s th e s tra te g ie s ) fo re ig n e rs. m ust have an d W ei K im s e ll r e c e n t w in n e r s ) . K im m ade have been s u g g e s ts th a t m oney, a lso or at tra d in g , an d to som e e x te n t in h e rd in g w ho had f o r e ig n p o s itiv e - le a s t lo s t le s s fo u n d e v id e n c e f u n d s b a s e d in th e U n ite d S ta te s a n d U n ite d K in g d o m feed b a ck p ro fita b le K o rean s c o u n te rp a rt o f th e (1 9 9 9 b ) m o re tra d e rs a n d W ei th a t m oney m u tu a l e n g a g e d in p o s itiv e - b e h a v io u r, in K o re a in 1 9 9 7 - 9 8 .2 N o te th a t a ll th e s e s tu d ie s fo c u s o n p o rtfo lio e q u ity in v e s tm e n t in th e s to c k m a rk e ts o f e m e rg in g c o u n trie s . A s B a rth a n d Z h a n g (1 9 9 9 ) p o in t o u t, p o rtfo lio e q u ity c h a n n e ls , o n e is i n v e s t e d o f w h ic h in e m e rg in g is p r iv a te m a rk e ts th ro u g h ( t h a t is , n o n - t r a d e d ) tw o a d d itio n a l e q u ity . B a rth and 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 is a s m a l l b u t r a t h e r s t a b l e flo w . I n t h e o t h e r c h a n n e l , e m e r g in g - m a r k e t c o m p a n ie s lis t t h e i r s h a r e s o n i n t e r n a t io n a l m a r k e ts s u c h a s N e w Y o rk (o f d o m i n a n t im p o r ta n c e fo r L a tin A m e r ic a n c o m p a n ie s ) o r L o n d o n ( d itto f o r S o u th A fric a n c o m p a n ie s ) . B a r th a n d Z h a n g s t a b l e s 6 - 1 2 show th a t in te r n a tio n a l p la c e m e n ts ro se to m a jo r im p o r ta n c e in th e m id 1 9 9 0 s a n d p e a k e d in 1 9 9 7 , b e fo re fa llin g s u b s ta n tia lly in 1 9 9 8 . T h e d e c lin e in in te r n a tio n a l p la c e m e n ts w a s n e v e rth e le s s m o d e s t c o m p a re d w ith th a t in fo re ig n in v e s tm e n t in lo c a l s to c k m a rk e ts : it m o v e d fro m U S $ 6 b illio n in 1 9 9 6 to U S $ 1 1 b illio n in 1 9 9 7 a n d U S $ 4 b illio n in 1 9 9 8 , w h ile in v e s tm e n t in U S $ 3 b illio n in A u th o rita tiv e lo c a l m a r k e ts fe ll f r o m U S $ 9 b illio n in 1 9 9 7 a n d p lu s U S $ 1 b illio n in so u rc e s p o rtfo lio e q u ity to a ssert th a t th e E a s t A sia d u r i n g t h e 1 9 9 6 to m in u s 1998. sh a rp re d u c tio n in th e in flo w of 1 9 9 7 c risis r e f le c te d q u ite d if f e r e n t b e h a v io u r o n th e p a r t o f tw o d iffe re n t g ro u p s o f in v e s to rs (a n a c c o u n t th a t is 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 ere m ade by g lo b a l fu n d s th a t h ad been s e a rc h in g fo r in v e s tm e n ts a n d h a d b e e n a ttr a c te d b y th e h ig h y ie ld s in h ig h -y ie ld in g E a st A s ia n s h a r e m a r k e ts p r io r to t h e c risis, b u t w h ic h h a d n o t a d v e r tis e d th e ir in v e s tm e n ts in e m e rg in g m a rk e ts . T h e y w ere em b a rra sse d to be h o ld in g a s s e ts w h o s e v a lu e h a d c o lla p s e d , a n d g o t o u t a s fa s t a s th e y c o u ld b e fo re th e ir h o ld in g s becam e w id e ly h o ld in g s by know n fu n d s m a rk e ts re m a in e d an d th a t c ritic iz e d . h ad a d v e rtis e d s te a d y , a n d B u t a c c o rd in g th e y w ere th e y m a y e v e n in v e s to rs w ere in th is account in h a v e p ic k e d u p s h a re s b e in g s o ld b y th e fo r m e r g ro u p , p e r h a p s to a llo c a tio n s . T h e s e to in v e s tin g e m e rg in g th e e m e rg in g so m e o f th e s u s ta in th e ir ta rg e t a sse t m a rk e ts fo r th e lo n g h a u l, w e re a w a re th a t th e s e w e re in h e r e n tly ris k y m a r k e ts t h a t w o u ld h a v e d o w n s a s w e ll as u p s , a n d p a n ic k e d . n e ith e r th e W o rry in g ly , m a n a g e rs o f th e G riffith -J o n e s (2 0 0 1 ) fu n d s n o r th e ir in v e s to rs s u g g e s ts th a t in re c e n t y e a rs John W illia m s o n th e im p o r ta n c e o f g lo b a l fu n d s h a s in c r e a s e d re la tiv e to 143 th a t o f d e d ic a te d e m e rg in g m a rk e t fu n d s . D o e s M ilto n b iliz in g F r i e d m a n s f a m o u s 1953 s p e c u la to r s m u s t lo s e m o n e y m u s t b u y n e a r th e p e a k a n d re q u ire s th e o p p o s ite ) - th e o re m s e ll n e a r t h e p ro v id e - (b e c a u se to w h ic h sa y s th a t d e s ta ­ d e s ta b iliz e a m a r k e t o n e tro u g h , w h e re a s m a k in g m o n e y re a ssu ra n c e th a t fu n d s th a t a m p lify th e b o o m - b u s t c y c le w ill lo s e m o n e y a n d s o a t le a s t e n r ic h d o m e s tic in v e s to r s ? N o t n e c e s s a rily . O n e p o s s ib ility , a llu d e d to e a r l i e r , is 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 le s b y f o r e ig n e r s w ill b e p u r c h a s e s b y o t h e r f o r e ig n e r s . B u t e v e n if fo r e ig n p o r tf o lio in v e s to r s d o in d e e d t e n d to fo llo w t h e h e r d , b u y in g w h e n t h e m a r k e t is r i s i n g a n d s e l l i n g w h e n i t is 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 is r i s i n g a n d b u y i n g w h e n i t is f a l l i n g , it d o e s n o t n e c e s s a r ily f o llo w t h a t th e f o r e ig n e r s w ill lo s e m o n e y . B u y in g o n a r is in g m a r k e t a n d b u y in g n e a r th e p e a k a re n o t th e s a m e th in g ; s p e c u la to rs w h o a re a le rt to c h a n g e s in tr e n d m a y b e a b le to q u i t b u y in g , a n d s e ll o u t s o o n a f t e r t h e p e a k is 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 ffe r c o n tr a d ic to r y v e rd ic ts o n w h e th e r m a n y fo re ig n in v e s to rs in fa c t g o t o u t o f E a s t A sia s u f f ic ie n tly q u ic k ly t o s a v e t h e i r s k i n s . W h a t is q u i t e c le a r is t h a t f o r e i g n in v e s t o r s a s a w h o le lo s t a n e n o r m o u s s u m o f m o n e y in E a s t A s ia , o r a t le 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 in g to th e c a lc u la tio n s b y B a rth a n d Z h a n g (1 9 9 9 : 2 0 4 ). M u c h th e s a m e a n a ly s is a p p lie s to lo n g - te r m b o n d s , w h o s e p ric e s a ls o f lu c ­ tu a te in re s p o n s e to c h a n g e s in e x p e c ta tio n s in s u c h a w a y as to e n s u re th a t t h e t o t a l s to c k o f b o n d s c o n t i n u e s t o b e w ill in g ly h e l d . F lo w e v e r, n o m i n a l l y lo n g - te r m b o n d s s o m e tim e s in c lu d e p u t o p tio n s , g iv in g th e h o ld e r th e r ig h t to d e m a n d e a rly r e p a y m e n t a t h is o r h e r d is c re tio n o n c e rta in d a te s . If 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 is m o s t n e e d e d , a s h a p p e n e d in K o re a in la te 1 9 9 7 . W h ile th e h o ld in g s o f th o s e w h o in te n tio n o f h o ld in g o n a s e p a ra te la rg e ly an d to th e m p e rh a p s buy e m e r g in g - m a r k e t a s s e ts w ith th e m a y n o t b e a s s ta b le a s o n e m ig h t w is h , m o re a c u te p ro b le m is posed by o v e rtly s p e c u la tiv e a c tiv itie s . H e d g e f u n d s - in s titu tio n s w h o s e m a n a g e r s q u ite c o n ­ s c io u s ly ra n g e t h e w o r ld lo o k in g fo r m a r k e t a n o m a lie s o r g o o d s p e c u la tiv e b e ts th a t a re e x p e c te d to y ie ld h ig h r e tu r n s a n d a re to ta lly u n r e g u la te d o n th e g ro u n d s th a t o n ly th e m ric h p e o p le w h o do n o t n eed p ro te c tio n in v e s t in - a re th e a rc h e ty p e . T h e p r o p rie ta ry tr a d in g d e sk s o f in v e s tm e n t b a n k s a n d o th e r f in a n c ia l c o m p a n ie s (c o m m e r c ia l b a n k s , s e c u ritie s firm s a n d e v e n a fe w in s u ra n c e c o m p a n ie s ) behave s im ila rly . H e d g e fu n d s w ere th e b u tt 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 th a t v ir tu a lly a ll in v e s tm e n t in s titu tio n s h a v e n o w a d o p te d th is in v e s tm e n t s ty le f o r a t le a s t a n im p o r ta n t p a r t o f th e ir a c tiv itie s . T he th e a c tio n s re p o rt S ta b ility b y o f th e s e th e in v e s to rs M a rk e t F o r u m s W o r k i n g in 1998 D y n a m ic s G ro u p o n com e S tu d y H ig h ly u n d e r o f fic ia l s c r u tin y G ro u p L e v erag ed of th e in F in a n c ia l In s titu tio n s (H L Is) C u rb in g the B o o m -B u s t C ycle 144 ( F in a n c ia l S ta b ility F o ru m , 2 0 0 0 ). T h e g r o u p b iliz in g im p a c t o f la rg e a n d c o n c e n tra te d e x a m i n e d t h e p o s s i b l e d e s t a ­ H L I p o s itio n s [in 1998] an d th e im p lic a ti 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 io u s a g g r e s s iv e p r a c t ic e s ( ib id .: 9 7 ). T h e e c o n o m ie s w ith w h ic h th e y w e r e c o n c e r n e d w e re A u s tra lia , F lo n g K o n g , M a la y s ia , N e w Z e a la n d , S in g a p o r e a n d S o u th A fric a , a l t h o u g h N e w Z e a la n d and S in g a p o r e e x p r e s s e d le s s c o n c e r n t h a n th e o th e r fo u r. T h e se c o u n trie s e x p e rie n c e d s tro n g p re s s u re o n th e ir fo re ig n e x c h a n g e a n d d o m e s tic f in a n ­ c ia l m a rk e ts in c u rre n c ie s th e m id d le o f 1 9 9 8 . B y th e n (e x c e p t th e F lo n g K ong b o a rd ) w ere u n d e rv a lu e d , y e t th e it w a s p r e tty c le a r th a t a ll th e d o lla r, w h ic h w a s fix e d by a cu rren c y s p e c u la tiv e p re s s u re s w e re a ll fo r f u r th e r d e p re c ia tio n . T h is w a s th e tim e w h e n th e H o n g K o n g m o n e ta ry a u th o rity u p s e t th e fre e m a rk e t f u n d a m e n ta lis ts b y b u y in g a b ig c h u n k o f th e e q u ity m a r k e t t o d e f e n d it s e lf a g a in s t t h e d o u b le p la y . T h e p r e s s u r e s w e r e r e lie v e d in S e p te m b e r a n d g a v e w a y to a s h a rp re b o u n d in e a rly O c to b e r w h e n th e H L Is w e re fo rc e d to d e liv e r f o llo w in g th e c o lla p s e o f L T C M . T he la rg e re p o rt d o c u m e n ts s h o rt p o s itio n s in th e f a c t t h a t a h a n d f u l o f H L Is e s ta b lis h e d th e s e o f n a tu ra l c o u n te rp a rtie s c u rre n c ie s (su c h th a t th e y as e x p o rte rs ) to s tre tc h e d th e such c a p a c ity o ffs e t th e ir p o s itio 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 in s t i n c t i v e l y a s k s is h o w t h e y e x p e c te 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 is 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 fo rc e a p ric e b e lo w its f u n d a m e n t a l v a lu e , b u t i t is q u i t e a n o t h e r t o m ake m o n e y o u t o f fo rc in g it th e re . T o d o th a t, o n e n e e d s to b e a b le to g e t o th e rs to s e ll 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 le v e ls i n o rd e r to o n e s s h o r t s a le 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 p ro fit by d o u b l e s e llin g th e p l a y , w h ic h in v o lv e d s e llin g H o n g K o n g d o lla r s h o rt, re ly in g o n ris e g e n e r a te d by th e cu rren c y b o a rd p ric e s . T h is w o u ld h a v e y ie ld e d t h e m ru le s in e q u itie s th e c lo se o u t H L Is s o u g h t t o sh o rt and th e n a u to m a tic in te re s t ra te o rd e r to fo rc e dow n e q u ity a p ro fit e v e n if th e H o n g K o n g d o lla r w a s n o t d e v a lu e d as lo n g as th e H o n g K o n g m o n e ta r y a u th o r ity p la y e d b y th e ru le s o f th e g a m e (w h ic h it d id n o t, b e c a u se it in te rv e n e d to b u y th e e q u ity in d e x ) . B u t in o th e r c a se s th e H L Is c o u ld h a v e e x p e c te d to p r o f it o n ly if th e y p a n ic k e d t h e m a r k e t. T h e e v i d e n c e is t h a t t h i s is 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 is c u s s e s a g g re s s iv e p r a c tic e s i n t h e f o r m in a tin g r u m o u rs d e s ig n e d to 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 ­ in f lu e n c e p ric e s so a s to b e n e f it th e p o s itio n s a lr e a d y ta k e n . A m a n a g e r o f a n H L I la r g e e n o u g h to h a v e s ig n if ic a n t m a r k e t p o w e r m ig h t m a k e n e g a tiv e c o m m e n ts o n a c u r r e n c y t h a t w o u ld d is c o u ra g e o th e r m a rk e t p a rtic ip a n ts fro m ta k in g c o n tra ry p o s itio n s . S o m e fin a n c ia 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 ig n e d to in flu e n c e th 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 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 by tra d in g ra th e r th a n tim e s to o k h e a v ily to a t illiq u id ra th e r th a n v ic e tra d in g b y o th e r p a rtic ip a n ts h o u rs , a p p a re n tly a tte m p tin g to m ove ra te s g e t tr a n s a c tio n s e x e c u te d a t th e b e s t p o s s ib le p ric e . H L Is a t c o rre la te d p o s itio n s w ith in an d a c ro s s m a rk e ts , p re s u m a b ly b y John W illia m s o n d e s ig n th o u g h n o o n e c o u ld p ro v e th a t it w as n o t b y 145 c o in c id e n c e . T h e se ta c tic s a t tim e s s u c c e e d e d in d riv in g m a n y re g u la r tra d e rs o u t o f th e m a r k e t fo r fear th a t th e y b y th e w o u ld be o v e rw h e lm e d by H L Is t h a t w e re n o t p la y in g n o r m a l ru le s o f a c o m p e titiv e m a rk e t. A t o th e r tim e s o th 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 ( ib i d .: 1 0 7 ) , o r a t l e a s t n o t to s ta n d i n t h e w a y o f p o s iti o n in g b y la r g e H L Is. A n d s o m e H L Is w e re a b le to ta k e a d v a n ta g e o f th e ir k n o w le d g e o f th e im p a c t o f p ric e c h a n g e s , fo r e x a m p le p ro p rie ta ry tra d in g k n o w le d g e a b o u t w h e n desks w ere a b le to ta k e a d v a n ta g e of d e c lin in g b o n d p ric e s w o u ld r e q u ir e b o n d th e ir s a le 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 te s t o le v e ls t h a t t h e y k n e w w o u ld trig g e r s to p -lo s s o rd e rs o r k n o c k - o u t o p tio n s . T h e s tu d y g ro u p d id n o t re a c h a consensus o n th e ro le a n d im p o rta n c e o f t h e a g g r e s s iv e t r a d i n g p r a c t ic e s t h a t i t d o c u m e n t e d , b u t i t is p r e t t y c le a r th a t m o s t m e m b e rs o f th e g ro u p m a r k e t in te g r ity . A fte r m a k in g c o n c lu d e d th a t s u c h p ra c tic e s th r e a te n e d a h o s t o f c a re fu l q u a lific a tio n s , th e re p o rt c o n c lu d e d : T h e g ro u p o f som e d u rin g is 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 o f th e a g g re s s iv e p r a c tic e s c ite d 1 9 9 8 ; i t is n o t , h o w e v e r , a b le t o in th e m a rk e t d y n a m ic s c a s e -s tu d y e c o n o m ie s re a c h a c o n c lu s io n o n th e s c a le o f th e s e p ra c tic e s , w h e th e r m a n ip u la tio n w a s in v o lv e d a n d th e ir im p a c t on m a r k e t in te g rity . fo r a s s e s sin g Som e m a n ip u la tio n g ro u p can m e m b e rs be se t to o b e lie v e h ig h th a t and th a t th e th r e s h o ld som e o f th e a g g re s s iv e p r a c tic e s r a is e i m p o r ta n t is s u e s f o r m a r k e t in te g r ity . T h e y a re o f th e v ie w th a t th e re is s u f f ic i e n t e v i d e n c e t o su g g e st th a t a tte m p te d m a n ip u la tio n c a n a n d d o e s o c c u r in fo re ig n e x c h a n g e m a rk e ts a n d s h o u ld b e a s e r io u s c o n c e r n f o r p o li c y m a k e r s ( ib id .) I t is d if f i c u lt t o im a g in e a m u c h m o re d a m n in g in d ic tm e n t c o m in g fro m a g r o u p o f o ffic ia ls . S tra te g ic issu e s T h e fo c u s h e r e w ill b e o n h o w u n s ta b le , r a th e r th a n o n t o m a k e in d i v i d u a l ty p e s o f c a p ita l f lo w le s s try in g to c a p ita l flo w s . A g o o d p la c e t o in flu e n c e th e m ix o f d iffe re n t fo rm s o f s ta rt c o n s id e rin g w h a t m ig h t b e d o n e in th is c o n n e c t i o n is t o c o n s id 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 th e e x p e c ta tio n s o f th o s e w h o a rg u e d th a t it w a s u n lik e ly to p o s e p ro b le m s o f in s ta b ility . I t c a n be c o n je c tu re d th a t th e re a so n lie s in th e w ay th a t f in a n c ia l m a rk e ts o p e ra te . C o n s id e r th e w o rd s o f K a u fm a n (2 0 0 0 : 6 1 ): A s m a r k e ts a n d a s s e ts h a v e c h a n g e d d r a m a tic a lly w ith th e e m e r g e n c e o f a new g lo b a l f in a n c ia l s y s te m , so h a s th e c o m p o s itio n o f f in a n c ia l in s ti­ tu tio n s th e m s e lv e s . T h e p o w e r a n d in flu e n c e o f tr a d itio n a l c o m m e rc ia l C u rb in g the B o o m -B u s t C ycle 146 banks, s a v in g s new an d w h ile a b re e d T h ese in s titu tio n s lo a n s , an d in s u ra n c e o f in s titu tio n a l a re c o m p a n ie s p a rtic ip a n ts d is tin g u is h e d by th e ir has have d im in is h e d , com e e m p h a s is to o n th e fo re . s h o rt-te rm in v e s tm e n t p e r f o r m a n c e , th e ir h e a v y u s e o f le v e ra g e , a n d th e ir w illin g n e s s to m o v e in a n d o u t o f m a rk e ts - w h e th e r e q u itie s , b o n d s , c u rre n c ie s , o r c o m m o d itie s - in a re le n tle s s q u e s t to m a x im iz e r e tu rn s . T h e n e w b re e d in c lu d e s t h e o f te n - r e v ile 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 le n o r th e le a d in g firm s , a n d c o n te s ta n ts . even a fe w In fa c t, m o s t p r o m i n e n t b a n k s , in s u ra n c e c o m p a n ie s p o ssess s e c u ritie s d e p a rtm e n ts th a t e m u la te th e tr a d in g a n d in v e s tm e n t a p p ro a c h o f th e h e d g e fu n d s . E v e n th e c o rp o ra te tre a s u rie s o f a n u m b e r o f n o n -fin a n c ia l c o rp o ra tio n s a re e n g a g e d i n th i s a c tiv ity . O n c e a r c a n e a n d e x o tic , t h e h e d g e f u n d a p p r o a c h to in v e s tm e n t h a s b e e n m a in s tre a m e d . In o th e r w o rd s th e f in a n c ia l m a rk e ts a re c u rre n tly d o m in a te d m e n t m a n a g e rs w ith a s h o rt-te rm is t p h ilo s o p h y , b a s e d o n to in m a x im iz e re tu rn s each an d e v e ry sh o rt ru n by in v e s t­ th e tru is m n e c e s s a rily th a t m a x im iz 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 ll. W h a t i t c le a r ly d o e s n o t m a x im i z e is t h e u s e fu ln e s s o f f in a n c ia l m a rk e ts to th o s e w h o ra ise fu n d s fro m A key q u e s tio n is w h e th e r s h o rt-te rm is t m anagem ent is th e m . re a lly in th e in te r e s t o f th e u ltim a te in v e s to rs : th e in d iv id u a ls w h o b u y m u tu a l f u n d s a n d t h e in s ti tu ti o n s w h o s e e n d o w m e n ts a n d w o r k in g a s s e ts a r e u n d e r m a n a g e ­ m e n t. T h e c o n tr a r y a r g u m e n t h a s b e e n d e v e lo p e d b y S w e n s e n (2 0 0 0 ), w h o is th 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 iv e rs ity and inter alia m anages its e n d o w m e n t . T h e b a s ic a r g u m e n t is 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 ris k s w h ip la s h ( s e llin g a n a s s e t ju s t b e f o r e i t ris e s o r b u y in g i t ju s t b e f o r e its p e a k ) a n d u n d e r m in e s th e lik e lih o o d o f s y s te m a tic c o n tr a r ia n in v e s tm e n t (b u y in g w h a t is c u r r e n t ly o u t o f fa s h io n S u c h a c tio n s o f te n s e e m an d s e l l i n g w h a t is c u r r e n t l y i n fa s h io n ). 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 is th a t o n a v e ra g e th e y a re m o re o fte n rig h t th a n w ro n g . T h e b a s ic c h a ra c te ris tic s o f a lo n g -te rm S w e n se n , in v o lv e c la s se s in a s tra te g ic d e c is io n ta rg e t p ro p o r tio n s b a s e d o n to in v e s t m e n t s tra te g y , a s la id o u t b y d iv id e lo n g -te rm th e p o rtfo lio am ong asset ris k -re tu rn c h a ra c te ris tic s . W i th in e a c h a s s e t c la s s, a s s e ts a re m a n a g e d b y in d iv id u a l m a n a g e r s w h o a re s e le c te d a c c o r d in g to th e ir p e r f o r m a n c e r e la tiv e to t h e r e s t o f th e a s s e t c la s s, a s in th e c o n v e n tio n a l s h o r t- te r m is t a p p r o a c h . B u t th e s tra te g ic e le m e n t in th is s tr a te g y le a d s to re s u lts t h a t a re e x a c tly c o n tr a r y to th o s e y ie ld e d b y th e D EA R ap p ro a c h d e s c rib e d a b o v e . F o r e x a m p le a m a rk et ru n o n e m e rg in g m a r k e t a s s e ts le 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 ts , i n o r d e r t o r e s to r e th e p r o p o r tio n o f th e p o rtfo lio in th a n to th e s a le o f s im ila r a s s e ts , t h a t a s s e t c la s s to its ta r g e t s h a r e , r a t h e r as u n d e r D E A R . T h is te n d s to s ta b iliz e m a rk e ts r a th e r th a n d e s ta b iliz e th 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 in d e e d a c h ie v e d s u p e rio r r e tu r n s . B u t John W illia m s o n so h a v e m o s t o f th e h e d g e fu n d s, th e par excellence e x a m p le o f th e 147 s h o rt- 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 is s u p e r i o r m a n a g e m e n t . O n e w o u ld need a m u ch m o re s y s te m a tic c o m p a ris o n to be a b le to d raw any s tro n g c o n c lu s io n a b o u t th e s u p e rio rity o f o n e a p p ro a c h o v e r th e o th e r fro m th e s ta n d p o i n t o f its a b ility to g e n e ra te re s u lts to th e u ltim a te in v e s to r. W h a t o n e c a n s u r e l y s a y is t h a t t h e r e is 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 lf-s e rv in g c la im o f th e s h o rt-te rm is ts th a t a n y a p p ro a c h o th e r th a n th e irs is s e lf - e v id e n tly a t t h e c o s t o f t h e in v e s to r . P e r h a p s th e b ig g e s t d if fic u lty w ith th e lo n g - te r m a p p r o a c h is t h e d i f f i c u l t y o f m o n ito rin g th e p e rfo rm a n c e o f in v e s tm e n t m a n a g e rs in re a l tim e . If o n e a b a n d o n s th e d is c ip lin e o f re g u la r c o m p a ris o n s w ith th e b e h a v io u r o f a p e e r g ro u p , p o o rly p e rfo rm in g m a n ag ers h a v e to o m u ch o p p o rtu n ity to p le 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 is 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 is n e e d e d t o g iv e t h e m a rk e t tim e to re a liz e th e e rro r o f its w a y s . B u t th e b e s t a n t i d o t e t o t h e la c k o f t h a t d is c i p lin e is 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 of d is c ip lin e in th e fo rm of a c o h e re n t lo n g -te rm s tra te g y such as th a t d e s c r i b e d a b o v e . I t is tr u s te 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 is c i p ­ li n e is i n p la 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 in v e s tin g ) a s a n y o n e e lse . E v e n th o u g h it c a n n o t b e p ro v e d a t th i s s ta g e , th e p re s u m p tio n is t h a t u ltim a te in v e s to rs a n d b o rro w e rs s h a re a c o m m o n in te r e s t in s e c u rin g a s h ift fro m th e c u rre n tly d o m in a n t m o d e o f s h o rt-te rm is t in v e s tm e n t m a n a g e m e n t to th e lo n g -te rm th e fo rm s tra te g y d e s c rib e d a b o v e . T h e y s h a re a c o m m o n e n e m y in o f t h e p o r tf o l io m a n a g e m e n t i n d u s tr y , a s i t is c u r r e n t l y o r g a n i z e d . T h is h a s a n in te r e s t in m a in ta in in g r e m u n e r a tio n b a s e d la rg e ly o n f r e q u e n t s h o rt-te rm c o m p a ris o n s h ig h re m u n e ra tio n in c o m e to done by p a y th e h ig h m eans w ith th e p erfo rm a n ce a n d lo ts o f p o rtfo lio s a la rie s . T h e q u e s tio n o f p u b lic p o lic y to o f p e e rs, w h ic h c h u rn in g to tilt th e g e n e ra te s g e n e ra te c o m m is s io n is w h e t h e r a n y t h i n g c a n b e b a la n c e o f a d v a n ta g e to w a rd s th o s e in v e s tm e n t m a n a g e r s w h o e m p lo y a lo n g - te r m s tra te g y . T h e r e m a in d e r o f th is c h a p te r c o n s is ts o f b r ie f e x p lo r a tio n s o f s e v e ra l id e a s t h a t m i g h t h e lp p u s h th in g s th a t w ay . A n a m en d ed UDROP P e rh a p s th e m o s t p r o m is in g p o s s ib ility in th is c o n n e c tio n is a n id e a th a t h a s s u r f a c e d a s a r e s u lt o f t h e r e p e a te d f in a n c ia l c ris e s a n d t h e c o s ts th e y h a v e im p o s e d o n th e ir v ic tim s : t h a t it s h o u ld b e p o s s ib le to d e c la re a m o r a ­ to riu m w ith o n d e b t s e rv ic e p a y m e n ts . M a n y o b s e rv e rs h a v e c o m e to fe e l th a t, p r iv a te c a p ita l flo w s a s la rg e a n d re s p o n s e to majeure. v o la tile a s th e y t h e o u t b r e a k o f a c u r r e n c y c r is is is t o T h is c o n c lu s io n is r e i n f o r c e d b y t h e a re n o w , th e in te rru p t a ru n b y fa c t th a t th e o n ly force c o u n trie s th a t c a m e o u t o f r e c e n t f in a n c ia l c rise s r e la tiv e ly q u ic k ly a n d le a s t b a d ly s c a rre d C u rb in g th e B o o m -B u s t C ycle 148 w e re th o s e q u ic k ly (n o ta b ly n e g o tia te d K o rea a an d B ra z il i n le n g th e n in g 1999) in w h ic h o f d e b t m a tu ritie s th e w ith a u th o ritie s an im p o rta n t c la s s o f c r e d i to r s . T h e t h i n k i n g is t h a t i n m a n y s u c h c r is e s t h e p r o b l e m is o n e o f illiq u id ity r a th e r th a n in s o lv e n c y ; th e c o u n tr y w o u ld b e c a p a b le 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 ) if o n ly th e r e p a y m e n t o b lig a tio n s w e re s p re a d b u t th e in c e n tiv e of an y in d iv id u a l c re d ito r o v e r a lo n g e r tim e p e rio d , is to cut an d ru n . s itu a tio n o n e n e e d s to s o lv e t h e c r e d ito r s c o o r d i n a ti o n p r o b le m th e m an in c e n tiv e to com e re s tru c tu rin g . A m o ra to riu m e lim in a tin g th e n eed to to th e ta b le an d q u ic k ly In th is b y g iv in g n e g o tia te a debt o r s ta n d s till c o u ld p ro v id e th a t in c e n tiv e b y cu t an d ru n . T h e p ro b le m is h o w to o ffe r th a t p o s s ib ility w ith o u t d e s tro y in g th e s a n c tity o f th e d e b t c o n tra c ts p rin c ip le th a t u n d e rlie s a n y c a p ita l m a rk e t. N o te s ta n d s till m e c h a n is m in v e s tm e n t s tra te g y a ls o t h a t a s u c c e s s fu lly d e s ig n e d m ig h t h a v e th e a ttra c tiv e fe a tu re o f s a b o ta g in g th e o f s h o rt-te rm is ts w h ile le a v in g lo n g -te rm s tra te g ie s re la tiv e ly u n s c a th e d . T o c o n s id e r th e p o s s ib ilitie s w e s h a ll s ta r t w ith th e m o s t c o n c re te p ro p o s a l fo r a s ta n d s till t h a t h a s y e t b e e n ta b le d , th e U D R O P p r o p o s a l b y B u ite r a n d S ib e rt (1 9 9 9 ). U D R O P is 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 ll 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 is in c lu d e s p r iv a te a n d s o v e re ig n , lo n g -te rm a n d s h o rt-te rm , m a rk e ta b le a n d n o n -m a rk e ta b le , n e g o tia b le a n d n o n -n e g o tia b le d e b t, in c lu d in g o v e r­ d ra fts , c r e d it lin e s , a n d c o n tin g e n t c la im s A ll b o r r o w e r s , p u b l i c and p r iv a te , m u s t b e g iv e n [a n ] o p t i o n . . . [th a t] w o u ld e n t itl e t h e b o rro w e r, a t h is s o le d is c r e tio n , to t h r e e o r s ix m o n t h s ) e x te n d m a tu rin g at a penalty rate. d e b t fo r a s p e c ifie d p e rio d (say T h e b o rro w e r w o u ld b e e n title d to t h e r o llo v e r o n ly if t h e d e b t i n q u e s tio n h a d b e e n s e r v ic e d i n fu ll, b a r r in g th e fin a l r e p a y m e n t... W e e x p e c t th e p e n a lty s p re a d a n d o th e r fe a tu re s o f th e ro llo v e r c o n tr a c t to b e n e g o tia te d b e tw e e n d e b to rs a n d c re d ito rs , r a th e r t h a n d e c re 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 ( ib id .: 2 3 1 - 2 ) . B u ite r a n d o th e rw is e cu rren c y S ib e rt s o lv e n t e m p h a s iz e b o rro w e rs d e b t b ecau se of a th a t w ho th e ir are liq u id ity schem e u n a b le c risis. is i n t e n d e d to ro ll H ow ever over m ost o n ly to th e ir fo re ig n c rise s a re h e lp n o t p u r e p a n ic s th a t a re re s o lv e d s im p ly b y th e p a s s a g e o f tim e . T h e y a rise w h e n c re d ito rs d e v e lo p d o u b ts a b o u t th e a b ility o f d e b to rs to on th e c o n tra c tu a lly ag re e d te rm s , an d th e y en d w h en s e rv ic e th e ir d e b ts th o s e d o u b ts are re s o lv e d . O n e h a s to a s k w h y a s ix - m o n th d e la y w ith o u t a n y r e s tr u c tu r in 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 is John W illia m s o n 149 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 rc is e d , w h ic h s u g g e s ts a d a n g e r t h a t a ll it w o u ld a c c o m p lis h w o u ld b e to d e la y th e c risis. N e v e rth e le s s an am ended v e rs io n o f th e U D RO P p ro p o s a l w o u ld be a n a tu r a l c o m p le m e n t to th e id e a s fo r a n in t e r n a t io n a l b a n k r u p tc y m e c h a n is m th a t w e re re c e n tly flo a te d b y A n n e K ru e g e r (2 0 0 1 ). E n fo rc in g th e s ta n d s till she e n v isa g e s w o u ld be m uch e a s ie r if a ll in t e r n a t io n a l lo a n s in c lu d e d a c la u s e th a t c o u ld b e in v o k e d to e x te n d th e m a tu r ity o f th e lo a n in th e e v e n t o f th e b o r r o w in g c o u n t r y f a c in g a c risis. T o tr a n s f o r m th a t c o u ld se rv e th e a lte r th e te r m fu n c tio n th is in to a p ro p o sa l o f a s ta n d s till, h o w e v e r, o n e w o u ld n e e d to fo r w h ic h th e ro llo v e r w o u ld a p p ly . T h e a b o v e d ia g n o s i s o f w h a t is n e e d e d t o e n d a d e b t c ris is s u g g e s ts 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 is l i k e l y t o b e n e e d e d . T h e t h r e e year e x te n s io n bank c re d ito rs In fa c t th is in s te a d of m a tu ritie s a t th e en d th a t of 1997 is a d i m e n s i o n n e g o tia te d b e tw e e n w as n e g o tia te d seem s m u c h th a t p ro b a b ly th e s h o u ld d e b to r a n d b e tw e e n K o re a m o re lik e ly to an d be its ty p ic a l. n o t b e p re s p e c ifie d , b u t a c re d ito r c o m m itte e ad hoc as a n d w h e n t h e r o ll o v e r o p t i o n is in v o k e d . T h e c r e d i to r s w ill p r e s u m a b ly s e e k th e s h o r te s t r o llo v e r p e r io d t h a t w ill a llo w th e d e b to r to r e s to r e its liq u id ity an d a escape r e a lis tic p a y in g fro m tim e th e c risis. B u t if th e y fra m e , a m o rtiz a tio n th e pro tern. s h o r te s t re a lis tic p e r io d a re d e b to r w o u ld T h e in c e n tiv e fo r th e r e c a lc itr a n t a b o u t a g re e in g be re lie v e d fo r th e r o ll o v e r is t o o f th e o b lig a tio n d e b to r to p re se rv e its a g ree to s ta n d in g in to of th e th e c a p ita l m a rk e ts . C re d ito rs h a v e re a c te d a d v e rs e ly to th e U D R O P id e a . If it tu r n s o u t th e y a re so s tro n g ly a v e rse to it as to b r in g le n d in g to a h a lt, o n e s o lu tio n m ig h t b e to e x e m p t lo n g -te rm b e a llo w e d to v o lu m e lo a n s a b o v e a c e rta in m a tu rity . T ra d e c re d its m ig h t s a tis fy th e o f c re d its to r e q u ire m e n t b y m e a n s o f a p ro v is io n re v o lv e o v e r tim e , o n th e a g re e m e n t w ith B ra z il. B u t l o a n s t h a t s h o u l d h ow im p a c t sev ere U D RO P th e w o u ld m e d iu m -te rm le n d e rs f in d s h o rt-te rm add to o n th e v o lu m e , ris k a re m o d e l o f th e fo r a g iv e n banks 1998 n o t b e e x e m p te d , n o s h o rt-te rm o f s h o rt-te rm lo a n s . le n d in g to I t is a d e b to r n a s s e ts th a t w h o se p o s i t i o n lo o k e d d o u b t f u l , b u t t h a t is t h e p o i n t . S h o r t- te r m is t it m o re d iffic u lt to p e rsu a d e th e m s e lv e s th a t th e y can buy a s s e ts a n d t h e n w in th e r a c e to e x it if th in 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 is e t h e i r c l ie n t s t h a t i t is s a f e t o te rm m a tte r tru e fro m c o u n try X b ecau se it lo o k s safe enough buy fo r m o n th s w o u ld b e u n d e r c u t. O n ly in v e s to rs w h o w e re w illin g to re la tiv e ly lo n g - te r m c o m m itm e n t w o u ld in v e s t in s h o rt­ th e next m ake a e m e r g in g m a r k e t lo a n s , a n d th o s e a re th e o n ly in v e s to rs w o r th h a v in g . U D R O P w o u ld n o t, o f c o u r s e , r e s o lv e t h e p r o b le m p o s e d b y s h o rt-te rm is 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 is a p r o b l e m h a v e to liv e w ith . w e a re g o in g to 150 C u rb in g th e B o o m -B u s t C ycle T ra d in g g u id e lin e s fo r fo r e ig n e x c h a n g e m a r k e ts In r e a c tio n to th e c ritic is m s by th e S u b -G ro u p o n M a rk e t D y n a m ic s of th e S tu d y G r o u p o n H ig h ly L e v e ra g e d I n s titu tio n s o f t h e F in a n c ia l S ta b ility F o ru m re fe rre d to above, in F e b ru a ry 2001 a g ro u p of 16 le a d in g banks a n n o u n c e d a v o lu n ta r y c o d e o f c o n d u c t. T h e id e a w a s th a t if a ll th e le a d in g b a n k s w ere to w hom s u b s c rib e to th e s e p rin c ip le s , a n d in c id e n ts lik e th o s e of A u g u s t-S e p te m b e r to p a rtie s th e re w o u ld b e n o th e y b e lie v e d to b e v io la tin g th e m , th e n deny fu rth e r 1998. liq u id ity T he p rin c ip le s th e y a n n o u n c e d w e r e a s fo llo w s : • B anks s h o u ld be s e n s itiv e to m a r k e t ris k an d c re d it m a n a g e m e n t a n d p a y s p e c ia l a t te n t io n to th e f in a n c in g o f tra d e s in a c u r r e n c y e x p e rie n c in g h ig h v o la tility . • F o re ig n exchange m a n a g e rs s h o u ld pay p a rtic u la r c a re w h e n e x e c u tin g o rd e rs in tim e s o f v o la tility a n d m a rk e t m a k e rs s h o u ld h a v e th e r ig h t to re fu s e c u s to m e r tra n s a c tio n s th a t th e y fe lt m ig h t f u r th e r d is r u p t o r in te n d to d is r u p t m a rk e ts . • S to p /lo s s o rd e rs: fo re ig n exchange m a n a g e rs s h o u ld c o m m u n ic a te fre ­ q u e n tly w ith c u s to m e r s o n m a r k e t d e v e lo p m e n ts , e s p e c ia lly w ith re g a rd t o in d i v i d u a l tr i g g e r le v e ls . • C a re s h o u ld b e ta k e n th a t c u s to m e rs in te re s ts w e re n o t e x p lo ite d w h e n fin a n c ia l in te rm e d ia rie s tr a d e d fo r th e ir o w n a c c o u n t. • I n s tit u tio n s s h o u ld b e a t te n t iv e a t a ll tim e s t o e n s u r e t h e in d e p e n d e n c e a n d in te g rity o f a n y m a rk e t-re la te d re s e a rc h th e y p u b lis h e d . • F in a n c ia l in te r m e d ia r ie s h a n d lin g o f ru m o u rs. s h o u ld D e a le rs im p le m e n t rig o ro u s s h o u ld n o t re la y g u id e lin e s in fo rm a tio n o n th a t th e th e y k n e w to b e fa lse o r s u s p e c te d m ig h t b e in a c c u r a te . • M a n ip u la tiv e p ra c tic e s b y b a n k s w ith e a c h o th e r o r w ith c lie n ts c o n s ti­ tu te d u n a c c e p ta b le tr a d in g b e h a v io u r. • F o re ig n exchange e x p lo ita tio n of tra d in g m an ag em en t e le c tro n ic d e a lin g s h o u ld s y ste m s to p ro h ib it th e g e n e ra te d e lib e ra te a rtific ia l p ric e b e h a v io u r. I t is r a t h e r s a d announ ce th e ir c lie n ts s h o u ld be th a t it w as th a t in o r to fu tu re n e c e ssa ry th e y p u b lis h w o u ld re se a rc h fo r le a d in g f in a n c ia l in s titu tio n s c o n s id e r it b a d th a t la c k e d fo rm to in te g rity , b u t p e r h a p s th a n k f u l fo r s m a ll m e rc ie s . A t p r e s e n t th e r e to m a n ip u la te ap p e a rs to be w e no in te n ti o n to in v e s tig a te w h e th e r b a n k s a re liv in g u p to th e ir v o lu n ta r y c o d e . I t w o u ld b e w o r th a d d in g th is to t h e ta s k s im p o s e d o n s u p e r v is o r s . L im ita tio n s o n in v e s tm e n t-g r a d e b o n d s In v e s to rs w ith fo rb id d e n fid u c ia ry re s p o n s ib ilitie s , s u c h (a t le a s t in th e U n ite d S ta te s ) t o as in s u ra n c e h o ld b onds c o m p a n ie s , a re t h a t a r e le s s t h a n John W illia m s o n i n v e s t m e n t g r a d e . A t f ir s t g l a n c e is m a y seem 151 s e n s ib le , s in c e it p re c lu d e s th e s e in s titu tio n s a b u s in g th e ir p o s itio n o f tr u s t b y u s in g in v e s to rs 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 , is t h a t t h i s r e q u i r e ­ m e n t is s p e c if ie d i n te 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 ire . T h e d iffe re n c e can be c ru c ia l. I n la te 1997 in s u ra n c e h o ld in g K o re a n b o n d s w e re fo rc e d b y th is re q u ire m e n t to c o m p a n ie s s e ll t h e m in th e m id s t o f th e m a r k e t im p lo s io n , w h e n th e c r e d it r a tin g a g e n c ie s h a d p a n ic k e d an d s u d d e n ly w e re n o t c u t K o r e a s a llo w e d to ra tin g e x e rc is e to th e ir b e lo w in v e s tm e n t g ra d e . T h e ju d g e m e n t o f w h e th e r h o ld e rs K o re a n bonds r e m a in e d a g o o d in v e s tm e n t ( w h ic h th e y c e rta in ly w e re a f te r th e ir p ric e h a d c o lla p s e d ) b u t w e r e f o r c e d t o s e ll 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 re a , a t th e c o s t o f th e ir c lie n ts . A n y such re q u ire m e n t s h o u ld be re d ra fte d to lim it w h a t fid u c ia ry in v e s to rs c a n b u y r a th e r th a n w h a t th e y c a n h o ld . T h a t w o u ld 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 ll 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 in g , as h a p p e n e d in K o re a in la te 1 9 9 7 . A s w e ll a s m a k in g b o n d le n d in g s o m e ­ w h a t m o r e s ta b le , th is c h a n g e w o u ld re d u c e th e p r e m iu m o n s h o rt-te rm is t a s s e s s m e n t o f w h e th e r a n d w h e n c re d it ra tin 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 c o n tr a c ts A fiv e -y e a r lo a n w ith a p u t o p tio n r e a lly a fiv e - y e a r b o n d ; f r o m m o n th be lo a n w ith c o u n te d as e x e rc is a b le in s ix -m o n th s tim e a r o llo v e r p r o v is io n if t h e le n d e r c o n s e n ts a n d su ch in th e is n o t a n e c o n o m i c s t a n d p o i n t i t is a s h o r t - t e r m , s ix - s ta tis tic s . C o rre c t re p o rtin g w o u ld it s h o u ld fo rc e b o th 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 ris k s b e i n g ta k e n . O n e w o u ld e x p e c t th a t th is w o u ld d im in is h th e a ttra c tiv e n e s s o f a g re e in g to th e in c lu s io n o f p u t o p tio n s in b o n d c o n tra c ts , an d hence le n g th e n th e e ffe c tiv e m a tu r ity o f b o n d s . C o lle c tiv e a c t io n c la u se s O n e o f th e re a s o n s fo r th e s w itc h fro m le n d in g b o n d s to in th e re s tru c tu rin g T h is w a s b a s e d in Y o rk la w in b a n k le n d in g in th e 1 9 9 0 s w as w ith o u t m u c h w hen a c o u n try p a rtic u la r o n 1 9 3 9 to re s tra in d o u b t th e ra n in to 1 9 7 0 s to b o n d le s s e r v u ln e r a b ility o f d e b t s e rv ic in g p ro b le m s . p ro v is io n s th a t w e re in tr o d u c e d in to a b u s iv e d e b t b u y b a c k s th a t h a d a rb itra rily e x p r o p r ia tin g s o m e c re d ito rs (B u c h h e it a n d th e N ew e ffe c t o f G u la ti, 2 0 0 0 : 6 6 -7 ). T h e p ro v is io n s in q u e s tio n r e q u ire d u n a n im o u s c o n s e n t b y b o n d h o ld e r s to a n y c h a n g e in th e te r m s o f th e p a y m e n t c la u s e s , w h ic h w e re th o s e c la u s e s th a t s p e c ifie d th e sum s to be p a id in debt s e rv ic e an d th e d a te s w hen p a y m e n ts w e re d u e . T h is g a v e a s in g le r e c a lc itr a n t b o n d h o ld e r - o r a v u ltu r e fu n d th a t b o u g h t u p d is tre s s e d d ebt - th e a b ility e ith e r to p re v e n t a d eb t r e c o n s tr u c tio n w h e n th a t w a s n e c e s s a r y o r to in s is t o n fu ll r e p a y m e n t e v e n w hen o th e r h o ld e rs h a d c o u ld n o rm a lly e x p e c t to a g re e d to dem and, a c c e p t le s s . I n d e e d an d w in fro m th e su ch a b o n d h o ld e r c o u rts, a c c e le ra te d 152 C u rb in g th e B o o m -B u s t C y cle 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 rv ic e w a s in t e r r u p te d b e f o r e th e d e b t r e c o n ­ s tru c tio n . N a tu ra lly s a c rific e s w h e n th e o th e rs p ro sp e c t d id , an d th a t som e c re d ito rs w o u ld n o t d e b to r w o u ld th a t th e in d e e d be m ake a b le to s e rv ic e th e c la im s o f th e h o ld o u ts p re c is e ly b e c a u s e t h e o th e r s h a d a g re e d to a c c e p t a w r ite - d o w n o f th e ir c la im s , m e a n t t h a t th e m a jo r ity w e re r e lu c ta n t to e n d o rse b o n d u n a b le to re s tru c tu rin g s . It c o u ld e v e n b e th a t th e h o n o u r th e re v is e d d e b t te rm s b ecau se o f th e d e b to r w o u ld b e p a y m e n t it w as fo rc e d to m a k e to th e h o ld o u t b o n d h o ld e rs . A s lo n g a s b o n d s w e re a s m a ll p a r t o f th e to ta l c la im s o u ts ta n d in g , it w a s s im p le r to a llo w th e m to r e m a in in ta c t w h e n b a n k c la im s w e re r e s tr u c tu r e d . I t w a s c le a r th a t th is c o u ld n o t c o n t in u e if d e b to r s r a n in to tr o u b le w h e n b o n d s h a d b e c o m e a la r g e p a r t o f t h e t o t a l d e b t, a n d in d e e d i n la te r y e a rs t h e o ffic ia l s e c to r s ta r te d to c a ll f o r p r iv a te s e c to r in v o lv e m e n t in d e b t w o r k o u ts (th e G 10 in 1 9 9 6 ). L ed by E ic h e n g re e n an d P o rte s (1 9 9 5 ), a n um ber of e c o n o m is ts h a d a lre a d y s ta r te d to a d v o c a te th e in c lu s io n o f c o lle c tiv e a c tio n c la u s e s in a ll b o n d c o n tr a c ts in o r d e r to fa c ilita te th e r e s tr u c tu r in 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 th i s p r o p o s a l w a s f ir s t m o o t e d th e r e w e r e d ir e p r e ­ d ic tio n s b y s o m e N e w Y o rk -b a s e d le n d e r s , e c h o e d b y s o m e o f th e ir c lie n ts , t h a t a n y a t te m p t to in c lu d e s u c h c la u s e s w o u ld b r in g le n d in g to a h a lt, o r a t th e le a s t le a d to d ra s tic in c re a s e s in in te r e s t ra te s . T h e n it w a s re a liz e d th a t about one th ird o f s u c h b o n d s , n a m e ly m o s t o f th o s e s ig n e d in L ondon, a lr e a d y in c lu d e d s u c h c la u s e s . E ic h e n g re e n a n d M o d y (2 0 0 0 a , 2 0 0 0 b ) th e r e ­ fo re fo r e x a m in e d b o rro w e rs, w h e th e r as per th e th e c la u se s h ad p re d ic tio n . re s u lte d It tu rn e d in o u t h ig h e r th a t th e in te re s t ra te s im p a c t w as m o d e s t a n d , in te re s tin g ly , t h a t th e d ir e c tio n o f th e im p a c t d e p e n d e d o n th 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 re d it ra tin g s d id in d e e d h a v e to p a y s o m e w h a t m o re to b o rro w w h e n th e y h a d th e a d d e d s e c u rity o f c o lle c tiv e a c tio n c la u s e s , p r e s u m a b ly re fle c tin g le n d e r s c o n c e r n th a t u n w ill­ in g n e s s to p a y m i g h t c a u s e b o rro w e rs to a b u s e th e c la u s e s , e v e n if th e y w e re a b le to p a y . B u t c o u n tr ie s w ith g o o d c re d it ra tin g s a c tu a lly p a id s o m e w h a t le s s , p r e s u m a b ly r e f l e c ti n g le n d e r s r e c o g n i t i o n t h a t t h e c la u s e s w o u ld r e d u c e t h e c o s t o f r e s tr u c tu r in g d e b t ( a n d th e p o s s ib le in t e r r u p ti o n in d e b t s e rv ic e p a y m e n ts w h ile th is h a p p e n e d ) in th e r e m o te p o s s ib ility th a t th e c o u n trie s f o u n d th e m s e lv e s u n a b le to p a y . L a w y e rs h a v e n o w f o u n d a w a y o f r e c o n s tr u c tin g b o n d s is s u e d u n d e r N e w Y o rk la w , e v e n w i t h o u t c o l le c t iv e a c t i o n c la u s e s ( B u c h h e it a n d G u la t i, 2 0 0 0 ) . T he key is t o accom pany th e o ffe r to sw ap o ld bonds fo r n e w o n e s th a t c o n ta in th e r e v is e d p a y m e n t te r m s b y a m e n d in g th e n o n - p a y m e n t c la 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 le s s a t tr a c t iv e a n d im p e d e h o ld o u t b o n d h o ld e r s fro m or a c c e le ra te d w a iv e r of s u c c e s s fu lly litig a tin g fo r c o n tin u e d p a y m e n t. F o r e x a m p le th e s o v e re ig n im m u n ity m ay be o ld b o nds m ay w ith d ra w n and be d e lis te d , th e n e g a tiv e p le d g e p r o te c tio n m a y b e re m o v e d , a ll w ith o u t th e n e e d fo r t h e u n a n im ity th a t p r e ­ v e n ts r e v is io n o f th e p a y m e n ts c la u s e s . S in c e th e s e d is f ig u r in g a m e n d m e n ts John W illia m s o n 153 to th e te rm s o f th e o ld b o n d s a re a d o p te d s im u lta n e o u s ly w ith b o n d h o ld e rs e x c h a n g in g th e ir o ld b o n d s fo r th e n e w d e b t in s tru m e n ts , th e y a re k n o w n a s e x i t c o n s e n t s . E x it 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 th e 1 9 8 0 s, a n d in 1 9 9 9 E c u a d o r w a s th e firs t c o u n tr y to u s e t h e te c h n iq u e to re s tru c tu re s o v e re ig n b o n d s . E x it c o n s e n ts h a v e o n e g r e a t a d v a n ta g e o v e r c o lle c tiv e a c tio n c la u s e s : th e y c a n b e u s e d to d e a l w ith th e s to c k o f o ld b o n d s , r a th e r t h a n s im p ly a llo w in 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 is a d v a n ta g e : th e y do n o t g iv e to t a l p r o te c ti o n a g a in s t th e th r e a t o f liti­ g a tio n b y h o ld o u ts . A n o p tim a l s tra te g y fo r a n e m e r g in g m a r k e t (o r a t le a s t fo r o n e w ith a re p u ta tio n as a g o o d c re d ito r) w o u ld b e to e n su re t h a t a ll n e w b o n d s c o n ta in e d c o lle c tiv e a c tio n c la u s e s , w h ile b e in g re a d y to u s e e x it c o n s e n ts o n o ld b o n d s s h o u ld t h e n e e d a rise . It w o u ld b e v e r y e a s y to e n s u r e th a t its n e w b o n d s c o n ta in e d s u c h c la u s e s : a ll it w o u ld n e e d to d o w o u ld b e to s h ift its b o r r o w in g to L o n d o n u n til N e w Y o rk la w w as am en d ed so th a t t h e te r m s o f its s ta n d a r d b o n d c o n t r a c t in c lu d e d c o lle c tiv e a c tio n c la u s e s . M ig h t th e in c lu s io n o f c o lle c tiv e a c tio n c la u s e s in b o n d c o n tr a c ts a c tu a lly m a k e b o n d s m o r e a t tr a c t iv e f o r c r e d ito r s t o h o l d a s w e ll a s m a k in g life e a s ie r f o r d e b to r s if th e w o r s t h a p p e n s ? T h a t w o u ld d e p e n d o n th e n e t o u tc o m e o f tw o o p p o s in g w o u ld c o n s id e ra tio n s . re d u c e th e d e b to r b e c o m e o th e r hand, cost u n a b le th e O n an d to th e one d is ru p tio n h an d , of debt pay th e ease g re a te r o n o rig in a lly of re n e g o tia tin g c o lle c tiv e a c tio n re s tru c tu rin g th e te rm s . O n c o n tra c te d te rm s c la u s e s s h o u ld th e m ig h t e n c o u ra g e a d e b to r to s u c c u m b to th e te m p ta tio n to a v o id p a y in g w h e n it c o u ld d o so . 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 le to d is c rim in a te b e tw e e n th e c o u n trie s in w h ic h e a c h e ffe c t d o m in a te s , w h ic h becom e s u g g e s ts t h a t th e y a re u n lik e ly ro u tin e . B y m a k in g m o re to s u ffe r if c o lle c tiv e e x p lic it th e p o s s ib ility a c tio n c la u se s t h a t b o n d s w ill h a v e to b e re s tru c tu re d , o n e w o u ld e x p e c t c o lle c tiv e a c tio n c la u s e s to m a k e p o te n tia l b u y e rs w e ig h u p h e lp to c u rb th e c h a n c e s o f th e ir b e in g in v o k e d , w h ic h w ill s h o rt-te rm is m . T h o s e w h o s till b u y th e m a re th e re fo re m o re lik e ly to p r o v e p a t ie n t h o ld e rs . C u r re n cy o f d e n o m in a t io n O ne re a so n le n d in g to w hy an c u rren c y e m e rg in g c rise s te n d to m a rk e t c o u n try be so d is ru p tiv e is th a t fo re ig n is a l m o s t a l w a y s d e n o m i n a t e d in e i t h e r d o lla r s o r (if d if f e r e n t) t h e c u r r e n c y o f t h e le n d e r . T h is m e a n s t h a t a n y d e v a lu a tio n in c re a s e s th e b o rro w in g o f its d o m e s tic c u rre n c y , w h ic h , in b a n k ru p tc y in A sia in 1 9 9 7 ). th e In c o u n t r y s f in a n c ia l a n d /o r c o rp o ra te c o n tra s t m a n y fo re ig n lia b ilitie s in te rm s e x tre m e c a se s c a n th r e a te n w id e s p re a d in d u s tria l s e c to rs (a s h a p p e n e d c o u n trie s b o rro w in E ast p re d o m in ­ a n t l y i n t h e i r o w n c u r r e n c ie 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 le s s th re a te n in g . C u rb in g th e B o o m -B u s t C y cle 154 T h e re fo re one change to th a t se e m s h ig h ly d e n o m in a te d e s ira b le w o u ld to use H ausm ann ( 1 9 9 9 ) i m p l y t h a t t h i s is 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 - to o r i g i n a l s i n . N o E ic h e n g re e n th e cu rren c y m a r k e t c o u n trie s a s s u ffe rin g fro m in te r n a tio n a l lo a n s . be b o r r o w e r s and e v i d e n c e is p r e s e n t e d ju s tify th e in n u e n d o t h a t th e p ra c tic e o f d e n o m in a tin g lo a n s in fo re ig n c u r r e n c ie s is 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 in s t a n c e s o f e m e r g in 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 is S o u t h A f ric a . I n s t e a d o f d is m i s s i n g t h e p o s s i b ili ty o f a c h i e v i n g s u c h a d e s ir ­ a b le re fo rm , it m a k e s m o re se n se to try to u n d e rs ta n d w h y it h a p p e n s so ra re ly , a n d th e r e f o r e w h a t c o n d i tio n s m i g h t b e n e c e s s a r y to m a k e it t h e n o r m . W h y m ig h t le n d e rs se e k to a v o id c u rre n c y e x p o s u re ? T h e s tro n g e s t re a s o n is a a d e s ire re c o rd to a v o id h o ld in g o f irre s p o n s ib le a s s e ts in a cu rren c y m a c ro e c o n o m ic w h o se a u th o ritie s m a n a g e m e n t th a t c o u ld have le a d to u n p r e d ic ta b le lo s s e s th r o u g h d e v a lu a tio n . B u t m o s t e m e r g in g m a r k e ts h a v e got beyond th e s ta g e o f th in k in g s tra te g y . S in c e m o s t e m e r g in g th a t c h e a tin g m a rk e ts d o m e s tic t h e i r c r e d i to r s is a c le v e r in te re s t ra te s a re h ig h e r t h a n d o lla r in te r e s t r a te s a t m o s t tim e s , it c a n b e e x p e c te d t h a t a le n d e r w ill e a rn m o re fro m lo a n s d e n o m in a te d in th e b o rro w e rs ’ c u rre n c y in n o rm a l t i m e s . I n d e e d t h e r e is 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 re m iu m w ill te n d t o m a k e d o m e s tic c u r r e n c y b o r r o w in g m o r e e x p e n s iv e to 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 tiv e t o th e le n d e r . W h a t it w ill a c c o m p lis h is 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 is 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 is le 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 lo a n s in th e lo c a l c u r r e n c y w o u ld e s s e n tia lly r e d is tr ib u te e a rn in g s o v e r tim e in s u c h a w a y a s to re d u c e t h e p re s s u r e o n b o r r o w e r s a t p a r tic u la r ly d iff ic u lt tim e s , w ith o u t r e d u c in g o f e x p e c te d e a rn in g s . A in d e e d , p ro b a b ly in c re a s in g le n d e r th a t w as p a rtic u la rly th e p re s e n t v a lu e co n c ern ed to a v o id s h o w i n g a b a l a n c e - s h e e t lo s s c o u l d c o v e r its p o s iti o n i n t h e f o r w a r d m a r k e t (w h e th e r th e b o rro w in g o f a d e v a lu a tio n w o u ld c o u n try depend w o u ld o n s till re d u c e w h e th e r th e its ris k s in th e event c o v e r w a s p ro v id e d by a d o m e s t ic o r a f o r e i g n p a r t y ) . T h is s u g g e s ts t h a t i t is p r e t t y d if f i c u lt t o ju s tif y le n d e rs o b s e s s io n w ith a v o id in g fo re ig n c u rre n c y e x p o s u re . T h e g re a te r s e c u rity o f o w n -c u rre n c y b o r r o w in g w a s re c o g n iz e d in th e 1 9 8 8 B a se l A c c o rd , w h ic h a llo w e d th e p r e f e r e n tia l 2 0 p e r c e n t ris k w e ig h t to a p p ly to lo n g -te rm b a n k le n d in g in n o n -O E C D c o u n trie s w h e n it w as d e n o m in ­ a t e d in , a n d f i n a n c e d in , t h e lo c a l c u r r e n c y . T h e p o li c y q u e s t i o n is w h e t h e r th e in d u s tria l c o u n trie s s h o u ld n o t g o f u r th e r a n d d r o p th e r e q u ir e m e n t th a t l e n d i n g b e f in a n c e d b y lo c a l c u r r e n c y d e p o s its o r b o r r o w in g , a n d t h u s g iv e a n in c e n tiv e fo r f o r e ig n le n d in g to b e d e n o m in a te d in t h e lo c a l c u rre n c y . R e m u n e r a tio n p r a c tic e s M o st m a n ag ers s tru c tu re th a t in is th e a s s e t m a n a g e m e n t b u s in e s s in te n d e d to a lig n th e ir p e rso n a l w e lfa re o f th e ir p r in c ip a ls . T h is ta k e s th e f o r m face a re m u n e ra tio n in c e n tiv e s w ith th e o f a b a s e s a la ry a u g m e n te d John W illia m s o n by a s u b s ta n tia l b o n u s s a la r y is i n t e n d e d even if th e ir o f th e to if a s u p e rio r p e rfo rm a n c e se c u re a re a s o n a b le s ta n d a rd p e rfo rm a n c e b e n e fit th a t w o u ld e x c e p tio n a l, th u s is a v e ra g e , ac c ru e p ro v id in g th e m to w h ile th e ir w ith is a c h ie v e d . T h e base o f liv in g fo r m a n a g e rs th e b o n u s p rin c ip a ls an 155 in c e n tiv e pays th e m if th e ir to p a rt re tu rn s s triv e to a re a c h ie 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 is 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 th e p o r tf o lio s th e y m a n a g e a c h ie v e a h ig h e r r e tu r n th a n th e n o r m fo r th e a s s e t c la s s in w h ic h th e y a re in v e s tin g , a s m e a s u r e d b y th e in d e x fo r th a t a s s e t c la s s. T h e p ro b le m w i t h t h i s p r a c t ic e is 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 re d e fin e d m a y n o t b e lo n g e n o u g h fo r a c o n tr a r ia n in v e s tm e n t p o lic y to b e a r f ru it. If b o n u s e s a re p a id a n n u a lly a n d a f a d la s ts o n ly a fe w m o n t h s , t h e n t h e b o n u s s y s te m w ill g iv e m a n a g e r s t h e r ig h t in c e n tiv e . B u t if b o n u s e s a re p a id o n a n a n n u a l b a s i s ( o r w o r s e , a s is n o r m a l i n m u t u a l f u n d s , q u a r ­ te rly ), a n d a f a d la s ts f o r y e a rs , t h e n r e s p o n s ib le in v e s t m e n t m a n a g e r s w h o m ake lo n g -te rm c o n tra ria n in v e s tm e n ts can fin d th e m s e lv e s fo re g o in g b o n u s e s f o r lo n g p e r io d s . W o rs e , th e y m a y ris k b e in g f ir e d f o r f a llin g b e h i n d th e in d e x fo r a p e rio d s h o rte r th a n a fa d c a n la s t. T h e b o n u s s y s te m a tte m p t to re s p o n d to th e re a l p ro b le m is a n o f m a k in g su re th a t m a n a g e rs a c t in th e in te r e s t o f th e ir p rin c ip a ls , b u t it c a n p ro v id e a n in c e n tiv e fo r m a n a g e rs to c o m p e te to b e a t th e in d e x in th e s h o r t te r m d e p a rt to o far fro m it in th e a n d m a k e su re th e y d o n o t lo n g e r te rm , a p ra c tic e th a t c a n a m p lify a n d p r o lo n g fa d s. T he im p o rta n c e a tta c h e d ch o sen b en c h m a rk o n th e to to m a n ag ers h a s th e u n fo rtu n a te p a rt o f m a n a g e rs. N o b e m is v a lu e d b y th e m a tte r h o w m a rk e t, th e y p erfo rm a n ce re la tiv e to th e ir e ffe c t o f in d u c in g h e r d b e h a v io u r s tro n g ly th e y b e lie v e a s e c u rity s im p ly c a n n o t a ffo rd to fo llo w th e ir c o n v i c t i o n s if t h e y b e l ie v e t h a t t h e c r o w d is g o i n g t o p e r p e t u a t e its e r r o r f o r a n y le n g th o f tim e . T h a t w a y th e y ris k n o t m e r e ly th e ir b o n u s e s , b u t p e r h a p s e v e n th e ir jo b s . P ro fe s s io n a l p r u d e n c e d ic ta te s n o t s tr a y in g to o fa r f r o m th e b e n c h m a r k , t h a t is , n o t d e f y i n g t h e h e r d . S in c e th e p r o b le m th e h e rd in lo n g -te rm e x p lo re th e is 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 s h o rt te rm w ith o u t p a y in g c o n se q u e n c e s o f w h e re th e h e rd th e p o s s ib ility o f in tro d u c in g p ro p e r a tte n tio n lo n g e r-te rm d e s ig n . S u p p o se , fo r e x a m p le , th a t m a n a g e rs a f te r a d e la y , a n d th e n to th e lik e ly is h e a d in g , i t s e e m s n a t u r a l t o w ere p e rfo rm a n c e p a id o n ly if s u b s e q u e n t e v e n ts h a d in to th e ir b o n u s th e o n ly n o t e s ta b lis h e d th a t t h e ir in v e s t m e n t s tr a te g ie s w e r e fla w e d . T h is w o u ld p r o v id e a v e r y c o n c r e te in c e n tiv e to assess th e lo n g e r-te rm s u s ta in a b ility of th e s tra te g ie s th e y w e re c h o o s in g to p u rs u e . A n d it w o u ld n o t b e d iffic u lt to u s e ta x p o lic y to e n c o u r a g e a ll a s s e t m a n a g e m e n t o r g a n iz a tio n s to re v is e th e ir r e m u n e r a ti o n p ra c tic e s p ro m p tly in or th is w a y : a p ro v is io n w ith o u t a p p ro p ria te c o u ld e x p e n s e th a t e m p lo y e rs w e re e n title d to la tin g ta x a b le p ro fit. be in tro d u c e d c o n d itio n a lity w o u ld d e d u c t fro m th a t b o n u se s n o t count rev en u e w h e n p a id as an c a lc u ­ C u rb in g th e B o o m -B u s t C ycle 156 Such th e an sam e a p p ro a c h jo b w o u ld be re la tiv e ly th e ir th ro u g h o u t c a re e r, a m a n a g e r q u itte d . O n e w o u ld easy b u t if a s s e t m a n a g e r s d iffic u ltie s n o t w a n t to g iv e a n w o u ld s ta y e d a rise in w hen a rtific ia l in c e n tiv e to a c c e le ra te tu r n o v e r b y p a y in g o u t th e b o n u s u n c o n d itio n a lly to a n y m a n a g e r w h o q u it h is o r h e r jo b . C o u ld o n e n o tio n a lly fre e z e t h e p o r tf o lio a s it w a s o n th e le a v in g d a te a n d a p p ly th e a g re e d te s t to th a t h y p o th e tic a l p o rtfo lio ? S in c e m a n a g e r s c h a n g e th e ir p o r tf o lio s q u ite f r e q u e n tly , t h a t w o u ld h a r d ly seem ju s t. W o u ld one lo o k at th e p erfo rm a n ce a c h ie v e d by h is or her 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 th e sa m e ? If th a t w e re a g o o d a s s u m p tio n , o n e w o u ld h a v e to d o u b t w h e th e r it w as w o rth m a n a g e r to c h a n g in g c o n tin u e th e m a n a g e r. m a n a g in g W o u ld one re q u ire a h y p o th e tic a l p o rtfo lio th e d e p a rtin g fo r th e n e x t fiv e y e a rs to e s ta b lis h w h e th e r s h e o r h e c o u ld h a v e a c h ie v e d th e h u r d le le v e l o f p e r f o r m a n c e ? T h i s is 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 is n e e d e d . A n a lte r n a tiv e a p p r o a c h w o u ld in v o lv e a m o r e ra d ic a l c h a n g e in th e w a y th e in d u s tr y f u n c tio n s , w ith tru s te e s ta k in g o n a b ig g e r p a r t o f t h e b u r d e n . In s te a d o f h irin g m a n a g ers to m ake th e c ritic a l d e c is io n s and s e e k in g to b la m e th o s e m a n a g e rs w h e n th in g s w e n t w ro n g , tru s te e s c o u ld th e m s e lv e s d e c id e to b uy an d h o ld a c e rta in p r o p o r tio n th e n h ire fo r th e lo n g te rm . O r th e y c o u ld d e c id e to in v e s t o f th e ir p o rtfo lio in , say, e m e rg in g -m a rk e t b o n d s a n d a m a n a g e r to lo o k a f te r it f o r fiv e o r t e n y e a rs, w ith th e bonus to b e d e te r m in e d o n ly a t t h e e n d o f t h a t p e r io d o n t h e b a s is o f c u m u la tiv e p erfo rm a n ce a s s ig n in g a over th e p o rtfo lio w h o le to a p e rio d . m anager T hey fo r a m ig h t even e x p e rim e n t te n -y e a r p e rio d and h is o r h e r s e n s e o f p ro fe s s io n a l re s p o n s ib ility to m o tiv a te h im in th e b e s t lo n g -te rm w ith re ly in g on o r h e r to a c t in te r e s t o f th e p rin c ip a ls . T h is a s s u m e s th a t th e r e a re c o m p e te n t p e o p le w h o fin d a p ro fe s s io n a l c h a lle n g e s u ffic ie n t m o tiv a tio n f o r e x c e p tio n a l e ffo rt, w ith o u t th e n e e d fo r m o n e ta r y in c e n tiv e s , w h ic h is ta k e n fo r g r a n te d in m a n y o th e r p ro fe s s io n a l a re a s. C o n c lu d in g rem a rk s T he th e to b o o m -b u st c y c le in s h o rt-te rm is t n a tu r e le n d in g w h ic h in d iv id u a l p a r tic ip a n ts in m e a su re s, such as to o f m o d e rn p e rs u a d in g e m e rg in g m a rk e ts f in a n c ia l m a rk e ts is an d e x a g g e ra te d th e by in c e n tiv e s th o s e m a rk e ts a re s u b je c t. W h ile s o m e banks to a b id e by th e ir v o lu n ta ry code of c o n d u c t, m a y b e r e la tiv e ly e a s y to a c h ie v e , m o s t o f th e o th e r e a s y o n e s (s u c h as re q u irin g p r o p e r a c c o u n tin g o f b o n d s w ith p u t o p tio n s ) s e e m u n lik e ly to a c h ie v e a g r e a t d e a l. C h a n g in g r e m u n e r a tio n p ra c tic e s m ig h t b e im p o r ta n t, a lth o u g h it w ill b e d if f ic u lt to f in d a f o r m u la t h a t w ill w o r k s a tis f a c to r ily f o r p e o p le w h o c h a n g e jo b s . P e rh a p s th e m o s t p r o m is in g m e a s u r e w o u ld b e to a llo w s ta n d s tills to be in v o k e d in a c risis, i n w h ic h U D R O P c la u s e in lo a n c o n tr a c ts m ig h t p ro v e h e lp fu l. c o n te x t a n am ended John W illia m s o n 157 N otes * 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 th an 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 fe re 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), F inancial M arkets and Devel­ opm The C in E ergingM ent: risis m arkets, Washington, DC: Brookings Institution. Bekaert, G., C. R. Harvey and R. L. Lumsdaine (1999) The Dynamics of Emerging Market Equity Flows, N E W B R orkingPaper no. 7219, Cambridge, MA: NBER. Buchheit, L. C. and G. M. Gulati (2000) Exit Consents in Sovereign Bond Exchanges’, U L LawReview48, 1 (October): 59-84. CA Buiter, W. H. and A. C. Sibert (1999) UDROP: A Contribution to the New Inter­ national Financial Architecture’, International F inance, 2, 2 (July): 227-48. Calvo, G.A. (1998) Capital Flows and Capital Market Crises: The Simple Economics of Sudden Stops, Journal ofAppliedE conom 1 (1): 35-54. ics, Choe, H., B. -C. Kho and R. M. Stulz (1998) Do Foreign Investors Destabilize Stock Markets? The Korean Experience in 1997, N E W B R orkingPaper 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 E erging M m arkets, London: Euromoney Publications in association with the World Bank. Eichengreen, B. and R. Hausmann (1999) Exchange Rates and Financial Fragility, NE W B R orking Paper no. 7418, Cambridge, MA: NBER. Available at h ttp :// papers.nber.org/papers/W7 418.pdf. and A. Mody (2000a) ‘Would Collective Action Clauses Raise Borrowing Costs?’, NE W B R orkingPaper no. 7458, Cambridge, MA: NBER. (2000b) Would Collective Action Clauses Raise Borrowing Costs? An Update and Extension, W orld B W ank orkingPaper no. 2363, Washington, DC: World Bank. and R. Portes (1995) C risis? What C risis? O rderly W orkouts for Sovereign D ebtors, London: CEPR. Ffrench-Davis, R. and H. Tapia (2001) Three Policy Varieties to Face Capital Surges in Chile, in R. Ffrench-Davis (ed.), F inancial C in Successful E erging E rises m conom ies, 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, N E W B R orkingPaper no. 6687, Cambridge, MA: NBER. Griffith-Jones, S. (2001) Capital Flows to Developing Countries: Does the Emperor Have Clothes?, UNU/WIDER, mimeo. 158 C u rb in g th e 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) O M n oney and M arkets: A W Street M oir, New York: all em McGraw-Hill. Kim, W. and S.-J. Wei (1999a) Foreign Portfolio Investors Before and During a Crisis, NE W B R orkingPaper no. 6968, Cambridge, MA: NBER. and (1999b) Offshore Investment Funds: Monsters in Emerging Markets?, NE W B R orkingPaper 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, N E W B R orking 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 M anagem An U ent: nconventional Approach to Institutional Investm New York: The Free Press: xvi, 366. ent, Corporate Risk Management and Exchange Rate Volatility in Latin America* G ra cie la M o g u illa n s k y I n tr o d u c tio n A fte r t h e T e q u ila an d im p a c t o f c a p ita l-flo w A s ia n c o u n t r ie s . I n p o lic y c irc le s th e d is c u s s io n c e n tre d c rise s th e r e v o la tility o n o n w as an im p o r ta n t d e b a te in v e s tm e n t a n d g ro w th in in c lu d in g a m o n g p o lic y -o rie n te d th e need fo r fu n d a m e n ta l re fo rm n a tio n a l f in a n c ia l a r c h ite c tu r e .1 T h e a c a d e m ic s tu d ie s o f th e on th e d e v e lo p in g a c a d e m ic s - o f th e in te r­ tim e fo c u se d o n t h e im p a c t o f t h e v a r io u s c o m p o n e n t s o f c a p ita l flo w s . T h is c h a p te r d e a ls w ith th e la tte r ty p e o f a n a ly s is , in p a r tic u la r th e f in a n c ia l m a n a g e m e n t o f m u ltin a tio n a l c o m p a n ie s w ith in v e s tm e n ts in L a tin A m e ric a . A d is tin c tio n is m a d e in v e stm e n t fro m b e tw e e n th e d eg ree o f re v e rs ib ility o f th e p h y s ic a l f o r e ig n d ir e c t in v e s tm e n t a n d th e flo w o f f u n d s lin k e d to it. T h e a n a ly s is c e n tr e s o n e p is o d e s o f c u r r e n c y o r f in a n c ia l s h o c k s a n d th e f in a n c ia l m a n a g e m e n t o f firm s th a t e x p e c t a s ig n if ic a n t d e v a lu a tio n . T h is a llo w s u s to e x p lo r e th e in t e r a c t io n b e tw e e n th e m ic r o e c o n o m ic b e h a v io u r o f a n d th e m a c ro e c o n o m ic im p a c t o n th e fo re ig n e x c h a n g e m a rk e t, b a s e d o n th e fo llo w in g q u e s tio n s : • Is c u r r e n c y ris k m a n a g e m e n t b y n o n - f in a n c ia l c o r p o r a tio n s a f f e c te d b y fo re ig n e x c h a n g e v o la tility a n d fin a n c ia l c o n ta g io n ? • D o th e d iv e r s e e x c h a n g e r a te p o lic ie s h a v e d if f e r e n t e ffe c ts o n m u ltin a ­ tio n a l c o m p a n ie s c a s h flo w m a n a g e m e n t? • C a n w e id e n tify m ic ro -m a c ro tra n s m is s io n m e c h a n is m s b e tw e e n c u rre n c y ris k m a n a g e m e n t a n d th e f o r e ig 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 is b a s e d u s e d t h e f o ll o w i n g m e t h o d o l o g y : in te rv ie w s w ith th e f in a n c e m a n a g e rs o f m u ltin a tio n a l c o m p a n ie s in v a rio u s s e c to rs b u t a ll w ith in v e s tm e n ts in L a tin A m e ric a a n d h e a d q u a rte rs in th e U n ite d K in g d o m o r S p a in ; a re v ie w o f t h e lite r a tu r e o n b u s in e s s a n d c u r r e n c y 159 C o rp o rate R isk M a n a g e m e n t a n d E xc h a n g e R a te V o la tility 160 ris k m a n a g e m e n t; a n d a n a n a ly s is o f s u rv e y s o n f in a n c ia l ris k m a n a g e m e n t in d e v e lo p e d c o u n tr ie s .2 S ix te e n f in a n c e m a n a g e r s w e r e in te r v ie w e d in 1 2 m u ltin a tio n a l c o m p a n ie s . T h e in d u s trie s r e p r e s e n te d w e re m in in g , o il a n d g as, e n e rg y , te le c o m m u n i­ c a tio n s , fo o d a n d fin a n c e . F o u r o f th e c o m p a n ie s ra n k e d a m o n g th e to p te n f irm s in te r m s o f s a le s i n in A m e ric a L a tin d u rin g th e th e re g io n an d a ll o f th e m h ad in v e s te d h e a v ily p r e v io u s fiv e y e a rs . A s a c o m p le m e n t t o th e re s e a rc h th e f in a n c e m a n a g e rs o f th e m u ltin a tio n a ls s u b s id ia rie s w e re in te r ­ v ie w e d in C h ile . T h e r e w e re f o u r r e a s o n s fo r c h o o s in g C h ile fo r t h e s tu d y : (1 ) t h e C h ile a n e x p e r ie n c e w a s c o n s id e r e d p a r a d ig m a tic a f te r t h e e c o n o m ic r e f o r m s , (2 ) i t h a d a v e r y s ta b l e e c o n o m ic r e g im e , (3 ) i t h a d g o o d c o u n t r y ris k q u a lif ic a tio n s a n d (4 ) th e f in a n c ia l s y s te m w a s r e la tiv e ly w e ll d e v e lo p e d . A s th e a n a ly s is a n d th e c o n c lu s io n s a re n o t b a s e d on s ta tis tic a l s a m p le s a n d th e r e a re n o f in d in g s th a t c a n b e s c ie n tific a lly te s te d , th is s tu d y c a n o n ly b e c o n s id e re d as a n essay o n th e s u b je c t, a n d p e rh a p s as a n in c e n tiv e fo r fu rth e r re se a rc h . F o reig n d ir e c t in v e s t m e n t a n d c a p ita l f lo w v o la t ilit y D u rin g th e 1 9 9 0 s f o r e ig n d ir e c t i n v e s t m e n t (F D I) i n L a tin A m e r ic a a n d t h e C a rib b e a n ro se fro m d e c a d e to a n a n n u a l a v e ra g e o f $ 6 b illio n a t th e b e g in n in g o f th e $ 8 5 b illio n in 1 9 9 9 . E ig h ty 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 ti n a , B ra z il, C h il e a n d M e x ic o . FDI an d 1980s an d c a p ita l fo r m a tio n m a in ta in e d 1 9 9 0 s (F fre n c h -D a v is a n d c e n ta g e o f F D I d u r in g a s tro n g re la tio n s h ip R e ise n , 1 9 9 8 ), b u t a n 1 9 9 9 a n d 2 0 0 0 c a m e fro m d u rin g th e im p o rta n t p e r­ m e rg e rs, a c q u is itio n s a n d p r iv a tiz a tio n s . E C L A C (2 0 0 1 ) e s tim a te s a n a c c u m u la te d fig u re o f $ 9 0 b illio n in tw o y e a rs, o r h a lf o f th e to ta l F D I in th a t p e rio d . M o s t o f th a t in v e s tm e n t w as in in fra s tru c tu re , p a rtic u la rly in th e te le c o m m u n ic a tio n and e n e rg y s e c to rs. A c o m p a r is o n o f t h e fig u re s f o r th e 1 9 8 0 s a n d th e 1 9 9 0 s sh o w s th a t FD I i n L a tin A m e r ic a w a s c o n s i s t e n t l y le s s v o la til e t h a n n e t c a p ita l tr 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 ie s i n T a b le 9 .1 ) . T h i s is c o n s i s t e n t w i th t h e f i n d i n g b y S a r n o a n d T a y lo r (1 9 9 9 ) t h a t F D I h a s a v e r y s ig n if ic 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 tin g t h a t i t is m o r e s e n s iti v e t o t h e lo 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 fin a n c in g . (2 0 0 1 ) a lso H ausm ann c o n c lu d e an d F ern án d ez t h a t F D I lia b ilitie s A ria s seem (2 0 0 0 a, to be 2000b) s a fe r (in an d th e L ip s e y sense of b e i n g le s s c r is is 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 ltin a tio n a l c o m p a n ie s h a v e v o la tility . D u rin g th e c o m m o d ity in fla tio n p ric e ra te s th is p ro b le m - 1 9 60s, shocks, in som e 1970s an d in c o n s is te n t cases a lw a y s b e e n 1 9 8 0 s th e m a c ro e c o n o m ic h y p e rin fla tio n . a w a re p ro b le m o f cu rren c y w as cau sed b y p o lic ie s M u ltin a tio n a ls b y a c c e le ra tin g th e r e m itta n c e o f d iv id e n d s a n d and h ig h ad d re sse d d e p re c ia tio n G ra c ie la M o g u illa n s k y 161 re s e rv e s . W ith th e o p e n in g o f th e c a p ita l m a r k e t a n d f in a n c ia l g lo b a liz a tio n , m u ltin a tio n a l c o m p a n ie s in c re a s e d th e ir d e b t f in a n c in g . T h is w a s s tim u la te d b y th e re v a lu a tio n o f L a tin A m e ric a n c u rre n c ie s d u r in g 1 9 9 0 -9 7 (F fre n c h - D a v is , 2 0 0 1 ) . F o re ig n d e b t e x p o s u r e d e p e n d s o n th e f in a n c ia l s tra te g y o f th e m u ltin a tio n a l c o m p a n y , th e m a c ro e c o n o m ic d o m e s tic a n d in te r n a tio n a l e n v ir o n m e n t a n d t h e b u s in e s s s e c to r i n w h i c h it is lo c a te d , a m o n g o t h e r f a c to r s . I n t h e c a s e o f C h ile , s ta tis tic s f r o m th e F o re ig n I n v e s tm e n t C o m m itte e s h o w m in in g s e c to r 7 0 p e r c e n t o f to ta l F D I c o m e s fro m o r th e in te r n a tio n a l f in a n c ia l sy ste m , w h ile in lo a n s fro m th a t in th e h e a d q u a rte rs m a n u f a c t u r i n g t h e f i g u r e is o n ly 2 2 p e r c e n t. I n th e c a s e o f th e p u b lic s e rv ic e s e c to r, a t th e b e g in n in g o f th e 1 9 9 0 s firm s h a d a v e r y lo w le v e l o f d e b t in f o r e ig n c u r r e n c y b u t t h e s h a r e in c re a s e d r a p id ly d u r in g th e re s t o f th e d e c a d e . I n s o m e c o u n trie s , in c lu d in g C h ile , f in a n c in g w ith fo re ig n lo a n s w a s e n c o u ra g e d b y ta x b e n e fits . F o r eig n 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 fir m s F in a n c ia l a n d c u rre n c y ris k m a n a g e m e n t h a s b e c o m e o f b u s in e s s a d m in is tr a tio n d u rin g th e p a s t 1 0 -1 5 a fu n d a m e n ta l p a rt y e a rs, b u t m u ltin a tio n a l firm s in d e v e lo p in g c o u n tr ie s w e re m a n a g in g th e ir ris k e x p o s u r e lo n g b e fo re th a t. It m u s t b e re m e m b e re d u n s ta b le a n d h ad th a t th e e x tre m e ly h ig h L a tin A m e ric a n c o u n tr ie s w e re v e ry in fla tio n ra te s , a n d f r e q u e n t. M a tc h in g a s s e ts a n d lia b ilitie s in m e n ts a n d re c e ip ts in c o m m o n m e c h a n is m A n o th e r th e a p a rtic u la r c u rre n c y c u rre n c y c rise s w e re sa m e c u rre n c y so th a t p a y ­ c o u ld b e o ffs e t, w a s th e m ost f o r d e a lin g w i t h f o r e i g n e x c h a n g e ris k . m e c h a n is m s till in use is t h e p o rtfo lio a p p ro a c h . T h is m e c h - a n is m , i n w h ic h t h e f ir m m a n a g e s a g r e a t d iv e r s ity o f c u r r e n t flo w s , p r o v id e s p ro te c tio n a g a in s t c u rre n c y ris k . I t im p lie s g e o g r a p h i c a l d iv e r s i f ic a t io n of b u s in e s s , d iv e rs ific a tio n o f ty p e s o f b u s in e s s a n d g e o g ra p h ic a l d iv e rs ific a tio 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 is is 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 ie s w i t h a la r g e v a r i e ty of goods an d b u s in e s s e s in d iffe re n t re g io n s and d iffe re n t c o u n trie s , s u c h a s th e c h e m ic a l a n d p h a r m a c e u tic a l in d u s trie s a n d m a n u f a c ­ tu r e r s o f fo o d , b e v e ra g e s a n d o th e r g o o d s . T h a n k s to th e d e v e lo p m e n t o f th e in te r n a tio n a l f in a n c ia l s y ste m , d u r in g th e 1980s an d a d o p te d n e w e s p e c ia lly d u r in g th e 1 9 9 0 s m o s t m u ltin a tio n a l c o m p a n ie s ris k m a n a g e m e n t in s tr u m e n ts - sw a p s, fo rw a rd c o n tra c ts a n d o p tio n s , th e s o -c a lle d d e riv a tiv e s - to d e a l w ith c u r r e n c y ris k e x p o s u r e .5 B u t is 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 typ ology o f finan cial strategies in currency risk m anagem ent T h e r e is n o s in g le a c c e p te d s tra te g ie s . A s F ro o t s o lu tio n s to etal. o p tim a l fra m e w o rk th a t c a n b e u se d to g u id e h e d g in g (1 9 9 3 ) s ta te d in th e e a rly 1 9 9 0 s, th e re a re m u ltip le h e d g in g by m u ltin a tio n a l firm s . A f i r m s o p tim a l h e d g in g s tra te g y - in te rm s o f th e a m o u n t o f h e d g in g a n d th e in s tr u m e n ts C o rp o rate R is k M a n a g e m e n t a n d E xch an g e R a te V o la tility 162 used itie s , th e depends o n th e n a tu re h e d g in g th e n a tu re o f th e in v e s tm e n t, th e of th e p ro d u c t, s tra te g ie s a d o p te d by th e d e g re e its of f in a n c in g o p p o r tu n ­ m a rk e t c o m p e titio n c o m p e tito rs . T h e re fo re and d e te rm in in g w h e t h e r a h e d g i n g s t r a t e g y is a p p r o p r i a t e is a v e r y c o m p l e x m a t t e r . In th e re a l w o rld e n te rp ris e s h a v e n e u tr a l, a v e rs e o r a c tiv e m a n a g e m e n t p o lic ie s . E v e n if th e y a r e ris k r e l u c ta n t th e r e m a y b e c ir c u m s ta n c e s in w h ic h m a tc h in g c u rre n c ie s b e tw e e n in c o m e s an d lia b ilitie s is i m p o s s i b l e in s tr u m e n ts fo r h e d g in g a re so e x p e n s iv e th a t th e firm e x p o su re to ris k . W e s h a ll th e r e f o r e assum e o r th e p re fe rs to h a v e so m e th a t e n te rp ris e s a lw a y s have s o m e p e r c e n ta g e o f ris k e x p o s u r e . B u t h e d g in g s tr a te g ie s d iffe r a m o n g firm s . F o r th e p u r p o s e o f o u r a n a ly s is , th is c h a p te r d e v e lo p s a ty p o lo g y o f f in a n c ia l s tra te g ie s , c la s s ify in g firm s b y d e g r e e o f ris k e x p o s u r e , w h ic h depends on m a r k e t o r ie n ta tio n a n d d iv e rs ific a tio n . Multinational companies in the export sector In a s c e n d in g o r d e r o f ris k e x p o s u r e a re m u l tin a tio n a l c o m p a n ie s t h a t d e a l w ith c o m m o d itie s , m in e r a l o il a n d g a s, w o o d p u lp , f is h m e a l, a n d s u b s id ia rie s in e x p o rt p ro c e s s in g z o n e s (a s s e m b ly p la n ts ). In g e n e ra l th e ir in v e s tm e n ts a r e f in a n c e d w i t h e q u i ty (F D I) a n d lo a n s i n f o r e ig n c u r r e n c y , a n d t h e y m a t c h in te re s t s e rv ic e s an d re m itta n c e s o f d iv id e n d s w ith in c o m e in th e sam 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 r r e n c y e x p o s u r e in t h e m in in g se c to r In v e s tm e n ts in a n tly in ta k e th e th e m in in g fo rm s e c to r (m in e ra ls , o il and o f p ro je c t fin a n c in g . A m a in gas) p re d o m ­ c h a ra c te ris tic o f t h i s t y p e o f f u n d i n g is t h a t t h e g u a r a n t e e is 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 is p a i d u n d e r a l o n g - t e r m o f th e p r o je c t its e lf. I n c o n tra c t w ith s o m e cases th e m in in g th e g ro ss e a rn in g s c o m p a n ie s e n te r in to p a y m e n t a r r a n g e m e n ts w ith o u tp u t in s te a d o f is s u in g o r d in a r y d e b t. A b a n k p r o v id e s u p - f r o n t c a s h a n d th e c o m p a n y u n d e r ta k e s to d e liv e r th e o u tp u t to th e b a n k a n d a rra n g e s fo r th e o u tp u t to b e re p u rc h a se d a t a g u a r a n te e d p ric e . A s e c o n d c h a r a c t e r i s t i c is 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 lw a y s o b ta in f r o m t h e h o s t c o u n t r y a f u ll g u a r a n te e t h a t th e r e w ill b e n o v a ria tio n in th e in v e s tm e n t c o n d itio n s , fre ed o m o f c a p ita l a n d c o m m e rc ia l m a n a g e m e n t, e s p e c ia lly w ith re g a rd to lo a n re p a y m e n ts . 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 th e rig h t to d e p o s it th e e x p o rt p ro c e e d s, a n d fro m th a t a c c o u n t, w ith o u t in flo w in t o th e c o u n try , to p a y th e in te r e s t a n d m o rtg a g e s o n th e lo a n s . G ra c ie la M o g u illa n s k y 163 B o th c h a ra c te ris tic s a re re la te d to th e lo n g m a tu r ity o f m in in g in v e s t­ m e n t . T h e r e s u l t is 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 in v e s tin g , b u ild a p ro te c tiv e u m b re lla a g a in s t f in a n c ia l c ris e s . If th e p r o je c t p r o d u c e s s u f f ic ie n t m in e r a ls , o il o r g a s t h e y s e ll t h e o u t p u t i n t h e i n t e r n a t io n a l m a r k e t, r e c e iv e th e in c o m e a b r o a d a n d f o re ig n lo a n s , a n d p a y o ff th e a ll o f t h i s is 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 th e h o s t c o u n try . B e c a u s e o f th e ris k a v e rs io n th a t p re v a ils in m in in g c o rp o ra tio n s m a n a g e a m in im u m th e host c o u n try . o p tim u m T he head o ffic e of d e v e lo p in g c o u n trie s , o f th e ir liq u id fu n d s in s id e th e c o rp o ra tio n chooses an o f in te r e s t r a te , ris k a n d ta x e x p o s u r e to m a k e its f in a n c ia l in v e s tm e n t a n d i t is a l w a y s d o n e o u ts id e th e c o u n try in w h ic h th e chosen to hedge th e i n v e s t m e n t is lo c a te d . O n th e o th e r h an d som e c o m p a n ie s have v a lu e o f e x p e c te d c o s ts b y in tr o d u c in g d e riv a tiv e s in t o th e ir 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 is 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 th a t o c c u rre d a fte r th e T e q u ila an d A sia n c rise s b r o u g h t b e n e fits to th e s e firm s b e c a u s e th e c o s t o f s a la rie s a n d o th e r lo c a l in p u t s i n te r m s o f s tr o n g c u rre n c ie s (y e n , m a rk , p o u n d o r e u ro ) d e c re a s e d . (Source: B a s e d o n in te rv ie w s a t m u ltin a tio n a l c o m p a n ie s in th e m in in g s e c to r .) Multinational companies that are regionally and geographically diversified N e x t in th e o rd e r o f d e g re e o f c u rre n c y e x p o su re c o m e m u ltin a tio n a l c o m ­ p a n ie s w h o se in v e s t in p ro d u c tio n m any is o r i e n t e d c o u n trie s an d to w a rd s re g io n s. Such th e lo c a l m a r k e t b u t w h ic h c o m p a n ie s can be fo u n d in e v e ry b r a n c h o f t h e m a n u f a c tu r in g s e c to r. W h ile th e e a rn in g s a re o b ta in e d in lo c a l c u rre n c y , lia b ilitie s s u c h a s s h o r t- te r m a n d lo n g -te rm lo a n s a re p a id m a in ly in f o re ig n c u rre n c y . T h e s e firm s fa c e tw o p r in c ip a l ty p e s o f c u r r e n c y ris k e x p o s u r e . T he f i r s t is m a n a g e rs, e c o n o m ic ris k . it is d if f i c u lt t o c o n c e p t re la te s to th e In fin d th e b u s in e s s a s in g le lite ra tu re , d e fin itio n im p a c t o f a d e v a lu a tio n and o f th is . In o f th e a lso am ong g e n e ra l th e p re s e n t v a lu e o f th e f u tu r e e a r n i n g s o f t h e f ir m . I t is v e r y d if f ic u lt 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 it d e p e n d s o n th e c o m p e titiv e c o n te x t o f th e firm and th e effe c t o f th 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 to m e r s . A s c a n b e s e e n i n T a b le 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 ris k . T he seco n d r i s k is t r a n s a c t i o n ris k e x p o s u re , w h ic h is e a s ie r t o m e asu re a n d to h e d g e . T ra n s a c tio n e x p o s u re o r c a s h flo w e x p o s u re re la te s to th e re a l c a s h flo w in v o lv e d in s e ttlin g tr a n s a c tio n s d e n o m in a te d in fo r e ig n c u rre n c y . 164 C o rp o rate R is k M a n a g e m e n t a n d E xch an g e 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 0.22 1.51 0.35 0.24 0.50 1.45 0.23 1.31 FDI Net capital transfers Source: ECLA C; b a l a n c e Table 9.2 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 t r ie s . Most important subjects of hedging strategies (per cent) Accounting earnings C flows ash Balance sheet accounts E conom risk ic firmvalue 44 55 49 34 0.9 7.4 8 12 United States Germany Source: B o d n a r a n d G e b h a r d t (1 9 9 8 ). A s T a b le 9 .2 s h o w s , 4 9 p e r c e n t o f U S f ir m s a n d 3 4 p e r c e n t o f G e r m a n f ir m s h e d g e a g a in s t th e ris k in v o lv e d in th is . In and o u r s tu d y , m u l tin a tio n a l c o m p a n ie s w ith re g io n s a lw a y s hedged b u s in e s s in a g a in s t tr a n s a c tio n m any c o u n trie s e x p o su re b u t v ery s e ld 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 is , t h e i m p a c t o f c u r r e n c y v o la tility o n t h e v a lu e o f a s s e ts a n d lia b ilitie s . T h e r e a r e tw o m a in r e a s o n s f o r s u c h a p o lic y : (1 ) d e v a lu a ti 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 te d w ith re v a lu a tio n in a n o th e r; an d (2 ) in th e v ery lo n g te rm , a s s e ts and n e t w o r th w ill n o t b e a ffe c te d b y c u r r e n c y v o la tility b e c a u s e e x c h a n g e r a te m o v e m e n ts m a in ly d e p e n d o n p ro d u c tiv ity . Multinational companies with investments concentrated in one region U n lik e th e a b o v e ty p e o f c o m p a n y , m u ltin a tio n a l c o m p a n ie s th a t c o n c e n ­ tr a te th e ir in v e s tm e n ts in ju s t a fe w c o u n tr ie s o r a s in g le re g io n an d d u c e e ith e r fo r fo re ig n o r fo r d o m e s tic m a rk e ts u s u a lly ta k e b a la n c e e x p o s u re in t o c o n s id e r a tio n . T h e e x p o s u re a rise s f r o m p ro ­ sheet th e p e rio d ic n e e d to r e p o r t th e c o n s o lid a te d w o rld -w id e o p e r a tio n s o f th e g ro u p in o n e r e p o r tin g c u rre n c y . In th is c a se th e y tr y to fin a n c e th e ir in v e s tm e n ts in th e d o m e s tic fin a n c ia l s y ste m a re h ig h ly hedge tra n s la tio n e x p e c te d as m u ch c o rre la te d w ith an d d iv id e n d s as th e an d cash can, or in lo c a l c u rre n c y tra n s a c tio n o f s tu d ie s (fo r e x a m p le D a v is B a rtra m , 2 0 0 0 ). th e y flo w etal., ris k w ith a basket of in th e lo n g d e riv a tiv e c u rre n c ie s th a t te rm . T h e y in s tru m e n ts : m o v e m e n ts , as d e s c rib e d in 19 9 1 ; G u ay , 1 9 9 9 ; P rév o st a a lso d e b t, num ber et al., 2000; G r a d e la M o g u illa n s k y 165 M u l t i n a t i o n a l c o m p a n ie s i n p u b li c s e rv ic e s M any m u ltin a tio n a l c o m p a n ie s v a tiz a tio n of p u b lic s a n ita tio n , ro a d s s e rv ic e s an d e n te re d L a tin A m e ric a (te le c o m m u n ic a tio n , p o rts ). T h e s e c o m p a n ie s fo llo w in g e le c tric ity , c o u ld be th e p ri­ w a te r and v ie w e d as b e in g m o s t e x p o s e d to c u r r e n c y ris k v o la tility b e c a u s e th e y o b ta in th e ir in c o m e in th e lo c a l m a r k e t a n d m a k e h u g e in v e s tm e n ts th a t th e lo c a l f in a n c ia l s y s te m s c a n n o t a ffo rd . S o if th e y fo llo w a ris k a v e rs e p o lic y th e y h a v e to e n g a g e in f in a n c ia l h e d g in g . S o m e m u ltin a tio n a l c o m p a n ie s - n a tu r a l m o n o p o lie s o p e r a tin g in re g u la te d m a r k e ts - h a v e n e g o tia te d ta riffs t h a t a re fu lly in d e x e d to th e d o m e s tic p ric e o f t h e d o lla r . I n o t h e r c a s e s t h e r e is p a r t ia l in 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 in p u t s s u c h a s g a s a n d o il a r e d e n o m in 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 itio n o f t h e a s s e ts o r th e c o s t o f e x p a n s io n (m a c h in e r y fo r e le c tric p o w e r p la n ts a n d w a te r tr e a tm e n t p la n ts , te le c o m m u n ic a tio n e q u ip m e n t, c o m p u te rs a n d o th e r in f o r m a tio n te c h n o lo g y e q u ip m e n t a re a lw a y s im p o r te d f ro m in d u s ­ tria l c o u n trie s ). A m o n g th is g r o u p th e r e a re v a r io u s k in d s o f c u r r e n c y ris k s tra te g y . S o m e c o m p a n ie s s u b s id ia ry a re v e ry re p o rts th e m a x im u m c o n s e rv a tiv e f in a n c in g an d have m o v e m e n ts to a c e n tra liz e d its h e a d ris k p o lic y . T h e o ffic e , w h ic h hedges o f th e le v e l o f e x p o s u r e . O th e r s tra te g ie s s e t a g lo b a l lim it 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 rv ic e m u l tin a tio n a l c o r p o r a tio n s b e in g h ig h ly in d e b te d in f o r e ig n c u r r e n c y a n d h a v in g b u s in e s s e s c o n c e n tr a t e d in o n e r e g io n . F o r th e m , tr a n s l a ti o n ris k is 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 ris e in th e ir in d e b te d n e s s a n d a c o n s e q u e n t fa ll in th e v a lu e o f th e com pany. I n s u m m a r y , it c a n b e c o n c lu d e d t h a t th e d e g r e e o f c o m p a n ie s ris k e x p o s u r e d e p e n d s n o t o n ly o n th e m a g n itu d e o f th e ir in d e b te d n e s s b u t a lso o n th e ir m a rk e t o rie n ta tio n a n d d e g re e o f d iv e rs ific a tio n . S o m e c o m p a n ie s , s u c h as e x p o r t firm s , d o n o t u s e h e d g in g a t a ll b e c a u s e th e c o s ts w o u ld b e g r e a te r t h a n t h e b e n e fits . F o r o th e r m u l tin a tio n a l c o m p a n ie s , s u c h a s firm s t h a t a re o rie n te d th e to w a rd s th e dem and d e riv a tiv e lo c a l m a r k e t a n d fo r d e riv a tiv e s m a rk et a re a is v e r y n e c e ssa ry have h ig h . In la rg e th is co m p o n en t of b e in g in d is p e n s a b le fo r s m o o th in g flu c tu a tio n s in fo re ig n c u rre n c y case, in s tru m e n ts fin a n c ia l d e b ts , in th e m a n a g e m e n t, th e in te re s t a n d fo re ig n e x c h a n g e ra te s . Statistics in derivative markets C o m p r e h e n s iv e g lo b a l s ta tis tic s o n d e riv a tiv e in s tr u m e n ts a re a v a ila b le f ro m th e B a n k fo r I n te r n a tio n a l S e ttle m e n ts v o lu m e (tu rn o v e r in th e (B IS ), w h i c h n u m b e r o f c o n tra c ts ) an d m e a su re s th e th e tra d in g n o tio n a l a m o u n t 166 C o rp o rate R is k M a n a g e m e n t a n d E xch an g e R a te V o la tility o u ts ta n d in g n o tio n a l (in US am o u n t d o lla rs ) re fe rs of to p ro v id e s a r o u g h in d ic a tio n d e riv a tiv e s cash flo w s by ty p e u n d er of in s tru m e n t. in d iv id u a l T he c o n tra c ts and o f t h e p o te n tia l tr a n s f e r o f t h e ris k a s s o c ia te d w ith th e m . P re s s r e le a s e s f r o m t h e B IS 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 th e 14 to ta l a m o u n t o f d e riv a tiv e s per cent per y e a r. T hen in c re a s e d v e ry ra p id ly a t a g lo b a l r a te th e in p e rio d b e tw e e n s ix -m o n th June of and D e c e m b e r 1 9 9 8 - in th e m id s t o f th e A s ia n c risis - in te r e s t r a te in s tr u m e n ts u n d e rw e n t an e x p lo s iv e fa ll. T h is w a s a ls o t h e ris e w h ile c a se w ith fo re ig n exchange c o n tra c ts began to n o n - f in a n c ia l c u s to m e rs . T h e d y n a m ic o f th e m a rk e t d u r in g th e fo llo w in g y e a rs c o n tin u e d to b e le d b y in te r e s t ra te in s tru m e n ts m a in ta in e d w h ile fo re ig n exchange c o n tra c ts a m o d e ra te of d e riv a tiv e u p w a rd tre n d . T he in te rn a tio n a l fin a n c ia l m a rk e t o ffers a b ro ad v a rie ty in s tr u m e n ts f o r f o r e ig n e x c h a n g e ris k m a n a g e m e n t (se e C h a p t e r 6 ), in c lu d in g p l a i n v a n i lla 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 tu r e s , h ig h l y s o p h is tic a te d c o m b in a tio n s o f s tr u c tu r e d d e riv a tiv e in s tm m e n ts (fo r e x a m p le c o lla rs a n d s w a p o p tio n s ) a n d h y b r id d e b t w ith e m b e d d e d d e riv a tiv 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 is k n o w n a b o u t th e e x te n t o r p a tte r n o f th e ir u s e b e c a u se c o m p a n ie s h a v e n o t b e e n r e q u ir e d - o r n o t u n ti l r e c e n tly in th e U n ite d S ta te s - to m a k e p u b lic th e ir d e riv a tiv e a c tiv itie s . C o r p o r a te a n n u a l re p o rts (b a la n c e s h e e t a n d o ffb a la n c e s h e e t r e p o r ts ) , w h e n a v a ila b le , c a n b e c o n f u s in g b e c a u s e t h e fig u re s c o rre sp o n d w h ic h w e to a re a c c o u n tin g in te re s te d , p e rio d s an d ra th e r th a n b ecau se th e to th e e c o n o m ic f in a n c ia l e x p o s u re e v e n ts or in h e d g in g tr a n s a c tio n s o f s u b s id ia rie s a re n o t a lw a y s r e p o r te d b y m u l tin a tio n a l c o m ­ p a n ie s . W e s h a ll d e a l w ith th is p r o b le m b y b a s in g o u r a n a ly s is o n in te rv ie w s w ith th e tr e a s u re r s o r f in a n c e m a n a g e r s o f la rg e c o m p a n ie s w ith b u s in e s s e s i n L a tin A m e ric a .8 H e d g in g ta c tic s u s e d in L a tin A m e r ic a n c o u n tr ie s O ne o f th e fin d in g s o f o u r in te rv ie w s c o in c id e d w ith U S a n d is t h a t t h e c o m p a n ie s in q u e s tio n G e rm a n c o m p a n ie s in te rm s o f th e ir p re fe re n c e fo 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 is , 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 ts s u c h as fo rw a rd s, sw a p s a n d o p tio n s (T a b le 9 .3 ) . T h e y d e a l m a in ly w ith th e m a in b a n k s in th e in te r n a tio n a l f in a n c ia l m a rk e t, s u c h a s C itib a n k and C h a s e M a n h a tta n , S p a n is h b a n k s s u c h E u ro p e a n b a n k s a n d as S a n ta n d e r a n d BBVA, o th e r in v e s tm e n t b a n k s s u c h a s M e rrill L y n c h a n d S ta n le y . T h e y n e g o tia te w ith lo c a l b a n k s o n ly in M o rg a n s p e c ia l c a se s w h e n s m a ll lia b ilitie s n e e d to b e c o v e re d . In th e in te rv ie w s th e re p re s e n ta tiv e s of th e m u ltin a tio n a l c o m p a n ie s a s s e r te d t h a t th e ir c u r r e n c y ris k p o lic ie s w e r e a im e d a t h e d g in g th e ir f in a n ­ c ia l ris k e x p o s u re a n d n o t a t m a k in g s p e c u la tiv e g a in s . T h e y in s is te d t h a t th e G ra c ie la M o g u illa n s k y T a b le 9 .3 167 M o s t u s e d in s t r u m e n t s i n t h e d e r iv a t iv e m a r k e t (p e r c e n t ) O TC F utures O TC O TC E ybrid xchange Structured H forwards swaps options traded derivatives debt options United States Germany 56.8 75.5 8.0 4.3 9.1 13.8 Source: B o d n a r a n d G e b h a r d t (1 9 9 8 ). m a in p u rp o s e o f th e tre a s u re r w a s to t h a t is , t o m a k e a p r o f i t f r o m th a t th e best w ay to do 1.1 0.0 6.8 1.1 1.1 0.0 s u p p o rt th e b u s in e s s o f th e c o m p a n y , p r o d u c i n g g o o d s a n d s e rv ic e s . T h e y i n d i c a t e d th is w as to in te r e s t ra te re g im e , a n d 18.2 18.1 m a in ta in th a t w as th e re a so n a fa irly s ta b le fo r m a k in g f in a n c in g c o n tra c ts in or th e d e r i v a ti v e m a r k e ts . T h i s a s s e r t i o n is c o n f i r m e d b y S tu lz ( 1 9 9 6 ) a n d F ite a n d P fle id e re r (1 9 9 5 ), w h o c o n c lu d e t h a t c o r p o r a te ris k m a n a g e m e n t r e s u lts in a r e d u c tio n o f c o r p o r a te c a s h flo w v o la tility , a n d th e r e f o r e in a lo w e r v a r ia tio n in firm v a lu e . T h e m a n a g e rs o f n o n - f in a n c ia l c o r p o r a tio n s a lso in d ic a te d th a t d u r in g th e p a s t d e c a d e , in o rd e r to a v o id b e in g ta k e n s u rp ris e b y u n e x p e c te d in L a tin A m e ric a n c o u n trie s , th e ir c o m p a n ie s h a d set u p e v e n ts te a m s to c o n d u c t c o u n tr y a n d re g io n a l m a c r o e c o n o m ic a n a ly s e s a n d m a n a g e fo re ig n e x c h a n g e ra te e c o n o m ic m o d e ls . T h e y a lso s tu d ie d in fo rm a tio n fro m in te rn a tio n a l a g e n c ie s a n d in v e s tm e n t b a n k s . B u t t h e b a n k in t e r v ie w e e s h a d a n o t h e r p o i n t o f v ie w . I n t h e c a s e o f C h il e th e y a rg u e d th a t fin a n c e m a n a g e rs engaged in a c tiv e ris k m a n a g e m e n t ( m a in ta in in g o p e n p o s itio n s ) , w h ic h fo re ig n exchange th e y in te rp re te d as s p e c u la tiv e m a n a g e m e n t. T h e y d e d u c e d th is f ro m th e s h o r t p e r io d fo r w h ic h firm s to o k d e riv a tiv e s . I n th is c a se th e y w e re e x p o s e d to m o v e m e n ts o f th 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 an d th e fu tu r e p ric e o f th e s p o t p ric e o f th e a s s e t to b e h e d g e d c o n tra c t u sed ) a n d th e d iffe re n c e b e tw e e n th e d o m e s tic a n d th e in te r n a tio n a l ra te o f in te re s t. T h e a n s w e r g iv e n b y th e f in a n c e m a n a g e r s o f s u b s id ia rie s o f n o n - f in a n c ia l c o rp o ra tio n s w a s th a t th e c o n c e n tr a tio n o f th e m a rk e t a m o n g a fe w o p e ra to rs a n d th e lo w d e v e lo p m e n t o f th e L a tin A m e ric a n d e riv a tiv e m a r k e ts d id n o t a llo w th e m to e n g a g e in o p tim a l m a n a g e m e n t. T h is w ill b e a n a ly z e d in th e n e x t s e c tio n . The Latin Am erican derivative m arket M u ltin a tio n a l c o m p a n ie s in L a tin A m e ric a tr y to n e g o tia te d e riv a tiv e c o n ­ tr a c ts in th e lo c a l m a r k e ts a s th e in s tr u m e n ts c a n b e o b ta in e d th e r e a t lo w e r c o s t. H o w e v e r th e y face som e re s tric tio n s in th a t th e m a rk e ts have o n ly b e e n r e c e n tly d e v e lo p e d - in th e p a s t tw o t o fiv e y e a rs i n m o s t c a se s . O n e o f th e in c e n tiv e s fo r th e ir c re a tio n w a s th e h u g e in v e s tm e n ts th a t w e re b e in g 168 C o rp o rate R is k M a n a g e m e n t a n d E xch an g e 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 ie s s in c e t h e p r iv a tiz a tio n o f p u b li c s e rv ic e s . T he p ro c e ss b e g a n in v e s tm e n ts , w ith fo llo w e d th e by a rriv a l o f m u ltin a tio n a l c o m p a n ie s a d em and fo r fo re ig n c o n s e q u e n t d e m a n d fo r d e riv a tiv e s to p r o te c t th e m W ith in th e e x c e p tio n o f B ra z il, t h e c u rre n c y fro m an d lo a n s th e ir an d th e c u r r e n c y ris k . in s titu tio n a l fra m e w o rk fo r d e riv a tiv e s L a tin A m e r ic a is s til 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 ­ tr a c ts i n th e C h ile a n c u r r e n c y w e r e n o t le g a liz e d in C h ile 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 is 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 in and M e x ic o a r e f o r m t o t h e le g a l f r a m e w o r k h a s o n l y ju s t a l lo w e d lo c a l in te rn a tio n a l b a n k s to m a rk e t d e v e lo p e d firs t in a c t as m a rk e t m a k e rs . N a tu ra lly th e th e U n ite d S ta te s , p r in c ip a lly in d e riv a tiv e N ew Y o rk a n d C h ic a g o . B ra z il h a s t h e m o s t s o p h i s t i c a t e d lo c a l d e r i v a ti v e m a r k e t w i t h m a n y ty p e s o f in s tr u m e n t. A p p ro x im a te ly 2 7 p e r c e n t o f a ll d e riv a tiv e s c o r r e s p o n d to U S d o lla r fu tu re s . T h e s e b u t in a c c o u n te d fo r o n ly 7 p e r c e n t o f th e to ta l in 1991, 1 9 9 7 th e y p e a k e d a t 3 6 p e r c e n t. M a n y ty p e s o f O T C in s tr u m e n t c a n a ls o b e f o u n d in M e x ic o , in c lu d in g f o r e ig n e x c h a n g e r a te o p tio n s , s e c u ritie s a n d sw a p s. F o r th e C h ile a n c u rre n c y , th e d a ily n e g o tia te d a m o u n t o f n o n ­ d e liv e ra b le fo rw a rd s (N D F s) in th e N ew Y o rk m a rk et is in th e $ 2 5 0 m illio n w h ile in th e lo c a l d e liv e ry fo rw a rd m a r k e t th e s u m $ 6 0 0 m illio n . In th e case o f a th in m a rk e t s u c h as th a t in ra n g e of is a r o u n d P e ru , o n ly N D F c o n t r a c t s a r e m a d e , w h ile i n B o liv ia t h e r e is n o d e r i v a ti v e m a r k e t a t a ll. A c c o rd in g to th e m u ltin a tio n a l c o m p a n ie s in o u r s u rv e y th e b e s t w a y to m a n a g e f in a n c ia l ris k in e m e r g e n t m a r k e ts w a s to e n te r lo n g - te r m c o n tra c ts d u rin g be at a a p e rio d lo w e r c o s t. o f e c o n o m ic M a k in g s ta b ility , w h e n lo n g -te rm c o n tra c ts in s tru m e n ts w as v e ry c o u ld fo u n d im p o rta n t fo r th e c o m p a n ie s in q u e s tio n , e s p e c ia lly if a s te p d e v a lu a tio n w a s e x p e c te d d u r in g t h e n e x t s ix t o tw 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 id g e o v e r t h e c risis p e r io d . H o w e v e r th e m a n a g e rs , o f n o n -fin a n c ia l c o rp o ra tio n s s a id t h a t th is w a s n o t a lw a y s p o s s ib le b e c a u s e in s tr u m e n ts w e re n o r m a lly a v a ila b le fo r o n ly a fe w m o n th s .9 F o r e x a m p le th e fo rw a rd c o n tra c ts m a rk e t w a s liq u id fo r 4 2 o r 90 days, a n d o n ly a fe w e n te rp ris e s c o u ld h e d g e fo r a y e a r o r m o re . O n e r e a s o n fo r th is w a s t h e la c k o f a s e c o n d a r y m a r k e t fo r lo n g - te r m in s tr u m e n ts . T h e re w ere n o in th e m a rk e t m a k ers, a n d lo n g -te rm s to c k m a rk e t. T h e e n te r p r is e s h a d to n e g o tia te a lo n g -te rm in s tr u m e n ts w e re n e g o tia te d w a it u n til s o m e o n e w a n te d to i n s t r u m e n t a n d s e t a p r ic e o n it. S ta tis tic s p u b lis h e d b y C e n tr a l B a n k o f C h ile a re c o n s is te n t w ith w h a t w a s s a id b y th e m u ltin a tio n a l c o m p a n y m a n a g e rs . B e tw e e n 1996 and 2 0 0 0 in th e fo rw a rd m a rk e t, m o re th a n 9 0 p e r c e n t o f p e s o - d o lla r c o n tra c ts w e re fo r p e r i o d s o f le s s t h a n 4 2 d a y s , a n d a s im ila r s itu a tio n p r e v a ile d fo r U F -d o lla r c o n t r a c t s (T a b le 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 ay s, th e d a ily a v e ra g e v o lu m e n e g o tia te d w a s $ 2 2 m illio n , w h ic h w a s a v e ry a m o u n t in te rm s o f tr a n s a c tio n s b y m u ltin a tio n a l c o m p a n ie s . s m a ll T a b le 9 .4 F o r w a r d c o n t r a c t s in C h ile , 1 9 9 6 - 2 0 0 0 Peso-dollar forwards Accum ulated annual am ount ($ m illion) 1996 1997 1998 1999 2000 Source: 36 96 99 101 107 Peso-dollar forwards m aturityperiod U to 42 days/ p total (% ) M than 42 days/ ore total (% ) 98.9 96.3 97.1 96.5 94.5 1.1 3.7 2.9 3.5 5.5 334 166 377 623 872 C e n t r a l B a n k o f C h ile , U /dollar F forwards Accum ulated annual am ount ($ m illion) 11 15 13 23 31 Informe Económ y Financiero (w w w .b c e n tr a l.c l/). ico 495 885 517 889 378 U F-dollar forwards m aturityperiod U to 90 days p 91-360 days M than ore 360 days 36.6 33.4 35.2 38.4 54.0 51.4 50.9 52.9 46.7 34.9 12.0 15.7 11.9 14.9 11.1 170 C o rp o rate R isk M a n a g e m e n t a n d E xch an g e R a te V o la tility F ig u r e s 9 .1 a n d 9 .2 s h o w th e a m o u n ts a n d p ric e s o f f o rw a rd c o n tr a c ts in C h il e . F ig 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 ll p e s o - d o l l a r c o n t r a c t s , i n w h ic h s h o rt-te rm in 1 9 9 5 -9 6 an d in s tr u m e n ts p r e d o m in a te . T h e in s tr u m e n ts w e re firs t u s e d show ed an u p w a rd tre n d fro m th e b e g in n in g . T h e re w a s a d r a m a tic in c re a s e d u r in g t h e A s ia n c risis a n d th e r e a f te r t h e to ta l a m o u n t n e g o tia te d e a c h m o n th o s c illa te d b e tw e e n $5 m illio n a n d $ 7 m illio n . T h is c o in c id e d w ith t h e p e r io d o f h ig h v o la tility in th e e x c h a n g e r a te in C h ile . F 9.1 igure Chile: total forward contracts with non-financial corporations, 1995-2001 Source: C e n t r a l B a n k o f C h ile . F 9.2 igure Chile: forward contracts for more than 42 days with non-financial corpor­ ations, 1995-2001 Source: C e n t r a l B a n k o f C h ile . Graciela Moguillansky 17 1 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 172 Corporate Risk Management and Exchange Rate Volatility Observed daily foreign exchange rate Domestic rate of interest Figure 9.3 dollar) Chile: daily foreign exchange rate an d interest rate, 1996-2001 (pesos per 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 17 3 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 m anagem ent and the im pact 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 m arket Graciela Moguillansky 175 Figure 9.5 M ultinational com panies currency risk m anagem ent an d th e foreign exchange m arket 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.1 During 2001 this happened in the Chilean foreign exchange market. 1 Interestingly, it was caused not by an expected financial or currency crisis in that country but by the crisis in Argentina. 176 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 17 7 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 macroeconomic 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 178 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 m acroeconom ic im pact of currency risk m anagem ent by m u ltinational com panies was suggested by Stephany Griffith-Jones, an d this chapter has benefited from stim ulating conversations w ith h e r th ro u g h o u t its developm ent. 1. See O cam po (1999, 2000), Griffith-Jones an d O cam po (1999) a n d G oldstein (2000), am ong others. Graciela Moguillansky 17 9 2. W harton School and CIBC W ood G undy (1996); W orld of Banking (1995). 3. The exception was th e second h alf of th e 1980s, w hen short-term capital an d loans did n o t enter th e region. 4. All these studies contrast w ith Claessens, D ws, b u t w ith observations com ing from few countries (Claessens etal., 1995). 5. See Davis etal. (1991), Stern an d C hew (1998), Guay (1999), Prevost eta l. (2000) and Bartram (2000) for analyses of currency risk m anagem ent in non-financial corporations. 6. Because of th e n ature of th eir business, several m u ltin atio n al com panies also hedge the com m odity price risk, using com m odity price derivatives for an im p o rt­ an t p o rtio n of th eir projected o u tp u t. For exam ple in th e N o rth American gold m in in g industry firms hedge over 26 per cent of th eir p roduction, o n average (Bartram, 2000). 7. See th e BIS press releases for Ju n e 1998, 13 N ovem ber 2000 an d 16 May 2001. 8. Interviews were conducted w ith finance m anagers of com panies w ith h ead ­ quarters in Britain or Spain. We also draw o n quarterly financial statem ents reported by m u ltinatio n al enterprises to th e US SEC (Form 20-F). 9. In th e derivative m arkets of developed countries, m atu rity was betw een three and six years before th e financial crises of th e 1990s, b u t th is range was reduced to one to three years after th e Asian crisis. 10. See also G etler and G ilchrist (1994), Bernanke et al. (1996), O liner an d Rudebusch (1996), C arpenter etal. (1998) an d Fazzari eta l. (2000). 11. See Patterns in financial markets: predicting th e unpredictable, The Economist, 2 June 2001. References Bartram, S. (2000) C orporate Risk M anagem ent as a Lever for Shareholder Value C reation, Financial Markets, Institutions and Instruments, 9, 5 (December). Bernanke, B., M. G etler and S. Gilrchrist (1996) The Financial Accelerator a n d the Flight to Q uality, Review o f Economics and Statistics, 78. Bodnar, G. an d G. G ebhardt (1998) Derivatives Usage in Risk M anagem ent by US and G erm an N on Financial Firms: A Com parative Survey, NBER Working Paper no. 6705, Cambridge, MA: NBER. C arpenter, R. E. F., S. M. Petersen an d C. Bruce (1998) F inancing C onstraints an d Inventory Investm ent: A C om parative Study w ith H igh-Frequency Panel Data, Review o f Economics and Statistics, 80, 4 (November): 513-19. Claessens, S., M. P. Dooley an d A. W arner (1995) Portfolio C apital Flows: H ot or Cold?, World Bank Economic Review, 9, 1 (January): 153-74. Davis, E., J. Coates, P. Collier a n d S. Longden (1991) Currency Risk Management in Multinational Companies, London: Prentice-Hall. ECLAC (2001) Foreign Investm ent in Latin America an d th e C aribbean 2000, LC/G.2125-P, Santiago: ECLAC. Fazzari, S. M., R. G. H ubbard an d B. C. Petersen (2000) Investm ent-C ash 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 Im pact of Financial Derivatives o n th e Broad Credit C hannel of M onetary Policy, BIS W orking Paper no. 94, Basel: BIS, November. (2000b) The Im pact of C orporate Risk M anagem ent o n M onetary Policy Transmission: Some Empirical Evidence, BIS W orking Paper no. 95, Basel: BIS, November. 180 Corporate Risk Management and Exchange Rate Volatility Fite, D. and P. Pfleiderer (1995) Should Firms Use Derivatives to M anage Risk?, in W. Beaver an d 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 an d J. C. Stein (1993) Risk M anagem ent: C o-ordinating C orporate Investm ent an d Financing Policies, Journal o f Finance, 48, 5 (December). Getler, M. and S. G ilchrist (1994) ‘The Role of C redit Market Im perfections in th e M onetary Transm ission M echanism ’, Scandinavian Journal o f Economics, 95, 1. G oldstein, M. (2000) S trengthening th e Intern atio n al Financial Architecture: W here We Stand?’, W orking Paper 00-8, W ashington, DC: In stitu te for International Economics. Griffith-Jones, S. and J. A. O cam po (1999) In tern atio n al C apital Flows to Latin America: Their Im plications for Intern atio n al an d N ational Policies’, LC/R.1954, Santiago: ECLAC. Guay, W. W. R. (1999) The Im pact of Derivatives o n Firm Risk: an Empirical E xam 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 W orking Paper WP-416, W ashington, DC: IDB. (2000b) Foreign Direct Investm ent: G ood C holesterol?, IDB W orking Paper WP-417, W ashington, DC: IDB. Lipsey, R. (2001) Foreign Direct Investm ent in Three Financial Crises, NBER Working Paper no. 84, Cam bridge, MA: NBER. O cam po, J. A. (1999) In tern atio n al Financial Reform: The Broad Agenda, CEPAL Review, 69 (December). (2000) A Broad Agenda for International Financial Reform, in J. A. O campo, S. Zamagni, R. Ffrench-Davis an d C. Pietrobelli (eds), Financial Globalization and the Emerging Economies, Santiago: ECLAC. Oliner, S. D. an d G. D. R udebusch (1996) Is There a Broad C redit C h an n el for M onetary Policy?, Federal Reserve Bank o f San Francisco Economic Review, 1. Prevost, A. K., L. C. Rose a n d G. Miller (2000) Derivatives Usage an d Financial Risk M anagem ent in Large an d Small Economies: A C om parative Analysis, Journal o f Business Finance and Accounting, 27, 5 -6 (June). Sarno, L. and M. P. Taylor (1999) H ot Money, A ccounting Labels an d th e Perm anence of C apital Flows to D eveloping Countries: An Empirical Investigation, Journal o f Development Economics, 59, 2 (August): 337-64. Stern, J. M. and D. H. C hew (1998) The Revolution in Corporate Finance, 3rd edn, Oxford: Blackwell. Stultz, R. M. (1996) R ethinking 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: U niversity o f Pennsylvania, April. W orld 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 asel C a p ita l A c c o rd a n d D e v e l o p i n g C o u n t r i e 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. 181 182 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 18 3 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 microeconomic 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.4 184 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 186 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 developedcountry 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 18 7 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 188 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 18 9 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 exam ine banks n e t exposure to developing countries in term s of assets an d liabilities. Banks exposure peaked in 1997 w ith a n et credit position of US$147 billion. However n e t claims o n developing co u n ­ tries th e n fell by a staggering US$292.8 billion, an d by 2000 banks had becom e n et debtors to th e tu n e of US$145 billion (see C hapter 5). 2. See Bank of England (2001). 3. For a m ore detailed discussion o f these issues see th e IDS finance website: w w w .ids.ac.uk/intfinance. 190 The New Basel Capital Accord 4. See C om m ents received o n th e Second C onsultative Package, www.bis.org/bcbs/ cacom m ents.htm . 5. The fact th a t capital requirem ents overstate th e risk for high-rated borrowers is a m ajor im petus b eh in d th e new proposals. However if these requirem ents are to be lowered an d th e overall level of capital in th e banking system is to rem ain fixed at 8 per cent, th e n th e requirem ents at th e low -rated end m u st rise. References Bank of England (2001) Quarterly Bulletin, London: Bank of England, Spring. Griffith-Jones, S., M. Segoviano an d S. Spratt (2002) Basel II an d D eveloping C oun­ tries: D iversification a n d Portfolio Effects, h ttp://w w w .ids.ac.uk/intfinance/. Reisen, H. (2001) W ill Basel II C ontribute to C onvergence in Intern atio n al Capital Flows?, m im eo, Paris: OECD D evelopm ent Centre. Powell, A. (2001) A C apital Accord for Emerging Economies?, Paper prepared w hile visiting research fellow at th e Financial Sector Strategy an d Policy division (World Bank), Bueros Aires: U niversidad Torcuato Di Telia, http://w w w .utdt.edu/~apow ell/ Capaccord.pdf. 1 1 T h e In s t a b ilit y o f th 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 l e * 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 sourcecountry conditions as determining the opportunity cost of capital (that is, the risk-free portion of the portfolio) and the overall asset stock; while 191 192 The Emerging-Market Assets Demand Schedule destination-country conditions determine the yield and risk of emergingmarket 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 threedimensional. 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 19 3 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 macroeconomic 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 pathdependent 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 194 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 microeconomic 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 dim ension 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 (IM 1992: 45 etseq.): F, • 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 (IM 1993, particularly the F, Valpy FitzGerald 19 5 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 (IM 1994). It also F, 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 (IM 1994: 34-7, 120-38). F, 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 (IM 1997), F, herding behaviour by portfolio investors - particularly fund managers - and contagion between emerging markets (IM 1998: 69-71), and highlighted F, the need for ratings agencies to take account of the exposure of private banks as well as macroeconomic data (IM 1999: 101-15, 180-203). F, 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 196 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 emergingmarket 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 Figure 11.1 197 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 (IM 2001). F, 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 198 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 d em an d com position, 1990-2001 (percentage o f to tal n et assets of all US equity m utual funds) Source: IMF (2001). 0.8 0.7 jd\ i » ___ _ l / Sjk J 1 Russian default Brazil /d e v a lu a tio n USHY sell-off \ Septem ber 11 \ Turkey \ 0.6 . » US interest rate concerns \ i„ devaluation 1 r 0.5 0.4 0.3 I f Q p 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 em erging 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-investmentgrade borrowers. Rate-spread widening and market volatility have been Valpy FitzGerald 19 9 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. M omentum trading and risk appetite - the m icroeconom ic dim ension o f 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 (IM 2000). F, 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 emergingmarket 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 200 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 202 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 meanvariance optimization model, but they did not explore variations in risk aversion over time. The IM however, recognizes that risk appetite changes F, over time, and to identify this it uses the JP Morgan global risk aversion index (IM 2001), which measures monetary liquidity and credit premia F, (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: E(R) = a+ K log(T2) E(R) = LR(P) - P P = LR(P) - a - K Ioga2 (11.1) (11.2) (11.3) 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: Valpy FitzGerald 1997 Figure 11.4 1998 1998 1999 1999 2000 2000 2001 203 2001 Global risk aversion Source: IMF (2001). A definition o f 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. 204 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, 12, then determines its overall return, R, and r 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 w 2 (11-8) 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: r, + r +a^+ 2 j\ jx + [ + «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 205 An orderly market - the effects of official interventions on the asset dem and 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 (IM 1998, 1999). Externalities F, 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 206 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 IM helping to restructure and refinance outstanding developing F); 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 207 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 IM F) 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 fu n d s in n in e O E C D c o u n trie s , 2 0 0 1 Direct limits on domestic asset holding (%) Equity Real estate Austria 50 65 h 302 403 France G erm any 651,0 .5 2 301, 102 0 25 Investment funds Loans 20 Belgium Corporate bonds Bank deposits * 30 403 30 504, 50s * Direct limits on foreign investment N on-euro investm ents an d foreign property investm ents, 50 p er cent m axim um Localization requirem ent: only assets located in EU, bu t includes securities issued by authorized institutions; 65 per cent OECD equities, 5 per cent foreign inv estm en t funds, non-OECD equities barred 10 50 50 30 per cent EU equity, 25 per cen t EU property, Ita ly Japan Spain UK US 20 * * \ 102 * * * * * * * * * * * * * io 6 No employerrelated loans * Notes: *N o limits. 1 2 3 4 5 6 Quoted equity. Unquoted. Joint limit. Mortgage loans. Other. If no mortgage guarantee. Source: O E C D (2001, correct as at M a y 2001), abridged by Alex Cobham. 20 * 15 D ebt and equity securities n o t traded in regulated markets: OECD 50 per cent, non-OECD barred. Non-OECD trad ed in regulated m arkets 5 per cent * No lim its for OECD countries * * * * 209 210 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 211 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 lastresort 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 sem inars o n C apital Flows to Emerging Markets since th e Asian Crisis in Santiago de C hile (8-9 M arch 2001) an d Helsinki (1-18 O ctober 2001). I w ould like to th an k colleagues at these sem inars for th eir critical yet constructive com m ents. 1. This problem is discussed in d ep th in Luttick (1998), w ho also addresses th e m ajor inconsistencies betw een asset-liability an d inflow -outflow statistics, recorded by th e countries of origin and destination. 2. N ot th a t th is h ad been absent from th e critical econom ics literature, of course, from Keynes th ro u g h to Kindleberger. 3. See IMF (1995), particularly th e section o n in stitu tio n al investor behaviour an d th e pricing of developing co u n try stocks (pp. 37-44). 4. According to the Bank of England, th e spread/rating curve tends to th e origin, moves th ro u g h 250 basis points at M oody’s A2 an d 500 basis p o in ts at B3, becom ing asym ptotic to infinity beyond B3 (C unningham et al., 2001). 5. The size of th e b and (th at is, th e speculative estim ate of future exchange rate m inus forward price) m ust logically be greater th a n th e square ro o t of th e volatility m ultiplied by th e risk aversion coefficient an d th e cost of inform ation. An increase of 1 per cent in in fo rm atio n costs as a p ro p o rtio n of th e gain from th e transaction can w iden th e b an d w id th by 20 per cen t u n d er reasonable param eter assum ptions. 6. These are W orld Bank estim ates for 1997; th e to tal assets am o u n ted to US$50-70 billion. 7. Such as JP M organs EMBI global index (IMF, 2001). 212 The Emerging-Market Assets Demand Schedule 8. In fact it w ould be m ore realistic to build a ‘decision tree in th e w ay th a t trade modellers do (derived from m odels of aggregate consum ption), allow ing for successive stages of disaggregation. Thus th e first division w ould be betw een hom e and international assets, th e second w ithin in ternational assets betw een th e OECD and em erging m arkets, th e th ird w ith in em erging m arkets betw een regions, an d so on. But th e essence of th e m odel w ould be similar. 9. The FSF Compendium o f Standards contains th e work of six separate bodies: th e Basel C om m ittee o n Banking Supervision (BCBS), th e C om m ittee o n Paym ent and Settlem ent Systems (CPSS), th e In ternatio n al Association of Insurance Supervisors (IAIS), th e Internation al M onetary Fund (IMF), th e In tern atio n al O rganisation of Securities Com m issions (IOSCO) and th e O rganisation for Econom ic C o-operation and D evelopm ent (OECD). 10. As has, for th a t m atter, th e c o n te n t of an d support for th e so-called W ashington Consensus. References Agenor, P -R. (1998) The Surge in C apital Flows: Analysis o f Push an d Pull Factors, International Journal Finance and Economics, 3: 39-57. A tkinson, A. B. and J. E. Stiglitz (1980) Eectures on Public Economics, New York: McGraw-Hill. Blinder, A. S. (1987) C redit R ationing an d Effective Supply Failures, Economic Journal, 97: 327-52. B rennan, M. J. an d H. H. Cao (1997) In tern atio n al Portfolio Investm ent Flows, Journal o f Finance, 52: 1851-80. Calvo, G. A., L. Leiderm an an d C. M. R einhart (1993) C apital Flows an d Real Exchange Rate A ppreciation in Latin America, IMF Sta ff Papers, 40, 1: 108-51. Caouette, J. B., E. I. A ltm an an d P. N arayan (1998) Managing Credit Risk: The N ext Great Financial Challenge, New York: Wiley. Clark, E., M. Levasseu, and P. Rousseau (1993) International Finance, London: C h apm an an d Hall. C unningham , A., L. D ixon an d S. Hayes (2001) Analysing Yield Spreads o n Emerging M arket 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, 2 n d edn, Oxford: Oxford U niversity Press. Devenow, A. and I. Welck (1996) R ational H erding in Financial Econom ics’, European Economic Review, 40: 603-15. Disyatat, P. and R. G. Gelos (2001) The Asset A llocation of Emerging Market Funds, IMF W orking Paper W P/01/11, W ashington, DC: IMF, August. Dumas, B. (1994) Partial Equilibrium Versus G eneral Equilibrium Models o f th e Inter­ n ational C apital M arket, in F. van der Ploeg (ed.), The Handbook o f International Macroeconomics, Oxford: Blackwell, 301-34. Femanadez-Arias, E. (1996) T he New Wave of Private C apital Flows: Push or Puli, Journal o f Development Economics, 48, 2: 389-418. Frankel, J. and S. Schmukler (1996) C o u n try Fund Discounts, Asymmetric Inform ation an d th e Mexican Crisis o f 1994: Did Local Investors Turn Pessimistic Before International Investors?’, NBER Working Paper no. 5714, Cambridge, MA: NBER. Gehrig, T. (1993) An Inform ation Based E xplanation of th e Dom estic Bias in International Equity Investm ent, Scandinavian Journal o f Economics, 21: 97-109. Valpy FitzGerald 213 G oodhart, C., P. H artm ann, D. Llewellyn, L. Rojas-Suarez and S. W eisbrod (1998) Financial Regulation, London: Routledge in association w ith th e Bank of England. Hiller, B. (1997) The Economics o f Asymmetric Information, Basingstoke: M acm illan. In tern atio n al M onetary F und (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. K ahnem an, D., P. Slovic and A. Tversky (1982) Judgement Under Uncertainty: Heuristics and Biases, Cambridge: C am bridge U niversity Press. Kaminsky, G., R. K. Lyons an d S. Schm ukler (2000a) M anagers, Investors an d Crises: M utual Fund Strategies in Emerging M arkets, NBER Working Paper no. 7855, Cambridge, MA: NBER. and (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 H ome Bias? An Analysis of Foreign Portfolio Equity O w nership in Japan, Journal o f Financial Economics, 46: 3-28. Kim, W. an d S -J. Wei (1999) Foreign Portfolio Investors Before an d D uring a Crisis, NBER Working Paper no. 6968, Cambridge, MA: NBER. Kumar, M. S. an d A. Persaud (2001) Pure C ontagion an d Investors Shifting Risk Appetite: Analytical Issues and Empirical Evidence, IMF W orking Paper 01/134, W ashington, DC: IMF. Lane, P. an d G. M. Lilesi-Ferretti (1999) The External W ealth of N ations: Measures of Foreign Assets and Liabilities for Industrial a n d D eveloping C ountries, IMF W orking Paper 99/115, W ashington, DC: IMF. Luttick, J. (1998) Accounting for the Global Economy: Measuring World Trade and Investment Linkages, Basingstoke: M acm illan. Mankiw, N. G. (1986) The A llocation of C redit an d Financial Collapse, Quarterly Journal o f Economics, 101: 455-70. Mody, A. and M. P. Taylor (2001) In tern atio n al C apital C runches: 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 D ynamics of C apital M ovem ents in Emerging Economies D uring th e 1990s, in S. Griffith-Jones, M. F. M ontes and A. N asution (eds), Short-term Capital Flows and Economic Crises, Oxford: Oxford U niversity 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 an d International Tax Principles, Journal o f Intemaional Economics, 44: 45-68. Stiglitz, J. and A. Weiss (1992) Asymm etric Inform ation in C redit Markets an d its Im plications for M acroeconom ics, Oxford Economic Papers, 44. Tobin, J. (1998) Money Credit and Capital, New York: McGraw-Hill. W orld Bank (2000) G lobal D evelopm ent Finance 2000, W ashington, DC: W orld Bank. P a r t II N a tio n a l P o lic y R esp o n ses I I 1 2 C a p ita l A c c o u n t a n d C o u n te r c y c lic a l P r u d e n t ia l R e g u la tio n s i n D e v e lo p in g C o u n tr ie 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 boombust 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 217 218 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 balancesheet effects of capital account fluctuations on domestic financial and nonfinancial 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 219 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 antiinflationary 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. 220 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 bestrun 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 (IM 1998; Bordo etal, F, 2001). The most important policy implication of this is that developingcountry 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 222 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 foreigncurrency 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 223 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 macroeconomic 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 224 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;7those 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 226 Chile Colombia Malaysia 0.25 0.20 0.15 0.10 0.05 -0.05 -0.10 (m)ooos -0.15 Figure 12.1 A * ^ Index of expansionary m onetary pressures, 1990-2000 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 = a R + b e -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. fosé Antonio Ocampo 227 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 pricebased 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 228 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 pricebased 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), nondiscretionary (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). 230 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 dollardenominated 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 ■ Primary deficit Q External debt interest payments ■ Internal debt interest payments Colombia Mexico 19 19 19 19 19 19 94 95 96 97 98 99 l Primary deficit □ External debt interest payments ■ Internal debt Interest payments 19 19 19 19 19 19 91 92 93 94 95 96 ■ 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 19 19 19 19 19 19 94 95 96 97 98 99 I US$ dollars ■ Variable rate □ Fixed rate DInflation indexed Figure 12.2 Composition of the national government’s domestic debt 19 96 19 97 19 98 Compostion of the federal governments domestic debt 19 99 ■ US$ dollars □ Fixed rate □ Inflation indexed 19 19 19 19 19 19 91 92 93 94 95 96 ■ US$ dollars ■ Variable rate b Fixed rate a Inflation Indexed Fiscal deficit an d public debt: Brazil (1994-99), Colom bia (1994-99) an d Mexico (1991-96) Source: Central Bank of Brazil; IDEA; Ministry of Finance of Colombia; Secretary of Finance and Public Credit of Mexico; 231 Bank of Mexico. 232 Capital Account and Countercyclical Regulations likely to cause v o la tile p o rtfo 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 in v esto rs m a y h e lp to dev elo p dom estic cap ital m arkets. T hus th e au th o rities m u st ch o o se b etw e en less v o latile e x te rn a l ca p ita l flow s a n d th e d e v e lo p m e n t o f deeper, liq u id d o m e stic ca p ita l m arkets. C h iles decisio n to e lim in a te th e o n e-y ear m in i­ m u m m a tu rity for p o rtfo lio flows in M ay 2000, as w ell as C olom bias decision in 1996 to allow foreign in v e stm e n t fu n d s to p a rtic ip a te in th e d o m e stic m a rk e t for p u b lic sector securities, m a y be u n d e rsto o d as a ch o ice for th e seco n d o f th e se o p tio n s a t th e cost of a d d itio n a l cap ital a c c o u n t v olatility. Sim ilar trade-offs m a y b e faced in re la tio n to th e d e v e lo p m e n t of deep d o m e stic p riv ate-sec to r stock a n d b o n d m arkets. The role of countercyclical prudential regulations M ic ro - a n d m a c r o e c o n o m ic d i m e n s io n s o f p r u d e n t i a l p o lic ie s As w e h av e seen, th e origins o f p roblem s th a t e ru p t d u rin g fin an c ial crises are asso ciated b o th w ith excessive risk ta k in g d u rin g b o o m s, as reflected in a rap id increase in le n d in g , a n d w ith m a tu rity a n d c u rre n c y m ism atch es o n fin an c ial a n d n o n -fin a n c ia l a g e n ts b alan c e sheets. In m a n y c o u n tries th e se p ro b lem s are related to in a d e q u a te risk analysis b y fin an cial agents, as w ell as w eak p m d e n tia l reg u la tio n a n d supervision o f th e dom estic fin an cial system s. T he c o m b in a tio n o f th e se factors becom es explosive u n d e r c o n d itio n s o f fin an c ial lib e raliz atio n in th e m id st o f a b o o m in e x te rn a l fin an c in g . T he u n d e re stim a tio n o f risks th a t characterizes e n v iro n m e n ts o f e c o n o m ic o p ti­ m ism is th e n c o m b in e d w ith in a d e q u a te practices for ev a lu a tin g risks, b o th b y p riv ate ag en ts a n d b y supervisory agencies. T his u n d ersc o re s ju st h o w im p o rta n t th e se q u en c in g o f fin an c ial lib eral­ iz atio n processes is. T his b ec am e e v id e n t d u rin g th e first w ave o f fin an c ial crises th a t h it L atin A m erica in th e early 1980s (see for ex a m p le DiazA lejandro, 1988: ch. 17) b u t w as b ro a d ly ig n o red in la ter ep iso d es of fin an c ial lib e raliz atio n in th e d ev e lo p in g w orld. Since th e A sian crisis it has fin ally b ec o m e a m a in stre a m idea. In d ee d it is n o w w id ely reco g n ized th a t fin an c ial lib e raliz atio n sh o u ld take place in a suitable in s titu tio n a l settin g , w h ic h includes stro n g p ru d e n tia l reg u latio n a n d supervision. Such reg u latio n sh o u ld ensure, first o f all, th e solvency o f fin an c ial in s titu tio n s b y estab ­ lish in g a p p ro p ria te ca p ita l a d e q u ac y ratio s relative to th e risk assu m ed b y le n d in g in stitu tio n s, strict w rite-offs o f q u e stio n a b le p o rtfo lio s a n d a p p ro ­ p riate sta n d ard s o f risk diversification. P roperly reg u lated a n d sup erv ised fin an c ial system s are stru ctu ra lly su p erio r in term s of risk m a n a g e m e n t since th e y create in c e n tiv e s for fin an c ial in te rm ed ia ries to av o id assu m in g u n m a n a g e a b le risks. To th e e x te n t th a t ag en ts assum e th a t th e sources o f fin an c ial risks h av e a m a cro ec o n o m ic origin, th e tra d itio n a l m ic ro eco n o m ic focus of p ru d e n tia l fosé Antonio Ocampo 233 re g u la tio n a n d su p erv isio n m u st be c o m p le m e n te d w ith reg u la tio n s th a t ta k e a c c o u n t o f su c h m a cro ec o n o m ic factors. T his is p articu la rly tru e in d ev e lo p in g c o u n tries, w h ere th e d y n am ics associated w ith b o o m -b u s t cycles in e x te rn a l fin a n c in g are p articu la rly in te n se . D ue a tte n tio n sh o u ld th u s b e p aid to th e links b e tw e e n d o m e stic a n d e x tern al fin an c in g , th e links a m o n g th e se factors a n d asset prices a n d e c o n o m ic activity, a n d th e links b etw e en d o m e stic fin an c ial risks a n d v aria tio n s in in te re st a n d e x c h an g e rates. T h e b asic p ro b le m in th is reg ard is th e in a b ility o f in d iv id u a l fin an c ial in te rm ed ia ries to in te rn a liz e th e collective risks assu m ed d u rin g b o o m p eriods, w h ic h are essentially o f a m a c ro e c o n o m ic ch a racter a n d th e re fo re e n ta il c o o rd in a tio n p ro b lem s th a t exceed th e possibilities o f a n y o n e ag en t. M oreover risk assessm ent a n d tra d itio n a l reg u la to ry tools, in c lu d in g Basel stan d ard s, h av e a procyclical bias in th e w ay th e y operate. In d ee d in a system in w h ic h loan-loss p ro v isio n s are tie d to lo a n d elin q u en cy , p re c a u tio n a ry reg u la to ry signals are ineffective d u rin g b o o m s, a n d h e n c e d o n o t h a m p e r cred it g row th. O n th e o th e r h a n d th e sh a rp increase in lo a n d e lin q u e n c y d u rin g crises does red u ce fin an c ial in s titu tio n s capital, a n d h e n c e th e ir le n d in g capacity. This, in c o n ju n c tio n w ith th e greater subjectively perceived level o f risk, triggers th e c re d it squeeze th a t ch aracterizes su c h p eriods, th e re b y rein fo rcin g th e d o w n sw in g in e c o n o m ic activ ity a n d asset prices, a n d in tu r n th e q u a lity o f th e p o rtfo lio s o f fin an c ial in te rm e d ia rie s.10 In d ee d th e su d d e n in tro d u c tio n o f stro n g reg u la to ry sta n d a rd s d u rin g a crisis m a y w o rsen a credit squeeze, so a lth o u g h th e a u th o ritie s m u s t a d o p t clearly d efin e d rules to restore co n fid e n ce d u rin g a fin an c ial crisis, th e ap p lic a tio n o f stro n g er sta n d a rd s sh o u ld be gradual. In o rd er to av o id m o ral h a z a rd p rob lem s, th e au th o ritie s m u st n ev e r b ail o u t th e o w n ers o f fin an c ial in s titu tio n s b y g u a ra n te e in g th a t th e ir losses w ill b e w ritte n off, u p to th e ir n e t w o rth , if regu lato rs h av e to in te rv e n e in th e se in stitu tio n s. In o rd er to take a c c o u n t of th e m a cro ec o n o m ic facto rs th a t affect risks, in stru m e n ts n ee d to b e designed th a t w ill in tro d u c e a countercyclical elem e n t in to p ru d e n tia l reg u la tio n a n d su pervision. In th is regard th e m a jo r in s tru ­ m e n t is u n d o u b te d ly forw ard -lo o k in g provisions. Such p ro v isio n s s h o u ld b e e stim a te d w h e n lo a n s are disb u rsed o n th e basis o f e x p ected o r la te n t losses, ta k in g in to a c c o u n t th e full busin ess cycle, ra th e r th a n o n th e basis of lo a n d e lin q u e n c y o r sh o rt-te rm ex p e ctatio n s o f fu tu re lo a n losses, w h ic h are h ig h ly procyclical. T his m ean s, in fact, th a t p ro v isio n in g s h o u ld a p p ro a c h th e criteria tra d itio n a lly follow ed b y th e in su ra n c e in d u s try (w here p ro v i­ sio n s are m a d e w h e n th e in su ra n c e po licy is issued) ra th e r t h a n th e b a n k in g in d u stry . T his practice co u ld h e lp to sm o o th o u t th e cycle b y in c reasin g p ro v isio n s or reserves d u rin g ca p ita l a c c o u n t surges, th u s h e lp in g to red u ce th e cred it c ru n c h th a t takes place d u rin g busts. It m u s t b e e m p h asized th a t all reg u lato ry ap p ro a ch es h a v e clear lim its a n d costs th a t c a n n o t b e overlooked. P ru d e n tia l reg u la tio n in v o lv es so m e n o n ­ p rice signals, a n d p ru d e n tia l su p erv isio n is full o f in fo rm a tio n p ro b lem s a n d 234 Capital Account and Countercyclical Regulations is a d isc re tio n a ry activ ity th a t is susceptible to abuse. Som e classic o bjectives o f p ru d e n tia l reg u latio n , su ch as risk diversification, m a y b e difficult to a tta in w h e n m a c ro e c o n o m ic issues are a t th e ro o t o f th e difficulties. T h e ex p eri­ en c e o f m a n y in d u stria liz e d c o u n tries in d ic ates th a t e v e n w ell-regulated system s are su b je ct to p erio d ic episodes o f eu p h o ria , w h e n risks are u n d e r­ e stim a ted . T he re c e n t crisis in A rg en tin a is a specific case in w h ic h a system o f p ru d e n tia l reg u la tio n s th a t w as co n sid ered to be o n e o f th e b est in th e d ev e lo p in g w o rld - w o rk in g w ith in th e fram ew ork o f a fin a n c ia l sector c h aracterized b y th e large-scale p resence o f m u ltin a tio n a l b an k s - clearly failed to avert th e effects o f m a jo r m a cro ec o n o m ic shocks o n th e d o m e stic fin an c ial system . M oreover, b e in g able to sep arate cyclical fro m lo n g -te rm tre n d s is alw ays a difficu lt task, as a n y process th a t in v o lv es le a rn in g w ill alw ays g en e rate p a th -d e p e n d e n t m e c h a n ism s in w h ic h sh o rt- a n d lo n g -te rm d y n am ics are in te rc o n n e c te d . L earning processes in c lu d e th o s e asso ciated w ith th e fo rm a tio n o f ex p e ctatio n s o f fu tu re m a c ro e c o n o m ic ev en ts, w h ic h is p articu la rly d ifficu lt in d ev e lo p in g ec o n o m ies facin g su b sta n tia l shocks (H eym an, 2000). M oreover m a n y reg u la to ry p ractices aim ed a t co rrec tin g risky practices o n th e p a rt o f fin an c ial in te rm ed ia ries sh ift th e u n d e rly in g risks to n o n -fin a n c ia l ag en ts, th u s g e n e ra tin g in d ire c t risks th a t are expressed in cred it risks. T he n e t effect o f re g u la tio n o n b a n k s v u ln e ra b ilities is th e re fo re p artial, as th e literatu re o n th e m ig ra tio n o f risks ind icates. T h u s reg u la to ry sta n d a rd s th a t estab lish low er risk ratin g s for sh o rt-te rm credits a n d red u ce m ism atch es b etw e en th e m a tu ritie s o f b a n k dep o sits a n d le n d in g w ill red u ce d irect b a n k in g risks, b u t w ill also reinforce th e sh o rt-te rm bias in le n d in g . M a tu rity m ism atch es are th e re b y disp laced to n o n -fin a n c ia l ag en ts. In d ee d th e n e t effect o f th is ty p e o f re g u la tio n m a y be a n in a d e q u a te su p p ly of lo n g -te rm fin a n c in g a n d red u c ed fixed ca p ita l in v e stm e n t. Also, p ru d e n tia l reg u la tio n s th a t fo rbid b a n k s to h o ld cu rren cy m ism atch es in th e ir p o rtfo lio s w ill red u ce th e ir d irec t risk, b u t m a y en c o u rag e n o n -fin a n c ia l ag en ts to b o rro w ab ro ad . T he risks assu m ed b y co rp o ratio n s, p articu la rly th o se o p e ra tin g in n o n -tra d ab le sectors, w ill ev en tu ally b e tran slate d in to cred it risk b y d o m estic fin an c ial in s titu tio n s th a t are also th e ir creditors. For th e sam e reaso n , stro n g e r re g u la tio n w ill resu lt in h ig h e r spread s in d o m e stic fin an c ial in te rm e d ia tio n , p articu la rly if it results in m o re strin g e n t d o m e stic vis-à-vis in te rn a tio n a l reg u la to ry practices, w h ic h is a likely o u t­ co m e g iven th e stro n g er v o la tility o f d ev e lo p in g co u n tries. H ig h er spreads w ill g en e rate in c e n tiv e s fo r c o rp o ra tio n s w ith d irect access to in te rn a tio n a l ca p ita l m arkets to b o rro w abroad, th u s in c reasin g th e lik e lih o o d o f c u rren cy m ism atch es in th e p o rtfo lio s o f th e se agents. T h ey m a y also resu lt in a su b o p tim al su p p ly o f fin a n c in g for SMEs, o r a n excessively sh o rt-te rm bias in th e su p p ly o f cre d it for su ch firm s. In all th e se cases th e red u c ed v u ln e r­ ab ility o f th e d o m e stic fin an c ial sector w ill h av e as a co ro llary th e m a tu rity a n d cu rrency m ism atch es o f n o n -fin a n cial agents (as w ell as su b o p tim al fixed José Antonio Ocampo 235 ca p ita l in v e stm e n t), w h ic h m a y b ec o m e cred it risks for d o m e stic fin an c ial ag en ts d u rin g th e d o w n tu rn . T h e d iffe ren tia tio n b etw e en system ic a n d n o n -sy stem ic risks th a t is typical in p o rtfo lio risk analysis is p articu larly rele v an t in th is regard. T he fo rm er d ep e n d s o n th e co rrelatio n o f th e price flu ctu atio n s o f ea ch p articu la r asset w ith prices for th e en tire m a rk e t a n d arises from exposure to c o m m o n factors (for ex am p le e c o n o m ic policy o r th e b u siness cycle) w h ile n o n -sy ste m ic risks d e p e n d o n th e in d iv id u al characteristics o f each stock a n d m a y b e red u ced b y diversification. W hereas th e seco n d ty p e of risk c a n b e red u ced b y ad e­ q u a te reg u latio n s aim ed a t im p ro v in g m ic ro eco n o m ic risk m a n a g e m e n t, th e first c a n n o t, a n d in th e face o f system ic risks th e use of c o m m o n risk m a n ­ a g e m e n t te c h n iq u e s c a n actually resu lt in greater m a cro ec o n o m ic v o la tility (Persaud, 2000). T hus to a large ex ten t, m a cro ec o n o m ic risks th a t are sys­ te m ic in ch a racter ca n o n ly b e sh ifted to o th e r m a rk e t ag en ts w ith in a spe­ cific e c o n o m y a n d are o n ly au th e n tic a lly diversified w h e n e x tern al ec o n o m ic ag en ts are w illing to assum e th e m . N oneth eless countercy clical p ru d e n tia l policies c a n h e lp to redu ce th e collective risks th a t agen ts m ay assu m e d u r­ in g p erio ds o f eu p h o ria . T hey ca n also h e lp to gen erate im p ro v e d in cen tiv es for fin an cial agen ts th a t b eh a v e procyclically (those ex p o sed to in d u stries w ith h ig h system ic risks). In all cases, as in th e case o f ca p ita l co n tro ls, im p ro v e d p ru d e n tia l reg u la­ tio n , in c lu d in g th e in tro d u c tio n o f stro n g co u n tercy clical c o m p o n e n ts th a t tak e in to a c c o u n t th e m acro eco n o m ics o f b o o m -b u s t cycles, is a co m p le m e n t b u t n o t a su b stitu te for a p p ro p ria te cou n tercy clical m a c ro e c o n o m ic policies. I n s tr u m e n ts to p r o te c t a g a in s t c re d it ris k U n d er g en erally accep ted a c c o u n tin g principles, p ro v isio n s s h o u ld cover ex p e cted losses, th o u g h of a n u n c e rta in m a g n itu d e , a n d are th u s registered as expenses, w h ile reserves ap p ly to u n e x p e c te d losses a n d are p a rt o f cap ital. T hese p rin cip les also im p ly th a t b an k s sh o u ld ch arg e a n in te re st p re m iu m for ex p ected risk w h ile sto ckholders s h o u ld cover u n e x p e c te d risks. A cc o u n tin g p ractices also d iffe ren tia te b e tw e e n gen eral a n d specific p ro v i­ sions. In m o st c o u n tries th e c a lc u latio n of specific p ro v isio n s is d o n e o n an in d iv id u a l basis for com m ercial lo a n s a n d o n a p o o le d basis for retail loans. G en eral p ro v isio n s are estim a ted o n th e basis o f pools o f loans, o r th e to ta l p o rtfo lio . In so m e c o u n tries th e y are tre a te d as reserves, a n d as su c h as capital, w h ile in o th e rs th e y are su b trac te d fro m assets. W ith tra d itio n a l a c c o u n tin g m e th o d s, specific p ro v isio n s are m a d e sh o rtly b efo re o r ev en after a lo a n beco m es d e lin q u e n t. In th is sense a system b ased w h o lly o n th is ty p e o f p ro v isio n w ill n o t reflect th e tru e cred it risk o f th e lo a n p o rtfo lio a n d , as in d ic a te d above, w ill be in h e re n tly procyclical. T h e rules o n g eneral p ro v isio n s a n d reserves are u sually m o re flexible a n d allow for m o re forw ardlo o k in g ap p ro a ch es in th e appraisal o f risk. 236 Capital Account and Countercyclical Regulations In som e co u n tries th e au th o ritie s (th e g o v e rn m e n t o r th e c e n tra l b an k ) ta k e a restrictive a p p ro a c h a n d estab lish sta tu to ry rules th a t d e te rm in e th e level o f provisions. In o th e rs th e system varies fro m a strict fo rm u la to statistical ap p ro a ch es th a t use h isto ric al data, in fo rm a tio n o n p eer g ro u p s a n d m o re explicit in te rn a l risk m odels. Several OECD c o u n tries allow th e c o n s titu tio n o f fo rw ard -lo o k in g p ro v isio n s b ased o n p ast ex p erien ce a n d th e ex p e ctatio n o f fu tu re events. H ow ever m o st o f th e m are o rie n te d to w ard s th e sh o rt term , u sin g a on e-y ear h o riz o n to m easure risk. T h e b est-k n o w n ex c e p tio n to th is rule is Spain, w h ic h in D ecem ber 1999 issu ed a re g u la tio n re q u irin g countercy clical p ro v isio n s ca lc u lated b y sta tis­ tic al m e th o d s. T h e m a in featu re of th is a p p ro a c h is th e e s tim a tio n o f la te n t risk b ased o n p a st ex p e rien c e over a p e rio d lo n g e n o u g h to cover a t least o n e b usiness cycle. T his gen erates a d y n a m ic in w h ic h p ro v isio n s b u ild u p d u rin g e c o n o m ic e x p a n sio n s a n d are d ra w n u p o n d u rin g d o w n tu rn s (Poveda, 2000; D e Lis e ta l., 2001). T he m a jo r in n o v a tio n o f th is system is its ex p licit re c o g n itio n th a t risks are in c u rre d w h e n cred its are a p p ro v e d a n d disb u rsed, n o t w h e n th e y fall due. M ore particularly, u n d e r th is sch em e statistical o r actu arial p ro v isio n s for la te n t risks m u s t b e e stim a te d for h o m o g e n e o u s categories o f cred it ac co rd in g to th e possib le loss th a t a ty p ic al asset (lo an , g u a ra n te e , in te r ­ b a n k o r fixed in c o m e p o rtfo lio in v e stm e n t) in ea ch categ o ry is ex p e cted to involve, estim a ted o n th e basis o f a full busin ess cycle. E ith er th e in te rn a l risk m a n a g e m e n t m o d e l o f th e fin an c ial in s titu tio n o r th e sta n d a rd m o d e l p ro p o se d b y th e B anco de E spaña ca n be u sed for th a t p u rp o se. T h e la tte r estab lishes six categories, w ith a n n u a l p ro v isio n in g ratio s th a t ran g e fro m 0 to 1.5 p er ce n t. T hese statistical p ro v isio n s m u st be a c c u m u la te d in a fu n d , to g e th e r w ith special p ro v isio n s (tra d itio n al p ro v isio n s for n o n -p e rfo rm in g assets o r th e p e rfo rm in g assets o f borrow ers in fin an c ial difficulties) a n d reco v ered n o n -p e rfo rm in g assets.11 T he fu n d ca n b e u sed to co v er lo a n losses, th u s in effect e n tire ly su b stitu tin g for special p ro v isio n s if resources are available in a d e q u a te a m o u n ts. If th is is so th e p ro v isio n s actu ally follow th e cre d it cycle. A lth o u g h th e a c c u m u la tio n a n d d raw in g d o w n o f th e fu n d m a d e u p b y statistical a n d specific p ro v isio n s h as a countercy clical d y n am ic, th is o n ly reflects th e cyclical p a tte r n o f b a n k le n d in g . In th is reg ard th e system is, strictly speaking, cy c le-n eu tra l ra th e r th a n countercyclical, b u t it is certain ly su p erior to th e tra d itio n a l procyclical p ro v isio n in g for lo a n losses o r forw ardlo o k in g p ro v isio n in g b ased o n sh o rt tim e h o rizo n s. T herefore a system su c h as th is s h o u ld b e c o m p le m e n te d b y strictly co u n tercyclical p ru d e n tia l p rovisions, d ecreed b y th e re g u la to ry a u th o rity for th e fin an c ial system a w hole, o r b y th e superviso ry a u th o rity for special fin an c ial in stitu tio n s, o n th e basis of objective criteria. T hese criteria co u ld in c lu d e th e g ro w th ra te o f credit, th e bias in le n d in g to w ard s sectors c h a r­ acterized b y system ic risks o r th e g ro w th o f fo re ig n -cu rre n cy -d en o m in ate d José Antonio Ocampo 237 lo a n s to n o n -tra d a b le sectors. V o lu n ta ry p ru d e n tia l p ro v isio n s co u ld also b e en co u rag ed . In b o th cases it is essen tial th a t ta x d e d u c tib ility b e g ra n te d to th e p ro v isions. In d ee d a c c o u n tin g a n d ta x a tio n rules c o n trib u te to failures in risk assessm ent because, in general, th e y m ake it necessary to register ev en ts th a t h av e alread y occurred. T h e fo regoing analysis in d ic ates th a t a n a p p ro p ria te po licy for m a n a g in g th e m a cro ec o n o m ic effects o f b o o m -b u s t cycles in d ev e lo p in g co u n tries s h o u ld in v o lv e a m ix tu re of: (1) forw ard -lo o k in g p ro v isio n s for la te n t risks, to b e m a d e w h e n cred it is g ra n te d so th a t fin a n c ia l in te rm ed ia ries w ill h av e to tak e a c c o u n t o f th e risks th e y in c u r th r o u g h o u t th e e n tire b u sin ess cycle; a n d (2) m o re d iscrete countercy clical p ru d e n tia l p ro v isio n s b ased o n a series o f o b jectiv e criteria. Specific p ro v isio n s sh o u ld b e m a n a g e d to g e th e r w ith fo rw ard -lo o k in g p rovisions, as in th e S p anish system . As w e sh all see in th e fo llo w in g sections, th e se p ro v isio n s sh o u ld be s u p p le m e n te d b y reg u la tio n s in o th e r areas. Reserves o r gen eral p ro v isio n s p lay a less clear role a n d in fact are n o t d istin g u ish a b le fro m th e role o f ca p ita l in co v e rin g u n e x p e c te d losses. A system o f p ro v isio n s such as th is w o u ld ce rta in ly b e su p erio r to th e use o f ca p ita l a d e q u ac y ratio s to m a n a g e th e effects o f busin ess cycles. C a p ita l ad e q u ac y re q u ire m e n ts s h o u ld in ste a d focus o n lo n g -te rm so lv en cy criteria ra th e r th a n o n cyclical p erfo rm an ce . Insofar as d ev e lo p in g c o u n tries are likely to face m o re m a c ro e c o n o m ic volatility, th e re m a y b e a n a rg u m e n t for re q u irin g h ig h e r c a p ita l-asse t ratio s (see th e a d d itio n a l arg u m e n ts below ), b u t th e re is n o n e for req u irin g th a t ca p ita l ad e q u ac y re q u ire m e n ts sh o u ld be, as such, countercyclical. It sh o u ld also b e rem e m b ere d th a t th e stricter sta n d a rd s in d ev e lo p in g c o u n tries for th e m a n a g e m e n t o f m a c ro e c o n o m ic risks - in te rm s o f p ro ­ visions, cap ital o r o th e r variables - increase th e costs o f fin an c ial in te r ­ m e d ia tio n , th e re b y red u c in g in te rn a tio n a l c o m p etitiv e n ess a n d cre atin g arb itrag e in c en tiv es to use in te rn a tio n a l fin an c ial in te rm e d ia tio n as a n alter­ n ativ e. Also, p ru d e n tia l policies are ce rta in ly n o t a so lu tio n fo r th e risks th a t p rocyclical m a c ro e c o n o m ic policies m a y g enerate. P r u d e n t ia 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 ris k s , a n d v o la tile a sse t p ric e s E xperience in d icates th a t cu rren c y a n d m a tu rity m ism atch es are essen tial aspects o f fin a n c ia l crises in d e v e lo p in g c o u n tries. P ru d e n tia l re g u la tio n sh o u ld th u s estab lish strict rules to p re v e n t cu rren cy m is m atch es (in clu d in g th o se associated w ith h ed g in g a n d related o p eratio n s) a n d to red u ce im b alan ces b etw e en th e m a tu ritie s o f th e assets a n d liabilities o f fin an c ial in term ed iaries. In a d d itio n , liq u id ity reg u la tio n s sh o u ld b e estab lish ed to m a n ag e su ch im balances. T h e strict p ro h ib itio n o f cu rren cy m ism atch es in th e po rtfo lio s o f fin an cial in te rm ed ia ries is th e b e st rule. T h e a u th o ritie s sh o u ld also closely m o n ito r 238 Capital Account and Countercyclical Regulations th e in te rm e d ia tio n of sh o rt-te rm e x tern al credits. As w e h av e seen, th e cu rren c y risks o f n o n -fin a n c ia l firm s, p articu la rly th o se o p e ra tin g in n o n ­ trad a b le sectors, m a y ev e n tu a lly tu r n in to credit risks for b a n k s .12 T his p o in ts to th e n e e d fo r b e tte r m o n ito rin g o f th e cu rren c y risks o f th e se firm s, a n d p ro b ab ly for specific reg u la tio n s o n le n d in g to firm s in n o n -tra d a b le sectors w ith su b stan tia l liabilities in fo reign currency. In p articu lar, reg u la tio n s co u ld b e u sed to estab lish m o re strin g e n t p ro v isio n s a n d /o r risk w e ig h tin g fo r th o se o p era tio n s, o r a stric t p ro h ib itio n o n le n d in g in fo reig n cu rren cies to n o n -fin a n c ia l firm s w ith n o in c o m e in th o se currencies; ca p ita l a c c o u n t reg u la tio n s w o u ld h av e to establish c o m p le m e n ta ry n o rm s fo r d irect b o rro w in g ab ro a d b y th e se firm s (see above). In ad d itio n , p ru d e n tia l re g u la tio n n ee d s to en su re a d e q u a te levels of liq u id ity for fin a n c ia l in te rm ed ia ries so th a t th e y c a n h a n d le th e m is m a tc h b etw e en th e average m a tu ritie s o f assets a n d liabilities th a t is in h e re n t in th e fin an cial system s essen tial fu n c tio n o f tra n sfo rm in g m a tu ritie s, w h ic h g en erates risks associated w ith v o la tility in dep o sits a n d /o r in te re st rates. T his u n d ersco res th e fact th a t liq u id ity a n d solvency p ro b lem s are far m o re closely in te rre la te d th a n tra d itio n a lly assum ed, p a rtic u la rly in th e face of m a c ro e c o n o m ic shocks. Reserve req u irem en ts, w h ic h are strictly a n in s tru ­ m e n t o f m o n e ta ry policy, p ro v id e liq u id ity in m a n y co u n tries, b u t th e ir d e c lin in g im p o rta n c e m akes it necessary to fin d n e w to o ls. M oreover th e ir tra d itio n a l stru c tu re is n o t geared to th e specific o b jectiv e o f en su rin g fin an c ial in te rm e d ia rie s liq u id ity in th e face o f th e m a tu rity m ism atch es th e y h o ld in th e ir p o rtfo lio s. A n im p o rta n t in n o v a tio n in th is area w as th e sy stem created in 1995 in A rgentina, w h ic h set liq u id ity re q u ire m e n ts b ased o n th e residual m a tu rity o f fin an c ial in s titu tio n s liab ilities ( th a t is, th e n u m b e r of days re m a in in g b efore re a c h in g m a tu rity ).13 T hese liq u id ity re q u ire m e n ts - o r a system o f reserve re q u ire m e n ts w ith sim ilar c h a ra c te r­ istics - h av e th e a d d itio n a l a d v a n ta g e th a t th e y offer a d irect in c en tiv e to th e fin an c ial system to m a in ta in a n a p p ro p ria te liab ility stru ctu re . T he q u a lity o f th e assets w ith w h ic h th e liq u id ity re q u ire m e n ts are m e t is o b v i­ o u sly a crucial factor. In th is regard it m u st b e p o in te d o u t th a t allo w in g su ch assets to b e in v e ste d in p u b lic sector b o n d s w as a n essen tial w eakness o f th e A rg e n tin e a n system , as it in c re a se d th e v u ln e ra b ility o f th e fin a n c ia l system to p u b lic secto r d e b t restru c tu rin g , a risk th a t tu r n e d in to reality in 2001. T h e v a lu a tio n o f assets u sed as collateral for lo a n s also p rese n ts p ro b lem s w h e n th e se assets e x h ib it price volatility, b ecause in m a n y cases ex an te assessm ents m a y be sig n ific an tly h ig h e r th a n ex p o s t prices. L im its o n lo an to -v alu e ratio s a n d rules to a d ju st th e v alu e o f collateral for cyclical price v aria tio n s s h o u ld be ad o p ted . O n e a p p ro a c h in th is reg ard is th e m o rtg ag e le n d in g v alu e, a v a lu a tio n p ro ced u re a p p lied in so m e E u ro p ean co u n tries th a t reflects lo n g -te rm m a rk e t tre n d s in real estate prices b ased o n ex p eri­ en c e (ECB, 2000). José Antonio Ocampo 239 T h e p ro p o sal for th e n e w Basel A ccord a tte m p ts to alig n risk w eig h ts w ith th e ev a lu a tio n s o f e x tern al cre d it ra tin g agencies. U n fo rtu n a te ly th is w o u ld in tro d u c e a n a d d itio n a l procyclical bias, giv en th e pro cy clical p a tte rn of cred it ratin g s (see C h a p te r 7). T he h ig h c o n c e n tra tio n o f th e ra tin g in d u s try is a n a d d itio n a l a rg u m e n t ag a in st a d o p tin g th is re c o m m e n d a tio n . M o reo v er it w o u ld b e d ifficu lt to ap p ly th is p ractice in d ev e lo p in g c o u n trie s d u e to th e ab sen ce o f ad e q u ate cred it ratin g s for m o st firm s. Conclusions T his c h a p te r h as ex p lo re d th e c o m p le m e n ta ry u se o f tw o in s tru m e n ts to m a n a g e ca p ita l a c c o u n t v o la tility in d e v e lo p in g co u n tries: ca p ita l a c c o u n t reg u la tio n s a n d th e co u n tercy clical p ru d e n tia l re g u la tio n o f d o m e stic fin a n ­ cial in te rm ed iaries. T hese in stru m e n ts sh o u ld b e seen as c o m p le m e n ta ry to co u n tercy clical m a c ro e c o n o m ic policies, b u t n e ith e r o f th e m c a n n u llify th e risks th a t procyclical m a c ro e c o n o m ic policies ca n generate. O verall th e in n o v a tiv e ca p ita l a c c o u n t reg u la tio n s o f th e 1990s c a n b e seen as useful in stru m e n ts in term s o f im p ro v in g d eb t pro files a n d facili­ ta tin g th e a d o p tio n o f (possibly tem p o rary ) co u n tercy clical m a c ro e c o n o m ic policies. T h e m a in ad v a n ta g es o f th e p rice-based u n re m u n e ra te d reserve re q u ire m e n t p io n e e re d b y C h ile a n d C o lo m b ia are its sim plicity, n o n d isc re tio n a ry ch a racter a n d n e u tra l effect o n c o rp o rate b o rro w in g decisions. T h e m o re q u a n tita tiv e M alaysian system h a s b e e n sh o w n to h a v e stro n g er sh o rt-term m acro eco n o m ic effects. T raditional q u an tita tiv e ex ch an g e co n tro ls m a y b e su p erio r if th e objective o f m a c ro e c o n o m ic po licy is sig n ifican tly to red u ce d o m e stic m a c ro e c o n o m ic se n sitiv ity to in te rn a tio n a l ca p ita l flows. P ru d e n tia l re g u la tio n a n d su p e rv isio n ca n , in p art, b e su b s titu te d for th e se direct regu latio n s o n th e cap ital ac co u n t. T he m a in p ro b le m w ith th is o p tio n is th a t it has, a t best, in d ire c t effects o n th e fo re ig n -cu rre n cy liabilities o f n o n -fin a n c ia l agents a n d m a y enco u rag e th e m to b o rro w ab ro ad . A cco rd in g ly th e y n e e d to b e s u p p le m e n te d w ith o th e r d isin c e n tiv e s for e x te rn a l b o rro w in g b y th o se firm s. U n re m u n e ra te d reserve re q u ire m e n ts m a y b e a su p e rio r a lte rn a tiv e a n d m a y b e sim p ler to ad m in ister. In th e case o f th e p u b lic sector, d ire c t re g u la tio n o f e x te rn a l b o rro w in g s h o u ld b e c o m b in e d w ith a strateg y a im e d a t th e d e v e lo p m e n t o f d o m e stic b o n d m ark ets. P ru d e n tia l re g u la tio n a n d su p e rv isio n s h o u ld take in to a c c o u n t n o t o n ly m ic ro eco n o m ic risks b u t also th e m a c ro e c o n o m ic risks asso ciated w ith b o o m -b u s t cycles. In particular, in stru m e n ts n e e d to be d esig n ed th a t w ill in tro d u c e a countercy clical e le m e n t in to p ru d e n tia l re g u la tio n a n d su p er­ v isio n . M ore specifically, w e argue for a reg u la to ry a p p ro a c h th a t involves a m ix tu re of: (1) fo rw ard -lo o k in g p ro v isio n s for la te n t risks, w ith p ro v isio n s to b e m a d e w h e n cred it is g ra n te d o n th e basis o f th e cre d it risks th a t are ex p e cted th r o u g h o u t th e full busin ess cycle (this w as th e a p p ro a c h a d o p te d 240 Capital Account and Countercyclical Regulations b y th e S panish au th o rities); a n d (2) m o re discrete co u n tercy clical p ru d e n tia l pro v isions, to be ap p lied b y th e reg u la to ry a u th o rity to th e fin an c ial system a w h o le, or b y th e su pervisory a u th o rity for special fin a n c ia l in stitu tio n s , o n th e basis o f ob jectiv e criteria (for ex am p le th e g ro w th rate o f credit, o r th e g ro w th o f cre d it fo r specific risky activities). C apital ad e q u a c y re q u ire m e n ts sh o u ld focus o n lo n g -term solvency criteria a n d sh o u ld n o t b e countercyclical, b u t it m ay b e advisable for c o u n tries facing stro n g cyclical flu c tu a tio n s to estab lish h ig h e r c a p ita l-a sse t ratios. T he system of countercyclical p ru d e n tia l reg u latio n a n d su pervision sh o u ld be c o m p le m e n te d b y reg u la tio n s in o th e r areas. In p articu lar, p ru d e n tia l re g u la tio n sh o u ld estab lish strict rules to p re v e n t cu rren c y m ism atch es (in clu d in g th o se in c u rre d b y firm s o p e ra tin g in n o n -tra d a b le sectors w h e n b o rro w in g in fo reig n currency), liq u id ity re q u ire m e n ts a n d lim its o n lo a n to co llateral v alu e ratio s o r rules o n th e v a lu a tio n o f co llateral d esig n ed to reflect lo n g -te rm m a rk e t tre n d s in asset prices. N o te s * 1. 2. 3. 4. 5. T his ch a p ter h a s b e n e fite d from jo in t w ork u n d erta k en w ith M aria Luisa C h ia p p e for t h e Expert G ro u p o n D e v e lo p m e n t Issues (EGDI), M in istry o f F oreign Affairs o f S w ed en . For d o c u m e n ts th a t su p p o rt t h e e ffe c tiv e n e ss o f th e se reg u la tio n s in C h ile see A g o sin (1 9 9 8 ), Larrain e t a l . (2 0 0 0 ), Le Fort a n d L e h m a n n (2 0 0 0 ), A g o sin a n d F fren ch -D avis (2 0 0 1 ) a n d P alm a (2 0 0 2 ). For a m o re m ix e d v ie w see V ald és-P rieto a n d S o to (1 9 9 8 ) A riy o sh i e t a l . (2 0 0 0 ), D e G regorio e t a l . (2 0 0 0 ) a n d L aurens (2 0 0 0 ). For stro n g v ie w s o n th e ir p o sitiv e effects in C o lo m b ia see O c a m p o a n d Tovar (1 9 9 8 , 1 9 9 9 ) a n d V illar a n d R in có n (20 0 2 ); for a m o r e m ix e d v ie w see C árd en as a n d Barrera (1 9 9 7 ) a n d C árd en as a n d S tein er (2 0 0 0 ). In d eed e v id e n c e o f t h e in s e n s itiv ity o f th e v o lu m e o f ca p ita l flo w s to cap ital a c c o u n t reg u la tio n s c o m e s from e c o n o m e tr ic a n a ly sis in w h ic h URR is n o t in c lu d e d as a d e te r m in a n t o f in te rest rate sp reads b u t rather as a n a d d itio n a l fa cto r a ffe c tin g ca p ita l flo w s. T h is m a y b e se e n as a n in a d e q u a te e c o n o m e tr ic sp ec ifica tio n . S o m e o f th e se m e c h a n ism s, su c h as th e u se o f h e d g in g , e n a b le in v e sto r s to co v er so m e o f th e effects o f th e se reg u la tio n s, b u t in large part t h is is d o n e b y tran sferrin g risks (m o re sp ecifica lly, t h e risk a sso cia ted w ith lo n g er-ter m fin a n c in g ) t o o th e r a g en ts 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 a d eq u a te reward. M ore gen erally, if th e re is n o sta b le ex tern a l d e m a n d for t h e d o m e s tic cu rrency, h e d g in g m a y b e a v a ila b le o n ly in lim ite d q u a n tities, a fact th a t a ffects t h e m a tu rities an d co sts in v o lv e d . In Brazil so m e a u th o rs h a v e argu ed th a t t h e cap ital a c c o u n t reg u la tio n s, w h ic h in c lu d e d a m e c h a n is m sim ilar to th e URR (direct ta x a tio n o f ca p ita l flo w s), w ere in e ffe c tiv e d u e t o w id esp re a d lo o p h o le s a sso cia ted w ith t h e e x is te n c e o f s o p h is ti­ ca ted d o m e stic fin a n c ia l in str u m e n ts (A riyosh i e t a l., 2 0 0 0 ; G arcia a n d V alpassos, 2 0 0 0 ). H o w ev er t h e y p ro v id e n o sta tistica l e v id e n c e co m p a ra b le to th a t availab le for C h ile a n d C o lo m b ia . T h is is t h e v e r y a p t in te r p r e ta tio n p r o v id ed b y W illia m s o n (2000: c h . 4). In d eed w ith th is in te r p r e ta tio n t h e c o n flic tin g e v id e n c e o n t h e C h ile a n sy stem largely d isappears. José Antonio Ocampo 24 1 6. See A riy o sh i e t a l. (2 0 0 0 ), Ó tker-R obe (2 0 0 0 ) a n d Rajaram an (2 0 0 1 ) for a d d itio n a l e v id e n c e o f t h e e ffe c tiv e n e s s o f th e s e reg u la tio n s. 7. T h e le v e l o f t h e URR m a y a c c o u n t for th is result. V ald és-P rieto a n d S o to (1 9 9 8 ) fin d e v id e n c e o f a th r e sh o ld effect, w h ic h w o u ld e x p la in w h y th e s e reg u la tio n s w ere o n ly e ffe c tiv e in r e d u c in g ca p ita l flo w s in 1 9 9 5 - 9 6 . It m u s t b e e m p h a s iz e d th a t t h is d o e s n o t im p ly a b etter e v a lu a tio n o f t h e o v era ll m a c r o e c o n o m ic p o lic y p a ck a g e o f 1 9 9 5 - 9 6 co m p a red w ith th a t o f 1 9 9 1 - 9 2 . A g o sin a n d F fren ch -D avis (2 0 0 1 ) argu e th a t, o n b road er gro u n d s, m a c r o e c o n o m ic m a n a g e m e n t in th e earlier part o f t h e 1 9 9 0 s w a s m o re ap p rop riate. 8. T h is is ca p tu red in o th e r stu d ie s (for e x a m p le C árd en as a n d S teiner, 2 0 0 0 ) t h r o u g h t h e u se o f a d u m m y variab le for t h e p erio d d u rin g w h ic h t h e URR w as in p la ce, a n d h a s b e e n in terp reted (in accu rately, a c c o r d in g t o t h e a ltern a tiv e v ie w p resen ted in t h e te x t) as e v id e n c e a g a in st t h e e ffe c tiv e n e ss o f reg u la tio n s. 9. For a n a n a ly sis o f th e se issu es se e W orld B an k (1999: 151) a n d S tiglitz an d B h attach arya (2 0 0 0 ). 10. For re c e n t a n a ly ses o f th e se issu es a n d p o lic y o p tio n s for m a n a g in g th e m , see BIS (2 0 0 1 : ch . 7), B o rio e t a l . (2 0 0 1 ), C lerc e t a l. (2 0 0 1 ) an d T urner (2 0 0 2 ). 1 1 . In a d d itio n , g en era l p r o v isio n s e q u iv a le n t t o 0 per c e n t, 0 .5 per c e n t a n d 1 .0 per c e n t o f th r ee cla sses o f assets are required. 12. For a n a n a ly sis o f t h e risks a sso cia ted w ith n o n -tra d a b le sectors see Rojas-Suárez (2001). 13. B a n co C en tra l d e la R ep ú b lica A rg en tin a (1 9 9 5 ), 1 1 -1 2 . R e fere n ce s A g o sin , M . (1 9 9 8 ) C a p ita l I n flo w a n d I n v e s tm e n t P erform an ce: C h ile in t h e 1 9 9 0 s, in R. F fren ch -D a v is a n d H. R eisen (ed s), C a p it a l I n f lo w s a n d In v e s tm e n t P e rfo rm a n c e : L e sso n s fr o m L a t in A m e r ic a , Paris a n d S an tiago: O ECD D e v e lo p m e n t C entre/E C L A C . a n d R. F fren ch -D avis (2 0 0 1 ) ‘M a n a g in g C ap ital In flo w s in C h ile, in S. G riffith J o n es, M . F. M o n te s a n d A. N a s u tio n (ed s), S h o rt-te rm C a p ita l F lo w s a n d E c o n o m ic C rise s, N e w York a n d O xford: O x fo rd U n iv e r sity Press for U N U /W ID E R . A riy o sh i, A., K. H aberm eier, B. Laurens, I. Ó tker-R obe, J. I. C an ales-K riljen k o an d A. K irilen k o (2 0 0 0 ) C a p ita l C o n tro ls : C o u n tr y E x p e rie n ce s w it h T h e ir Use a n d L ib e r a l­ iz a t io n , O c c a sio n a l Paper 190, W a sh in g to n , DC: IMF. B a n co C en tra l d e la R ep ú b lica A r g e n tin a (1 9 9 5 ) I n fo r m e A n u a l, B u e n o s A ires, O ctob er. B ank for In te r n a tio n a l S e ttle m e n ts (BIS) (2 0 0 1 ) 7 1 s t A n n u a l R e p o rt, Basel: BIS, Ju n e. B ordo, M ., B. E ich en g reen , D . K lin g eb iel a n d M . S. M artin ez-P eria (2 0 0 1 ) Is t h e Crisis P ro b lem G ro w in g M ore Severe?, E c o n o m ic P o lic y , 3 2 (April). B orio, C ., C. F urfine a n d P. 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(2 0 0 0 ) S e n d in g th e H e r d O f f th e C l i f f E d g e: T h e D is t u r b in g In te r a c tio n b e tw e e n H e r d in g a n d M a r k e t- s e n s itiv e R is k M a n a g e m e n t P ra c tic e s , L o n d o n : State Street. P ov ed a , R. (2 0 0 0 ) L a R e fo rm a d e l S is te m a d e P ro v is io n e s d e In s o lv e n c ia , M adrid: B a n co d e España, January. R ajaram an, I. (2 0 0 1 ) M a n a g e m e n t o f t h e C ap ital A ccou n t: A S tu d y o f In d ia a n d M alaysia, m im e o , N e w D e lh i, N a tio n a l In stitu te o f P ub lic F in a n ce a n d P olicy, M arch. Reddy, Y. V. (2 0 0 1 ) O p era tio n a lisin g C ap ital A c c o u n t L ib eralisation : T h e In d ia n E x p er ie n c e’, D e v e lo p m e n t P o lic y R e v ie w (O verseas D e v e lo p m e n t In stitu te ), 19, 1 (M arch). Rodrik, D . a n d A. V elasco (2 0 0 0 ) Short-Term C ap ital F low s, A n n u a l W o r ld B a n k C o n fe re n c e o n D e v e lo p m e n t E c o n o m ic s 1 9 9 9 , W a sh in g to n , DC: W orld Bank. Rojas-Suárez, L. (2 0 0 1 ) C an In te r n a tio n a l C ap ital S tandards S tr en g th en B anks in E m ergin g M arkets, m im e o , W a sh in g to n , DC: In stitu te for In tern a tio n a l E c o n o m ics, O ctober. Ros, J. (2 0 0 1 ) From t h e C ap ital Surge t o t h e F in a n cia l Crisis a n d B eyon d : M e x ic o in t h e 1 9 9 0 s, in R. F fren ch -D avis (ed .), F in a n c ia l C rise s i n S u c c e s s fu l E m e rg in g E c o n o m ie s , W a sh in g to n , DC: B rook in gs In stitu tion /E C L A C . S a ch s, J., A. T o r n e ll a n d A. V e la sc o (1 9 9 6 ) ‘T h e M e x ic a n P e so C risis: S u d d e n D e a th o r D e a th F o reto ld ?, N B E R W o r k in g P a p e r n o . 5 5 6 3 , C a m b rid g e , MA: NBER, M ay. S tiglitz, J. E. (1 9 9 4 ) T he R ole o f t h e State in F in a n cia l M arkets, P ro cee d ing s o f th e W o r ld B a n k A n n u a l C o n fe re n c e o n D e v e lo p m e n t E c o n o m ic s 1 9 9 3 , W a sh in g to n , DC: W orld Bank. a n d A. B h attacharya (2 0 0 0 ) T he U n d e r p in n in g s o f a Stable a n d E q u itable G lob al F in a n cia l System : From O ld D eb a tes to a N e w P aradigm , A n n u a l W o r ld B a n k C o n fe re n ce o n D e v e lo p m e n t E c o n o m ic s 1 9 9 9 , W a sh in g to n , DC: W orld Bank. Taylor, L. (1 9 9 8 ) C a p ital M arket Crises: L ib eralisation , F ixed E x c h a n g e Rates a n d M a rk et-D riv en D e s ta b ilis a tio n , C a m b r id g e J o u r n a l o f E c o n o m ic s , 2 2 , 6 (N o v em b er ). Turner, P. (2 0 0 2 ) P ro cy clicality o f R egu latory R atios, in J. E atw ell a n d L. T aylor (eds), In te r n a tio n a l C a p ita l M a rk e ts - S ystem s in T r a n s itio n , N e w York: O xford U n iv e r sity Press. V aldés-P rieto, S. a n d M . S o to (1 9 9 8 ) T he E ffectiv e n e ss o f C ap ital C on trols: T h eo r y a n d E v id en ce fro m C h ile ’, E m p íric a , 25 (D ord rech t: K luwer). 244 Capital Account and Countercyclical Regulations Villar, L. a n d H. R in co n (2 0 0 2 ) T he C o lo m b ia n E c o n o m y in t h e N in eties: C ap ital F low s a n d F oreign E x c h a n g e R egim es, in A. Berry (ed .), C r it ic a l Issu e s in F in a n c ia l R e fo rm : A V ie w fr o m th e S o u th , N e w Brunsw ick: T ransaction. W illia m so n , J. (2 0 0 0 ) E x ch a n g e Rate R egim es for E m ergin g M arkets: R ev iv in g th e In term ed ia te O p tio n , P o lic y A n a ly s e s in I n t e r n a t io n a l E c o n o m ic s , 6 0 , W a sh in g to n , DC: In stitu te for In te r n a tio n a l E c o n o m ics, Septem ber. W orld B ank (1 9 9 9 ) G lo b a l E c o n o m ic P ro spe cts a n d th e D e v e lo p in g C o u n trie s , 1 9 9 8 - 9 9 B e y o n d F in a n c ia l C ris is , W a sh in g to n , DC: W orld Bank. 1 3 H ow O ptim al are the Extremes? Latin American Exchange Rate Policies during the Asian Crisis* Ricardo Ffrench-Davis and Guillermo Larrain O n e c o m m o n featu re of th e c o u n tries m o st affected b y th e A sian crisis a n d its shockw aves - su c h as T h ailan d , M alaysia, In d o n esia, th e R epublic of K orea a n d Brazil - is th a t th e y h a d ex c h an g e rate system s th a t in d ifferen t v ersio n s w ere closer to pegged system s th a n to flo a tin g system s (th ey w ere o fte n called so ft pegs). C o u n trie s w ith e x c h an g e rate b an d s, su ch as Israel, C h ile a n d C o lo m b ia also suffered, w h ile flo a tin g co u n tries su ch as A ustralia, N ew Z ealand a n d M exico a p p a re n tly fared better. Based o n th is, m a n y observers h av e c o n c lu d e d th a t in te rm e d ia te e x c h an g e rate system s are d an g e ro u s a n d th a t o p tim a lity is lo c ate d a t th e extrem es. T his ch a p te r ev alu ates th is c o n c lu sio n b y an a ly z in g th e experiences o f th re e d iffe ren t ex c h an g e rate system s: T hose o f A rgentina, C h ile a n d M exico, w h ic h h av e div erg in g e x c h an g e rate policies, a t least fo rm ally.1 A stra ig h t o b se rv a tio n o f re c e n t ev en ts is th a t c o u n tries w ith p egged system s, su ch as th e cu rren c y b o ard s in H o n g K ong a n d A rg en tin a, suffered sig n ific an t c o n ta g io n in tim es o f in te rn a tio n a l fin an c ial stress. A rg en tin a ex p e rien c ed deep recessions d u rin g b o th th e M exican a n d th e A sian crisis. H o n g K ong suffered a recession as a co n seq u e n ce o f th e A sian crisis, b u t d u rin g th e M exican crisis g ro w th m erely decelerated fro m 5.4 p e r c e n t in 1994 to 4.0 p er c e n t in 1995. T h ere are reaso n s to believe th a t c o m p letely rig id ex c h an g e rate system s am p lify e x te rn a l shocks. A p p aren tly th e y p u t o verly stro n g a n d th e re fo re u n re a listic re q u ire m e n ts o n d o m e stic flexibility, p articu la rly o n w age a n d price flexibility. T he am p lific a tio n effect arises d u rin g a n ex tern al sh o ck w h e n ag en ts co n sid er th a t th e sh o ck m a y b e stro n g e n o u g h to in d u c e th e au th o ritie s to m o d ify th e ex c h an g e rate policy; th is is p articu la rly so w h e n th e e x c h an g e rate appears to b e o v erly ap p reciated . Rigid system s are th e re fo re p ro n e to ch a n g es in m a rk e t s e n tim e n t a n d cred ­ ib ility (or a t least eventually, w ith th e e x c ep tio n o f full d o llarizatio n ). Likewise ex c h an g e rate b a n d s d id n o t fu n c tio n w ell d u rin g th e A sian crisis. In m a n y cases th is w as p a rtly th e resu lt o f m a n a g e m e n t o f th e b an d s. 245 246 Latín American Exchange Rate Policies T h e h u g e increase in cap ital inflow s to em erg in g e c o n o m ie s b e tw e e n 1990 a n d 1997 p u t severe u p w a rd pressure o n th e value o f d o m e stic currencies. T h e resp o n se in te rm s o f e x p a n d in g th e size o f b a n d s o r ap p re c ia tin g th e m caused a cred ib ility loss. S u b seq u en tly th e b a n d s h a d tro u b le a d a p tin g to th e n e w real ex c h an g e rate w h e n th e A sian crisis ap p e ared a n d cap ital inflow s su d d e n ly sto p p e d . T hese ev en ts aggravated th e b a n d s m is m a n a g e m e n t a n d th e re fo re caused a fu rth e r cred ib ility loss. T h e m a jo r b e n e fit o f th e b a n d sys­ te m arises in tim es o f n o rm a lity w h e n th e re are n o severe o r o n e-sid ed shocks. In such circum stances b a n d s ca n m a in ta in ex ch an g e rate stability a n d p artially absorb th e effects o f sta n d a rd shocks. C o n s e q u e n tly th e ex c h an g e rate m o re efficiently fulfils its allocative role b e tw e e n trad ab les a n d n o n ­ trad ab les. T he m a in tro u b le w ith b a n d s appears in tim es o f fin an c ial distress. A fter a g eneral discussion, th is ch a p te r ex a m in e s th e ex p erien ces o f th re e sym b o lic cases o f e x c h an g e rate policies. O n th e cu rre n c y b o a rd side, it co n sid ers th e ex p erien ce o f A rg en tin a in o rd er to u n d e rs ta n d th e ap p eal th is system h as h a d for o th e r co u n tries, som e o f w h ic h later dollarized. It th e n ex am in es C h ile for th e case of in te rm e d ia te regim es a n d M exico for th e flo atin g regim e. T he analysis focuses o n th e p erio d in w h ic h th e A sian crisis to o k place. Exchange rate regime and stability of financial and real sectors T h e A sian crisis a n d its a fte rm a th caused a co n sid erab le sh o ck n o t o n ly in Asia b u t in L atin A m erica as w ell, b u t w ith v ary in g degrees o f in ten sity . C h ile w as b y far th e m o st directly affected d u e to its sig n ific an t tra d e rela­ tio n s w ith Asia. B ut as em erg in g -m ark et spreads increased , especially after th e Russian d efau lt, Brazil a n d A rgen tin a also felt its co n seq u e n ces. Later th e B razilian d e v a lu a tio n in tro d u c e d a d d itio n a l u n c e rta in tie s th a t affected all of L atin A m erica. It w as th e re fo re a p erio d o f in sta b ility a n d large shocks. Table 13.1 co m p ares th e o u tc o m e in te rm s o f th e fin an c ial a n d o u tp u t v o la tility o f a n u m b e r o f c o u n tries w ith d ifferen t in itia l e x c h an g e rate regim es in th e p e rio d im m e d ia te ly after th e ex p lo sio n o f th e A sian crisis. In o rd er to co m p are fin an c ial a n d real volatility, w e c o n s tru c t a fin an c ial v o latility in d ex (FVI), w h ic h ca n be co m p u ted in d e p e n d e n tly o f th e ex ch an g e rate (ER) regim e.2 If CV d e n o te s th e coefficient of v aria tio n , th e in d e x is d efin ed sim ply as FVI = CV(ER) + CV(reserves) + C V (n o m in al in te rest rates). W h e n a c o u n try faces a p e rio d o f stress it n o rm a lly reacts b y d e p re c ia tin g th e ex c h a n g e rate, sellin g in te rn a tio n a l reserves or in c re a sin g in te re st rates. In fix ed ex c h a n g e rate regim es, v o la tility ap p ears in reserves a n d in te re st rates, w h ile in a p u re flo a t v o la tility s h o u ld a p p e ar in th e ex c h a n g e rate a n d in te re st rates. B ands o r d irty flo a tin g system s c o m b in e all th re e e lem en ts. Real sector v o la tility is c a p tu re d u sin g th e s ta n d a rd d e v ia tio n of GDP grow th. Ricardo Ffrench-Davis and Guillermo Larraín 247 V o la tility in se lecte d c o u n tr ie s d u rin g in te r n a tio n a l fin a n c ia l tu r m o il, 1 9 9 7 (Q 3 )-9 9 (Q 4 ) T a b le 1 3 .1 C o e ffic ie n t o f v a r ia tio n o f th e leve ls o f V o la t ilit y In itia l N o m in a l I n te r n a tio n a l In te r e s t In d e x o f e xch a n g e e xch a n g e reserves (% ) ra te s f in a n c i a l o f GDP ra te syste m ra te (% ) (»/a) v o la t i l it y ( % ) (s .d .) (% ) (a ) A rg en tin a H o n g K on g A ustralia M e x ic o N e w Z ea la n d C h ile C o lo m b ia T h a ila n d M a laysia Brazil Korea F ixed F ixed F loat Float Float B an d B an d S o ft p e g S o ft p eg S oft p eg S o ft p e g (b ) (b ) (a ) + (b ) + (c) 0 .0 0 .1 5 .7 8 .5 7.8 8 .2 1 6 .7 9 .4 9 .8 2 5 .1 1 4 .8 7.9 3 .9 14.5 5 .6 5 .7 8 .2 8 .2 9 .0 1 9 .0 2 6 .8 3 6 .4 13.1 2 3 .0 1 4 .2 2 2 .6 2 7 .4 3 1 .1 2 6 .4 4 2 .1 3 7 .9 2 6 .4 3 0 .7 2 1 .0 2 7 .0 3 4 .4 3 6 .7 4 1 .0 4 7 .5 5 1 .3 6 0 .5 6 6 .7 7 8 .3 8 1 .9 5 .3 5 .5 0 .6 1.9 2 .3 5 .3 4 .5 7.3 7 .8 1.6 8 .5 Source: Calculations based on IMF data. Table 13.1 ran k s th e c o u n tries ac co rd in g to th e ir fin an c ial v o la tility in d e x a n d reveals five im p o rta n t a n d to so m e e x te n t su rp risin g co n c lu sio n s a b o u t th e ro le o f e x c h an g e rate policy d u rin g th e A sian crisis: • R an k ing co u n tries ac co rd in g to th e ir fin an c ial v o la tility in d e x resu lts in th e ir b e in g g ro u p ed ac co rd in g to th e ir e x c h an g e rate system . • Fixed system s ap p e ar to h av e delivered m o re n o m in a l sta b ility th a n altern ativ e system s, b u t th e y displayed m o re v o la tility in a real variable, n a m e ly GDP g row th. • F lo ating regim es h a d th e low est GDP v olatility, b u t th e y d isp lay ed greater fin an c ial v o la tility th a n fixed system s. • Soft pegs disp lay ed th e w o rst c o m b in a tio n o f fin an c ial a n d real volatility. • Bands fell in to a n interm ediate position, w ith h igher financial volatility th a n cred ib le fixed system s a n d m o re real v o la tility th a n flo a tin g regim es. Som e q u alifica tio n s are re q u ire d a t th is p o in t. First, th e lesser fin an c ial v o la tility in fixed ex c h an g e rate regim es w as p ro b ab ly d u e to th e fact th a t in th e p erio d in q u e s tio n th e re w ere n o serious challen g es in A rg e n tin a or H o n g K ong to th e stab ility o f th e e x c h an g e rate policy.3 T h erefo re it c a n be c o n c lu d e d th a t a credible fixed ex c h an g e rate policy delivers g reater fin an cial stability. But it also follow s th a t, desp ite h a v in g h a d credible ex c h an g e rate policies, A rg en tin a a n d H o n g K ong also h a d h ig h o u tp u t v olatility. 248 Latin American Exchange Rate Policies In th e case o f A rgentina, so m e observers h av e suggested th a t th e p ro b lem w as d u e to rig id ity in th e la b o u r m arket, b u t th e fact th a t H o n g K ong also ex p erien ced greater v o la tility suggests th a t th is a rg u m e n t m a y b e o v erstated . M oreover if w e co m p are th e tw o c o u n trie s in fla tio n reco rd s w e fin d th a t th e y w ere n o t sig n ifican tly dissim ilar: d u rin g th is p erio d c u m u lativ e a n n u a l in fla tio n in A rg e n tin a w as - 0 . 4 p e r c e n t w h ile in H o n g K ong it w as 1.8 p er ce n t. T herefore prices c o n trib u te d m o re to real d e p re c ia tio n in A rg en tin a th a n th e y d id in H o n g K ong.4 Second, as w e sh all see, th e C h ile a n b a n d w as alread y su fferin g fro m lack o f credibility d u rin g th e p e rio d consid ered . T herefore faced w ith a sh o ck as stro n g as th e A sian crisis, w h e n th e stab ilizin g p ro p ertie s o f th e rigid p a rt o f th e b a n d m e c h a n ism sh o u ld h av e appeared , th e y d id n o t becau se cre d ib ility h a d b e e n lost. H ence it ca n be c o n c lu d e d th a t w h e n faced w ith a sh o ck a n o n -cred ib le b a n d causes h ig h volatility, b o th fin a n c ia l a n d real. W h a t c a n n o t be arg u ed is th a t th e lack o f cred ib ility is in h e re n t in th e b a n d system . T h ird, soft pegs disp lay ed th e w o rst p erfo rm an ce. A nalyzed ex p o s t th e soft peggers all h a d repressed e x c h an g e rates a n d in som e cases th e m a rk e t d id n o t h av e e n o u g h in fo rm a tio n o n fu n d a m e n ta ls (for in stan c e, sh o rt-te rm e x tern al liabilities). W h e n a cu rren c y is overv alu ed a n d th e re is pressure fo r co rrectio n , soft p eg system s are p ro n e to sp e c u la tio n a n d th u s fin an c ial volatility. Four, flo atin g regim es d id b e tte r in te rm s o f real v ariab les b u t less so in te rm s of fin an c ial volatility. B eyond th e ex c h an g e rate v o la tility th a t is in h e re n t in a flo a tin g system , in te re st rates sw ang in flo atin g co u n tries as m u c h as th e y d id in c o u n tries w ith pegged system s. F lo tatio n co u ld n o t av o id in te re st rate volatility. As is clear fro m Table 13.1, p o licy reactio n s differed co n sid erab ly a m o n g th e co u n tries. For in stan c e, d esp ite th e flo at A ustralia u sed its in te rn a tio n a l reserves q u ite intensively, w h ile N ew Z ealand u se d in te re st rates m o re intensively. A m o n g th e floaters, M exico w as th e m o st in te n siv e u ser o f th e e x c h an g e rate. Table 13.1 also suggests th a t ea c h c o u n try chose d iffe ren t c o m b in a tio n s of n o m in a l d ep re cia tio n , reserve a c c u m u la tio n a n d in te re st rate ch an g es w h e n facin g th e shocks. It appears th a t, for th e co u n tries in th e sam ple, th e less h a rm fu l fin an c ial c o n se q u e n c e in te rm s o f g ro w th w as v o la tility in th e ex c h an g e rate, as c a n be seen in Figure 13.1. T his im p lies th a t e x c h an g e rate ch a n g es m ay h av e b e e n effective in p ro d u c in g th e n ecessary e x p e n d itu re sw itc h in g to red u c e th e n e t d e m a n d for trad ab les a n d m in im iz e th e im p a c t o n n o n -tra d a b le s.5 Also, it ap p ears th a t th e m o st h a rm fu l resp o n se w as in te r­ est rate changes. T h e a d ju s tm e n t o f e x tern al diseq u ilib ria te n d e d to w o rk as a global d em a n d -re d u c in g to o l, g e n e ra tin g u n e m p lo y m e n t a n d idle cap ital in n o n -tra d a b le sectors. B eyond th e e x c h an g e rate system , c o u n trie s ab ility to sm o o th th e cycle is co rrelated w ith th e ir fin an c ial in te g ra tio n w ith th e rest o f th e w orld. T he Ricardo Ffrench-Davis and Guillermo Larraín 249 Volatility of GDP F ig u re 1 3 .1 G D P v o la tility versu s v a rio u s fin a n c ia l v o la tilitie s (per c en 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 n ite d States ru n s a n e n o rm o u s c u rre n t a c c o u n t deficit b u t th e m a rk e t does n o t ask for its im m e d ia te co rrec tio n (n o r d o th e au th o ritie s th in k it is necessary), as has h a p p e n e d m a n y tim es in L atin A m erica. A m o n g th e reaso n s for th is is th e fact th a t foreigners h a v e a h ig h d e m a n d for dollard e n o m in a te d assets, a n d th a t th e U n ite d States does n o t n e e d to m ake its fin an c ial o b lig a tio n s c o n tin g e n t o n c o m m o d ity price m o v e m e n ts as its e c o n o m y is so diversified th a t th e n eg a tiv e co v arian ce o f shocks is p ro b ab ly stro n g e n o u g h to stabilize overall risk. H en ce to reduce th e d o m e stic im p a c t of e x te rn a l shocks it is n ecessary to im p ro v e th e q u a lity o f L atin A m ericas fin an c ial links w ith th e rest of th e w orld. T hree m e th o d s h av e b e e n discussed recently. O n e is to create a fo reig n d e m a n d for assets d e n o m in a te d in th e n a tio n a l currency, as in sp ire d b y th e A ustralian a n d N ew Z ealan d cases. T he degree o f in te rn a tio n a l fin a n ­ cial in te g ra tio n o f th e se tw o OECD co u n tries is far m o re th a n th a t o f a ty p ical em erg in g econom y. A m o n g o th e r th in g s, th e y h av e o ffsh o re m ark ets for securities issued in d o m e stic currencies (see C h a p te r 4), a n d are th e re fo re able to h ed g e th e ir ex posure to ex c h an g e rate risk in th e ir n o n -tra d a b le 250 Latin American Exchange Rate Policies sectors.6 Second, ac co rd in g to C aballero (2001), L atin A m erican fin an c ial in s tru m e n ts are in c o m p le te in th a t th e y are n o t c o n tin g e n t o n th e m a in shocks faced b y th e se ec o n o m ies. If C h ile a n b o n d s w ere c o n tin g e n t o n th e p rice o f copper, a n e x te rn a l sh o ck w o u ld be less d e m a n d in g in te rm s o f c u rre n t a c c o u n t a d ju s tm e n t.7 It is n o t o b vious th a t a ty p ical em erg in g e c o n o m y w ill m o v e q u ick ly in e ith e r o f th e se d irectio n s. T hird, th e q u a lity o f fin an c ial lin k s co u ld b e im p ro v e d w ith p ru d e n tia l m a c ro e c o n o m ic p o li­ cies o n excessive sh o rt-te rm o r liq u id e x tern al liabilities, th e size o f th e ex tern al deficit a n d th e a p p re c ia tio n o f th e real e x c h an g e rate in p erio d s of ca p ita l surges.8 T h e m a in b e n e fit o f th e flo a tin g regim e appears w h e n sig n ifican t, longla stin g shocks em erge abruptly. In th is case a p u re flo a tin g regim e delivers a ra p id a d ju stm e n t in th e ex c h an g e rate a n d th e au th o ritie s stay o u t o f th e scene, th u s k ee p in g its cred ib ility in ta c t, ex cep t w h e n d e p re c ia tio n leads to in fla tio n a n d th e c o u n try h a s a d o p te d a n in fla tio n ta rg e tin g sch em e. By in c reasin g th e e x c h an g e rate risk perceived b y th e p u b lic, it also b e tte r p re ­ p ares ag en ts fo r su d d e n shocks. C onversely flo a tin g regim es cause signifi­ c a n tly h ig h e r e x c h an g e rate in sta b ility across th e cycle, w h ic h m a y h av e h a rm fu l effects o n g ro w th , w ith in effic ien t allocativ e signals. In p a rtic u la r a flo atin g regim e c a n n o t av o id o v erv a lu atio n in episodes o f cap ital surge. W e shall n o w briefly analyze th e b e h a v io u r o f ex c h a n g e rate regim es in th e p erio d fro m th e M exican crisis to 1999, u sin g o u r m easu res o f fin an c ial a n d real volatility. Figure 13.2 considers th re e subperiods: o n e en c o m p assin g th e M exican crisis (th e f o u rth q u a rte r o f 1994 to th e first q u a rte r 1996) a n o rm a l su b p e rio d b e tw e e n th e seco n d q u a rte r of 1996 a n d th e th ird q u a rte r o f 1997, a n d th e o n e in w h ic h th e A sian crisis to o k p lace (th e fo u rth q u a rte r o f 1997 to th e fo u rth q u a rte r o f 1999). Figure 13.2 suggests th a t in crisis p eriods th e re is a h ig h e r co rrela tio n b e tw e e n fin an c ial a n d real v o la tility th a n in n o rm a l p eriods. In n o rm a l p erio d s th e c o rre la tio n b e tw e e n fin an c ial a n d real v ariab les is alm o st zero. H ow ever th e co rrela tio n varies b e tw e e n crises, a n d su rp risin g ly it w as h ig h e r in th e M exican crisis th a n in th e A sian o n e. This c a n b e ex p la in e d b y th e fact th a t th e degree o f c o n ta g io n was less d u rin g th e M exican crisis as, a m o n g th e co u n tries in th e sam ple, it o n ly spread to A rg en tin a.9 H ence th e h ig h R2 reflects a statistical issue ra th e r th a n an e c o n o m ic on e. If th e d ata are d eco m p o se d acco rd in g to th e ex ch an g e rate regim e p rev ail­ in g at th e b e g in n in g o f ea ch period, M exico appears in th e g ro u p o f b a n d s in o n e p erio d a n d as a flo at in th e la tte r tw o (Figure 13.3). T h e figure show s th a t, across crises, th e m o re stable b e h a v io u r in fin an c ial a n d real te rm s w as e x h ib ite d b y flo a tin g regim es. W h e n neg ativ e shocks arrived, all system s b u t th e flo atin g o n e s e x h ib ite d h ig h fin an c ial a n d /o r real v olatility, w ith soft pegs p e rfo rm in g w orst. Pegged system s ap p e ar to h av e a cu rio u s p ro p erty : w ith o u t n eg a tiv e shocks th e y display low real a n d fin a n c ia l v o latility , b u t w h e n th e re is a shock, fin a n c ia l v o la tility rem a in s m u c h th e sam e a n d th e Ricardo Ffrench-Davis and Guillermo Larraín 251 9.0 8.0 ♦ Mexican crisis ■ Asian crisis • No crisis ■ Korea 1998 R2 = 0.13 7.0 6.0 I c3 5.0 g 4.0 C D 3.0 2.0 1.0 0.0 20.0 F ig u re 1 3 .2 40.0 60.0 80.0 Financial volatility 100.0 120.0 Real a n d fin a n c ia l v o la tility i n th r ee e p iso d e s (per c e n t) Source: Based on IMF data. sh o c k tran slate s in to real sector volatility. B ands e x h ib it sim ilar b e h a v io u r w ith resp ect to real v o la tility in stress periods, b u t w ith g reater fin an c ial volatility. It is in te re stin g to n o te th a t in n o rm a l tim es, flo atin g regim es cause rela­ tiv ely m o re fin an c ial v o la tility th a n d o th e o th e r system s, b u t d u rin g a crisis o verall v o la tility is red u ced in flo atin g reg im es.10 In lig h t o f th e above co n sid eratio n s, a n id e a l b u t cru d e e x c h an g e rate sy stem th a t m ig h t be able to m in im iz e real sector v o la tility w o u ld in v o lv e a tw o -p ro n g e d ap p ro a ch . In n o rm a l tim es, w h e n shocks are sm all a n d u n ifo rm ly distrib u ted , m a n ag e d flexibility o r a craw ling b a n d w o u ld increase sta b ility a n d th e re fo re g ro w th . W h e n large shocks ap p e ar a n d th e ir d istri­ b u tio n is biased in th e sam e n eg a tiv e d ire c tio n (term s o f tra d e fall, e x tern al fin a n c in g declines a n d so on), th e n ideally th e re s h o u ld b e a te m p o ra ry sw itch to a flo atin g regim e. H ow ever im p le m e n tin g su c h a sy stem w o u ld b e difficult. First, it w o u ld b e p ro b le m a tic to d e te rm in e w h e th e r a sh o c k w as large o r sm all, te m p o ra ry o r p e r m a n e n t.11 Second, in o rd er to b e successful, fixed ex c h an g e rate regim es n e e d full cred ib ility in d e p e n d e n t o f th e sh o ck suffered; su ch a n id eal sw itc h in g ex c h an g e rate system is in c o m p a tib le w ith a fix ed rate system . 252 Latin American Exchange Rate Policies 9.0 ♦ Band ■ Float a Pegged • Soft peg 8.0 ■Korea 1998 7.06.0.g’ H 1998 K Chile 1998 Argentina 1998 a A • 13 5.0-1 A Mexico 1995 ^ Colombia 1998 A Argentina 1995 D 4.0 (5 3.0 New Zealand 1998 2.0 t l 1.0 * : ■ K 0.0 20.0 F ig u re 1 3 .3 40.0 60.0 80.0 Financial volatility 100.0 120.0 E x c h a n g e rate reg im es sin c e 1 9 9 4 (per cen t) Source: Based on IMF data. Argentina: low inflation and output volatility under the currency board A fter ex p erien cin g h y p e rin fla tio n in 1989 a n d 1990, in 1991 A rg en tin a a d o p te d an ex tre m e e x c h an g e rate policy: a cu rren c y b o ard . T his system , like th e tra d itio n a l fixed e x c h an g e rate system , links th e n a tio n a l currency, in th is case th e peso, in a giv en p ro p o rtio n to a fo reign currency. In A rg en tin a th e p arity w as fixed o n e -to -o n e w ith th e US dollar. In th e tra d itio n a l fixed e x c h an g e rate system th e c e n tra l b a n k is able to realig n th e p arity a t its dis­ cre tio n a n d h as th e freed o m to c o n tro l th e q u a n tity of h ig h -p o w ered m oney. H ow ever in A rg e n tin a p a rity w as fixed b y law (th e C o n v e rtib ility Law) a n d th e ce n tral b a n k w as req u ired to m a tc h a n y increase in h ig h -p o w ered m o n e y w ith a n a c c u m u la tio n o f in te rn a tio n a l reserves. In th is sense it was a n ex trem e v ersio n o f a fixed e x c h an g e rate system , w ith n o space for d o m e stic m a c ro e c o n o m ic policy. O f course th e m o st rad ical o p tio n was sim p ly to suppress th e d o m e stic cu rren c y a n d fully dollarize. T h e m a in rea so n for th e a d o p tio n o f a cu rren c y b o a rd in A rg en tin a in 1991 w as to fig h t h y p e rin fla tio n , th a t is, th e strateg y was a d elib erate Ricardo Ffrench-Davis and Guillermo Larraín 253 an ti-in fla tio n a ry device. B etw een 1975 a n d 1990 th e lo w est in fla tio n rate in A rg en tin a w as 9 0 p er c e n t (1986), a n d d u rin g th e h y p e rin fla tio n years it scored as h ig h as 3079 p er c e n t (1989). A fter th e im p le m e n ta tio n o f th e c u rren c y board , a n n u a l in fla tio n fell to b elo w 5 p er c e n t in 1994, a n d th e n to a n average o f - 0 .3 p er c e n t b e tw e e n 1996 a n d 2000. At th e sam e tim e as in fla tio n w as collapsing, GDP g ro w th w as accelerating. A fter a n average rate of - 0 . 9 p e r c e n t in th e 1980s, g ro w th resu m ed a n d averaged 4.1 p er c e n t in th e 1990s. T his w as d u e to th re e m a in factors. First, a ro u n d th e tim e th a t co n v e rtib ility w as ad o p ted , in te rn a tio n a l liq u id ity in c re ase d significantly. U n til 1994 A rg en tin a w as able to a ttra c t a h u g e a m o u n t o f capital, fu rth e r e n c o u rag ed b y its m assive p riv a tiz a tio n p ro g ra m m e . T his, in c o m b in a tio n w ith th e m e ch a n ics o f co n v e rtib ility d escrib ed before, p ro v id e d a sig n ific an t stim u lu s to aggregate d e m a n d , ex p e ctatio n s a n d e c o n o m ic ac tiv ity .12 Average GDP g ro w th in th e p erio d 1 9 9 1 -9 4 w as 7.9 p er ce n t. H ow ever at th e e n d o f 1994 M exico d ev alu ed its currency, a n d th e su sp icio n th a t A rg en tin a w o u ld fo llo w su it in creased its sovereign risk fro m 434 b p o ver Treasuries in 1994 to 1259 in 1995 (Table 13.2). T h e n e t cap ital in flo w of US$4.3 b illio n in th e la st q u a rte r of 1994 reversed ab ru p tly to a n o u tflo w o f US$3.3 b illio n in th e first q u a rte r o f 1995. T he resu lt w as a severe recession in w h ic h GDP fell b y 2.9 p e r c e n t in 1995 a n d u n e m p lo y m e n t rose to 18 p er ce n t. H ow ever in 1 9 9 6 -9 8 ca p ita l flow s re tu rn e d a n d o u tp u t recovered. T h e n b e tw e e n S ep tem b er 1998 a n d F ebruary 1999 th e R ussian d efa u lt a n d th e B razilian d e v a lu a tio n ag ain in d u c e d cap ital o u tflow s a n d a recession th a t lasted ov er th re e years. H en ce th e A rg e n tin e an ex p erien ce after 1995 w as o n e o f low g ro w th ac co m p an ie d b y sig n ific an t volatility, associated w ith th e in sta b ility of ca p ita l flows. S econd, th e ac ce leratio n o f g ro w th in th e first h a lf o f th e 1990s w as th e resu lt n o t o n ly o f cap ital inflow s b u t also o f so m e im p o rta n t stru ctu ra l reform s, tw o o f w h ic h m e rit specific m e n tio n : trad e reform a n d p riv atiza tio n . T rade po licy in A rg en tin a to o k place u n d e r th e fram ew o rk o f MERCOSUR, th e free trad e ag re em e n t A rgentina signed w ith Brazil, P araguay a n d Uruguay. A fter th is trad e lib e raliz atio n ex p o rts soared fro m US$18 b illio n in 1990 to a p eak o f US$34 b illio n in 1998. W ith regard to p riv atiza tio n , as described b y L arrain a n d W in o g ra d (1997), giv en th e in itia l size of th e p u b lic sector a n d th e low p ro d u c tiv ity levels in p u b lic co m panies, th e m assive p ro g ra m m e u n d e rta k e n in th e first h a lf o f th e 1990s resu lted in h u g e gains in th e average value ad d e d p er w orker in p riv atize d firm s, especially in th e n o n ­ trad a b le sector. T his n o t o n ly h a d a p ositive im p a c t o n g ro w th b u t also h e lp e d to red u ce th e o v era p p re cia tio n of th e real ex c h an g e ra te .13 T hird, a m o st rele v an t a n d u su ally ig n o red factor, th e ac ce le ra tio n of g ro w th in A rgentina, is lin k e d to th e p o o r recessive sta rtin g p o in t. Take as a b e n c h m a rk 1974, th e year in w h ic h real GDP p er ca p ita rea ch ed its peak. A fter 1974 th e re w as a steady d e te rio ra tio n in GDP a n d b y 1990, th e year b efo re co n v e rtib ility w as ad o p ted , it w as 16 p er c e n t b elo w th a t in 1974, 254 Latin American Exchange Rate Policies T a b le 1 3 .2 A rgen tin a: ca p ita l flo w s, real e x c h a n g e rate a n d m a c r o e c o n o m ic p erfo rm ­ a n c e , 1 9 9 4 -9 9 1994 C u rren t a c c o u n t - 1 1 158 b a la n ce (U S$ m illio n ) N e t fo reig n d irect 2 620 in v e s tm e n t (US$ m illio n ) N e t p o r tfo lio 8 389 in v e s tm e n t (US$ m illio n ) A ll o th e rs 341 (US$ m illio n ) C h a n g e in reserves -6 7 5 (US$ m illio n ) T otal ca p ita l in flo w s 10 484 (US$ m illio n ) W ith o u t FDI 7 864 (US$ m illio n ) A verage spread o v er FRB G ro w th o f m o n e y su p p ly (%) E xtern al d e b t/ ex p o rts (%)* E xtern al d e b t/ G D P (%)* Term s o f trade in d e x (a n n u a l average) G D P g ro w th (%) Real e x c h a n g e rate (average 1 9 8 7 - 9 0 = 10 0 ) 434 1995 1996 1997 - 5 191 - 6 843 - 1 2 497 - 1 4 603 - 1 2 312 4 112 5 348 5 50 3 4 546 22 665 1893 9 832 10 8 8 7 8 337 - 6 323 - 1 100 - 3 451 835 4 990 - 1 637 -2 3 1 1 3 258 3 16 2 4 090 2 013 2 879 10 10 0 15 65 9 18 6 9 4 14 3 2 5 - 1 233 4 752 10156 14 14 8 - 8 340 1 259 635 301 608 726 1998 1999 1 1 .6 - 1 .8 1 4 .4 12.3 - 0 .9 - 2 .9 5 4 0 .8 4 7 0 .1 4 6 1 .0 4 7 1 .3 5 3 0 .6 6 0 6 .9 3 3 .3 3 8 .2 4 0 .3 4 2 .5 4 6 .9 5 0 .1 1 0 1 .5 1 0 1 .8 1 0 9 .8 1 0 8 .4 1 0 2 .5 9 6 .4 5 .8 5 8 .6 - 2 .9 6 6 .0 5.5 6 7 .9 8.1 6 6 .1 3 .9 6 4 .2 -3 .0 5 6 .6 * Outstanding public and private debt at year end, as a share of annual exports and annual GDP, respectively. Source: BBVA; IMF/EFI. h a v in g fallen sh a rp ly since 1988. Two in te rp re ta tio n s c a n b e m a d e o f th is: th a t c o n v e rtib ility a n d th e stru c tu ra l reform s m e n tio n e d abo v e w ere able to co rrect th e lo n g -sta n d in g loss in o u tp u t p e r capita; a n d th a t g ro w th w as relativ ely easy to ach iev e initially, d u e to th e sig n ifican t gap b e tw e e n ac tu a l GDP a n d p o te n tia l GDP.14 T h e g ro w th reco v ery in th e early 1990s a n d th e im p ressiv e d ro p in in fla ­ tio n w ere p ro b a b ly th e m a in reaso n s w h y c o n v e rtib ility a ttra c te d so m u c h a tte n tio n in th e in te r n a tio n a l econom y. H ow ever th e cu rre n c y b o a rd h a d Ricardo Ffrench-Davis and Guillermo Larraín 255 pitfalls, m a in ly its d e p e n d e n c e o n in te rn a tio n a l ca p ita l flow s, a variable th a t w as far fro m th e sp h e re o f in flu e n c e o f th e d o m e stic a u th o ritie s. O n to p o f th a t, v o la tility in c re ase d d u e to a rela tiv e ly n e w p h e n o m e n o n in th e in te r n a tio n a l ec o n o m y : fin a n c ia l c o n ta g io n a n d th e g lo b a liz a tio n o f fin a n c ia l v o la tility (Ffrench-D avis a n d O cam po, 2001). B ut c o n ta g io n attack s all c o u n trie s m o re o r less equally, th e differen ce a m o n g th e m b e in g th e d ifferen tial in e c o n o m ic fu n d a m e n ta ls a n d th e ca p ac ity to co rrect th e m , p a rtic u la rly w h e n th e y are m isalig n ed . A fixed ex c h a n g e ra te sy stem adds a n o th e r p o te n tia l risk, n a m e ly forced re a lig n m e n t, w h ic h is n o rm a lly p re ­ ced ed b y efforts to av o id it. In th is sense fix ed ex c h a n g e rate system s m a y am p lify th e o rig in a l e x te rn a l shock. In Table 13.2 it is sh o w n th a t in th e recession years, 1995 a n d 1999, th e ca p ita l flows to A rg en tin a decreased significantly. T he o th e r side o f th e co in w as a sig n ific an t increase in sovereign spread. B etw een 1994 a n d 1995, as sta te d earlier, th e d iffe ren tia l co st o f p u b lic secto r b o rro w in g in c re ase d b y 825 b p. A fter a sh a rp d ro p in 1996 a n d ag ain in 1997, d u rin g th e A sian crisis th e sp read in creased to 608 b p in 1998 a n d 726 b p in 1999. In th e c o n te x t o f a n o p e n ca p ita l ac co u n t, th is im plies a n in crease in th e d o m e stic cost o f b o rro w in g . T h e red u c ed ca p ita l inflow s a n d th e h ig h e r cost of b o rro w in g resu lted in a su d d e n h a lt in m o n e y su p p ly g ro w th a n d tw o sig n ific an t recessions, a relativ ely sh o rt o n e in 1995, w ith a loss o f 2.9 p e r c e n t in real GDP, a n d a q u ite lo n g o n e in 1999-2000, w h e n GDP fell b y 4.0 p er ce n t. A rg en tin a a n d U ru g u ay w ere th e o n ly tw o L atin A m erican co u n tries to suffer a d o m e stic recession in b o th th e fin an c ial crises.15 The crawling-band approach in Chile In th e early 1990s, in th e c o n te x t o f m assive ca p ita l inflow s, th e C h ilea n au th o ritie s id e n tified tw o m a in p rio rities for m a c ro e c o n o m ic m a n a g e m e n t, a n d p articu la rly ex c h an g e rate policy. First, as th e e c o n o m y w as p ro n e to h u g e cycles16 it w as crucial to achieve su stain e d m a c ro e c o n o m ic stability. Second, it w as v ita l to em p h asize g ro w th as th e d o m in a n t criterio n in p o licy m a k in g . T his m e a n t assig n in g ex p o rts a strategic role, in te rm s o f b o th e x p a n sio n a n d diversification. Several w orks, in c lu d in g th o se b y C aballero a n d C orb o (1990) a n d ECLAC (1998: ch . 4), n o te th a t in o rd er fo r ex p o rts to be a n e n g in e o f g ro w th , m a in ta in in g th e level a n d sta b ility of th e real e x c h an g e ra te is crucial. T he C h ile a n au th o rities co n sid ered th a t th is co u ld b e placed in je o p ard y if capital surges caused excessive ex c h an g e rate ap p re c ia tio n , a n d th a t th e re w o u ld b e g reater fu tu re v o la tility if th e d ire c tio n o f n e t flow s w e n t in to reverse. In th e early 1990s th e au th o ritie s decid ed to reg u late th e fo reig n ex c h an g e m a rk e t a n d ca p ita l inflo w s in o rd er to p re v e n t large m is a lig n m e n ts in th e real ex c h a n g e ra te relativ e to w h a t th e y assu m ed to b e its lo n g -te rm tre n d . 256 Latin American Exchange Rate Policies T h e in te n tio n w as to m ak e lo n g -te rm fu n d a m e n ta ls p rev a il o v er sh o rt-te rm factors, based o n th e a s su m p tio n th a t th e re w as b e h a v io u ra l a sy m m e try b e tw e e n th e m a rk e t a n d th e m o n e ta ry au th o ritie s: th e la tte r n e e d e d a lo n g ­ te rm p la n n in g h o riz o n w h e n seeking su stain a b le m a c ro e c o n o m ic stability, in c o n tra st to p riv a te agen ts, w h o o p e ra te d m o re in te n siv e ly a t th e s h o rt­ te rm e n d o f th e m a rk e t a n d w ere rew ard ed w ith p ro fits d u rin g th a t te rm . In o rd er to deal w ith m a rk e t u n c e rta in ty , ra th e r th a n se ttin g a u n iq u e p rice th e a u th o ritie s u se d a craw lin g b a n d c e n tre d o n a referen ce p rice th a t w as lin k e d to a b ask et co m p risin g th e dollar, th e D e u tsc h m a rk a n d th e y en , w e ig h te d ac co rd in g to th e ir sh a re in C h ile a n tra d e .17 T h e c e n tre o f th e b a n d craw led ac co rd in g to in fla tio n d iffe ren tia l criteria, th u s fo llo w in g a PPP ru le a d ju ste d b y e stim a te s o f n e t p ro d u c tiv ity im p ro v e m e n ts in C h ile. T h e ch an g es ta k in g place in th e global fin an c ial m ark ets, th e in c re asin g in te rn a tio n a l a p p ro v a l o f C h iles e c o n o m ic policies, h ig h d o m e stic in te re st rates a n d th e s m o o th tra n s itio n to dem o cracy stim u la te d a ca p ita l in flo w to C h ile fro m m id 1990. T his flow w as earlier a n d relativ ely stro n g e r th a n in o th e r em erg in g ec o n o m ie s a n d w as q uickly reflected in a n a p p re c ia tin g real ex c h an g e rate. B e g in n in g in Ju ly 1990, th e m a rk e t ra te lay a t th e a p p re cia ted ex tre m e o f th e b a n d . D u rin g th e follow ing m o n th s th e e c o n o m ic au th o rities d esig n ed a n e w m a c ro e c o n o m ic policy th a t, c o n tra ry to th e fa sh io n a m o n g m u ltila te ra l in s titu tio n s a n d fin an c ial agents for acro ss-th e-b o ard o p e n in g o f th e cap ital ac co u n t, w as based o n th e p re d ic tio n th a t th e large e x tern al su p p ly o f fin a n c in g w as n o t su stainable a n d th a t sh o rt-te rm factors affecting th e c u rre n t ac c o u n t, su ch as th e h ig h price o f copper, w o u ld te n d to reverse in th e m e d iu m te rm .18 T h e set o f policies th a t follow ed w ere desig n ed to p ro v id e a p ru d e n tia l m a c ro e c o n o m ic e n v iro n m e n t in o rd er to achieve su stain a b le equilibria. In J u n e 1991 a n o n -in te re st-b e a rin g reserve re q u ire m e n t o f 20 p e r c e n t w as im p o sed o n fo reig n loans. Reserves h a d to b e m a in ta in e d a t th e c e n tra l b a n k for a m in im u m o f 90 days a n d a m a x im u m o f o n e year. C e n tral b a n k p ro p o n e n ts o f a d irty flo at argued th a t th e p rev a ilin g rules, w ith a p u re b a n d , a n in creasin g ly active in fo rm a l m a rk e t a n d a m o re p o ro u s fo rm al m arket, w o u ld lead to th e ex c h an g e rate m o v in g to w ard s e ith e r ex tre m e o f th e b a n d (it h a d alre ad y h it th e ceilin g in 1 9 8 9 -9 0 , a n d th e floor la ter o n ). T his p ro m p te d th e b a n k to in itia te d irty flo a tin g in M arch 1992. T h ereafter th e rate flu c tu a te d w ith in a ran g e of o n e to eig h t p erc en ta g e p o in ts above th e floor for several years, w ith th e b a n k c o n tin u in g to m ak e p u rch ases b u t also so m e sales (overall th e re w as a sig n ific an t n e t ac cu m u la­ tio n of reserves). In th e en su in g m o n th s US in te re st rates c o n tin u e d to declin e, en c o u rag ed b y th e recession th e U n ite d States w as experiencing, w h ic h p u t pressu re o n C h iles C e n tral Bank. H ow ever th e C h ile a n e c o n o m y w as b o o m in g a n d its GDP g ro w th ra te h a d risen in to tw o digits. For reaso n s of m a c ro e c o n o m ic e q u ilib riu m th e c e n tra l b a n k decid ed to increase ra th e r th a n low er th e Ricardo Ffrench-Davis and Guillermo Larraín 257 d o m e stic in te re st rates. In o rd er to m ake space fo r m o n e ta ry p o licy in th e c o n te x t of c o n tin u e d cap ital inflow s, th e reserve re q u ire m e n t w as tig h te n e d . In M ay 1992 it w as raised to 30 p e r c e n t a n d w as ex te n d e d to tim e d ep o sits in fo reig n currency, a n d in 1995 to p u rchases o f C h ilea n se c o n d a ry ADRs b y foreigners. T he p erio d over w h ic h th e d ep o sit h a d to b e m a in ta in e d w as ex te n d e d to o n e year, regardless o f th e m a tu rity o f th e inflow . P e rm a n e n t m o n ito rin g w as c o n d u c te d in o rd er to id e n tify lo o p h o le s, w h ic h w ere th e n closed. In general, ev asio n w as q u ite lim ite d (Zahler, 1998; Le F ort a n d L e h m a n n , 2000). T h e system o f reserve re q u ire m e n ts a n d taxes o n fo reig n le n d in g w as d irec ted a t relative m a rk e t prices. T h e im p licit ta x rate o n in flo w s in creased d ram a tic ally as m a tu ritie s sh o rten e d . For in sta n c e b y 1995, fo r in flo w s w ith a o n e-y ear te rm it sto o d a t 4 p e r ce n t, w h ile for 90 d ay-term s it rep rese n ted a cost o f 13 p e r c e n t (Agosin a n d Ffrench-D avis, 2001). W ith th e o u tb re a k of th e A sian crisis a n d th e su b se q u e n t scarcity o f fin an c ial inflow s, th e reserve re q u ire m e n t rate w as red u c ed to 10 p er c e n t a n d th e n to zero in 1998. As a resu lt o f th e po licy m ix im p le m e n te d in 1990-94 , p lu s th e im p ro v e d te rm s o f tra d e in 1995 after th e T equila crisis ex p lo d ed in la te 1994 a n d its effects sp read to A rgentina, C h ile m a in ta in e d a solid e x te rn a l secto r (a sm all deficit o n th e c u rre n t ac co u n t, a su stain ab le ex c h an g e rate a n d a lim ite d a m o u n t o f sh o rt-term e x tern al liabilities). T herefore th e acro ss-th e-b o ard cu t-o ff in liq u id fu n d in g fo r L atin A m erica d id n o t d a m p e n th e C h ilea n eco n o m y . Tow ards m id 1995 ca p ita l flow s b eg a n to re tu rn to th e reg io n , a n d w ith special in te n sity to C hile. G iv en th e e x p e c ta tio n s o f cu rren cy ap p re c ia tio n w h e n th e T equila sh o ck was over, th e large in te re st rate d ifferen tial b e tw e e n th e p eso a n d th e d o llar gave fo reign p o rtfo lio a n d sh o rt-te rm in v esto rs a p ro fitab le b et, in sp ite of th e p rice th e y h a d to p ay for e n te rin g th e C h ile a n fin an c ial m a rk e t (in th e fo rm of th e reserve req u irem en t). T he tre n d to w ard s ap p re c ia tio n co u ld h av e b e e n cu rb ed b y in te n sify in g th e price restric tio n s o n in flo w s (th a t is, in c re asin g th e size o f th e reserve re q u ire m e n t; Le F ort a n d L e h m a n n , 2000). H ow ever th e a u th o ritie s m o re o r less m a in ta in e d th e in te n s ity o f th e p o licy to o ls th e y w ere u sin g in 1 996-97, a n d a co n seq u e n ce ca p ita l in flo w s o v er­ w h e lm e d th e d o m e stic m ark et. T h e c e n tra l b a n k w as u n a b le to p re v e n t a sig n ific an t real a p p re c ia tio n o f th e peso a n d th is c o n trib u te d to a w id e n in g o f th e c u rre n t a c c o u n t deficit, w h ic h clim b e d to 5.7 p e r c e n t of GDP in 1 9 9 6 -9 7 (Table 13.3). In th e n e g o tia tio n s for a free trad e ag re em e n t w ith C a n a d a th e C h ilea n au th o rities successfully defen d ed th e m a in te n a n c e o f th e reserve req u irem en t as a p o lic y to o l to reg u late fin an c ial inflow s. B ut th e gen eral o v ero p tim ism in d o m e stic a n d fo reign fin an c ial m arkets, th e w id esp read ag re e m e n t th a t th e crisis h a d b e e n left b e h in d a n d th e risky te m p ta tio n to speed th e red u c­ tio n o f d o m e stic in fla tio n w ith ex ch an g e-rate ap p re c ia tio n , w ea k en e d th e p o licy o f su stain ab le m a c ro e c o n o m 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 A ctu al G D P g ro w th (%) P ro d u ctiv e ca p a city g r o w th (%) In v e s tm e n t ratio (% o f GDP) In fla tio n (%) C u rren t a c c o u n t b a la n c e (% o f GDP) F iscal b a la n ce (% o f G D P) T erm s o f trade (% o f GDP) N e t ca p ita l in flo w s (% o f GDP) Real e x c h a n g e rate ( 1 9 8 6 = 100) 1 9 9 6 -9 7 1998 1999 2000 7.8 7.8 2 6 .1 1 4 .7 - 2 .5 7.4 6 .8 3 1 .6 6 .3 - 5 .7 3 .9 7.3 3 2 .2 4 .7 - 6 .2 - 1 .1 5 .9 2 6 .9 2 .3 -0 .2 5 .4 4 .2 2 6 .6 4 .5 - 1 .6 1.8 0 .2 6.9 9 9 .5 2.1 -1 .4 8 .0 8 1 .4 0 .4 -3 .0 2 .8 7 8 .0 - 1 .5 0 .2 - 0 .9 8 2 .3 0 .1 0 .0 1.7 8 5 .9 N o te : The terms of trade effect are expressed in current prices. Sources: Central Bank of Chile; Ffrench-Davis (2002). T h e a u th o ritie s ex c h an g e -rate m a n a g e m e n t d id n o t d eter sp ecu lativ e inflow s after 1995. In sp ite o f th e ir fo rm al a d h e sio n to a craw lin g b a n d in 1996-97, in o rd er to ap p re cia te th e b a n d (b ey o n d a fo rm a l b ro a d e n in g o f th e b a n d to ± 1 2 .5 p er cent), in 1997 th e au th o ritie s tin k e re d w ith th e w eights assigned to each currency, m a k in g th e peg to a cu rren cy bask et rath e r th a n th e do llar less credible. In N o v em b er 1994 th e w e ig h t of th e US d o llar h a d b e e n red u c ed fro m 50 p e r c e n t to 45 p e r cent, reflectin g th e fallin g use o f th a t cu rren c y in C h ile a n trad e. In J a n u a ry 1997 it w as arb itra rily raised to 80 p er ce n t. Also, th e e x te rn a l in fla tio n u sed to co rrect th e referen tial e x c h an g e rate w as o v ere stim a te d b y 10 p erc en ta g e p o in ts b e tw e e n 1995 a n d 1997, g en eratin g considerable a d d itio n a l revaluation. F u rth erm o re a n a n n u a l 2 p e r c e n t a p p re c ia tio n o f th e reference ra te h a d b ee n set in N o v em b er 1995, b ased o n th e a ssu m p tio n th a t C h ilea n p ro d u c tiv ity w o u ld grow faster th a n th a t of its m a in tra d in g p artn e rs. T h e A sian crisis n o ta b ly w o rsen ed te rm s of trad e in 1 9 9 8 -9 9 a n d C hile fo u n d itself w ith a n overvalued real ex ch an g e rate a n d a deficit o n th e c u rren t a c c o u n t th a t was m o re th a n tw ice as large as th e average for 1 9 9 0 -9 5 .19 C ap ital outflow s b e g a n in late 1997 a n d accelerated in 1 9 9 8 -9 9 , in d u c in g a n ex c h an g e rate d e p re c ia tio n in th e c o n te x t o f a relativ e p rice co rre c tio n process after th e sig n ific an t m a c ro e c o n o m ic im b a la n ce created in 19 9 6 -9 7 . Since 1991 ca p ita l o u tflow s h a d b e e n e n c o u rag ed as a w ay of allev iatin g ap p re cia tin g pressures o n th e ex ch an g e rate. P ension fu n d s h a d b e e n allow ed to in v e st u p to 16 p e r c e n t o f th e ir to ta l asset abro ad , in g rad u al steps. H ow ever th e h ig h e r rates o f re tu rn o n fin an c ial assets in C h ile th a n ab ro a d a n d ex p e ctatio n s o f p eso a p p re c ia tio n h a d d iscourag ed fo reig n in v e stm e n t b y C h ilea n in s titu tio n a l investors. By m id 1997 p e n s io n fu n d s h a d in v e ste d m e re ly 0.5 p e r c e n t o f th e ir fu n d s abroad. T he o u tflo w sp ed u p w ith th e Ricardo Ffrench-Davis and Guillermo Larraín 259 A sian crisis, w h e n th e c o n ta g io n to C hile reversed ex p e ctatio n s fro m ap p re ­ cia tio n to d ep re cia tio n . W ith in a sh o rt p e rio d th e o u tflo w fro m p e n s io n fu n d s rea ch ed th e eq u iv a le n t o f 4.8 p er c e n t o f GDP. T his w o rsen ed C hiles ex te rn a l p o sitio n a n d w as a n im p o rta n t source o f th e sh a rp m o n e ta ry c o n ­ tra c tio n in 1998-99. T h e C e n tral B ank h a d b e e n soft w ith th e ap p re cia tin g pressures in 1996-97, b u t it sharp ly repressed th e depreciatin g pressures a t th e e n d of 1997, arg uing th a t in a n o v e rh e a te d e c o n o m y d e v a lu a tio n w o u ld b e to o in flatio n ary . In S eptem ber 1999, w h e n th e e c o n o m y w as alread y in reces­ sion, th e c e n tra l b a n k a n n o u n c e d th e su sp e n sio n o f th e ex c h a n g e ra te b a n d to en a b le a su b sta n tia l d e v a lu a tio n u n d e r a freely flo atin g rate. T h e stab ilizin g p ro p ertie s of a b a n d em erge w h e n th e re is cre d ib ility in its param eters, n a m e ly th e level o f th e ce n tral parity, th e rate o f craw l a n d th e b a n d s w id th . T he craw ling b a n d - th e in te rm e d ia te regim e in force in C hile u n til 1999 - grad u ally lo st cre d ib ility d u e to its m is m a n a g e m e n t.20 In d e e d th e lack o f activ e in te rv e n tio n to en fo rce th e b a n d , th e v ario u s rea lig n ­ m e n ts to th e c e n tra l p arity a n d /o r th e w id th of th e b a n d , a n d th e arb itrary changes in th e w eights used to d eterm in e th e central parity all gave th e signal th a t th e p ara m ete rs co u ld be c h a n g e d a t w ill.21 E v en tu ally th e m o n e ta ry a u th o ritie s recognized th e n e e d to co rrect th e excessively ap p re cia ted real ex c h an g e rate. T h e p erio d o f active in te rv e n tio n in capital inflow s a n d th e m a n a g e m e n t of th e real ex c h an g e rate w as correlated w ith a h ig h rate o f p ro d u ctiv e cap acity u tiliz a tio n . T he n egligible gap b e tw e e n effective a n d p o te n tia l GDP ach iev ed in 1 9 9 1 -9 7 p ro v ed to b e a d e te rm in in g fac to r in th e sig n ific an t in crease in ca p ita l fo rm a tio n a n d p o te n tia l GDP (Agosin, 1998). In fact th e in v e stm e n t ratio rose 10 p o in ts in 19 9 0 -9 8 c o m p a re d w ith 1 982-89 , a n d GDP g ro w th ju m p e d fro m 2.9 p e r c e n t a y ear to 7 p e r c e n 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 o f v ig o ro u s rec o v ery in 2 0 0 0 -1 , th e in v e s tm e n t ra tio lo st n e a rly o n e h a lf o f its p rev io u s gain . O u r in te r p re ta tio n is th a t th e in te n s ity o f w h a t w as a n u n a v o id a b le d o w n w a rd a d ju s tm e n t w as a sso cia te d w ith th e d ise q u ilib ria in 1 9 9 6 -9 7 , first th e excessive a p p re c ia tio n a n d th e n th e d elay in a llo w in g a d e p re ­ c ia tio n in 1998. T h erea fter th e a u th o ritie s failed to e x p lo it all th e p o sitiv e fea tu re s o f th e C h ile a n e c o n o m y th a t w o u ld allo w m o v e m e n t to w a rd s th e p ro d u c tio n fro n tier, th u s e n c o u ra g in g e c o n o m ic e m p lo y m e n t a n d ca p ita l fo rm a tio n . Mexico: the oldest floating exchange rate regime in Latin America T h e a d o p tio n o f a flo a tin g e x c h an g e rate regim e in M exico w as th e o u tc o m e o f a full-scale b a la n c e o f p a y m e n t crisis in D ecem ber 1994. Before th a t, since O cto b e r 1992, M exico h a d u se d a n e x c h an g e rate b a n d in w h ic h th e floor 260 Latin American Exchange Rate Policies w as fixed in n o m in a l te rm s a n d th e ceiling craw led daily. In sp ite of th e fact th a t th e e c o n o m y grew a t a n average o f o n ly 3.8 p er c e n t p er y ear b etw e en 1989 a n d 1993, M exico a ttra c te d a lo t o f a tte n tio n for tw o reasons. First, it b ecam e a le ad in g c o u n try in te rm s of p riv atiza tio n , w ith rev en u es of 3.3 per c e n t o f GDP in 1991 a n d 1992. Second, in 1993 M exico jo in e d th e N o rth A m erican Free Trade A greem en t (NAFTA), a n d th is led to its b e c o m in g a m e m b er o f th e OECD. T hese tw o associations resu lted in th e rap id lib eral­ iz a tio n of cap ital flows. T h e m arkets rea cte d p o sitiv ely to th e se events, as reflected in th e fact th a t 49 per c e n t o f to ta l ca p ita l inflow s to L atin A m erica w e n t to M exico in 1 9 9 0 -93. O n average th e c o u n try received U S$23.6 b illio n p e r year, 83 p er c e n t o f w h ic h co n siste d o f flow s o th e r th a n foreign d irect in v e s tm e n t (FDI). O n th e d o m e stic fro n t, h ig h e r ex p ected re tu rn s ev e n tu a lly led to a b o o m in p riv ate e x p e n d itu re . As a resu lt th e deficit o n th e c u rre n t a c c o u n t rose fro m US$7 b illio n in 1990 to US$30 b illio n in 1994 a n d th e real b ilateral ex c h an g e rate w ith th e U n ite d States ap p re cia ted 30 p e r c e n t in fo u r years. A ccording to Ros (2001) th e M exican crisis w as n o t th e o u tc o m e o f in c o n siste n c y in e c o n o m ic policy, n o r a self-fulfilling m e c h a n ism . In stea d h e p o in ts to (1) th e p a rt play ed b y th e ill-conceiv ed p e rc e p tio n th a t th e shocks b ein g faced b y M exico - h ig h e r in te re st rates in th e U n ite d States a n d p o litica l tu rm o il a t h o m e - w ere tem p o rary , a n d (2) p e rc e p tio n s of th e h ig h cost in v o lv e d in tig h te n in g m o n e ta ry policy in early 1994 o r m o d ify in g th e ex ch an g e rate policy. T hese tw o co n sid eratio n s led th e g o v e rn m e n t to sell in te rn a tio n a l reserves a n d increase th e issuance of d o lla r-d e n o m in a te d , sh o rt-te rm T esobonos ag ain st th e p eso -d e n o m in a te d C etes. Reserves fell fro m US$26 b illio n in th e first q u a rte r o f 1994 to US$16.5 b illio n th re e m o n th s later. T he d e b t n o t o n ly c h a n g e d d e n o m in a tio n b u t th e average te rm sh o rte n e d as w ell. U S$28.6 b illio n in T esobonos w ere d u e to m a tu re in 1995, 35 p er c e n t o f th is d u rin g th e first q u a rte r (Ros, 2001). G iven th e sta te o f th e in te rn a tio n a l reserves, th is p u t th e c o u n try in d an g e r of d efa u lt a n d ev e n tu a lly led to specu lativ e attack s o n th e peso. T he n e w g o v e rn m e n t tried to c h a n g e th e b a n d b y lo w erin g th e ceiling b y 15 p e r ce n t, b u t it w as to o late a n d it w as forced to q u it th e b a n d system . At th e sam e tim e in te re st rates ro cketed, m a rk in g th e start o f th e severe a n d costly T equila crisis (C alvo a n d M endoza, 1996).22 A ccording to C a rsten s a n d W erner (1999) th e crisis h a d th re e aspects. First, sh o rt-te rm ca p ita l inflow s en co u rag ed a n d fin an c ed th e o v ersp e n d in g th a t caused th e a b o v e m e n tio n e d c u rre n t a c c o u n t deficit. Second, e v e n if th e p u b lic d eb t a n d th e fiscal b a lan c e suggested a h e a lth y p u b lic sector, th e sh o rt m a tu rity o f th e stock o f g o v e rn m e n t d e b t ex p o sed th e c o u n try to a fin an c ial p a n ic (ibid.) In th a t c o n te x t, a n y d o u b t a b o u t th e w ill of m ark ets to c o n tin u e ro llin g ov er th e ex istin g d e b t w o u ld h av e cau sed a n attac k o n M exicos e x te rn a l d eb t. Finally, a severe b a n k in g crisis occu rred . A fter th e ex ch an g e rate b a n d w as a b a n d o n e d a n d a float w as ad o p ted , th e re w as an Ricardo Ffrench-Davis and Guillermo Larraín 261 a b ru p t d e v a lu a tio n o f a b o u t 95 p e r c e n t b e tw e e n ju st b efo re th e crisis a n d M arch 1995. To av o id th e in fla tio n a ry co n seq u e n ces o f th is d ev a lu a tio n , th e c e n tra l b a n k tig h te n e d m o n e ta ry po licy b y raising th e in te re st rate fro m 16 p e r c e n t in D ecem ber 1994 to 86 p er c e n t th re e m o n th s later. Fiscal p o licy was tig h te n e d b y 2.6 p er c e n t o f GDP in 1995. T his c o n tra c tio n a ry package resu lted in a sh a rp recession in w h ic h GDP fell b y 6.2 p er c e n t a n d d o m estic d e m a n d b y 12.9 p er cen t. Ju st after th e crisis th e re w as a b rief e x p e rim e n t w ith m o n e ta ry targ e tin g , b u t as in fla tio n cam e d o w n a n d th e re w as stro n g evid en ce o f in sta b ility in th e d e m a n d for m oney, th e c e n tra l b a n k sta rted to set a n n u a l in fla tio n targ ets (Ortiz, 2000). T he m a in elem e n ts o f th e c u rre n t fram ew o rk are (1) th e m e d iu m -te rm goal of red u c in g in fla tio n to th e in te rn a tio n a l level in 2003, w ith a n n u a l in fla tio n targets, (2) m o n e ta ry p o licy actio n s b ased o n a n assess­ m e n t o f in fla tio n a ry pressures, a n d (3) a tra n s p a re n t sy stem b ased o n th e p u b lic a tio n o f q u a rte rly in fla tio n reports. A b asic difference b e tw e e n M exico a n d o th e r in fla tio n targ eteers is th e fo rm ers ch o ice o f p o licy in s tru m e n t. W h ile m o st in fla tio n targ eteers use th e sh o rt-te rm in te re st rate, th e M exican c e n tra l b a n k uses a reserve o p e ra tin g p ro ce d u re k n o w n as th e c o rto . T his system causes sig n ific an t sh o rt-te rm v o la tility in n o m in a l in te re st rates, le ad in g to a m o re stab le e x c h an g e rate a n d h e n c e a m o re stable in fla tio n a ry e n v iro n m e n t. B etw een 1996 a n d 2000 M exico en jo y ed a relatively p ro sp ero u s p erio d in w h ic h GDP g ro w th averaged 5.3 p er cent; h ow ever b y 2 0 0 0 th e ec o n o m y w as clearly o v erh eated . In d ee d in th a t year GDP grew 6.9 p er ce n t, w ell b e y o n d w h a t h a d b e e n estim a ted , th e real e x c h an g e rate h a d ap p re cia ted 13 p e r c e n t sin ce 1997 a n d th e deficit o n th e c u rre n t a c c o u n t h a d m o re th a n d o u b le d o ver th e sam e perio d , d esp ite th e h ig h oil prices (Table 13.4). W ith regard to th e float, th is w as n o t a p u re float as th e re w as a c o m p li­ ca te d ru le to reg u late in te rv e n tio n in th e fo reig n ex c h an g e m ark et. T h e rule in c lu d e d a tw o -p ro n g e d a p p ro a c h in w h ic h a n o p tio n m e c h a n ism w as u sed to ac cu m u late reserves a n d a c o n tin g e n t sale w as used w h e n th e ce n tral b a n k w a n te d to m in im iz e a su d d e n d ep re cia tio n . T his a p p ro a c h w as aim ed at fig h tin g peso a p p re c ia tio n a n d a c c u m u la tin g in te rn a tio n a l reserves. H ad th e ce n tra l b a n k in te rv e n e d d irectly in th e sp o t m a rk e t th e o u tc o m e w o u ld h av e b e e n m o re sim ilar to th a t ac h iev ed w ith a n e x c h an g e rate b a n d o r a soft peg. T h e m e c h a n ism , n o w a b a n d o n e d , w as asy m m etric in th a t it p u t g reater em p h asis o n sto p p in g a su d d e n d ep re c ia tio n th a n o n sto p p in g a su d d e n a p p re c ia tio n (G alán e ta l., 1999). T his in te rv e n tio n m e c h a n ism a n d M exicos su rre n d er to in te re st rate v o la tility ra th e r th a n e x c h an g e rate v o la tility resu lted in M exico e n jo y in g a sig n ific an t degree o f ex c h an g e rate stability. T he a d o p tio n o f th e flo atin g regim e co in cid e d w ith a p erio d o f h ig h a n d relatively stable GDP g ro w th a n d sig n ific an t fin an c ial stability. O f course a su b stan tia l p a rt of th is w as d u e to th e fact th a t M exicos largest tra d in g p artn e r, th e U n ite d States, 262 T a b le 1 3 .4 M ex ico : ca p ita l flo w s, real e x c h a n g e rate a n d m a c r o e c o n o m ic p erfo rm a n c e, 1 9 9 2 - 2 0 0 0 1992 C urrent a c c o u n t b a la n ce (US$ m illio n ) N e t ca p ita l in flo w s (US$ m illio n ) C h a n g es in reserves (US$ m illio n ) G DP g ro w th (%) Terms o f trade (1 9 9 5 = 10 0 ) Real e x c h a n g e rate (average 1 9 8 7 - 9 0 = 100) E xternal d e b t/ G DP (%) Source: ECLAC. 1993 1994 1995 1996 1997 1998 1999 2000 448 - 1 6 090 - 1 4 325 - 1 7 690 6 190 21 4 4 7 19 3 0 0 18 6 0 2 24 800 - 1 806 - 1 0 512 - 2 138 -5 9 2 - 2 824 - 2 4 442 - 2 3 400 - 2 9 662 - 1 575 - 2 330 26187 30 632 12 4 6 5 - 1 4 735 - 1 173 - 6 057 18 3 9 8 - 9 648 -7 3 .6 1 0 5 .0 2 .0 1 0 4 .9 4 .4 1 0 3 .3 - 6 .2 1 0 0 .0 5 .2 1 0 2 .8 6 .8 1 0 4 .0 5 .0 1 0 0 .4 3 .8 1 0 2 .3 6 .9 1 0 7 .4 7 4 .0 70.3 72.1 1 0 6 .0 9 5 .4 8 3 .5 8 4 .0 7 6 .7 7 1 .6 3 2 .0 3 2 .4 3 3 .2 5 7 .9 4 7 .3 3 7 .2 38.1 3 4 .7 2 5 .9 Ricardo Ffrench-Davis and Guillermo Larraín 263 ex p e rien ced d y n a m ic g ro w th u n til 2000, w ith a su b sta n tia l in crease in im p o rts (particularly fro m M exico). T he sto ry ch a n g ed sh a rp ly for b o th fro m late 2000. Concluding remarks In th e c o n te x t o f th e m o re in te g ra te d w o rld econom y, e x c h an g e rate p o licy is cru cial as it is th e variable th a t links n a tio n a l prices to fo reig n prices. It also affects re tu rn s in m a n y sig n ific an t sectors o f th e eco n o m y , su c h as th e p ro d u c tio n o f exportables. Also, b ein g a n in te rn a tio n a l b e n c h m a rk it acts as a gauge to d o m e stic investors, a n d also affects sh a d o w prices. T h e review in th is ch a p te r o f th e A rg e n tin e an , C h ile a n a n d M exican ex p erien ces show s th a t a po licy th a t is su itab le in o n e m a c ro e c o n o m ic e n v iro n m e n t m a y n o t be so in an o th er. Each e x c h an g e rate system h as its o w n logic a n d requires m easures to e n h a n c e its credibility. In th is sense, a cru cial p o in t to b ea r in m in d w h e n a d o p tin g a n e x c h an g e rate p o licy is th e co st o f sw itc h in g to a n a ltern ativ e policy if it fails. H ow ever in som e cases, p u b lic discu ssio n o n a n ex it strategy m a y h av e a n eg a tiv e effect o n th e cred ib ility o f th e policy, for ex a m p le in fixed e x c h an g e ra te regim es. C red ib le p egged system s p ro m ise g rea ter (n o m in a l) fin a n c ia l stability, a n d to so m e e x te n t th a t w as th e case in A rg e n tin a d u rin g th e p e rio d e x a m ­ in e d . B ut th e re q u ire d c o m p le m e n ta ry p o lic y is h ig h price-level flex ib ility in o rd er to ad ju st to n eg a tiv e real shocks b y c u ttin g prices. T h e lo n g -te rm cre d ib ility of th is sy stem th e re fo re d e p e n d s o n h ig h flex ib ility in th e la b o u r m a rk e t a n d a n activ e fiscal p o lic y to re sp o n d a d e q u a te ly to n eg a tiv e shocks. W ith o u t th e se m easures, p egged system s are p ro n e to g rea ter real secto r v o latility. F loating system s in d u c e m o re real stability b u t a t th e price of in creased fin an c ial instability. T here m a y also be a cost in term s o f g ro w th as th e real e x c h an g e rate loses po w er to allo cate resources, in w h ic h case it is n ecessary to co n sid er th e use o f o th e r po licy in stru m e n ts to p ro m o te ex p o rts, su ch as te c h n o lo g y policy, trad e po licy a n d so o n . F loatin g system s are useful in tim es o f fin an c ial distress w h e n th e au th o ritie s h av e d o u b ts a b o u t th e level o f th e real ex c h an g e rate, th e n a tu re o f th e sh o ck th e y face a n d th e ir resp o n se to it, as flo ta tio n enab les th e m to av o id je o p ard izin g th e ir re p u ta ­ tio n b y d efe n d in g th e w ro n g ex c h an g e rate. Finally, b a n d s are u seful in tim es o f n o rm a lity w h e n th e re are n o large shocks o n th e h o riz o n . In th is situ a tio n , b a n d s h e lp to stabilize th e n o m in a l ex c h an g e rate a n d h e n c e th e real e x c h an g e rate, w h ic h h a s a p o sitiv e effect o n ex p o rts a n d g ro w th . But b a n d s are o f less u se if a large sh o c k o ccurs a n d th e au th o ritie s fail to m ake a p ro m p t a n d a d e q u a te resp o n se, becau se th e y o p e n th e w ay to sp e cu la tio n a n d sig n ifican t fin an c ial in stab ility . P ro b ab ly th e b est policy h ere is active in tra m a rg in a l in te rv e n tio n w ith in th e b a n d . In te rv e n tio n is likely to be m o re effective w h e n th e ex c h a n g e rate is k ep t far 264 Latín American Exchange Rate Policies fro m th e edges o f th e b a n d (M undaca, 2000). T his suggests th a t th e re m ay b e so m e o p tim a l b a n d w id th , as th e C h ile a n ex p erien ce show s. C o rn er so lu tio n s d o n o t h a v e sy m m etrical co n seq u en ces. E x ch an g e rate p o licy m akes a d ifference w h e n sig n ifican t cap ital surges o ccu r a n d su b ­ se q u e n t shocks cause a su d d e n reversal o f th e flow s (W illiam son, 2000; F french-D avis a n d O cam po, 2001). M ost sig n ifican t increases in th e su p p ly o f e x tern al fin a n c in g are n o t o n e-o ff events b u t a process th a t takes tim e, as in 19 7 7-81, 1 9 9 0 -9 4 a n d 1 996-97. W h e n ca p ita l inflow s o cc u r th e c u rre n t a c c o u n t deteriorates, asset prices increase a n d th e real e x c h an g e rate a p p re ­ ciates. D ifferent ex ch an g e rate policies deliver different co m b in atio n s of th ese th re e elem en ts. W ith pegged system s, a n u p w a rd surge in fo reig n cap ital flow s creates a d e m a n d b o o m , w ith co n seq u e n ces fo r asset prices, p ro b ab ly a cro w d in g o u t o f d o m e stic savings a n d a w o rsen in g o f th e e x te rn a l b alan ce. In fla tio n in n o n -tra d a b le s m a y lead to real a p p re cia tio n . W ith flo a tin g regim es a n o m in a l ap p re c ia tio n w ill take place, m a k in g th e process of real ap p re c ia tio n faster (a n d h e n c e fo rth p o te n tia lly m o re d isru p tiv e if th e in creased liq u id ity is tran sito ry ) th a n w ith th e pegged system . In fact w h e n th e force b e h in d th e ca p ita l surge is ex tern al, sm all e c o n o m ie s m a y suffer fro m sig n ifican t o v erv a lu atio n . Pegs te n d to w o rk b e tte r in th e u p w ard p h ase of th e cycle, b u t after th e p ea k th e float does b e tte r in te rm s of th e necessary e x p e n d itu re sw itch in g . As sh o w n b y W yplosz (1999) a n d Ros (2001), in th is ty p e o f cycle th e re is th e p o ssibility o f m u ltip le eq u ilib ria b ased o n self-fulfilling beliefs: ex p ec­ ta tio n s of m o re inflow s (outflow s) m ay fu rth e r ap p re cia te (depreciate) an alre ad y ap p re cia ted (depreciated) currency. E x ch ange rate in sta b ility is n o t costless, a n d large d e v ia tio n s fro m th e e q u ilib riu m level b y th e real e x c h an g e rate are n o t costless eith er. E xports, in te rm s o f b o th g ro w th a n d d iv ersificatio n , b e n e fit fro m stab le e n v ir­ o n m e n ts (ECLAC, 1998: ch . 4). T h erefo re ex c h a n g e rate p o lic y faces tw o c h a lle n g es w h e n a tte m p ts are b e in g m a d e to im p ro v e o v erall g ro w th p e r­ form ance: th e n e e d to m axim ize real ex ch an g e rate stab ility w ith o u t p egging th e currency, a n d th e n e e d to av o id sig n ific an t cu rre n c y m isalig n m en ts, t h a t flo a tin g d oes n o t im p e d e. B ands, th e o b v io u s so lu tio n , m a y ad d ress b o th b u t th e y are sen sitiv e to large shocks.23 Irresp ectiv e o f th e p o licy a d o p te d , c e n tra l b a n k s m u s t c o n c e rn th e m se lv es w ith b o th th e level a n d th e sta b ility o f th e ex c h a n g e rate. In th is respect, a n d d esp ite w h a t h as h a p p e n e d since th e A sian crisis, craw lin g b a n d s are still a n o p tio n to consider. Latin A m erican financial in stru m e n ts suffer from at least tw o sh o rtco m in g s. O n e is lin k e d to th e in s tru m e n ts them selves, in th a t th e y lack c o n tin g e n c y m easu res to deal w ith th e shocks th a t are c o m m o n in L atin A m erican c o u n ­ tries. T he o th e r is lin k e d to th e m arkets, w h ere th e re is a lack o f su stain ab le fo reig n d e m a n d for in stru m e n ts d e n o m in a te d in local currencies. M acroe c o n o m ic policies m a y e x p a n d in term s o f addressin g b o th in stru m e n ts a n d Ricardo Ffrench-Davis and Guillermo Larraín 265 m ark ets, b u t it is n o t clear a t all th a t c o u n tries w ill be able to d o b o th th in g s in sig n ific an t w ays in th e sh o rt term . In th e c u rre n t p h ase of th e cycle, w h e n th e re is a sig n ific an t sh o rtag e of cap ital inflow s, m a n y co u n tries in L atin A m erica h av e m o v e d to w ard s acrossth e -b o a rd liberalization of th e cap ital ac co u n t. H ow ever p o licy m akers w ill n e e d to take care w h e n th e cycle m oves in to th e n e x t p h ase. R ecent ex p eri­ en c e in em erg in g ec o n o m ies show s th a t th e b e h a v io u r o f ca p ita l in flo w s can b e in c o n siste n t w ith m a c ro e c o n o m ic sustainability, p articu la rly in te rm s of th e sta b ility o f th e e x c h an g e rate a n d e c o n o m ic activity. T h erefo re th e au th o ritie s n e e d to follow closely th e d e v e lo p m e n ts in v ario u s m ark ets a n d h av e flexible policy packages ra th e r th a n single, rigid p o licy tools. N o tes * 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. W e a c k n o w le d g e t h e c o m m e n ts m a d e b y A m ar B h attacharya, S te p h a n y G riffith J o n es, José A n to n io O c a m p o , A v in a sh P ersaud, H elm u t R eisen , R ogerio Studart a n d H eriberto Tapia. All r e m a in in g errors are o u r resp o n sib ility . T h e o p in io n s ex p ressed in th is ch a p te r are th o s e o f th e a u th o rs an d d o n o t n ecessa rily reflect t h o s e o f ECLAC or t h e BBVA. See Fischer (2 0 0 1 ) a n d L evy a n d S tu rzen n eger (1 9 9 9 ) for a c la ssific a tio n o f e x c h a n g e rate reg im es. For a r ece n t d isc u s sio n o f t h e sou rces o f v o la tility in L atin A m erica n e c o n o m ie s, see R odrik (2 0 0 1 ). T h is b e c o m e s e v id e n t w h e n w e c o n sid e r A rg en tin a in 2 0 0 1 . H o w ev er w e h a v e n o t c o n tr o lle d for t h e d egree o f o v e r v a lu a tio n o f th e e x c h a n g e rate in ea ch cou n try. B ecause in A rgen tin a th e e x c h a n g e rate w as u se d e x p lic itly as a n a n ti-in fla tio n a ry d e v ic e an d it ap p reciated sh arp ly in 1 9 9 1 -9 2 , t h e required fall in d o m e stic p rices a n d w a g es w a s greater th a n th a t w h ic h e ffe c tiv e ly to o k p la ce. T h is d o e s n o t ta ck le t h e p r o b lem p o se d b y t h e n e g a tiv e effe ct o f real e x c h a n g e rate in sta b ility o n t h e p r o d u c tio n o f trad ables a n d t h e d iv ersifica tio n o f ex p o rts. See C ab allero a n d C o rb o (1 9 9 0 ) a n d ECLAC (1 9 9 8 ). A rece n t m o v e in th is d ir e c tio n h a s in v o lv e d C h ile. T h ere h a v e b e e n tw o b o n d issu es, o n e b y t h e IADB a n d t h e o th e r b y t h e g o v e r n m e n t o f U ru gu ay in in stru ­ m e n ts d e n o m in a te d in C h ile a n p e so s in d e x e d to C h ile a n in fla tio n . C h ile d e v e lo p e d a n e ffic ie n t p r o x y b y e sta b lish in g a co p p er sta b iliz a tio n fu n d . O th er c o u n tr ie s h a v e a lso u tiliz e d fu n d s, su c h as t h e F o n d o C afetero in C o lo m b ia , a n d t h e o il sta b iliz a tio n fu n d s in M e x ic o a n d V en ezu ela. Real e x c h a n g e rate m isa lig n m e n t ca n a lso o ccu r in d e v e lo p e d e c o n o m ie s , for e x a m p le t h e h u g e sw in g s o f t h e US d ollar in t h e 1 9 9 0 s a n d its sh arp a p p recia tio n v is -à -v is t h e eu ro sin c e 1 9 9 8 (W illia m so n , 2 0 0 0 ). For e m e r g in g e c o n o m ie s , see F fren ch -D a v is a n d O c a m p o (2 0 0 1 ). C o u n tr ie s n o t in c lu d e d in t h e sa m p le w ere a lso su b ject t o c o n ta g io n , in c lu d in g Peru a n d U ruguay. T h e title c h o s e n b y Braga e t a l. (2 0 0 1 ), 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 a rg u m en t. T h is p ro p o sa l is c o n s is te n t w ith t h e c o n te n t a n d title o f Frankel (1 9 9 9 ). In t h e m e a n tim e t h e real e x c h a n g e rate ap p recia ted sharply, t h e d eficit o n th e cu rren t a c c o u n t rose a n d gross cap ital fo r m a tio n reco v ered o n ly m o d e s tly (Frenkel e t a h , 1 9 9 8 ). 266 Latin American Exchange Rate Policies 1 3. M o st o f t h e p riv a tiz ed c o m p a n ie s b e lo n g e d t o t h e n o n -tra d a b le sector. In th e se firm s, a verage p r o d u c tiv ity p er w ork er rose after p riv a tiz a tio n . T h e lin k to real e x c h a n g e rate is b e c a u se - con tra ry t o t h e B a la ssa -S a m u elso n effe ct, in w h ic h n e t p r o d u c tiv ity g r o w th in t h e trad able se cto r cau ses a real a p p recia tio n o f th e cu rren cy - t h e tr a n sm iss io n m e c h a n is m w as a r e d u c tio n in t h e real co st o f th e serv ices p r o d u c e d b y th o s e c o m p a n ie s. T h is p r o d u c tiv ity g a in d o e s n o t c o n sid e r th a t a ll u n e m p lo y e d h a d zero p ro d u ctiv ity . As su c h o v era ll p r o d u c tiv ity g ro w th , w h ic h tak es a c c o u n t n o t o n ly o f e m p lo y e d p e o p le b u t o f all t h e la b o u r force, in crea sed b y m u c h less. 14. In fa ct a n n u a l g r o w th in 1 9 8 8 - 2 0 0 0 w as a m ere 2 .3 p er c e n t. It c a n b e a ssu m e d t h a t t h e gap b e tw e e n e ffe c tiv e a n d p o te n tia l G D P in 1 9 9 1 w a s q u ite large. 1 5. Several LACs e x p e r ie n c e d a recessiv e gap (T h e g a p b e tw e e n e ffe c tiv e a n d p o te n ­ tia l G DP), b u t a b so lu te G D P k ep t risin g. A verage G DP g r o w th d ro p p ed from 5 .2 p er c e n t in 1 9 9 4 a n d 1 9 9 7 to 1.1 p er c e n t in 1 9 9 5 a n d 0 .3 per c e n t in 1 9 9 9 . 16. In 1 9 7 5 a n d 1 9 8 2 C h ile h a d e x p e r ie n c e d t h e sh arp est rec e ssio n s o f all Latin A m erica n co u n tries; see F fren ch -D avis (2002: c h s 1, 6). 1 7. C h ile w as a p io n e e r in im p le m e n t in g e x c h a n g e rate p o lic ie s b a sed o n t h e v a rio u s cra w lin g -p eg a p p ro a ch es (W illia m so n , 1 9 8 1 ). T h is h a p p e n e d b e tw e e n A pril 1 9 6 5 a n d Ju ly 1 9 7 0 . S u b seq u en tly , from O ctob er 1 9 7 3 t o J u n e 1 9 7 9 , a se c o n d ex p eri­ m e n t o f th is k in d w as carried o u t. In t h e 1 9 8 0 s, after t h e 1 9 8 2 crisis, a cra w lin g p e g w a s rein sta ted a n d th is e v o lv e d in t o a cra w lin g b a n d , w h ic h c o n t in u e d u n til S ep tem b er 1 9 9 9 (F fren ch -D avis, 2 0 0 2 : c h s 4, 10). 18. In a d d itio n C h ile w a s c o m in g o u t o f a p r o fo u n d d eb t crisis, w h ic h h a d b e e n a c c o m p a n ie d b y sh a rp e x c h a n g e rate d e p r e c ia tio n . C o n s e q u e n tly th e re w a s r o o m for so m e e q u ilib r a tin g a p p recia tio n . H o w ev er as a g en ts e x p e c ta tio n s c h a n g e d fro m p e ss im is m t o o p tim ism , t h e y so u g h t a n e w sto c k o f in v e s tm e n t in t h e e m e r g in g m ark et o v er a sh o r t p erio d o f tim e . T h is im p lie d e x c e s siv e ly large tra n ­ sito ry in flo w s. 19. A n en la rg ed d e fic it o n t h e cu rren t a c c o u n t in 1 9 9 5 - 9 7 , a d ju ste d b y th e tren d in t h e term s o f trade, w as p r o o f o f an o v e r ly ap p reciated e x c h a n g e rate th a t a d ju sted faster th a n p r o d u c tiv ity im p r o v e m e n ts. W e c o n t e n d th a t t h e a ctu a l a p p recia tio n in 1 9 9 0 - 9 4 h a d b e e n eq u ilib r a tin g (g iv en t h e m o d e ra te d e fic it o n t h e cu rren t a c c o u n t a n d a n a p p recia tio n t h a t w as so fter t h a n in all o th e r e m e r g in g Latin A m erica n c o u n tr ies). See F fren ch -D avis (2000: c h . 10). 2 0 . T h e b a n d a n d its ce n tr e h a d b e e n cred ib le for a lo n g tim e . M a g e n d z o e t a l. (1 9 9 8 ), u s in g d ata u n til 1 9 9 7 , b efo re t h e A sian crisis reach ed C h ile, fin d th a t cred ib ility in t h e b a n d h a d d ecreased , b u t t h e y d o n o t q u a n tify t h e d eg ree o f cred ib ility th a t h a d e x iste d prior t o th a t tim e . 2 1 . A cco r d in g t o K ru gm an (1 9 9 1 ) th e r e is e x o g e n o u s fu ll c r e d ib ility in t h e b an d s p aram eters w it h o u t in tra m a rg in a l in te r v e n tio n . T h e ‘h o n e y m o o n e ffe c t’, th a t is, sta b ilizin g sp e c u la tio n , ap p ears b eca u se o f su c h cred ib ility. In p ractice cred ­ ib ility a n d r e p u ta tio n n e e d e d t o b e b u ilt u p b y t h e cen tra l b a n k . In tram argin al in te r v e n tio n d irected at e n fo r c in g t h e lim its o f t h e b a n d w a s cru cial as w ith o u t it sp e c u la tio n w o u ld te n d t o b e d esta b ilizin g . 2 2 . Larrain e t a l. (2 0 0 0 ) s h o w th a t cred it risk a g e n c ie s a lso fa ile d to p la y a c o u n te r ­ cy clica l role. T h e m a in tw o a g en cies d o w n g ra d ed th eir ratin g o n ly after t h e d ev a lu ­ a tio n to o k p la ce. 2 3 . W y p lo sz (1 9 9 6 ), c o m m e n t in g o n a p ap er b y L eid erm an (1 9 9 6 ), states t h a t t h e a rg u m en ts in fa v o u r o f b a n d s w ere so stro n g th a t it w a s d iffic u lt t o b e sc ep tica l a b o u t it. H o w ev er h e m e n tio n s so m e o f t h e e le m e n ts t h a t u ltim a te ly le d b an d s Ricardo Ffrench-Davis and Guillermo Larraín 26 7 in to tro u b le, a m o n g w h ic h w as t h e le v e l o f t h e b an d , th a t is, h o w it c o u ld c o p e w ith c h a n g e s in t h e real e x c h a n g e rate (for e x a m p le in re sp o n se to a sh o ck ) th a t la y b e y o n d th e lim its o f t h e b an d . References A g o sin , M . R. (1 9 9 8 ) C apital In flo w a n d In v e s tm e n t P erform ance: C h ile in t h e 1 9 9 0 s’, in R. F fren ch -D a v is a n d H. R eisen (ed s), C a p ita l I n flo w s a n d In v e s tm e n t P e rfo rm a n c e : L esso n s fr o m L a t in A m e r ic a , Paris a n d S an tiago: ECLAC a n d O ECD D e v e lo p m e n t C en tre. a n d R. F fren ch -D a v is (2 0 0 1 ) M a n a g in g C ap ital In flo w s i n C h ile , in S. G riffith J o n es, M . F. M o n te s a n d A. N a s u tio n (ed s), S h o rt-T e rm C a p ita l F lo w s a n d E c o n o m ic C ris e s , O xford: O xford U n iv ersity Press for U N U /W ID E R . Braga d e M a ced o , J., D . C o h e n a n d H. R eisen (2 0 0 1 ) M o n eta ry In teg ra tio n for S u sta in ed C o n v erg en ce : E arnin g R ather T h an Im p o rtin g C red ib ility, in D o n t F ix , D o n t F lo a t, Paris: O ECD D e v e lo p m e n t C en tre. C ab allero, R. (2 0 0 1 ) M a c ro e c o n o m ic V o la t ilit y in R e fo rm e d L a t in A m e r ic a , W a sh in g to n , DC: IDB. a n d V. C o rb o (1 9 9 0 ) The Effect O f Real E x c h a n g e Rate U n c e r ta in ty o n Exports: E m pirical E v id en ce, T h e W o r ld B a n k R e v ie w , 3, W a sh in g to n , DC: W orld Bank. C a lv o , G. A. a n d E. G. M e n d o za (1 9 9 6 ) P etty C rim e a n d C ru el P u n ish m en t: L esson s fro m t h e M ex ica n D eb a cle, A m e r ic a n E c o n o m ic R e v ie w , 8 6 , 2 (M ay). C a rsten s, A. a n d A. W erner (1 9 9 9 ) M exicos M o n e ta r y P o lic y F ram ew ork U n d er a F lo a tin g E x c h a n g e Rate R egim e, B a n co d e M é x ic o W ork in g Paper n o . 9 9 0 5 , M e x ic o C ity: B a n co d e M éx ico . ECLAC (1 9 9 8 ) P o lic ie s to Im p ro v e L in k a g e s w it h th e G lo b a l E c o n o m y , S an tiago: F o n d o d e C u ltu ra E c o n ó m ic a a n d ECLAC. F fren ch -D avis, R. (2 0 0 0 ) R e fo rm in g th e R e fo rm s in L a t in A m e r ic a : M a c ro e c o n o m ic s , T ra d e , F in a n c e , L o n d o n a n d N e w York: M a cm illa n a n d St M artins Press. (2 0 0 2 ) E c o n o m ic R e fo rm s in C h ile : F ro m D ic t a t o r s h ip to D e m o c ra c y , A n n Arbor, MI: U n iv e r sity o f M ic h ig a n Press. a n d J. A. O c a m p o (2 0 0 1 ) T h e G lo b a liz a tio n o f F in a n cia l V o la tility , in R. F frenchD a v is (ed .), F in a n c ia l C rise s in S u cce ssfu l E m e rg in g E c o n o m ie s , W a sh in g to n , DC: B ro o k in g s In stitu tion /E C L A C . Fischer, S. (2 0 0 1 ) E x ch a n g e Rate R egim es: Is T h e B ipolar V iew C orrect?’, J o u r n a l o f E c o n o m ic P e rspe ctive s, Spring. Frankel, J. A. (1 9 9 9 ) ‘N o S in gle C u rren cy R egim e Is R igh t for A ll C o u n tr ie s or at All T im es, E ssays in In te r n a tio n a l F in a n c e , 2 1 5 , P rin ceton , NJ: P rin ceto n U n iv ersity Press. Frenkel, R., J. M . F an elli a n d C. M o n v e c c h i (1 9 9 8 ) C ap ital F low s a n d In v e s tm e n t P erfo rm a n ce in A rg en tin a, in R. F fren ch -D avis a n d H. R eisen (ed s), C a p ita l F lo w s a n d In v e s tm e n t P e rfo rm a n c e : L esso n s fr o m L a t in A m e ric a , Paris: OECD/ECLAC. G alán , E., G . D u cla u d a n d J. G arcia (1 9 9 9 ) U n a E strategia d e A c u m u la c ió n d e R eservas M e d ia n te O p c io n e s d e V en ta d e D ólares: El C aso D e M é x ic o ’, m im e o , M e x ic o C ity: B a n co d e M éx ico . K rugm an, P. (1 9 9 1 ) Target Z o n es a n d E x c h a n g e Rate D y n a m ic s, Q u a r te r ly J o u r n a l o f E c o n o m ic s , 5 6 , 3: 6 6 9 - 8 2 Larraín, G. a n d C. W in o g ra d (1 9 9 7 ) ‘P rivatisation s M assives: le C as d e lA rg en tin e et d u C h ili’, R evue E c o n o m iq u e , 4 7 , 6: 1 3 7 3 - 1 4 0 8 . H . R eisen a n d J. v o n M altzan (2 0 0 0 ) ‘E m ergin g M arket Risk a n d S o v ereig n C redit R a tin g s’, in H . R eisen (ed .), P e n s io n s , C a p ita l F lo w s a n d A g e in g , N o rth a m p to n : Edward Elgar. 268 Latin American Exchange Rate Policies Le Fort, G . a n d S. L e h m a n n (2 0 0 0 ) El Encaje, lo s F lujos d e C a p ita les y el G asto: u n a E v a lu a ció n E m p írica’, W ork in g Paper n o . 6 4, S an tiago: B a n co C en tral d e C h ile, February. L eid erm an , L. (1 9 9 6 ) E x ch a n g e Rate Bands: t h e C ase o f Israel, in R. H a u sm a n n an d H. R eisen (ed s), S h o ck P ro n e E c o n o m ie s , Paris: OECD D e v e lo p m e n t C en tre. Levy, E. a n d F. S tu rzen n eger (1 9 9 9 ) C la ssify in g E x ch a n g e Rate R egim es: D eed s vs W ords, m im e o , B u e n o s Aires: U n iv ersid a d T orcu ato d i Telia. M a g en d zo , I., P. Rojas a n d R. Vergara (1 9 9 8 ) B andas C am biarías: E xp erien cia C h ilen a , 1 9 9 0 -1 9 9 4 , in F. M o ran d é a n d R. Vergara (ed s), A n á lis is E m p ír ic o d e l T ip o de C a m b io e n C h ile , W a sh in g to n , DC: G e o r g e to w n U n iversity, C en tro d e E stu d ios P ú b lico s an d ILADES. M u n d a ca , G. (2 0 0 0 ) ‘T h e E ffect o f In te r v e n tio n s o n R e a lig n m en t P rob ab ilities, J o u r n a l o f I n te r n a tio n a l F in a n c ia l M a rk e ts , 10. O rtiz, G . (2 0 0 0 ) C o m m en ta ry : H o w S h o u ld M o n eta ry P o licy m a k ers R eact to th e N e w C h a lle n g e s o f G lo b a l E c o n o m ic In teg ra tio n , m im e o , M e x ic o C ity: B a n co d e M éx ico . Rodrik, D . (2 0 0 1 ) W h y Is T h ere So M u ch E c o n o m ic In secu rity in L atin A m erica, E C L A C R e vie w , 73 (April). Ros, J. (2 0 0 1 ) From t h e C ap ital Surge t o t h e F in an cial C risis a n d B eyon d : t h e M ex ica n E c o n o m y in t h e 1 9 9 0 s, in R. F fren ch -D avis (ed .), F in a n c ia l C ris e s in S u cce ssfu l E m e rg in g E c o n o m ie s , W a sh in g to n , DC: B rook in gs In stitu tion /E C L A C . W illia m so n , J. (ed .) (1 9 8 1 ) T h e C ra w lin g -p e g , L on d on : M a cm illa n . (2 0 0 0 ) E x ch a n g e Rate R egim es for E m ergin g M arkets: R ev iv in g t h e In term ed ia te O p tio n , P o lic y A n a ly s e s in I n t e r n a t io n a l E c o n o m ic s , 6 0 , W a sh in g to n , DC: In stitu te for In tern a tio n a l E c o n o m ics, Septem ber. W y p lo sz, C. (1 9 9 6 ) C o m m e n t, in R. H a u sm a n n a n d H . R eisen (ed s), S h o ck P ro n e E c o n o m ie s , Paris: O ECD D e v e lo p m e n t C en tre. (1 9 9 9 ) ‘In te r n a tio n a l F in a n cia l In stab ility, in I. Kaul, J. G ru n b erg a n d M . Stern (ed s), G lo b a l P u b lic G o o d s, N e w York: O xford U n iv e r sity Press. Zahler, R. (1 9 9 8 ) T he C en tral B an k a n d C h ile a n M a c r o e c o n o m ic P o lic y in t h e 1 9 9 0 s, C E P A L R e vie w , 6 4 (April). 1 4 Countercyclical Fiscal Policy: A Review o f the Literature, Empirical Evidence and Som e Policy Proposals* Carlos Budnevich Introduction At th e b e g in n in g o f th e 1990s th e U n ite d States ex p erien ced a recession, b u t th e US g o v e rn m e n ts large b u d g e t deficit d id n o t allow th e u se o f a d is­ cre tio n a ry co u n tercy clical fiscal p o lic y to stim u la te th e eco n o m y . W ith th e e lim in a tio n o f b u d g e t deficits in re c e n t years, th e use o f d isc re tio n a ry fiscal p o licy h as re-em erged. In fact, in th e face o f a n e c o n o m ic d o w n tu rn th e U n ite d States re c e n tly e n a c te d a ta x reform th a t red u ced ta x rates. Sim ilarly in C h ile a law to red u ce p erso n a l in c o m e ta x rates h as b e e n a p p ro v e d b y th e g o v e rn m e n t in o rd er to cool aggregate d e m a n d a n d im p ro v e efficiency. B oth c o u n tries h av e c o n sid ered e x p a n d in g th e ir fiscal e x p e n d itu re to accelerate th e ir e c o n o m ic recovery. D iscretio n ary co u n tercy clical fiscal p o lic y ag ain ap p ears to be a feasible o p tio n . O ver th e last d ecade m a n y o f th e w orlds c e n tra l b an k s h av e c h a n g e d th e ir p ro ce d u re for c o n d u c tin g m o n e ta ry policy. D ecisions o n th e n a tu re of m o n e ta ry po licy h a v e b e c o m e m o re explicit, m o re tra n s p a re n t, m o re sy stem atic a n d m o re sensitive to ch a n g es in in fla tio n . In th e case o f th e U n ite d States, C hile a n d several o th e r countries, th e se n ew policies h av e b ee n v ery effective in re d u c in g in fla tio n , a lth o u g h th e ir effect o n th e sta b ility of th e real e c o n o m y d u rin g d o w n tu rn s h as b e e n q u estio n e d . T h e a p p ro p ria te m a c ro e c o n o m ic ro le o f fiscal p o lic y w h e n m o n e ta ry p o lic y is sy stem a tic ally a n d stro n g ly re a c tin g to ch a n g e s in in fla tio n is e v id en t: to su sta in p u b lic a c c o u n ts a n d p la y a co u n te rc y c lic a l role. T h e ta sk of co u n tercy c lic al m o n e ta ry p o lic y c a n b e d escrib ed as try in g to keep real G D P n e a r p o te n tia l GDP w h e n in fla tio n is o n ta rg e t. O f co u rse w ith th e effects of a c h a n g e in m o n e ta ry p o lic y o c c u rrin g w ith lo n g a n d v a ri­ ab le lags, th e c e n tra l b a n k m ig h t n o t b e able to m a tc h ag g reg ate d e m a n d w ith p o te n tia l GDP ra p id ly e n o u g h to p re v e n t in c ip ie n t in fla tio n fro m b e c o m in g a reality. 269 270 Countercyclical Fiscal Policy T h ere is som e co n tro v e rsy a b o u t w h e th e r c e n tra l b an k e rs s h o u ld try to a d ju st in te re st rates in o rd er to c h a n g e aggregate d e m a n d in th e w ay described here. T his issue h as b ro u g h t to th e d eb a te th e p o ssib ility of u sin g fiscal po licy as a co u n tercy clical device. W h e n discussing fiscal p o lic y issues a d is tin c tio n sh o u ld b e m a d e b etw e en d isc re tio n a ry ch a n g es in tax es a n d sp en d in g , a n d c h a n g es in taxes a n d sp e n d in g d u e to a u to m a tic stabilizers, su ch as in creased s p e n d in g o n u n e m p lo y m e n t b e n e fit a n d th e decrease in ta x rev en u e caused b y re d u c tio n s in in c o m e d u rin g a recession. B o th types o f c h a n g e in taxes a n d s p e n d in g affect aggregate d e m a n d , b u t th e a u to m a tic o n es m ay b e m o re p red ic tab le a n d w o rk m o re q u ick ly th a n th e d iscre­ tio n a ry ones. T his ch a p te r discusses d isc re tio n a ry countercy clical m o n e ta ry a n d fiscal policies. It analyzes th e role o f a u to m a tic stabilizers in fiscal policy, a n d review s co ncepts, m e a su re m e n ts a n d m e th o d o lo g ic a l issues to assess th e sta n ce o f fiscal policy. It th e n analyzes fiscal policy rea ctio n s to e x te rn a l shocks, p u b lic a n d e x tern al fin a n c e a n d th e ec o n o m ics o f sta b ilizatio n fu n d s in c o u n tries w h o se ex p o rts co n sist m a in ly o f v o la tile co m m o d ities. An analysis o f th e role o f fiscal po licy in L atin A m erica follow s, in c lu d in g C h iles rec en t ex p erien ce w ith fiscal policy. N ext, som e p ro p o sals for fiscal refo rm are discussed. The macroeconomic role of discretionary countercyclical monetary and fiscal policy Fiscal p o lic y h as tw o m a c ro e c o n o m ic objectives: to su stain p u b lic ac co u n ts a n d to regulate aggregate d e m a n d . It is m o re or less e v id e n t th a t p o licy efforts h av e c o n c e n tra te d o n th e first objective, le av in g th e stab ilizin g ro le to m o n e ta ry policy. S u stain ab ility o f p u b lic d e b t im plies k ee p in g th e lo n g -ru n so lv en cy o f th e g o v e rn m e n t so as to satisfy its in te rte m p o ra l b u d g e t c o n s tra in t. P ublic d eb t fin a n c in g o f p u b lic deficits is su stain a b le if in te re st rates are lo w er th a n th e g ro w th of th e econom y. W h e n in te re st rates exceed GDP g ro w th th e p ersist­ en ce o f a p rim a ry deficit leads to a n e x p lo sio n of p u b lic d eb t, en d a n g e rin g th e solvency o f th e p u b lic sector. U n d er tra d itio n a l K eynesianism , fiscal po licy m u s t r a n surpluses u n d e r full e m p lo y m e n t a n d allow for deficits d u rin g recessions. M a cro eco n o m ic sta b ilizatio n requires sym m etric, countercy clical re g u la tio n o f aggregate d e m a n d . K eynesianism differs fro m th e neoclassical view in th e re c o m m e n ­ d a tio n of m o re activ e policies, resu ltin g in m o re p ro n o u n c e d flu c tu a tio n s in fiscal ac co u n ts b u t alw ays w ith a n u ll resu lt o n average in th e cycle. Strict fiscal d iscip lin e in n o rm a l circu m stan ces is req u ired to p reserve th e ability to in te rv en e w h e n adverse eco n o m ic events occur. Fiscal d iscipline a n d flexibility are tw o fu n d a m e n ta l p rin cip les o f b u d g e t p o licy u n d e r ec o n o m ic globalization. Fiscal discipline is essential to th e credibility o f m acro eco n o m ic Carlos Budnevich 271 policy, w h ile flexibility is n e e d e d to face u n e x p e c te d shocks in a h ig h ly v o la tile e c o n o m ic e n v iro n m e n t. If fiscal po licy c a n sh ift aggregate d e m a n d a n d c h a n g e real GDP in th e sh o rt term , h o w s h o u ld th is p o w er be used? From a n o rm a tiv e perspective, a rea so n ab le countercy clical goal of fiscal p o lic y w ill 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 te n tia l GDP w h e n in fla tio n is o n targ et. H ow ever countercy clical fiscal p o lic y m a y n o t b e n e e d e d if a c e n tra l b a n k w isely uses its p o w er to m o v e th e aggregate d e m a n d curve to try to keep real GDP in lin e w ith p o te n tia l GDP. H ow ever th is m a y n o t b e th e case for em erg in g m ark ets th a t are su b je ct to sizeable shocks to th e term s o f tra d e a n d th e capital ac co u n t, a n d w h ere th e re are fre q u e n t ex tern al fin a n c in g co n strain ts. In fact u sin g b o th policies in a co m p lem en ta ry m a n n e r m a y b e tte r d istrib u te th e b u rd e n o f th e ir effects b etw e en d iffe ren t m arkets. As arg u ed b y Taylor (2000) n o t all re c e n t d e v e lo p m e n ts suggest a sm aller role for d isc re tio n a ry fiscal policy. If m o n e ta ry po licy targ ets in fla tio n a t a rate n e a r zero th e re is a risk th a t th e sh o rt-te rm in te re st rate w ill a p p ro a c h its low er b o u n d o f zero in a recessio n .1 W h a t c a n a n d sh o u ld c e n tra l b a n k s d o to stabilize o u tp u t a n d em p lo y ­ m e n t? A ccording to K ing (1999) th e u n c e rta in effect o f m o n e ta ry p o licy o n real variables - o rig in a te d in tra n sm issio n m e c h a n ism s th a t are n e ith e r su fficien tly w ell u n d e rsto o d n o r sufficiently stable ov er tim e - p u ts a c o n ­ siderable c o n s tra in t o n th e ab ility o f c e n tra l b a n k s to ta rg e t real variables. T his lead s to th e c o n c lu sio n th a t m o n e ta ry po licy sh o u ld focus o n k ee p in g in fla tio n close to its ta rg e 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 e n m o n e ta ry po licy reacts to th e sta te of th e real econom y, e x p e c ta tio n s th a t m o n e ta ry po licy is try in g to e x p lo it th e Phillips cu rv e m a y develop, re d u c in g its cred ib ility a n d its scope to resp o n d . To reco v er credibility, m o n e ta ry p o lic y sh o u ld focus e n tire ly a n d p u b lic ly o n reactin g to in fla tio n , so th a t th e c e n tra l b a n k c a n d evelop a stro n g re p u ta tio n as a n in fla tio n fighter, w h ile fiscal po licy sh o u ld focus o n th e co u n tercy clical job of k ee p in g real GDP close to p o te n tia l GDP. E xperience h a s sh o w n th a t, w ith th e e x c e p tio n o f a u to m a tic fiscal stab il­ izers, im p le m e n ta tio n lags are m u c h sh o rte r for m o n e ta ry p o lic y th a n for fiscal policy, w h ic h p u ts legislated ch a n g es in fiscal po licy a t a d isa d v an tag e as co u n tercy clical tools. T he c e n tra l b a n k c a n m ak e a d ju stm e n ts in in te re st rates relatively q uickly - all th a t is n e e d e d is a b o a rd m e e tin g a n d a vote, a n d th e n to co n v ey th e d ecision to th e tra d in g desk, w h ere th e sh o rt-te rm in te re st rate is ch an g ed . F u rth e rm o re th e use o f tra d itio n a l d isc re tio n a ry fiscal p o lic y c a n m ak e th e jo b of a fully a u to n o m o u s c e n tra l b a n k m o re difficult, b ecau se of th e n e e d to sp e n d tim e forecastin g th e size o f fiscal pro p o sals a n d d e te rm in in g th e p ro b a b ility th a t su ch pro p o sals w ill be passed. T his c a n b e c o u n te re d w ith stro n g day -to -d ay c o o rd in a tio n a n d in fo rm a tio n ex ch an g es b e tw e e n b o th in stitu tio n s. 272 Countercyclical Fiscal Policy O n e w ay of o v erc o m in g th e lack o f tim elin ess a n d p red ic tab ility o f c u rre n t fiscal policy is to give th e g o v e rn m e n t, in c o n s u lta tio n w ith th e ce n tral b an k , th e a u th o rity to raise o r low er th e v alu e-ad d e d ta x (VAT) rates a n d p e n s io n fu n d c o n trib u tio n s, o r to accelerate o r d ecelerate ce rtain p u b lic sp en ding. The role of automatic stabilizers in fiscal policy E co n om ic flu c tu a tio n s h av e a sig n ific an t effect o n p u b lic ac co u n ts. Fiscal a u to m a tic stabilizers are d efin e d as p u b lic ea rn in g s a n d exp en ses th a t are directly lin k ed to th e ec o n o m ic cycle. A utom atic stabilizers are th o se elem en ts o f fiscal p o licy th a t te n d to m itig a te o u tp u t flu c tu a tio n s w ith o u t a n y ex p licit g o v e rn m e n t ac tio n . T hey in c lu d e all c o m p o n e n ts o f th e g o v e rn m e n t b u d g e t th a t act to offset flu c tu a tio n s in effective d e m a n d b y red u c in g tax es a n d in creasin g g o v e rn m e n t s p e n d in g d u rin g a recession, a n d d o in g th e o p p o site d u rin g a n ex p a n sio n a ry cycle. P erhaps th e m o st c o m m o n ly an aly zed a u to ­ m a tic stabilizer is in c o m e tax, w h ic h reduces th e m u ltip lie r effects of d e m a n d shocks th ro u g h th e m a rg in al ta x a tio n o f in c o m e flu ctu atio n s. A progressive in c o m e ta x w ith h ig h m a rg in al rates c a n su b stan tia lly red u ce flu c tu a tio n s in after-tax in c o m e a n d p riv ate sp e n d in g w ith o u t th e n e e d for ex p licit d iscre­ tio n a ry policy changes. M oreover a u to m a tic stabilizers av o id th e im p le m e n ­ ta tio n tim in g p ro b lem s th a t cause d isc re tio n a ry policy to lag b e h in d events. A u to m atic stabilizers m u s t be triggered b y a sh o ck th a t causes e c o n o m ic activ ity to fall o r rise. As argued b y A uerbach a n d Feenberg (2000), th e effectiveness o f a n a u to m a tic stabilizer n o t o n ly d e p e n d s o n h o w m u c h of a c h a n g e in d isposable in c o m e it produces, b u t also o n h o w sig n ifican t th e effect is o n p riv ate c o n s u m p tio n . P otentially, progressive in c o m e taxes, v alu e-ad d ed taxes, taxes o n c o rp o rate pro fits a n d u n e m p lo y m e n t in su ra n c e p re m iu m s a n d b en e fits ca n serve as a u to m a tic stabilizers. O n e of th e m o st fam iliar m easures of th e sen sitiv ity o f tax es to in c o m e ch a n g es is th e elasticity o f aggregate in c o m e taxes w ith resp ect to ch an g es in aggregate in c o m e. T his elasticity serves as a n in d ic a to r o f th e ta x system s o verall progressiveness. For a given level of taxes, th e h ig h e r th e elasticity th e sm aller th e c h a n g e in after-tax in c o m e th a t results fro m a g iv en ch an g e in in c o m e befo re tax. H ow ever, in term s o f m e a su rin g th e ta x sy stem s ro le as a n a u to m a tic stabilizer th e in c o m e elasticity o f tax es h a s a severe s h o rt­ co m ing: it is in v a ria n t w ith respect to w h e th e r th e sh a re o f in c o m e ta k e n as tax es is h ig h o r low. If tax es take a large share o f th e e c o n o m y th e y w ill b e m o re able to act as a n a u to m a tic stabilizer th a n if th e y tak e a sm aller share. Key d e te rm in a n ts o f th e m a g n itu d e of a u to m a tic fiscal stabilizers are th e share of ta x revenues, a n d th e size o f ta x a n d e x p e n d itu re elasticities, w ith resp ect to GDP. For o u tp u t to b e stabilized it is necessary for th e m itig a tin g effect o f taxes d u e to ch an g es in b efo re-tax in c o m e to tra n sla te in to m o re stable h o u s e h o ld Carlos Budnevich 273 c o n s u m p tio n . However, a h ig h rea ctio n of c o n su m p tio n to a sh o rt-term shock to c u rre n t disposable in c o m e requires th e p resen ce o f a liq u id ity c o n s tra in t th a t reduces h o u se h o ld c o n s u m p tio n to b elo w its desired level. A ny c h a n g e in ta x p a y m e n ts m u st tra n sla te in to ch an g es in aggregate d e m a n d if a u to ­ m a tic stabilizers are to succeed. For ex a m p le th e effect o f c o rp o rate in c o m e tax es o n c o n s u m p tio n w ill be te n u o u s if th e o w n ersh ip o f c o rp o rate sto ck is stro n g ly c o n c e n tra te d a m o n g in d iv id u als w h o are u n lik e ly to face liq u id ity co n stra in ts. In th e case o f sta te u n e m p lo y m e n t b en e fit, it is im p o rta n t to n o te th a t th is flu ctu ate s in resp o n se to rises a n d falls in u n e m p lo y m e n t d u rin g th e b u siness cycle. T he re la tio n sh ip b etw e en o u tp u t flu c tu a tio n s a n d ch a n g es in th e level o f u n e m p lo y m e n t b e n e fit d ep e n d s o n th e re la tio n sh ip b e tw e e n o u tp u t a n d u n e m p lo y m e n t, th e e x te n t o f u n e m p lo y m e n t co v ered b y u n e m p lo y m e n t in su ran c e, th e rate o f b en e fits d e m a n d e d b y th o se w h o are eligible, a n d th e fra ctio n o f lo st w ages th a t is replaced b y u n e m p lo y m e n t b en e fit. It is im p o rta n t to create e n o u g h ro o m for a u to m a tic stabilizers to w ork fully d u rin g a recession in o rd er to c o m p le m e n t th e reg u la to ry ro le of m o n e ta ry policy. In L atin A m erica fiscal po licy h as n o t p la y e d a c o u n te r­ cyclical role. D u rin g recessions, fiscal po licy is ty p ically o rie n te d to w ard s k ee p in g fin an c ial solvency u n d e r co n tro l, w h ile d u rin g b o o m s e x p e n d itu re te n d s to e x p a n d w ith th e cycle. It is n ecessary to d esign a n in s titu tio n a l fram ew o rk th a t w ill en su re th e co n siste n cy o f fiscal policy, su ch as stab ilizatio n fu n d s fro m ta x rev en u es.3 S uch m e c h a n ism s ca n w o rk coun tercy clically to allow saving d u rin g b o o m s a n d w ith d raw als for sp e n d in g purp o ses d u rin g crises.4 P ublic sp e n d in g m a n a g e m e n t m u st follow clear, lo n g -te rm su stain a b ility criteria. T h e m a in co u n tercy clical c o m p o n e n ts sh o u ld b e social safety n e t p ro v isio n a n d th e p rese n ce o f a ta x rev e n u e stab ilizatio n fund. Review of concepts and measurement issues in fiscal policy F ollow ing H eller e ta l. (1985), th is se ctio n review s th e ex istin g te c h n iq u e s for assessing th e sta n ce of fiscal policy, w ith th e p u rp o se of ch aracterizin g th e ex p a n sio n a ry o r c o n tra c tio n a ry n a tu re o f c u rre n t fiscal policy. T h e first ap p ro a ch , used b y th e IMF, m easures th e to ta l im p u lse o r in itial stim u lu s to aggregate d e m a n d arising from fiscal policy, w h e th e r d iscretio n ary o r o th erw ise, d u rin g a giv en perio d . C o n c e p tu a lly it id en tifies as a fiscal im p u lse a n y c h a n g e in th e a c tu a l b u d g e t th a t is n o t caused b y th e b u sin ess cycle. T h e idea is to o b ta in a n e w m easu re o f th e b u d g e t in iso latio n from en d o g e n o u s forces th a t arise fro m changes in GDP. T he IMF m easu re cu rren tly m akes n o d istin c tio n b e tw e e n a c h a n g e in aggregate d e m a n d th a t results fro m a d isc re tio n a ry b u d g e t decisio n a n d o n e th a t results fro m a u to m a tic fiscal stabilizers. 274 Countercyclical Fiscal Policy T h e a p p ro a c h starts b y estab lish in g a base year in w h ic h th e ta x rev e n u e to effective o u tp u t ratio, t0, a n d th e p u b lic s p e n d in g to p o te n tia l o u tp u t ratio , g0, c o rre sp o n d to a p e rio d o f m a cro ec o n o m ic stability, in c lu d in g a b a l­ an c e b etw e en p o te n tia l a n d effective GDP. T he cyclically n e u tra l b u d g e t is d eriv ed fro m th e a c tu a l b u d g e t b y assu m in g th a t n o m in a l ta x rev en u es are u n it elastic w ith resp ect to ac tu a l n o m in a l o u tp u t, a n d n o m in a l g o v e rn m e n t ex p e n d itu res are u n it elastic w ith resp ect to p o te n tia l o u tp u t v alu ed a t c u rre n t prices. T his gives a b e n c h m a rk to d e te rm in e w h e th e r fiscal p o licy is procyclical, n e u tra l o r countercyclical. G ro w th in e x p e n d itu re th a t is above, eq u al to o r b elo w p o te n tia l o u tp u t, y p t, g ro w th is resp ectiv ely d efin e d as ex p ansionary, n e u tra l o r c o n tra ctio n ary . Similarly, g ro w th in ta x rev en u es th a t is above, eq u a l to o r b elo w effective o u tp u t, yt, g ro w th is respectively classified as contractionary, n eu tra l o r expansionary, regardless of th e source of th e c h a n g e in rev e n u e (d iscretio n ary ta x increase, progressive ta x stru ctu re). This sim ple IMF a p p ro a c h calculates th e cyclically n e u tra l b u d g e t u n d e r th e a ssu m p tio n o f u n ita ry elasticities of e x p e n d itu re a n d rev e n u e w ith resp ect to p o te n tia l a n d ac tu a l o u tp u t, th e re fo re allo ca tin g th e c o n trib u tio n o f a u to m a tic stabilizers to th e fiscal im pulse. A c h a n g e in p u b lic deficit h as a cyclical ch a racter w h e n it is d u e to th e d ifference b etw e en c u rre n t a n d p o te n tia l GDP. A stru c tu ra l deficit is e q u i­ v a le n t to th e differen ce b e tw e e n th e effective deficit a n d th e cyclical deficit. A n effective deficit in excess o f th e cyclically n e u tra l deficit is d ee m e d ex p an sio n ary , relativ e to th e base-year fiscal stance. T h e effective b u d g e t surplus, B t, c a n b e d ec o m p o se d in to tw o elem en ts: th e cyclically n e u tra l b u d g e t surplus, t0 y t - g 0 y p t, a n d th e fiscal stance, Fist, w h ic h rep rese n t th e d ev iatio n s b e tw e e n th e cyclically n e u tra l b u d g e t su rp lu s a n d th e effective b u d g e t surplus: B t = t0 y t - g0 y p t - Fist (14.1) A ny increase (re d u ctio n ) in th e b u d g e t su rplus abov e th e cyclically n e u tra l b u d g e t leads to a c o n tra c tio n a ry (ex p an sio n ary ) stan ce in fiscal policy. T he fiscal im pulse, FIt, is d e fin e d as th e c h a n g e (first difference) in th e fiscal sta n ce m easure: FIt = Fist - Fis t - ! = d G t - g 0 d yp t - (d T t - t0 d y t) (14.2) T h e fiscal im p u lse in a giv en p erio d reflects th e c h a n g e in th e fiscal stance. T h e fiscal im p u lse a t b e st prov id es a m easure o f th e m a g n itu d e o f th e in itia l stim u lu s to aggregate d e m a n d arising fro m th e n e t ch a n g es o f fiscal p o licy in a given perio d . O n e a d v a n ta g e o f th is a p p ro a c h is th e sim p lic ity o f th e c a lc u la tio n a n d in f o rm a tio n re q u ire m e n ts . To ca lc u late th e fiscal im p u lse , o n e o n ly n e e d s a c tu a l a n d p o te n tia l o u tp u t g ro w th , a set o f b ase-y ear p u b lic e x p e n d itu re a n d p u b lic re v e n u e to o u tp u t ratio s, a n d th e c h a n g e in th e a c tu a l b u d g e t b a la n c e . H o w ev er su c h a m e a su re m a y m iss th e in te n s ity a n d d ire c tio n o f Carlos Budnevich 275 th e effects. In fac t th e e la stic ity o f ta x re v e n u e s w ith re sp e c t to o u tp u t is a n e m p iric a l m a tte r th a t is likely to v a ry w ith th e ra te o f in f la tio n a n d th e effects o f p ro g re ssiv ity a n d a d m in is tra tiv e lags in c o lle c tio n . In p a rtic u la r th e e la stic ity o f VAT d e p e n d s o n th e c o m p o s itio n o f p riv a te c o n s u m p ­ tio n o f d u ra b le a n d n o n -d u ra b le goods, th e e la stic ity o f im p o rts w ith re sp e c t to GDP a n d th e cy clical b e h a v io u r o f ev a sio n . In fact, as d u ra b le c o n s u m p tio n is m o re se n sitiv e to e c o n o m ic a c tiv ity th a n n o n -d u ra b le c o n s u m p tio n , a h ig h e r p r o p o rtio n o f d u rab le s m a y raise th e in c o m e e la stic ity o f VAT. T h e e la stic ity o f g o v e rn m e n t e x p e n d itu re s is also a n e m p iric a l issue. T his a p p ro a c h also suffers fro m th e so-called b a la n c e d b u d g e t m u ltip lie r p ro b lem . T he m easure im p licitly assum es th a t eq u al increases in g o v e rn m e n t s p e n d in g a n d taxes p ro v id e n o a d d itio n a l stim u lu s to aggregate d e m a n d , w h ereas m o st c o n v e n tio n a l m o d els im p ly th a t a c h a n g e in g o v e rn m e n t sp e n d in g h as a larger effect o n in c o m e th a n a n e q u iv a le n t tran sfe r o r ta x ch a n g e. T herefore th is m e th o d m u s t be c o m b in e d w ith a n a p p ro a c h to m easu re e x p e n d itu re o n goods a n d services, tran sfers a n d tax es o n a m o re disaggregated basis to o b ta in a fin d in g o n th e p o te n tia l im p a c t o n aggregate dem and. M oreover, as th is te c h n iq u e calculates th e fiscal im p u lse residually, it w ill in c lu d e th e effects n o t o n ly o f ch an g es in fiscal policy a n d th e su b se q u e n t effects o f a u to m a tic stabilizers, b u t also of stru ctu ra l ch an g es in th e econom y. Finally, th e ca lc u la tio n of th e fiscal stan ce o n ly adjusts th e b u d g e t for d ev i­ atio n s o f o u tp u t fro m its p o te n tia l level - a p ro b lem also e n c o u n te re d w ith o th e r te c h n iq u e s. T h e effects o f prices, in te re st rates (b o th real a n d n o m in a l) a n d th e ex c h an g e rate are ignored. T he OECD provides a n altern ativ e te c h n iq u e th a t h as tw o m a jo r differences fro m th e IMF m easure. First, th e elasticities o f cyclically n e u tra l e x p e n d itu re a n d rev en u e w ith resp ect to real o u tp u t are n o t c o n s tra in e d to u n ity in th e OECD m e th o d . H en ce th e OECDs fiscal im p u lse in d ic a to r is free fro m a u to ­ m a tic stabilizer effects. S econd, th e OECD m e th o d uses ratio s of e x p e n d itu re a n d rev e n u e to p o te n tia l a n d ac tu al o u tp u t, respectively, in th e p rev io u s perio d , n o t b ase-period values. T h e OECD a p p ro a c h has a larger d a ta re q u ire m e n t th a n th e IMFs m e th o d as it in clu d es estim ates of g o v e rn m e n t e x p e n d itu re a n d rev e n u e elasticities. T h e elasticity o f p u b lic e x p e n d itu re is a fu n c tio n of th e m a g n itu d e o f th e subsidies given to th e u n e m p lo y e d . T he relative im p o rta n c e of th e cyclical deficit d e p e n d s o n th e size o f in c o m e elasticity o f ta x rev en u es, th e o u tp u t g ap m e asu red b y th e d ifference b etw e en effective a n d p o te n tia l o u tp u t a n d th e p ro p o rtio n o f ta x reven u es relativ e to th e level of e c o n o m ic activity. A n o th e r m e th o d is th e w eig h ted sta n d ard iz ed su rp lu s m easu re. This p ro v id es a g o o d em p irical e stim a te of fiscal po licy aim ed at m e asu rin g dis­ c re tio n a ry a c tio n b y th e au th o rities. T h e m e th o d w as first d ev elo p ed b y B linder a n d G oldfeld (1976) u sin g US d ata. S im u la tio n te c h n iq u e s are 276 Countercyclical Fiscal Policy em p lo y ed to d ec o m p o se th e b u d g e t in to a u to n o m o u s (exogenous) a n d in d u c e d (endo g en o u s) c o m p o n e n ts . T he fiscal im p u lse is d e fin e d as th e ch a n g e in th e ex o g e n o u s c o m p o n e n t o f th e b u dget. In th e IMFs c u rre n t fiscal im p u lse m e th o d o lo g y th e g ro w th of g o v e rn m e n t e x p e n d itu res o th e r th a n u n e m p lo y m e n t b en efits is reg ard ed as cyclically n e u tra l if it is eq u a l to p o te n tia l o u tp u t g ro w th . U n e m p lo y m e n t b en e fits are ex clu d ed fro m th e base-year e x p e n d itu re ratio a n d fro m a c tu a l e x p e n d itu re in a g iven perio d , im p ly in g th a t a n y ch a n g es in u n e m p lo y m e n t b en e fits are tre a te d as a fully cyclical p h e n o m e n o n . As u n e m p lo y m e n t b en e fits d e p e n d o n th e sta te o f th e eco nom y, th is m e th o d o lo g y im p licitly assu m es th a t eco ­ n o m ic recovery w ill re tu rn th e u n e m p lo y m e n t rate to th e level p rev a ilin g in th e b ase year. It is im p o rta n t to stress th a t, d e p e n d in g o n th e po licy q u e stio n , ce rtain m easures of th e fiscal b u d g e t w ill be m o re ad e q u ate th a n o th ers. If th e policy q u e s tio n ce n tres o n th e sh o rt-te rm fin an c ial pressure cau sed b y th e g o v e rn ­ m e n ts fin a n c in g re q u ire m e n ts, th e n th e re is a stro n g case for a b u d g e t b alan c e m easure th a t accu rately reflects th is pressure. T h e cash b ase b u d g e t d a ta d o m in a te s in th is regard. H ow ever if th e m a in c o n c e rn is to an aly ze th e effects o f g o v e rn m e n t e x p e n d itu re a n d rev e n u e po licy o n aggregate m acroe c o n o m ic variables, su c h as c o n s u m p tio n a n d in v e stm e n t, th e n a stro n g case ca n be m a d e for u sin g n a tio n a l a c c o u n t d a ta w h e n c o n s tru c tin g th e fiscal im pulse, so th a t th e b u d g e ta ry d a ta is m o re sy stem atically rela ted to aggregate d e m a n d . Stabilization funds, public and international finance, fiscal policy and external shocks C o m m o d ity price risk is th e risk th a t c o m m o d ity prices m a y c h a n g e rapidly, su b stan tia lly a n d u n p red ic tab ly . G o v ern m e n ts ty p ically b ea r tw o k in d s of co m m o d ity price risk. First, m a n y g o v e rn m e n ts o b ta in su b sta n tia l rev en u e fro m c o m m o d ity p ro d u c tio n /e x p o rta tio n . Second, m a n y g o v e rn m e n ts try to sm o o th som e d o m e stic c o m m o d ity prices to m itig ate th e social, e c o n o m ic a n d p o litical im p a c t o f large a n d fre q u e n t ch an g es in prices. In th e ab sen ce o f fin a n c in g o p p o rtu n itie s , w h e n p rices go d o w n for a p ro d u ce r o r u p for a con su m er, th e g o v e rn m e n t h as to c u t e x p e n d itu re or raise o th e r rev en u e. This is difficu lt to d o q u ick ly a n d efficiently. In creasin g sp e n d in g w h e n e x p o rt prices rise is easier, b u t it is difficu lt to d o efficiently. R eliance o n c o m m o d ity rev e n u e n o rm a lly leads to s to p -g o fiscal policy. It is also likely to m ak e fiscal po licy procyclical. O th e r p ro b lem s in c lu d e th e d ifficu lty o f p la n n in g , su c h as b asin g a b u d g e t o n c o m m o d ity price as su m p ­ tio n s th a t co u ld tu r n o u t to b e very w rong. D ev eloping c o u n tries ty p ically base th e ir in te rn a tio n a l tra d e o n a few co m m o d ity ex p o rts a n d im p o rts th a t are sub ject to h ig h ly v o la tile m a rk e t prices. A practice th a t h as b e e n ex tensively u se d in th e p ast h as b e e n for Carlos Budnevich 277 g o v e rn m e n ts to estab lish stab ilizatio n fu n d s to red u ce c o m m o d ity price volatility, to m ake prices a n d rev en u es m o re p red ic tab le a n d to keep e x p e n d ­ itu re in lin e w ith p e rm a n e n t in c o m e flows. For c o m m o d ity p ro d u cers, th e fu n d ac cu m u lates resources w h e n th e in te rn a tio n a l sp o t p rice is ab o v e its referen ce price, a n d vice versa. For co m m o d ity consum ers, th e fu n d su b ­ sidizes d o m e stic c o n s u m p tio n w h e n th e sp o t price is ab o v e its reference level, a n d vice versa. R ecen t em pirical w o rk o n c o m m o d ity prices show s th a t m o s t c o m m o d ity prices ev e n tu a lly rev ert to th e ir m e a n - a re q u ire m e n t for a sta b ilizatio n f u n d to b e v iable - b u t o n ly very slowly, w ith th e average reversal tim e b ein g m e asu red in years ra th e r th a n m o n th s . H ence a c o m m o d ity stab ilizatio n fu n d h a s to be very large to be effective. F u rth erm o re, in th e case o f an e x p o rt (im port) sta b ilizatio n fu n d it is stro n g ly re c o m m e n d e d to in itia te it in scen arios o f h ig h (low) prices ra th e r th a n lo n g -te rm o r tre n d prices, so th a t th e fu n d ca n fin a n c e su b se q u e n t n eg a tiv e price situ a tio n s.5 M a n y co u n tries h av e a b a n d o n e d th e se fu n d s as g o v e rn m e n t in te rv e n tio n to stabilize c o m m o d ity prices a n d red u c e u n c e rta in ty h a s o fte n p ro v ed in effectiv e a n d costly. N o n eth e le ss th e re are so m e successful cases, su c h as th e c o m m o d ity sta b ilizatio n fu n d s in C hile (copper) a n d C o lo m b ia (coffee), w h ic h are aim ed a t stab ilizin g co m m o d ity -rela ted g o v e rn m e n t rev en u es in ste a d o f prices. W h e n g o v e rn m e n ts collect co m m o d ity -rela ted revenues, th ese fu n d s are app ro p riate m echanism s for separating th e term s o f trad e cycle fro m th e fiscal cycle. T hey are characterized b y th re e elem en ts: (1) a reference p rice for raw m aterial, d e te rm in e d in th e b u d g e t fo rm u la tio n a n d , b ased o n conservative, m ed iu m -term projections; (2) a fu n d th a t accu m u lates resources d u rin g b o o m s a n d p ays o u t d u rin g adverse periods; a n d (3) o p e ra tin g m les th a t estab lish a re la tio n b e tw e e n price flu c tu a tio n s a n d c o n trib u tio n s to or w ith d raw a ls fro m th e fund. In stea d o f se ttin g u p a sta b ilizatio n fu n d , g o v e rn m e n ts c a n b o rro w o r ru n d o w n assets w h e n th e in te rn a tio n a l price goes a g a in st th e m . T h e p ro b le m is th a t w h e n th e c o u n try m o st needs fu n d in g it is less likely to b e able to o b ta in it. Also, m a n y c o u n tries d o n o t h av e sig n ifican t fo reign assets to disp o se of. F u rth e rm o re it is p o litica lly difficult to g en e rate a sufficien t su rp lu s to rep ay th e d e b t w h e n th e s itu a tio n is reversed, le ad in g to solven cy p ro b lem s. To h e d g e ag ain st c o m m o d ity price volatility, policy m akers c a n co n sid er th e use o f c o m m o d ity derivatives. T his has several ad van tag es: c o m m o d ity d erivatives red u ce u n c e rta in ty a b o u t fu tu re revenues, th e y rely o n m a rk e t prices ra th e r th a n a d m in istra tiv e prices, th e y sh ift th e risk o u tsid e th e c o u n try a n d th e y red u ce th e cost o f c o m m o d ity fin an c in g , th u s in c reasin g th e cre d itw o rth in ess of th e c o m m o d ity producer. H ow ever a d isa d v an tag e is th a t th e y w ill n o t p re v e n t a p e rsiste n t d e te rio ra tio n o f or su d d e n spikes in c o m m o d ity prices.6 T h ey ty p ically m itig ate th e sh o rt-te rm effects o n o u tp u t o f adverse price m o v e m e n ts,7 b u t as th e y co n c e n tra te o n th e sh o rt-te rm th e y are u n a b le to m a tc h th e lo n g p ro d u c tio n h o riz o n o f som e co m m o d ities. 278 Countercyclical Fiscal Policy In theory, if p rice shocks are o f a p e rm a n e n t n a tu re it is b e b e tte r to ad ju st ra th e r th a n to use co m p e n sa to ry fin an c in g . H ow ever th e q u e s tio n is h o w q u ickly to ad ju st to th e n e w price c o n d itio n s in o rd er to m in im iz e d o m e stic a d ju stm e n t costs w ith a n in c o m p le te derivatives m ark et. Let us p ro v id e a fo rm a l fram ew ork to analyze a price sta b ilizatio n sch em e for c o n s u m p tio n p u rp o ses.8 Suppose th e g o v e rn m e n t w ishes to m in im iz e th e cost o f exp ected , E , q u a d ra tic d ev iatio n s o f th e d o m e stic p rice fro m th e in te rn a tio n a l price, ( p t - p * ) 2 9 T h e g o v e rn m e n t is ag ain st th e q u ick a d ju stm e n t of dom estic prices over tim e ( p t - p t - i ) 2, so it n egatively w eights q u a d ra tic d e v iatio n s o f th e c u rre n t d o m e stic prices fro m p ast d o m e stic prices. As is w ell d o c u m e n te d in th e literatu re , if in te rn a tio n a l prices follow a ra n d o m w alk process, a sta b ilizatio n sch em e w ill b e n e ith e r feasible n o r su stain ab le w ith o u t ex p licit fiscal su p p o rt.10 If th e g o v e rn m e n t is c o n c e rn e d a b o u t a d ju s tm e n t costs, th e re is a sm o o th in g role for prices ev en if th e sh o ck is o f a p e rm a n e n t n a tu re . If th e g o v e rn m e n t does a tta c h a n eg a tiv e w eig h t to th e quick a d ju s tm e n t o f d o m e stic prices it is b e tte r to in tro d u c e a fo rm al sta b ilizatio n sch em e, su ch as a form al price b a n d w ith rules ra th e r th a n a n im p licit b a n d w ith n o rules. T h e g o v e rn m e n ts o p tim iz a tio n p ro b lem is to m in im iz e th e fo llo w in g cost fu n ctio n : M in a E (p t - p * ) 2 + b E (p t - p t-\)2 (14.3) su b ject to th e ra n d o m w alk process follow ed b y in te rn a tio n a l prices: P t* = p t - 1* + th (14.4) T h e o p tim a l sta b ilizatio n po licy w ill lead to th e s m o o th in g o f in te rn a l prices b ased o n th e fo llo w in g rule: p t = b /(b + a)pt - i + a /{b + a)pf_!* (14.5) In tu itiv ely , th e h ig h e r th e co st a tta c h e d to th e a d ju s tm e n t o f d o m e stic prices over tim e (b ) a n d th e low er th e w e ig h t giv en to d e v ia tio n s o f th e local price w ith resp e ct to in te rn a tio n a l prices (a), th e m o re g rad u a l th e o p tim a l process o f a d ju stm e n t for in te rn a l prices w ill b e to n ew in te rn a tio n a l c o n d itio n s. D u ring e x tern al bo o m s, m o n e ta ry sterilizatio n m u s t be p erfo rm ed th ro u g h th e g en eratio n o f a fiscal surplus. In th e presence of a c o m m o d ity stab ilizatio n fu n d , a h ig h e r (low er) c o m m o d ity e x p o rt price is a u to m a tic a lly tra n sfo rm e d in to a h ig h e r (low er) fiscal su rp lu s b y th e rules of a c c u m u la tio n (d ep letio n ) o f th e fu n d . U n d er su c h c o n d itio n s th e a d ju stm e n t effo rt does n o t rely o n h ig h e r ta x a tio n or low er p u b lic ex p e n d itu re. If th e o w n e rsh ip o f a co m m o d ity e x p o rt is p u b lic (foreign), th e n a stab il­ iz atio n fu n d (FDI fin an cin g ) w ill stabilize th e ec o n o m y th ro u g h a n ad e q u ate response b y p u b lic savings (profit repatriation). In th e case o f m in in g , projects ty p ically m a tu re in several years. T he associated d e b t for p ro jec t fin an c e has Carlos Budnevich 279 to p ay in te re st periodically, w h ile a m o rtiz a tio n ty p ically tak es place after c o n s tru c tin g th e p la n t. If th e re is a n excess o f cash flow g en e ratio n , th e last in s ta lm e n t of th e lo a n is p rep aid , w h ile th e o p p o site occurs u n d e r a d efic it.11 To d eal w ith shocks th a t trigger e x tern al crises, c o n tin g e n t p olicies b ased o n sim ple, easily verifiable rules, a n d a fu n c tio n o f variables n o t d irectly c o n tro lle d b y th e a u th o ritie s c a n be o f h e lp .12 T he first step is to id e n tify a sm all set of shocks th a t c a p tu re a large share o f trig g erin g factors. For ex a m p le p o sitiv e in d e x a tio n to th e term s o f tra d e a n d in v erse in d e x a tio n to a n in d ic a to r o f tig h tn e ss in in te rn a tio n a l fin an c ial m ark ets su ch as th e EMBI sp read w o u ld p ro b ab ly suffice as in d e x a tio n m e c h a n ism s for in te re st p a y m e n ts o n p u b lic a n d e x tern al d eb t, o r for p u b lic ex p en ses th a t are less co stly a n d in effic ien t to stop. In d e x a tio n to th e price o f a c o m m o d ity avoids m a n ip u la tio n a n d m o ral h az ard prob lem s, d u e to its ex o g en o u s n atu re . Several firm s h av e e x p e rim e n te d w ith c o m m o d ity -in d e x e d b o n d s, b u t m o st seem to h ed g e c o m m o d ity price v o la tility u sin g th e o p tio n s m arkets. W ith respect to c o n tin g e n t p u b lic d e b t m a n a g e m e n t, p riv ate secto r in v e s tm e n t w ith p u b lic sector in su ra n c e rep rese n ts a strictly procyclical fiscal policy, as g u ara n tee s are freely given d u rin g bo o m s, w h e n th e p riv ate sector invests, a n d fall d u e d u rin g d o w n tu rn s. T he general policy p resc rip tio n w o u ld in ste a d suggest e stab lish in g a n explicit p u b lic secto r fu n d fin an c ed b y a n in su ra n c e p re m iu m ch arg ed to th e p riv ate sector, w h ic h is essen tial in co u n tercy clical policies today. It is im p o rta n t to recognize th a t u n e m p lo y ­ m e n t in su ran c e, p u b lic w orks guaran tees, d ep o sit in su ra n c e a n d m in im u m p e n s io n g u ara n tee s s h o u ld be explicit, lim ite d a n d fin a n c e d b y tax es or p re m iu m charges. E x a n te fu n d in g has a relative a d v a n ta g e a n d ex p o s t fin a n c in g a relative d isa d v an tag e in s m o o th in g cash flow s alo n g th e p a th to im p ro v e d stab iliza­ tio n . Flat rate p re m iu m s are m o re a p p ro p ria te th a n risk a d ju ste d p re m iu m s for s m o o th in g a n d stabilizing in th e course o f th e cycle, as risk te n d s to b e low d u rin g b o o m s a n d h ig h d u rin g d o w n tu rn s. In a sm all o p e n e c o n o m y fiscal policy h as to p lay a co u n tercy clical role w h e n e x tern al shocks occur. W h e n ca p ita l inflow s are a p riv ate sector p h e n o m e n o n th e fiscal ac c o u n ts m a y n o t be s tre n g th e n e d e n o u g h , th u s re q u irin g a n in c re a se in ta x e s o r a r e d u c tio n in p u b lic e x p e n d itu re . In c o m b in a tio n w ith tig h t m o n e ta ry po licy a n d restrictiv e fiscal policy, m easu res d ev o ted to lim itin g ca p ita l surges m a y b e co n sid ered . W h e n th e a c c u m u la tio n o f in te rn a tio n a l reserves is a ttrib u ta b le to a n e x p o rt b o o m , it is d ifficu lt to q u e s tio n th a t th e h ig h e r g e n e ra tio n of sav in g sh o u ld b e a n effo rt m a d e b y th e sector th a t d irectly b en e fits fro m it. If th e e x tern al surplus h as its o rig in in th e p riv ate sector, it is m o re d ifficu lt to d istrib u te th e savings e q u itab ly .13 T h e use o f a te m p o ra ry restrictive fiscal po licy m a y b e o f h elp w h e n th e re are surges in ca p ita l inflow s. A lth o u g h su ch a policy w o u ld n o t sto p th e inflow s, it co u ld c o n ta in th e in fla tio n a ry im p a c t a n d red u ce aggregate 280 Countercyclical Fiscal Policy d e m a n d .14 As th e n e e d to issue p u b lic d e b t is reduced , it is also possible th a t a restrictive p o lic y m a y h e lp to low er d o m e stic in te re st rates. If ta x ch an g es are tra n sito ry a n d th e re are b o rro w in g co n stra in ts, a n in c re ase in tax es m a y b e effective in c o n tro llin g ab so rp tio n . As c o rp o rate taxes, progressive in c o m e taxes, v alu e ad d e d tax es a n d cu sto m s d u ty revenues n o rm ally have a n o u tp u t elasticity of greater th a n one, stro n g cap ital inflow s w ill h e lp fin an c e g ro w th in a b s o rp tio n ab o v e GDP, le ad in g to a n increase in ta x collection. F ollow ing a stru ctu ra l su rp lu s rule, th e g o v e rn m e n t s h o u ld save m o re a n d o b ta in a h ig h e r effective su rp lu s.15 H ow ever w o u ld th a t be en o u g h ? P robably n o t. T herefo re in a d d itio n to th e a u to m a tic stabilizers, policy m akers m ig h t con sid er m easu res to increase VAT, p ay ro ll taxes o r c o n trib u tio n s to th e p e n s io n fu n d o r th e u n e m p lo y m e n t in su ran c e fu n d . T his w o u ld b e tte r d istrib u te th e b u rd e n o f m o n e ta ry a n d fiscal po licy to c o n ta in ab so rp tio n . If stro n g ca p ita l inflow s g en e rate a n ab so rp tio n th a t exceeds p o te n tia l GDP, a c o n tra c tio n a ry d e m a n d policy w ill be requ ired . If th e c e n tra l b a n k ap p lies a restrictive m o n e ta ry policy, th e n quasifiscal losses a n d fu rth e r ca p ita l inflow s w ill ta k e place. To av o id su ch a v iciou s circle, it m a y b e m o re d esirable to ap p ly a c o n tra c tio n a ry fiscal policy. C onversely, w h e n m assive ca p ita l outflow s take place a n d th e e c o n o m y is o v erh e ate d , b o th c o n tra c ­ tio n a ry fiscal a n d m o n e ta ry policies m a y b e need ed . Public sector and the level of activity: theory and empirical evidence U n d er K eynesian u n e m p lo y m e n t a n d th e n ee d to red u ce th e fiscal deficit a n d p u b lic debt, fiscal a d ju s tm e n t m easures w ill depress th e eco n o m y . A p u b lic d eficit u n d e r th e se c o n d itio n s ex p a n d s th e level o f activity. U n d e r th e n eo c la ssic al full e m p lo y m e n t m o d e l, th e re p e rc u ssio n s o f fis­ cal p o lic y d e p e n d o n th e n a tu re o f th e fiscal a d ju s tm e n t. Tax in c re ase s t h a t le ad to d is to rtio n s in m a rk e t prices o r a n in c re a se in c u r r e n t e x p e n ­ d itu re s th a t are e x p e c te d to b e fin a n c e d b y fu tu re ta x e s w ill h a v e a c o n ­ tra c tio n a ry effect o n th e lev el o f e c o n o m ic activ ity . R e d u c tio n s in b o th e x p e n d itu re a n d ta x te n d to in c re ase th e level o f e c o n o m ic ac tiv ity . A c re d ib le c u t in e x p e n d itu re w ill p r o m p t e x p e c ta tio n s o f re d u c e d taxes, p ro d u c in g p o sitiv e su p p ly -sid e effects th a t w ill in c re a se G D P in th e s h o r t­ te rm . S u pply-side m o d e ls a ssu m e th a t fiscal a d ju s tm e n t is e x p a n s io n a ry if it is b ased o n e x p e n d itu re re d u c tio n s, b u t c o n tra c tio n a r y if ta x e s are ra is e d .16 O th e r m o d els describe m a c ro e c o n o m ic b e h a v io u r ac co rd in g to th e level o f p u b lic debt. W h e n th e stock o f pu b lic d e b t ap p ro a ch es d efa u lt level, a n in crease in th e deficit sig n ifican tly raises th e p ro b a b ility o f in so lv en c y a n d o f h ig h e r in te rest rates, lead in g to reduced dom estic activ ity .17 Carìos Budnevich 281 In th e L atin A m erican c o n te x t, G avin e t al. (1996) h av e fo u n d th a t th e v o la tility o f m a c ro e c o n o m ic o u tc o m es is greatly a u g m e n te d b y th e h ig h ly procyclical fiscal responses in th e region. Procyclical fiscal resp o n ses are m o st p ro n o u n c e d d u rin g recessions a n d th e y stem fro m th e fact th a t access to in te rn a tio n a l ca p ita l m arkets o fte n v an ish es in th e face o f adverse shocks, forcing a fiscal c o n tra c tio n in a n alread y w eak en ed econ o m y . T h u s p o licy m u s t b e c o n c e rn e d w ith e n s u rin g fiscal su sta in a b ility a n d solvency. B ut th e w eak re la tio n sh ip w ith in te rn a tio n a l cap ital m ark ets is d u e to th e v o la tility o f th e m a c ro e c o n o m ic e n v iro n m e n t in L atin A m erica, a n d creates th e n ee d for large fiscal a d ju stm e n ts th a t ca n b e p o litica lly unfeasib le, th u s red u c in g cre d itw o rth in ess a n d p ro m p tin g in v esto rs to exit fro m th e reg io n a t th e first sign o f tro u b le .18 A ccording to G avin e t al., deficits in L atin A m erica vis-à-vis th e d o m e stic fin a n c ia l system (or taxes) are th re e tim es larger th a n in th e OECD c o u n ­ tries. F u rth e rm o re th e ta x base in L atin A m erica is h ig h ly v o latile a n d procyclical. L atin A m erica relies exten siv ely o n n o n -ta x , in d ire c t ta x a tio n a n d tra d e taxes. W ith regard to sp e n d in g p a tte rn s, G avin e t al. n o te th a t L atin A m erica sp en d s a h ig h e r p ro p o rtio n o n in te re st p a y m en ts, cap ital e x p e n d itu re a n d wages, a n d less o n n o n -in te re st tran sfers th a n d o OECD co u n tries. M oreover L atin A m erica ex h ib its less flexibility in tim es o f crisis as in te re st p a y m e n ts o n d e b t te n d to increase. F u rth e rm o re L atin A m erica pays h ig h e r a n d m o re variab le c o u n try risk p re m iu m s th a n th e OECD co u n tries. T h e ratio of fiscal deficit to GDP in L atin A m erica is tw ice as v o la tile as in th e OECD c o u n tries (ibid.) Fiscal deficit w ith respect to th e fin an c ial system is five to te n tim es m o re v o latile th a n in th e OECD. W h e n GDP increases, th e su rp lu s in OECD c o u n tries increases, b u t in th e L atin A m erican reg io n th e y te n d to re m a in stable o r fall. Tax rev en u es are also m o re sensitive in L atin A m erica th a n in th e OECD. T his im p lies th a t p u b lic sp e n d in g in L atin A m erica is h ig h ly procyclical a n d fiscal o u tc o m es are p articu la rly c o n tra c tio n a ry d u rin g recessions. In te rn a tio n a l ca p ita l flow s to L atin A m erica o fte n d isa p p ea r ju st w h e n th e y are n e e d e d to fin an c e a co u n tercy clical fiscal policy. G iv en th e reg io n s precario u s access to in te rn a tio n a l fin an c ial m arkets, procy clical fiscal m e as­ ures are th e best to o ls available to th e fiscal au th o rities. P recarious cre d it­ w o rth in e s s is ro o te d in w eak fiscal s tru c tu re s in a v o la tile m a c ro e n v iro n m e n t. Talvi a n d V egh (2000) p ro v id e a p o litical e x p la n a tio n o f th e p u zzlin g b e h a v io u r o f fiscal po licy in d ev e lo p in g co u n tries. S tartin g fro m th e o b se rv a tio n th a t flu c tu a tio n s in th e ta x base are m u c h larger in d ev elo p in g co u n tries th a n in th e G 7 co u n tries, full ta x s m o o th in g w o u ld im p ly r u n n in g large b u d g e ta ry surpluses in g o o d tim es a n d large b u d g e ta ry deficits in b a d tim es. H ow ever, d u e to p o litical co n stra in ts it m a y b e im p o ssib le to ru n large b u d g e ta ry surpluses w h e n tim es are good. If a g o v e rn m e n t is u n a b le 282 Countercyclical Fiscal Policy to g en e rate large e n o u g h surpluses d u rin g ex p a n sio n s it is fo rced to b o rro w less d u rin g recessions in o rd er to satisfy th e solvency co n stra in t. T h e p a tte rn o f procyclical fiscal deficits in L atin A m erica h as b e e n in te r ­ p re te d as arising fro m su b o p tim a l policies, a n d p ro b ab ly fro m th e fin an c ial co n stra in ts faced b y th e g o v e rn m e n ts co n c ern ed . H ow ever ac co rd in g to C aballero (2000, 2001), w h e n e x te rn a l fin an c ial shocks are a n im p o rta n t cause o f flu ctu atio n s , th e e c o n o m ic au th o ritie s sh o u ld o p tim a lly d istrib u te th e ir scarce in te rn a tio n a l resources a m o n g d o m e stic ag en ts in o rd er to sm o o th th e differences in fin an c ial distress. A lth o u g h in prin cip le it m a y b e possible to follow a countercyclical ta x a tio n a n d /o r fiscal sp e n d in g p o lic y th a t co u ld co m p letely elim in a te th e v arian ce in GDP grow th, th e p o ssib ility o f ac h ie v in g su c h a degree o f flex ib ility seem s u n realistic. T ax -sm o o th in g co n sid eratio n s, th e difficu lty o f a d ju stin g a n d co n tro llin g w ages, th e n e e d to m ake ex p e n d itu re s req u ired b y law a n d th e tim e n e e d e d to b u ild p u b lic w orks m a y red u ce th e a u th o ritie s a b ility to exercise th e req u ired degree o f flexibility for cou n tercy clical p u rp o ses. A sto p -g o process in in v e s tm e n t is likely to g en e rate w aste, a n d th e re fo re a m o re stable s p e n d in g p a tte rn m ay im p ro v e m atters. The experience of Chile T h e role play ed b y fiscal po licy in C hile h as b e e n ex ten siv ely an a ly zed a n d d eb ated . Its in te rp re ta tio n is n o t easy, since a lth o u g h a n average su rp lu s of 1.9 p e r c e n t o f GDP w as m a in ta in e d in 1990-97 , p u b lic s p e n d in g grew stro n g ly a t 6.5 p e r ce n t. Increased p u b lic sp e n d in g o n h e a lth , e d u c a tio n a n d o th e r social p ro v isio n s w as fin a n c e d th ro u g h in creased tax es a n d rev en u es lin k ed to th e c o u n try s stro n g ec o n o m ic grow th, a n d c o n trib u te d to a fu rth e r e x p a n sio n o f aggregate d em an d . T h e key d e v e lo p m e n ts in C h iles fiscal p o lic y in th e p a s t 15 years h a v e b e e n th e m a in te n a n c e o f a fiscal su rp lu s b e tw e e n 1985 a n d 1998, a n d th e c re a tio n o f a co p p e r sta b iliz a tio n fu n d in 1985 a n d a p e tro le u m sta b iliz a tio n fu n d in 1991. T h e p u rp o se o f th e co p p e r sta b iliz a tio n fu n d is to stabilize p u b lic e x p e n d itu re , w h ile th e p e tro le u m f u n d is in te n d e d to s m o o th th e v o la tility o f in te r n a tio n a l prices o n th e a d ju s tm e n t p a th o f d o m e stic oil prices. In th e case o f th e co p p e r sta b iliz a tio n fu n d , a t th e b e g in n in g o f ea c h y ea r th e b u d g e t office sets a referen c e p rice, a n d w ith ­ draw als a n d d e p o sits are m a d e q u a rte rly as a step f u n c tio n o f a c tu a l a n d referen ce prices. T h e fin a n c e m in is te r decid es th e a m o u n t a n d th e tim in g o f w ith d ra w a ls fo r tw o precise p u rp o ses: to c o m p le m e n t in c o m e w h e n th e effective p rice is sig n ific a n tly b elo w th e b u d g e t p ro je c tio n s, o r to p rep a y d e b t d u rin g b o o m s. C h ile has also e x h ib ite d p a rtia l flexibility in resp ect o f VAT in th e rec en t p ast, as in 1996 th e g o v e rn m e n t w as allow ed b y law to set th e VAT rate Carlos Budnevich 283 b e tw e e n 16 p er c e n t a n d 18 p er ce n t. In th e e v e n t th e au th o ritie s d ecid ed to in crease VAT fro m 17 p e r c e n t to 18 per c e n t to h e lp fin a n c e th e e d u c a tio n refo rm s.19 Ffrench-D avis a n d Tapia (2001) argue th a t fiscal po licy in th e p erio d 1 9 9 0-95 w as very p ru d e n t. T he increases in social ex p e n d itu re w ere fin an ced w ith n ew ta x reven u es a n d fiscal po licy strictly follow ed th e a c c u m u la tio n or d e p le tio n rules o f th e co p p e r sta b ilizatio n fu n d . W ith regard to fiscal resp o n sib ility for th e excess aggregate d e m a n d th a t to o k p lace in 1996-97, fiscal e x p e n d itu re (7.9 p e r cent) rose m o re th a n GDP g ro w th (7.4 p e r cent). H ow ever th e fiscal sector in C h ile o n ly a c c o u n te d for 20 p er c e n t of th e e c o n o m y a n d th e re fo re th e m a in im p u lse for aggregate d e m a n d g ro w th (8.5 p er cent) m u st h av e co m e fro m th e p riv ate sector. T he ev e n tu a l fiscal c o n trib u tio n w as clearly in su fficien t. T he fiscal b u d g e t was sh o w in g a surplus a n d th e g o v e rn m e n t n o t o n ly rejected n e w lo a n s fro m th e W orld B ank a n d th e IDB b u t also p re p a id d eb t. T he effective fiscal surplus w as e v e n h ig h e r as th e co p p e r sta b ilizatio n fu n d w as a c c u m u la tin g resources a t th e tim e. In 1999 C hile ra n a fiscal deficit for th e first tim e since 1985. At th e e n d of 1999 th e c o u n try s m a c ro e c o n o m ic policies sh ifte d to w ard s m o re rules a n d a less d isc re tio n a ry fram ew ork, w ith m o n e ta ry p o lic y follo w in g a n in fla tio n ta rg e t ap p ro a ch . T he g o v e rn m e n t th a t to o k p o w er in M arch 2 0 0 0 p ro p o sed to recover th e fiscal surplus b y estab lish in g a stru c tu ra l b u d g e t su rp lu s rule o f 1 p er ce n t, sta rtin g in 2001. T h e fiscal policy rule allow s th e o p e ra tio n o f a u to m a tic stabilizers in th e b u d g e t a n d avoids th e n e e d for fin e -tu n in g ac co rd in g to th e p h a se o f th e ec o n o m ic cycle, leav in g th is role to m o n e ta ry policy. W h ile so m e e x p e n d ­ itu re s a n d rev en u es d e p e n d o n th e e v o lu tio n o f th e econ o m y , a n im p o rta n t p ro p o rtio n o f expenses a n d rev en u es are n o t flexible becau se th e y rep rese n t legal c o m m itm e n ts. T h e n e w m e th o d o f p re p a rin g th e b u d g e t in C h ile delivers in d ic ato rs for id e n tify in g th e sta n ce o f fiscal policy, avoids a procyclical bias in p u b lic fin an ce, allow s e v a lu a tio n o f th e m a c ro e c o n o m ic im p a c t o f fiscal policy, en su res th e sta b ility a n d c o n tin u ity o f fiscal policy a n d rein fo rces fiscal d iscip lin e. In th e c o n s tru c tio n o f th e stru c tu ra l b alan c e in d ic ato r, th e g o v e rn m e n t h as co n sid ered th e existen ce o f a stro n g rev e n u e c o m p o n e n t o rig in a tin g in th e p ro d u c tio n o f co p p e r t h a t ex h ib its m e a n rev ersio n in its p rice b eh av io u r. T he stru ctu ra l b a lan c e excludes th e cyclical effect o f GDP (th e g ap b etw e en effective a n d p o te n tia l o u tp u t) a n d ra n d o m effects o f th e p rice o f copper. T h e stru c tu ra l b u d g e t is n o t o n ly e x p lain e d b y a u to n o m o u s d ecisio n s o f th e g o v e rn m e n t (discretion) b u t also reflects flu c tu a tio n s in th e fiscal b a lan c e th a t are d u e to factors o th e r th a n th e busin ess cycle. Taxes a n d co p p e r reven u es are believed to b e cyclical; s p e n d in g is assu m ed to b e n o n -cyclical. T h e m e th o d o lo g y a d o p te d b y C hile for d e fin in g th e 284 Countercyclical Fiscal Policy stru ctu ra l b u d g e t su rp lu s follow s th e OECD m e th o d , allo w in g for a ta x rev e n u e elasticity w ith resp e ct to GDP th a t is d iffe ren t fro m u n ity : In T pt - In T pt _j = 1,05 * (In Ypt - In Ypt _ i) ( p e rm a n e n t ta x rev e n u e increases) (14.6) In T t - In Tt _j = 1,05 * (In Y t - In y t _j) (cu rre n t ta x rev e n u e increases) (14.7) In R cut = In P cut + In Q cut (cu rre n t revenues fro m In R Scut = In P cupt + In Q cut (tre n d rev en u es fro m copper) (14.8) co p p er) (14.9) T here is a clear sep aratio n b etw een th e structural c o m p o n e n t a n d th e cyclical c o m p o n e n t o f th e effective b a lan c e th a t allow s th e o p e ra tio n o f a u to m a tic b u d g e ta ry stabilizers.20 S tructural surpluses allow tra n s ito ry fiscal deficits u p to th e d esired levels a n d av o id th e in e ffic ien t c o n tra c tio n o f sp e n d in g d u rin g recessions. T h ey also av o id th e o v e re x p a n sio n of e x p e n d itu re s u sin g tra n sito ry w in d fall fiscal revenues. This policy p ro m o te s saving, enables th e fin an c in g o f c o n tin g e n t liabilities, co m p en sa tes th e c e n tra l b a n k deficit a n d saves fin an c ial resources for fu tu re g en eratio n s w h o w ill n o t b e n e fit directly fro m n o n -re n ew ab le resources such as copper. T he n e w p o lic y fram ew ork b rin g s to g e th e r g reater resp o n sib ility a n d tra n sp a re n c y in th e a d m in istra tio n o f p u b lic resources. T otal C h ile a n p u b lic d e b t is relatively sm all, re a c h in g 14.2 p er c e n t of GDP in 2000. C o n tin g e n t liabilities d o n o t co m p ro m ise th e fiscal b a lan c e in th e sh o rt te rm , a lth o u g h th e y m a y d o so in th e m e d iu m term . C o n tin g e n t liabilities lin k e d to m in im u m p e n sio n s are estim a ted a t US$7.2 b illio n ,21 a n d th e C h ile a n g o v e rn m e n t pro p o ses to p u t fiscal surpluses in to a fu n d to fin an c e fu tu re social secu rity e x p e n d itu re. Fiscal policy proposals As n o te d b y M assad (1998), w ith in creasin g ca p ita l m o b ility a h ig h e r degree o f flexibility in fiscal policy is req u ired to keep p u b lic savings h ig h in periods o f stro n g ca p ita l inflow s. To reduce th e procyclical b e h a v io u r of C hiles GDP, B u d n ev ich a n d Le Fort (1997) suggest lim itin g th e g ro w th o f p u b lic a b s o rp tio n (th e rele v an t m a c ro e c o n o m ic in d ic ato r) to p o te n tia l o u tp u t g ro w th .22 T h ey p o in t to th e n e e d for escape clauses, a n d co n sid er it desirable to allow so m e flex ib ility in resp ect of p u b lic in v e stm e n t a n d em erg en cy situ atio n s. In th e area o f ta x flexibility, B udnevich a n d Le Fort arg u e th a t VAT m a y be a useful to o l because of its b ro a d base, h ig h revenue response, low er efficiency costs a n d red istrib u tiv e character. It h as several o th e r ad v an tag es, su ch as its a b ility to h e lp stabilize c o n s u m p tio n , its q u ic k co llec tio n resp o n se a n d th e sim p licity o f its a d m in istra tio n . VAT ch an g es o p era te th ro u g h ad ju stm e n ts Carlos Budnevich 285 to d isp o sable in c o m e as w ell as to relative prices. A m o n g th e costs o f VAT flex ib ility are a n increased m e n u of costs a n d g reater sh o rt-te rm in fla tio n in stab ility, w h ic h te n d to lim it th e p o te n tia l use o f su ch a m e c h a n ism .23 A n a d d itio n a l cost of u sin g taxes as countercy clical devices is th e u n c e r­ ta in ty th e y g enerate. B u d n ev ich a n d Le F ort also argue th a t it m a y b e usefu l to c o m p le m e n t VAT flex ibility w ith so m e in c o m e ta x flexibility.24 M oreover, g iv en th a t th e p ro fit b ase h as a m u c h h ig h e r cyclical flu c tu a tio n th a n GDP, a n d g iv en th e progressive stru c tu re o f p erso n a l in c o m e tax, b o th c o rp o rate a n d p erso n al in c o m e ta x c o n s titu te a u to m a tic stabilizers. T he creatio n o f a stab ilizatio n fu n d w o u ld co m p le m e n t th e co u ntercyclical fiscal p o licy p ro p o sal, for th e p u rp o se o f m o n ito rin g a n d a c c u m u la tin g th e co u n tercy clical responses o f fiscal policy. T he fu n d s h o u ld accu m u late (pay o u t) resources w h e n a d d itio n a l (low er) rev en u es are o b ta in e d becau se o f increases (reductions) in th e VAT rate w ith respect to its lo n g -te rm level. To en su re th e tra n sito ry n a tu re o f su c h a policy, B u d n ev ich a n d Le Fort p ro p o se floor a n d ceiling levels for th e sta b ilizatio n fu n d o f 0 p er c e n t a n d 8 p er c e n t o f GDP. If o n e of th e se lim its w ere to b e h it, a m e c h a n is m s h o u ld b e ac tiv a te d to in crease or red u ce taxes, as applicable. In th e L atin A m erican co n te x t, G av in e t al. (1996) suggest th a t th e fiscal b u d g e t sh o u ld be c o n siste n t w ith a grad u al m o v e m e n t to w ard s th e desired d e b t levels in th e m e d iu m term . T his m e an s th a t fiscal surpluses s h o u ld be ac c u m u la te d a n d n e t p u b lic d e b t red u ced d u rin g e c o n o m ic b o o m s, a n d th a t th e fiscal b alan ce sh o u ld be allow ed to m o v e in to deficit d u rin g co n tra ctio n s. T h e a u th o rs n o te th a t it is h a rd to reverse p u b lic sp e n d in g c o m m itm e n ts a n d to c h a n g e ta x rates in resp o n se to ch an g es in lo n g -te rm fu n d a m e n ta ls. Fiscal d eficit a n d d e b t sh o u ld ad ju st in resp o n se to tra n sito ry shocks. T h ey p ro p o se as an o p e ra tio n a l fiscal ta rg e t a cyclically a d ju ste d fiscal deficit, ta k in g in to a c c o u n t differences b etw e en c u rre n t a n d fu tu re ex p e ctatio n s of th e level o f o u tp u t, th e level of d o m e stic ab so rp tio n , th e te rm s o f tra d e a n d th e real ex c h an g e rate. M ean w h ile th e Business C o u n c il o f A ustralia (1999) h a s ex p lo re d th e p o ssib ility of re-en g in eerin g A ustralian in stitu tio n s to increase th e tim elin ess a n d effectiveness o f fiscal policy. W h e n th e re is a sh a rp a n d serious d e te rio ­ ra tio n in n a tio n a l in co m e, for ex a m p le as a resu lt o f a su d d e n d ec lin e in th e te rm s o f trade, th e m o st a p p ro p ria te e c o n o m ic resp o n se w o u ld b e a sm all a n d te m p o ra ry n o m in a l w age cut. If sh o rt-te rm w age flex ib ility is p u t in place before th e occu rren ce o f shocks, a cap acity for rap id a d ju stm e n ts can b e b u ilt in to w age se ttin g in stitu tio n s, for ex a m p le b y allo w in g a p o rtio n of w ages to be p aid in th e fo rm o f b o n u se s lin k e d to p ro fits.25 Profits w o u ld b e less v o la tile a n d b o o m s a n d b u sts w o u ld b e m o d e ra ted , a n d th e im p a c t o n la b o u r costs a n d firm s in c e n tiv e to h ire a n d fire w o u ld b e co u n tercy clical. B o n u ses c a n h a v e p ro c y c lic a l effect o n e m p lo y e e s c o n s u m p tio n . Em pirically, how ever, countercy clical effects are d o m in a n t. W h ile th e 290 Countercyclical Fiscal Policy 11. P roject fin a n c e le n d in g in m in in g is a lso sta b ilizin g as d e b t p a y m e n ts accelerate or d ecelera te d e p e n d in g o n ca sh flo w b eh a v io u r, w h ic h b a sic a lly reflects t h e price o f t h e p ro d u ct so ld . For m o r e d eta ils see B u d n e v ic h e t a l. (2 0 0 1 ). 1 2 . See C ab allero (2 0 0 0 , 2 0 0 1 ) for m o r e d etails. 13. In fact w ith a fiscal su rp lu s it is p o ssib le t o red u ce th e m o n e ta r y b ase a n d in terest rates b y p r e p a y in g p u b lic e x te r n a l d eb t a n d red u cin g t h e d e m a n d for fu n d in g . 14. O ur a n a ly sis o f ca p ita l flo w s a ssu m e s n o effe ct o n t h e d e m a n d for m o n e y . 15. T h is o n ly takes p la c e if ta x re v e n u e e x p a n sio n s a b o v e G D P g r o w th are cy clica l. 16. See Frenkel a n d R azin (1 9 8 9 ) for m o re d etails. 17. For m o d e ls e x p la in in g su c h b eh a v io u r, see B ertola a n d D razen (1 9 9 3 ) an d S u th erla n d (1 9 9 5 ). 18. T h is effect is in a d d itio n t o t h e ty p ic a l k ey price m isa lig n m e n ts a n d u n su sta in a b le a c c u m u la tio n o f p u b lic d eb t. 19. In fact th is ta x rate fle x ib ility w a s n o t u se d for co u n te r c y c lic a l p u rp o ses. 2 0 . To m ea su re t h e stru ctu ral b u d g e t a n estim a te o f p o te n tia l o u tp u t is req u ired . T h e first step is to e s tim a te a C o b b -D o u g la s p r o d u c tio n f u n c t io n for t h e C h ilea n e c o n o m y , a n d t h e se c o n d is t o ca lcu la te p o te n tia l o u tp u t as t h e v a lu e o f t h e p ro ­ d u c tio n f u n c t io n e v a lu a ted at tren d in p u t lev els. 2 1 . E stim ate b y t h e M in istry o f F in an ce. 2 2 . A ltern a tiv e w a y s o f c a lc u la tin g p o te n tia l o u tp u t g ro w th c a n b e fo u n d in M o ra n d é a n d Vergara (1 9 9 7 ) a n d F fren ch -D avis (2 0 0 1 ). 2 3 . B u d n ev ich a n d Le Fort (1 9 9 7 ) p r o p o se a lim ite d v a ria tio n o f VAT o f ± 1 per c e n t. 2 4 . A cco rd in g to sim u la tio n ex ercises c o n d u c te d for C h ile b y B u d n e v ic h a n d Le Fort (1 9 9 7 ), a h y p o th e tic a l co u n te r c y c lic a l fiscal p o lic y c o u ld red u ce t h e v a ria n ce o f G D P g ro w th b y 2 4 p er c e n t. T h is r e d u c tio n in t h e v a ria n ce o f GDP g r o w th is d u e in 5 8 per c e n t t o t h e sta b iliz a tio n o f p u b lic a b so rp tio n g ro w th , w h ile t h e rest co rresp o n d t o t h e o p e r a tio n o f co u n te r c y c lic a l sta b ilizin g taxes. 2 5 . T h is p ra ctice is w id esp re a d in c o u n tr ie s su c h as Japan, T aiw an a n d Korea. 2 6 . A sim u la tio n c o n d u c te d b y t h e B u sin ess C o u n c il o f A ustralia (1 9 9 9 ) su g g ests th a t if a b o n u s sy ste m h a d b e e n o p e r a tin g at t h e tim e o f th e la st m a jo r r e c e ssio n th e re w o u ld h a v e b e e n a m u c h m o r e m o d e ra te fall in e m p lo y m e n t in A ustralia th a n in fact to o k p la ce. 2 7 . See C ab allero (2 0 0 0 , 2 0 0 1 ) for furth er d etails. 2 8 . H o w ev er in fla tio n a r y b ias d o e s n o t affect u n d e r ly in g in fla tio n , relev a n t for p o lic y d ecisio n s. 2 9 . O n o c ca sio n , in a d d itio n to tra d itio n a l m a c r o e c o n o m ic m a n a g e m e n t in stru m e n ts, S in g a p o re h a s u se d its c o m p u ls o r y sa v in g s v e h ic le , t h e C en tral P ro v id e n t F und, w ith so m e su ccess. 3 0 . C o m p u lso r y p e n s io n fu n d sy ste m s u su a lly p ro h ib it t h e u se o f a c c u m u la te d fu n d s as co lla tera l for o b ta in in g lo a n s. R e feren ces A u erb ach , A. a n d D . F een b erg (2 0 0 0 ) T he S ig n ifica n ce o f Federal Taxes as A u to m a tic Stabilizers, J o u rn a l o f E c o n o m ic P e rspe ctive s, 14, 3: 3 7 - 5 6 . Bertola, G . a n d A. D ra zen (1 9 9 3 ) Trigger P o in ts a n d B u d get C uts: E x p la in in g th e Effects o f Fiscal A u sterity, A m e r ic a n E c o n o m ic R e vie w , 8 3 , 1: 1 1 -2 6 . Blinder, A. a n d S. M . G o ld fe ld (1 9 7 6 ) N ew M easu res o f Fiscal a n d M o n e ta r y P olicy, 1 9 5 8 -1 9 7 3 , A m e r ic a n E c o n o m ic R e vie w , 6 6, 5: 7 8 0 - 9 6 . B u d n ev ich , C., F. Larrain a n d J. Q u iroz (2 0 0 1 ) Sector M in ero y M ercad o d e C ap itales e n C h ile, In stitu to d e E c o n o m ía , P o n tific ia U n iv ersid a d C a tó lica d e C h ile, rep ort prepared for t h e M in istry o f t h e E co n o m y , M in in g a n d Energy, C h ile. Carlos Budnevich 29 1 a n d G. Le Fort (1 9 9 7 ) ‘La P o lítica Fiscal y e l C ic lo E c o n ó m ic o , R e v is ta de la C e p a l n o . 6 1 , S an tiago: ECLAC, April. B u sin ess C o u n c il o f A ustralia (1 9 9 9 ) A v o id in g B oom /B u st: M a c r o e c o n o m ic R eform for a G lo b a liz ed E c o n o m y , D is c u s s io n P a p e r n o . 2, M elb ou rn e: BCA, O ctob er, 1 -7 6 . C ab allero, R. J. (2 0 0 0 ) M a c r o e c o n o m ic V o la tility in L atin A m erica: A V iew a n d T hree C ase Stu d ies, p ap er p rep ared for LACEA m e e tin g , M ay. (2 0 0 1 ) C o p in g w ith C h ile ’s E xtern al V u ln erab ility: A F in an cial P rob lem , m im e o , S an tiago: B a n co C en tra l d e C h ile. C a sh in , P., H. L iang a n d C. J. M cD e rm o tt (1 9 9 9 ) H o w P ersisten t are S h ock s t o W orld C o m m o d ity Prices, D isc u s sio n Paper 9 9 /8 0 , W a sh in g to n , DC: IMF. F fren ch -D avis, R. (2 0 0 1 ) E c o n o m ic R e fo rm s in C h ile , A n n Arbor, MI: U n iv e r sity o f M ic h ig a n Press. a n d H. Tapia (2 0 0 1 ) Three V arieties o f P o licies t o Face C ap ital F low s A b u n d a n c e in C h ile, in R. F fren ch -D avis (ed .), F in a n c ia l C rise s in S u c c e s s fu l E m e rg in g E c o n o m ie s , W a sh in g to n , DC: B ro o k in gs In stitu tio n . Frenkel, J. A. a n d A. R azin (1 9 9 6 ) F is c a l P o lic ie s a n d G ro w th i n th e W o r ld E c o n o m y , 3rd e d n , C am b ridge, MA: MIT Press. G a v in , M ., R. H a u sm a n n , R. P erotti a n d E. Talvi (1 9 9 6 ) M a n a g in g Fiscal P o lic y in L atin A m erica a n d t h e C aribbean: V olatility, P rocy clica lity a n d L im ited C red it­ w o r th in e ss, W o rk in g Paper 3 2 6 , W a sh in g to n , DC: IDB, O ffice o f t h e C h ie f E c o n o m ist, M arch, 1 -2 3 . H eller, P. S., R. H aas a n d A. M an su r (1 9 8 5 ) A R eview o f th e Fiscal Im p u lse M easure w ith E stim ates o f t h e Structural B u d get B alan ce, d ep a rtm en ta l m e m o r a n d u m , W a sh in g to n , DC: Fiscal Affairs a n d R esearch D ep a rtm e n t, IMF. K ing, M . A. (1 9 9 9 ) C h a llen g es for M o n eta ry P olicy: N e w a n d O ld , B a n k o f E n g la n d Q u a r te r ly B u lle tin , 3 9 , 4: 3 9 7 - 4 1 5 . M ariner, R. (2 0 0 0 ) Estrategias d e P olítica E c o n ó m ic a e n u n M u n d o In cierto: Reglas, In d ica d o res, C riterios, C u a d e rn o s d e l lip e s , 4 5 . M assad, C. (1 9 9 8 ) La P o lítica M o n eta ria e n C h ile, E c o n o m ía C h ile n a , 1, 1 (A u gust). M o ra n d é, E a n d R. Vergara (eds) (1 9 9 7 ) A n á lis is E m p íric o d e l C re c im ie n to en C h ile , W a sh in g to n , DC: G e o r g e to w n U n iversity: C en tro d e E stu d ios P ú b lico s e H ades. S u th erla n d , A. (1 9 9 5 ) Fiscal C rises a n d A ggregate D em a n d : C a n H ig h P u b lic D eb t R everse t h e E ffects o f Fiscal P olicy?, C EPR W o r k in g P a p e r 1 2 4 6 , L on d on : CEPR. Talvi, E. a n d C. V eg h (2 0 0 0 ) Tax Base V ariab ility a n d P rocyclical Fiscal P olicy, N B E R W o r k in g P a p e r n o . 7 4 9 9 , C am b ridge, MA: NBER, January. Taylor, J. (2 0 0 0 ) ‘R ea ssessin g D isc r e tio n a r y F iscal P o licy , J o u r n a l o f E c o n o m ic P e rspe ctive s, 14, 3: 2 1 - 3 6 . V arangis, P. a n d D . L arson (1 9 9 6 ) D ea lin g w ith C o m m o d ity Price U n certa in ty , P o lic y R esearch W o r k in g P a p e r 1 6 6 7 , W a sh in g to n , DC: In te r n a tio n a l E c o n o m ic s D ep a rtm e n t, C o m m o d ity P o licy a n d A n a ly sis U n it, W orld Bank, O ctob er, 1 -4 3 . 1 5 Financial Regulation and Supervision in Emerging Markets: The Experience o f Latin America since the Tequila Crisis B a rb a ra S ta llin g s a n d R ogerio S tu d a r t Introduction T h e in creasin g in te g ra tio n o f in te rn a tio n a l fin an c ial m ark ets poses n ew ch allenges to d o m e stic fin an c ial m arkets everyw here, b u t especially th o se in em erg in g eco n o m ies. T he fin a n c ia l crises o f 1 994-95 a n d 1 9 9 7 -9 8 so u n d e d w ake-up calls to L atin A m erica a n d East Asia, respectively, in d ic a tin g th a t re g u la tio n a n d su p e rv isio n n e e d e d to be s tre n g th e n e d su b stan tially . Since th e n im p o rta n t steps h av e b e e n ta k e n to im p ro v e th e rules a n d en su re th e ir im p le m e n ta tio n , b u t fin a n c ia l re g u la tio n a n d su p e rv isio n d o n o t ta k e p lace in a v acuum . O n th e o n e h a n d th e y m u st b e co n siste n t w ith d o m estic m acroec o n o m ic policies, a n d th e y n e e d a su p p o rtiv e m a cro ec o n o m ic e n v iro n m e n t in w h ic h to o p era te - as th e A rg en tin e crisis th a t b e g a n in 2001 show s o n ly to o w ell. O n th e o th e r h a n d th e y h av e to take in to a c c o u n t th e in te rn a tio n a l rules set b y th e B ank for In te rn a tio n a l S ettlem en ts (BIS), th e In te rn a tio n a l M o n e tary F und (IMF) a n d o th e r in stitu tio n s. T he issue th a t links th is ch a p te r w ith th e o th e rs in th e UNU/W IDER p ro ject is th a t v o la tility - d eriv in g fro m in te rn a tio n a l cap ital flow s as w ell as m acroe c o n o m ic tre n d s in in d iv id u al co u n tries - is a le ad in g cause o f fin an c ial crises. P roblem s in in d iv id u a l b an k s c a n set off c h a in rea ctio n s b ecau se of th e direct links b e tw e e n b anks, a n d because o f th e effects th a t b a n k collapses c a n h av e o n b o rro w ers ca p ac ity to h o n o u r th e ir co m m itm e n ts. T his is th e m a in ratio n ale for th e c o n c e p t o f system ic risk. F inancial reg u la tio n is m e a n t to m itig ate system ic risk b y im p o sin g restrictio n s o n th e w ay in w h ic h b an k s fin an c e th e ir o p e ra tio n s a n d allocate th e ir portfolios. T h e aim is to en su re th a t th e y co n d u c t ad e q u ate assessm ents o f th e risks im p lied in th e ir activities, m ak e p ro v isio n s for ex p e cted losses a n d m a in ta in e n o u g h cap ital to absorb u n e x p e c te d losses. 292 Barbara Stallings and Rogerio Studart 293 T here is a good deal of evidence th a t fin an cial activity is h ig h ly procyclical. T his p ro b lem goes b e y o n d th e u su a l a sy m m e tric in fo rm a tio n p ro b le m a n d h as to d o w ith a t least tw o processes. First, in c reasin g co n fid e n ce a m o n g in d iv id u a l in v esto rs te n d s to g en e rate a self-fulfilling process o f c h a n g e in asset prices. As in v esto rs b ec o m e m o re o p tim istic, th e y try to e x p a n d th e ir h o ld in g s o f su ch assets a t a pace th a t is far m o re ra p id th a n th a t o f th e ir supply. B oom s in asset prices th e n te n d to co rro b o ra te p a st ex p ectatio n s, le ad in g to fu rth e r o p tim ism . In d iv id u a l risk assessm en t th u s ch a n g es w ith th e sta te o f collective en th u sia sm . S econd, b a n k s are also procyclical, ev en th o u g h th e c h a in of re a c tio n is slig h tly differen t. W aves o f o p tim ism in th e b a n k in g sector lead to a n e x p a n sio n o f le n d in g , w h ic h affects th e level of aggregate d e m a n d a n d th u s th e in c o m e a n d cash flow of co n su m ers a n d th e p ro d u c tiv e sector. In tim es of ex p a n sio n , real a n d fin an c ial asset prices increase, as does th e v alu e o f collateral. T h ro u g h th e se self-fulfilling p ro ­ cesses, b an k s te n d to increase th e ir leverage a n d th u s th e ir v u ln e ra b ility to ch a n g es in th e variables th a t affect th e ir risks: e c o n o m ic activ ity a n d level o f e m p lo y m e n t (credit risk), b o rro w in g in te re st rates (liq u id ity risk) a n d asset prices (m arket risk). This ch a p te r exam ines financial sector b eh a v io u r in L atin America, alth o u g h m a n y o f th e sam e p ro b lem s a n d a tte m p ts a t so lu tio n s c a n b e fo u n d in o th e r em erg in g e c o n o m ie s.1 It beg in s w ith a brief lo o k a t th e stru ctu re o f th e fin an c ial sector as a w hole, w h ic h h as c h a n g e d su b sta n tia lly o ver th e last d ecade. D espite th e se changes, b an k s c o n tin u e to d o m in a te th e secto r a n d so th e analysis focuses o n th e m . In th is c o n te x t, th e c h a p te r tu rn s n e x t to th e reg u lato ry a n d sup ervisory system s for b a n k s a n d to d e v e lo p m e n ts since th e M exican crisis in 1 994-95. It also looks briefly a t th e n e w in te rn a tio n a l g u id elin es b ein g p ro p o sed b y th e BIS a n d th e IMF to in v estig ate w h e th e r th e y c a n h e lp sh elter th e b a n k in g system s fro m th e ty p es o f sh o ck th e y h av e suffered in th e re c e n t past, o r w h e th e r th e y are likely to create a d d itio n a l p ro b lem s. T h e c h a p te r th e n looks a t case studies o f fo u r o f th e m o s t im p o rta n t c o u n tries in th e region: A rgentina, Brazil, C h ile a n d M exico. By ex a m in in g th e ex periences o f th e se c o u n tries w e c a n g ain a b e tte r id ea o f h o w th e ch an g es cam e a b o u t a n d th e w ay in w h ic h in d iv id u al c o u n try ch aracteristics h av e affected th e o p e ra tio n o f th e fin an c ial system s. T hese tw o sections p ro v id e evid en ce th a t b a n k re g u la tio n a n d su p erv isio n in L atin A m erica h av e im p ro v e d in rec en t years, b u t m u c h rem a in s to b e d o n e. T h e ch a p te r co n c lu d e s w ith a set of po licy re c o m m e n d a tio n s. W e are ce rtain ly n o t th e first to discuss th e se topics, as o ver th e p ast few years th e re h a s b e e n a n e x p lo sio n o f research o n th e fin an c ial secto r in d ev e lo p in g co u n tries, in c lu d in g issues o f reg u la tio n a n d su p e rv isio n .2 We d raw o n th e th e o re tic a l a n d em p irical d im e n sio n s o f th is lite ra tu re w h ere relev an t, a n d b rin g it to b ear o n th e issues u n d e r co n s id e ra tio n in th e U N U / WIDER research project. 294 Financial Regulation and Supervision The financial sector in Latin America in the 1990s Liberalization, crisis and rescue: some stylized facts T h e essential b a c k g ro u n d for u n d e rs ta n d in g c u rre n t d e v e lo p m e n ts in th e fin an c ial sector in L atin A m erica is th e fin an c ial lib e raliz atio n process, b o th d o m e stic a n 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 o st co u n tries. C hile w as a n im p o rta n t ex c e p tio n in th a t b o th lib e raliz atio n a n d crisis preceded th o se o f its n e ig h b o u rs b y at least a decade. M o v in g fro m a system in w h ic h th e au th o ritie s set in te re st rates, d irected c re d it a n d h e ld a large share o f b a n k dep o sits as req u ired reserves, g o v ern ­ m e n ts freed co m m ercial b an k s to m ake th e ir o w n decisio n s o n borrow ers, lo a n v o lu m e a n d prices. At a p p ro x im a te ly th e sam e tim e, ca p ita l a c c o u n t lib eralizatio n en a b le d local b an k s to engage in tra n sa c tio n s in foreign cu rren cies a n d allow ed foreign in s titu tio n s to e n te r local m ark ets. Such ch a n g es w ere fre q u e n tly m a d e w ith o u t th e re b e in g a n a d e q u a te reg u la to ry a n d su p ervisory system in place, w h ic h c o m p o u n d e d th e p ro b lem s for b an k ers w h o lacked su fficien t ex p erien ce in c o n d u c tin g cre d it analyses o f local b o rrow ers a n d w ere n o t c o n v e rsa n t w ith th e co m p lex ities o f in te r­ n a tio n a l fin an c ial m arkets. T h e typical results w ere cred it b o o m s, m ism atch es b e tw e e n m a tu ritie s a n d currencies, a n d e v e n tu a lly b a n k in g crises. As seen in th e em b lem atic C h ile a n case (b u t also la ter in M exico, East Asia a n d A rg en tin a), errors by d o m e stic actors p ro v id ed th e basis fo r su ch crises, a n d if th is w as c o m b in e d w ith e x tern al shocks th e situ a tio n b ecam e far m o re serious (see H eld a n d Jim én ez, 2001). G o v e rn m e n t rescues te n d e d to follow a sta n d a rd p ro ced u re. In th e first in sta n c e th e y in v o lv e d th e takeover o f n o n -p e rfo rm in g lo an s, th e rec ap ita liz atio n o f b an k s a n d liq u id a tio n s a n d m ergers, u su a lly in v o lv in g fo reig n in stitu tio n s. Later, in a n a tte m p t to p re v e n t fu tu re crises, reg u la tio n a n d su p ervision w ere ste p p ed up, greater in fo rm a tio n a n d tra n sp a re n c y w ere req u ired a n d d ep o sit in su ra n c e w as som etim es p u t in place.3 In th e process th e ch aracteristics o f th e sector c h a n g e d significantly. Characteristics of the new financial sector T h e fin an c ial sectors in L atin A m erican c o u n tries re m a in b an k -b ased , b u t th e y h av e u n d e rg o n e a n u m b e r o f im p o rta n t ch an g es in re c e n t years. First, th e size a n d d e p th o f th e fin a n c ia l secto r in creased in m o st c o u n tries d u rin g th e 1990s. In p a rt th is w as th e resu lt o f th e d ra m a tic d e c lin e in in fla tio n th r o u g h o u t th e reg io n , su c h th a t in m o st c o u n tries prices rose a t single-digit rates co m p ared w ith th e th ree - o r fo u r-digit rates o fte n fo u n d in th e 1980s. T h u s in d iv id u als, h o u se h o ld s a n d firm s b ec am e m o re w illin g to h o ld m o n e y a n d o th e r fin an c ial assets, p ro v id in g th e necessary p rereq u isite for th e d e v e lo p m e n t o f ro b u st fin an c ial system s. B etter in s titu tio n s c o m p le m e n te d th e b eh a v io u r o f in d iv id u a l a g e n ts.4 Table 15.1 gives a n id ea o f th e e x te n t o f th e tre n d to w ard s fin a n c ia l d ee p en in g , u sin g M 2 as a sh a re o f GDP as Barbara Stallings and Rogerio Studart 295 Table 15.1 Money supply (M2) as share of GDP, 1992-2000 (per cent) 1992 1994 1996 1998 14 n .a . 38 20 32 29 21 n .a . 37 20 32 28 23 28 43 20 33 26 29 39 72 36 75 41 80 47 78 43 92 56 81 58 95 61 103 2000 L a t in A m e r ic a A rg en tin a Brazil C h ile C o lo m b ia C o sta Rica M e x ic o 31 46 24 33 28 32 29 50 26 35* 21 A s ia R ep u b lic o f Korea M a laysia P h ilip p in es T h a ila n d 80 103 62 10 6 * Figure for 1999. Source: Based on IMF international financial statistics. a n in d icator. It show s a n increase for four o f th e six L atin A m erican co u n tries d u rin g th e decade; th e p ro m in e n t ex cep tio n w as M exico. T he biggest increase w as in A rgentina, a lth o u g h C h ile h a d th e h ig h e st levels. T h e ta b le also show s d a ta for fo u r A sian co u n tries. T he in te rre g io n a l c o n tra st is strik in g in tw o senses: n o t o n ly w ere th e levels h ig h e r in every case in Asia, b u t th e rate o f in crease w as also higher. Second, th e ex istin g b an k s w ere allow ed to engage in n e w activities, re su ltin g in th e fo rm a tio n o f so-called u n iv ersal bank s. In g en eral th is w as th e resu lt of th e d ere g u latio n o f b a n k in g activities, w h ic h led to b a n k o p e r­ atio n s e x p a n d in g in to securities tra d in g a n d in su ra n c e a n d in creased th e ir real estate activities. D ereg u latio n also en a b le d b an k s to o w n n o n -fin a n c ia l firm s. T his tr e n d m o v e d in ta n d e m w ith ev en ts in m a tu re e c o n o m ie s,5 b u t u n lik e som e o f th e latter, th e securities m ark ets in em erg in g ec o n o m ie s w ere still v e ry u n d e rd e v e lo p e d a n d shallow . T h erefo re m o s t b a n k p o r t­ fo lio d iversificatio n w as in to sh o rt-te rm securities, in su ra n c e a n d real estate activities. T h ird , fo reign in s titu tio n s becam e in c re asin g ly sig n ific an t acto rs in th e fin an c ial sector. T h eir greater ro le w as p a rt of th e lib e raliz atio n process, as n e w sectors w ere o p e n e d to fo reign p a rtic ip a tio n . T hree v eh icles w ere u sed b y fo reign b an k s a n d fin an c ial service firm s to e n te r d ev e lo p in g -c o u n try m arkets: privatizations, m ergers a n d acquisitions, a n d g reen field in v e stm e n t. C o n seq u en tly , as ca n be seen in Table 15.2, fo reign assets as a sh are o f to ta l assets rose su b stan tia lly in all seven L atin A m erican c o u n tries for w h ic h d a ta is available (A rgentina, Brazil, C hile, C o lo m b ia, M exico, P eru a n d V enezuela); th e increase fo r M exico w o u ld be m u c h g reater if th e rec en t 296 Financial Regulation and Supervision F oreign b a n k assets as sh are o f to ta l b a n k assets, 1 9 9 4 - 2 0 0 0 (per cen t) T a b le 1 5 .2 1994 1999 2000 17.9 8 .4 16.3 6 .2 1 .0 6 .7 0 .3 4 8 .6 1 6 .8 5 3 .6 1 7 .8 1 8 .8 3 3 .4 4 1 .9 49 23 54 26 24 40 42 5 .8 1 9 .8 2 .1 2 .7 4 9 .3 5 6 .6 5 2 .8 1.7 66 62 70 n .a . 0 .8 6 .8 0 .5 4 .3 11.5 5 .6 3 18 12 L a t in A m e ric a A rgen tin a Brazil C h ile C o lo m b ia M ex ico Peru V en ezu ela C e n tra l E u ro p e C zech R ep u b lic H u n gary P o la n d Turkey A s ia Korea M alaysia T h a ila n d Sources: IMF (2000: 153) for 1994 and 1999; BIS (2001: 25) for 2000. sale o f th e c o u n try s seco n d largest b a n k w ere in c lu d e d in th e tab le. It is in te re stin g to n o te th a t th e re w ere sim ilar tre n d s in E astern E urope b u t n o t in Asia.6 F o u rth, th e re w as a decrease in th e n u m b e r o f b an k s - especially in L atin A m erica a n d Asia - as a result of th e m ergers a n d acquisitio n s ju st m e n tio n e d , in c lu d in g p riv atiza tio n s (Table 15.3). W h a t is so m e w h a t su rp risin g is th a t th is process d id n o t resu lt in a sig n ifican t increase in c o n c e n tra tio n . In d ee d in Asia a n d E astern E urope th e re appears to h av e b ee n a decrease in c o n c e n ­ tra tio n . In L atin A m erica th e share of th e largest te n b an k s rose, b u t n o t b y a large a m o u n t. T his im p lies th a t th e in s titu tio n s th a t d isa p p ea re d fro m th e m a rk e t w ere th e sm allest ones. Fifth, th e re w as so m e e x p a n sio n o f cap ital m arkets. T his d e v e lo p m e n t h a d several causes: th e increase in p o rtfo lio flow s to th e reg io n u n til 1998; th e p riv atiza tio n o f social security a n d th e d ere g u latio n o f p riv ate in s titu tio n a l investors, w h ich led to a n increase o f in v e stm e n ts in securities; a n d th e v ir­ tu o u s circle created b y th e process o f sta b ilizatio n a n d securities m a rk e t e x p a n sio n in som e e c o n o m ie s in th e region. Table 15.4 show s o n e in d ic a to r o f th is tren d : th e v o lu m e o f d e b t securities issued in d o m e stic m a rk e ts (b o th in ab so lu te a m o u n ts a n d as a share of th e w o rld to ta l) b e tw e e n 1989 a n d 2000. W hile th is in d icates th a t such issues in L atin A m erica e x p a n d e d rap id ly d u rin g th e perio d , m o re th a n d o u b lin g b e tw e e n 1992 a n d 2000, th e v ast Table 1 5 .3 Indicators of concentration in the banking sector, 1994 and 2000 (share in total deposits) 2000 1994 N um ber L a rg e s t L a rg e s t o f banks 3 banks 1 0 banks 7 5 6 .9 1 2 2 0 .9 8 3 0 .4 1 0 0 5 .4 9 7 9 .2 113 193 29 23 42 3 9 .8 5 5 .2 3 9 .5 5 6 .3 4 6 .7 8 0 .7 8 5 .6 8 2 .0 9 4 .5 75.7 8 6 5 .7 1 2 7 8 .6 8 5 7 .9 1 3 6 0 .5 9 2 3 .1 8 6 .9 7 8 .3 8 0 .3 8 3 .5 1 2 6 3 .6 9 1 8 .9 8 1 9 .7 1 0 3 1 .7 13 10 27 13 4 3 .5 4 3 .4 3 9 .6 4 1 .7 7 7 .7 8 2 .2 73.3 7 9 .4 8 9 9 .7 1 0 0 5 .1 7 8 9 .9 8 5 4 .4 9 7 .0 8 4 .7 8 6 .7 79.1 2 1 0 1 .5 1 5 7 8 .8 1 2 6 3 .6 9 5 7 .2 42 39 77 79 6 9 .7 5 1 .5 4 3 .5 3 5 .9 9 0 .3 8 0 .7 77.7 7 2 .0 1 7 5 7 .8 1 2 4 1 .8 8 9 9 .7 7 1 0 .2 N um ber L a rg e s t L a rg e s t o f banks 3 banks 1 0 banks 206 245 37 36 43 3 9 .1 4 9 .9 3 9 .5 4 8 .3 4 3 .9 73.1 78.8 79.1 8 0 .8 78.6 30 25 41 15 5 2 .8 4 4 .7 3 9 .0 4 7 .5 55 40 82 72 7 2 .0 5 7 .9 5 2 .8 4 0 .7 H H In d e x H H In d e x L a t in A m e ric a A rg en tin a Brazil C h ile M e x ic o V en ezu ela A s ia R ep u b lic o f Korea M alaysia P h ilip p in e s T h a ila n d C e n tr a l E u ro p e C zec h R ep u b lic H u n g a ry P o la n d Turkey 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 1989 All issuers OECD (excl. Mexico) France Germany Japan United States Latin America Argentina Brazil Chile Mexico Peru Source: 1992 14 149.7 13 790.0 605.8 729.4 2 558.5 6 682.2 101.2 44.7 n.a. 7.0 49.5 n.a. 18 713.2 18 231.8 956.3 1 260.2 3 355.5 8 546.5 190.5 15.5 111.0 17.4 46.6 n.a. B a s e d o n B IS 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 ). Percentage of total 1997 25 24 1 1 4 12 572.7 631.3 102.5 732.1 399.3 071.7 448.7 27.3 344.5 36.5 38.5 1.9 2000 29 28 1 1 6 14 951.3 852.9 068.1 688.9 088.8 571.6 446.3 38.5 297.0 34.9 72.3 3.6 1989 1992 1997 2000 100.0 97.5 4.3 5.2 18.1 47.2 0.7 0.3 n.a. 0.0 0.3 n.a. 100.0 97.4 5.1 6.7 17.9 45.7 1.0 0.1 0.6 0.1 0.2 n.a. 100.0 96.3 4.3 6.8 17.2 47.2 1.8 0.1 1.3 0.1 0.2 0.0 100.0 96.3 3.6 5.6 20.3 48.7 1.5 0.1 1.0 0.1 0.2 0.0 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 w ith the increasing strength of financial crises, a greater mix of activities, the increasing operational com plexity 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 m any 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 m inim um capital-asset ratio requirement, currently set at 8 per cent by the BIS through the Basel I agreement. While the United States sets its m inim um 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 Minimum capitalasset ratio requirement (%) Actual risk-adjusted capital ratio (%) Capital stringency index Capital regulation index Overall bank activities and ownership restrictiveness index US 11.5 11.0 10.0 8.0 8.0 9.1 10.0 8.0 16.4 15.8 11.4 12.3 13.0 12.7 14.0 12.0 6.0 3.0 5.0 3.0 4.0 5.0 2.0 4.0 8.0 6.0 8.0 5.0 7.0 6.0 2.0 6.0 1.8 2.5 3.0 2.8 3.0 2.0 2.5 3.0 Source: B a r t h 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 w ho 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, w hich is com m only 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 Figure 15.1 Venezuela US Overall regulation index (ORI) Source: B a s e d Peru o n T a b l e 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 autonom y 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 Professional bank supervisors per institution Official supervisory index Prompt corrective action index Restructuring power index Declaring insolvent power index Forbearance discretion index Supervisor tenure index Likelihood that supervisor will move into banking index Percentage of top ten banks rated by international credit rating agencies Private monitoring index Source: B a r th US 2.4 4.0 6.0 3.0 11.5 3.6 1.0 0.1 12.0 15.0 11.0 13.0 10. 14.0 14.0 14.0 n.a. 6.0 n.a. 3.0 3.0 4.0 5.0 5.0 3.0 3.0 3.0 3.0 3.0 3.0 3.0 3.0 3.0 3.0 3.0 3.0 3.0 3.0 3.0 3.0 3.0 2.0 2.0 1.0 2.0 2.0 1.0 2.0 6.2 15.0 6.0 n.a. n.a. 13.5 n.a. 7.0 3.0 2.0 3.0 3.0 1.0 3.0 3.0 1.0 100.0 100.0 20.0 50.0 n.a. 50.0 40.0 100.0 8.0 8.0 7.0 8.0 6.0 8.0 6.0 8.0 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 econom y we created an overall supervision index (OSI), following the same m ethodology 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 l e 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, w e have to turn to other studies of the region. We shall consider two such studies before turning to our ow n country analysis. In one of the m ost 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 m ainly 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 autonom y for supervisors. 304 Financial Regulation and Supervision Basel II and th e IMF fin ancial sector assessm ent program m es 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 developm ents at the international level have also played a part. In particular the BIS and the Basel Com m ittee on Banking Super­ vision have been influential in putting these issues onto the agenda and hom ogenizing the standards in developed and developing countries. At the m om ent, 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 m ilestone in banking regulation. The 8 per cent m inim um capital requirement for internationally active banks, w hich was adopted by over 100 countries (including m ost in Latin America), clearly contributed to financial stability. N onetheless the criticism began to be voiced that the approach was too rigid and sim plistic and that it did not correspond to actual levels of risk. D eveloping countries were especially concerned that the rules provided incentives for short-term rather than long-term lending. Basel II was m eant 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 econom ies 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 implem entation 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 econom ies through the financial sector assessment programmes. While agreeing that the measures could be helpful, developingcountry representatives have complained that they had no say in determining the standards and that im plem enting all of them would be an extremely expensive undertaking. At the same time they fear that not being able (or willing) to com ply 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 a tio n a l responses to re c e n t fin a n 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 m uch in com m on but also important differences in timing, operational characteristics and the macroeconomic environm ent in w hich the financial sector operates. All four econom ies went through a process of financial liberalization at som e 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 econom ic 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 w hen 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 m ost 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 econom ies and a significant number of developing economies. These improvements were the result of several important events. First, a process of m onetization - 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 com petition 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 developm ent 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, investm ent 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 m ent 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 o n th e stability o f the b anking 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 econom ic 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 unem ploym ent 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 m any 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 m ost 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 m any respects. In the second half of the 1990s private bank provisions in relation to total credit increased substantially, liquidity w ithin 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 w ith 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 m entioned 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 PROES) 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 m ost significant of these additional measures was a preventative law that gave the central bank authorization to restructure financial institutions that were not m eeting system requirements or were demonstrating financial problems. W hile 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. N ow 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: p o lic y lessons fro m th e L a tin A m erican ex p e rien c e 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 m ounts as the problems of individual banks quickly spread to other institutions and to the real econom y 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 nom ic 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 employm ent 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 econom ic growth for a long period, and it gave policy makers room to follow flexible policies w hen 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 m ind that the tightest regulations are not necessarily found in the best-performing banking systems. This may mean that very strict regulations are necessary w hen 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 ow n 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 m ethod 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 consum ption 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 com plem ent 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 m ost 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 o f 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 com m on 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 o f 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 o f the database, w hich 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 o f the data and question the relevance o f 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 o f 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 o f reforms at that time. For an analysis of the earlier attempt see Studart and Hermann (2001: 34-8). 11. In the first m onths o f the im plementation of the Plano Real, Brazils central bank expanded the monetary base very rapidly to accommodate the increased demand for m oney that usually occurs after a successful price stabilization programme. This also increased the reserve base o f the domestic banks, permitting them to expand credit. 12. This mechanism, w hich was designed to deal with liquidity problems, did not work during the recent crisis because o f 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 w hen specific banks experienced reduced liquidity. However the m echanism was not meant to deal with potential solvency problems, as in the case o f 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 ow n 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. In d ex 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(n l), 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 1 7 1 ,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(n l0) GDP (1971-2002) 28t liquidity requirements (1995) 238 low inflation and output volatility 252-5 m oney supply (M2) as share o f GDP (1992-2000) 295t macroeconomic performance (1994-99) 254t national response to financial crises 305, 306-7, 307-8, 314(n l0) 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(n l2) share of foreign banks in domestic market 310 stock exchange prices (1990-2002) 23t Ariyoshi, A. 2 4 0 (n l, n4, n6) Asia 20, 63, 65, 84, 89, 296, 313(n l) bank flows (1998-2001) 67f banking sector (concentration, 1994-2000) 2 9 7t 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 involvem ent of international banks (1998-2000) 71t m oney 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 o f 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(n l3) 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(n l2) 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) o f 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(n l2) 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(n l2) acquired 40(n l0) 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 involvem ent 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 o f 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 im plementation 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 o n Banking Supervision (BCBS) 7 3 ,1 1 9 -2 0 , 135, 183-9, 207, 212(n9), 305 developing country representation 188 hom ogenization 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(n l7) 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 m odel 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) comm odity-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(n l0), 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(n l0), 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 m oney supply (M2) as share o f GDP (1992-2000) 295t national response to financial crises (case study) 305, 307, 308, 3 1 4 (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), 2 9 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(n l), 139, 157(nl), 196, 212 Canada 11, 257 Cantor, R. 120-1 Cantor-Packer m odel 121, 121t Cao, H. H. 196 capital 190(n5), 199 serves two functions 114 short-term 179(n3) too m uch 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, 2 4 0(n l-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(n l), 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, 3 1 4 (n ll-1 2 ) 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(n l5), 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(n l6-21) 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 (n l9 -2 1 , n24) foreign bank assets as share of total bank assets (1994-2000) 296t Foreign Investment comm ittee 161 forward contracts 168-71 m oney supply (M2) as share of GDP (1992-2000) 295t national response to financial crises (case study) 305, 308-9 overall regulation index (ORI) 3 0 If 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(n l, 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(n l0) 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(n l6, 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 m oney 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) comm odities 35, 162 prices 36, 179(n6), 249, 276-7, 288 sudden spikes 277-8, 289(n6) stabilization funds 36, 276-8, 288, 289 com m on action problem 206 com m on 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 consum ption 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; m oney 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, 26 6 (n 2 0 -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 denom ination 62, 95, 153-4; local 7, 9, 71n, 73, 77, 88-9, 101-2, 104-5, 109-10, 117(nl0, n l2 ), 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(n l2) 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(n l2), 266(n l9), 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 1 7 6 ,1 7 7 ,1 9 2 -3 , 211(n l), 240(n4) Davis, E. 164, 179(n5) De Grauwe, P. 200-1 de Gregorio, J. 223, 240(n l), 242 de Lis, F. S. 220, 242 dealers 102-5, 109-10, 112-15, 1 17(n l2-13), 117(nl6) registration 112 debt 21, 75, 140, 164, 195, 197, 218, 225, 266(n l8), 285 corporate 30 dollar-denominated 38 emerging-market 135 ex ante rules 15 external 29, 76, 122, 123, 222, 223, 250, 262t, 290(n l3), 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 (n l3 , n l8 ), 308 short-term 5-6, 60, 84, 85-6, 90, 223 debt payments/debt service 128, 147-8, 152, 2 9 0 (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 com m odity 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 involvem ent (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(n l0) 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 econom ic 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(n l8) aims of book xi asset stocks (1994-2001) 197f capital flows 1-19 cross-border portfolio flows (1995-2002) 48f equity investm ent 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 dim ension 194-9 microeconomic dim ension 199-204 em ploym ent 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(n l0), 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 1 5 9 ,1 7 2 -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(n l7) 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(n l8) 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(n l3), 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(n l), 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(n l6, n l9 ), 283, 289n, 290(n22) finance managers 1 6 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(n l3) 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 tim ing 289 Fischer, S. 265(nl), 314(n3) Fitch IBCA 1 1 9 ,1 2 6 -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 1 6 6 ,1 6 8 -7 1 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 1 9 6 ,2 1 0 ,2 1 1 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, 2 5 If 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(n l2) 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 o f safety creates risk’ 54-5 Hermann, J. 314(n l0) Highly Leveraged Institutions (HLIs) 143-5, 150, 195 double play 144 Hong Kong 60, 63t, 73, 107t, 144, 245, 2 4 7t, 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 o f 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 dom estic/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 6 1 -2 currency denom ination 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(n l8), 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(n l) public 38, 284 stop-go 282 systematic contrarian 146, 147, 155 investm ent banking 38, 47-8, 143, 149, 195, 307 investm ent funds 208-9t investm ent 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(n l) Kim, W. 141-2 Kimmis, J. xi, 19(nl0) Kindleberger, C. 1 1 ,2 1 1 (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 m oney 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. 1 05,110 Lamfalussy, A. 60 Larrain, F. 223, 240(n l), 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(n l), 40(n l0), 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 o f 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 involvem ent 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 m oney supply (M2) as share o f 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(n l) Le Fort, G. 40(n9), 223, 240(n l), 257, 284-5, 289(n, n3), 290(n23-4) Lehmann, S. 40(n9), 223, 240(n l), 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 denom ination 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(n l0), 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 synonym ous’ 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(n l) macroeconomic behaviour 280, 288 countercyclical policy 270-2 dim ension (asset demand schedule) 194-9 effects/results 225, 227, 287 environm ent 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 m oney supply (M2) as share o f 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(n l), 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 m oney 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 dim ension (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) m ining 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 mom entum trading 202 monetary base 3 1 4 (n ll) indicators 123 policy 1 7 8 ,2 2 1 ,2 8 7 pressures 223, 225, 226f m oney 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 m ining 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) 2 6 5 (n ll) non-deliverable forwards (NDFs) 168 non-tradable sector 237, 238, 241(n l2), 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(n l), 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, 3 1 4 (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 investm ent 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 investm ent 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(n l8) 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(n l3), 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(n l3, 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(n l0-13), 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 m oney 72 public sector 229, 239, 253, 260, 270 level of activity 280-2 theory and empirical evidence 280-2 public services 1 6 1 ,1 6 5 ,1 7 7 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(n l6) real estate 22, 25, 37, 38, 208-9t, 220, 238, 295 property 56 recessions 22, 72, 253, 255, 256, 259, 261, 2 6 6 (n l5-16), 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 (n l), 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, 2 4 7t, 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(n l) 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 cash flow 177 com m odity 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 1 9 9 -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(n l2) 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 com m odity 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(n l), 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 im munity 152 sovereign yield spreads 132 Spain 60, 159, 179(n8), 313 countercyclicality regulations (December 1999) 2 3 6 ,2 3 7 , 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(n l), 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(n l) Sub-Saharan Africa 6, 8, 9 subsidiaries 91, 162, 166, 167, 174, 176, 177, 305 Sutherland, A. 290(n l7) Index 339 swaps 166, 167t, 168 Swaps Monitor 1 1 7 (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) sm oothing 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 incom e 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(n l9), 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, 2 5 If, 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(n l3) 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(n l0) twin crises 299 Ukraine 128 unem ploym ent 37, 123, 248, 253, 266(n l3), 273, 275, 280, 308 unem ploym ent 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 o f 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 econom ic slowdown 64-5 GDP (1950-2010) 64t imports from Mexico 263 investm ent 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, 2 4 0 (n l-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(n l), 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(n l) 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 Zhang, X. 146-7 141-3