Emerging Markets in the New Financial System
University of California,
Chief Economist, East
Gregory A. Root
Thomson BankWatch, Inc.
Head, Economic and
Market Research Asia
Department of Economics
Director, Monetary and Exchange Affairs
Barents Group LLC
Advisor, Financial Sector
Group World Bank
Principal & Global Head
of Risk Policy
Morgan Stanley Dean
Global Strategist, Global
Deutsche Bank Group
Haas School of
Business/London School of Business
In the span of one exceptionally volatile decade—the 1990s—private capital flows and economic development ceased being two separate discussions and became a single urgent debate, Gary Perlin, Senior Vice President of the World Bank, observed in opening the Emerging Markets in the New Financial System Conference. The March 30–April 1 event, cosponsored by the World Bank, the IMF, and The Brookings Institution, took place in Florham Park, New Jersey.
Participants from financial markets, academia, policymaking, and international organizations focused on the Asian crisis and recovery and ways to deal with future volatility. Discussions addressed prospects for external flows to emerging markets, financial and corporate restructuring in Asia, ways to accelerate bank and corporate restructuring, and frontiers in risk management. Volatility and restructuring were recurring themes in the conference. If indeed volatility is expected to continue, and perhaps increase, Perlin noted the world had better be prepared to deal with it.
External financing flows
Providing a background for the discussion of crisis prevention and resolution strategies, Uri Dadush of the World Bank surveyed the prospects for external financing flows. Citing the World Bank’s Global Development Finance 2000, Dadush pointed to a significantly improved outlook. A recovery was under way, he noted, but it was marked by significant differentiations among regions—with the Middle East and North Africa and sub-Saharan Africa lagging behind Asia and Latin America. Dadush also cautioned that while the report’s overall prognosis was upbeat, there were clearly downside risks. Investors continue to fret about the prospects for a soft landing of the U.S. economy, the effectiveness of Japan’s fiscal stimulus, and the health of east Asia’s financial and corporate sectors. The report also examined capital flow surges over the past 130 years and found them typically associated with periods of rapid growth, technological innovation, and, ultimately, hard landings.
Capital flows to emerging markets should come back “big time,” Dadush said, but the causes of volatility will not disappear. Developing economies are inherently less stable and less diversified, and information asymmetries are commonplace, he said.
Dipak Dasgupta of the World Bank pointed to excessive short-term borrowing as a trigger for, if not a cause of, the Asian crisis. Loan maturities rapidly shortened in the lead-up to the crisis, and even without excessive overall debt, that shortening took its toll. He explained that increased trade and greater financial liberalization had spurred the region’s appetite for short-term lending, while intense competition at home, a dramatic increase in bank-to-bank lending, and pegged exchange rates had fueled the banks’ readiness to lend. In theory, Dasgupta added, financial liberalization should provide a smoothing mechanism, but experience suggests short-term borrowing tends to intensify cyclical trends, and flows generally pour out twice as fast in bad times as they flow in during good times.
Ashoka Mody of the World Bank and Ken Kletzer of the University of California, Santa Clara, examined the pros and cons of using liquidity measures (additional reserves and credit lines) and capital controls. Holding increased international reserves might forestall a crisis unwarranted by fundamentals, but at a price—fiscal costs and weakened fundamentals. Contingent credit lines, they suggested, could be a superior option—fiscal costs would be lower, but contingent credit lines afford less flexibility and may require expensive collateral. Capital controls address volatility more directly, but taxes on short-term capital flows are difficult to implement. Limiting short-term debt exposure, which reduces government contingent liabilities and could lower the cost of crises, could be more effective, they said.
Restructuring in Asia
Masahiro Kawai of the World Bank, presenting a paper coauthored with colleagues Ira Lieberman and William Mako, assessed the generally slow progress east Asia has made in corporate restructuring. In the absence of effective legal mechanisms, out-of-court processes have played a key role, though court-based procedures are beginning to increase. For the future, Kawai said, it will be critical to find ways to monitor the health of financial corporations (notably large ones), restore banking sector confidence, segment and prioritize crises, strengthen out-of-court restructuring frameworks, resolve disputes between creditors, and use public asset management companies to resolve corporate distress.
On the financial side, Asia’s crisis was set off by grave weaknesses at the sovereign and bank sector levels, undercapitalized banks, serious asset quality problems, heavy “related” lending, and inadequate regulatory enforcement and disclosure provisions, according to Gregory Root of Thomson BankWatch. He cautioned that now the risk in Korea is complacency, Japan still needs to take harsh measures up front, Thailand remains burdened with a very high (60 percent) ratio of unserviceable loans but the involvement of foreign banks is encouraging), and Indonesia’s situation remains “considerably worse” than that of the rest of the region. More market discipline is needed, he concluded.
Surveying future prospects for Asia’s emerging markets, Bernhard Eschweiler of J.P. Morgan stressed that last year’s economic recovery was real and that the business cycle should provide further impetus. In a series of blunt assessments, he argued that Korea and Thailand had made the most progress to date; Malaysia had made progress, but none of its politically connected companies had yet to “face the music”; and Indonesia’s progress had been on the political rather than the economic front. Ascribing the Asian crisis to “speeding” and “bad safety standards,” Eschweiler was decidedly bullish on the region’s future. The crisis had not derailed long-term growth (except in Indonesia), saving rates remained high (again, except for Indonesia), capital market activity had picked up, and the region’s openness to trade and foreign investment was unshaken, he said.
Challenging conventional wisdom, Benjamin Friedman of Harvard University contended that rescheduling and other forms of restructuring keep new money flowing, but not all nonperforming debts should be restructured. He suggested that a higher rate of default might be healthy for the system and that temporarily constrained credit flows to some emerging market countries could be desirable. Friedman also argued that it was unwise to avoid all instances of lost output and temporarily interrupted development—longer-term output growth and development might be aided if borrowers, as well as lenders, bore real costs at times. He also contended that the IMF acts as an arranger of cartels and expressed surprise that losses on official loans were not more widely considered.
Facilitating bank, corporate restructurings
In systemic crises, Stefan Ingves of the IMF noted that governments, in addition to serving as lenders of last resort, also become “owners of last resort.” In the vacuum created by widespread financial turmoil, governments will need to exert leadership and, in some instances, take on uncustomary responsibilities. In banking crises, governments should act to maintain the effectiveness of the system, ensure appropriate resolution mechanisms and burden sharing, promote efficient governance for intervened banks, and involve the private sector. In all actions, he stressed, transparency is the key to maintaining credibility and restoring public confidence.
The complex task of corporate restructuring warrants a comprehensive approach, Ingves added. Governments will need to make certain that appropriate legal and debt restructuring frameworks are in place, nonviable debts are separated from viable ones, credit discipline is maintained, and macroeconomic policies and tax measures are credible and effective. Corporate restructuring typically lags behind banking sector efforts, and can be sped up, he noted, only when effective legal and enforcement mechanisms, strong government leadership, and political support are in place.
In the restructuring process, the IMF largely provides advice on calculating the cost of restructuring, Ingves said, and in the early stages helps countries identify the legal and institutional infrastructure that will be needed. In the end, he said, restructuring will require something the IMF cannot lend—political will.
David Scott of the World Bank, arguing that governments can indeed accelerate effective restructuring, emphasized the importance of leveraging resources and building a working consensus around a businesslike focus. Government should always seek, he said, to minimize controllable costs. Time is critical, because delays and uncertainty compound carrying and other financial costs and expand opportunities for waste and looting of assets.
Analyzing corporate restructuring from a private sector perspective, Joel Binamira of the Barents Group criticized the close ties many corporates in the region had cultivated with governments. Profits, he said, had typically reflected monopoly advantages rather than sound business practices, and managers had more finely honed political skills than business expertise. At best, corporate restructuring in the region has been slow, Binamira explained. Corporations have been reluctant to recognize the severity of the problem, feared a loss of face, and unrealistically clung to hopes that a recovery would solve everything. Troubled assets needed realistic pricing and real buyers, he stressed, and governments needed to provide greater transparency, encourage a more level playing field, and reduce their own ties with business.
Without adequate legal mechanisms in place to cope with a tidal wave of defaults, Gerald Meyerman of the World Bank explained, many Asian crisis countries had turned to out-of-court debt restructurings largely patterned after the “London Approach.” This approach relied on nonbinding principles of restructuring debt that minimized losses to the bank and other parties, avoided unnecessary liquidations of viable corporations, and ensured financial support for viable corporations while they restructured. It would be an overstatement, Meyerman said, to term the use of the London Approach in Asia a success, but the approach had advantages over other available options. Asia’s experience suggests that out-of-court provisions were no substitute for more permanent solutions and underscores the need for new solvency and restructuring legislation, a stronger business environment, and better corporate governance.
The likelihood of increasing volatility is also helping drive the growing demand for risk management. Timothy Wilson of Morgan Stanley Dean Witter, examining financial risk management at the firm level and responses to liquidity crises, underscored the priority that firms now give to being keenly aware of current economic conditions, measuring quantifiable risks, and monitoring risks that are less easily quantified. To manage risks, firms are hedging when they can, diversifying or insuring when they cannot hedge, managing capital structure with an eye toward risk, and communicating as much information as possible on financial conditions and risk.
Financial markets are proving they can deal with firm-specific crises, Wilson said, but there is perhaps a more important role than ever for central banks in macro liquidity crises. One of the most promising new mechanisms, he observed, is to have central banks write options and collect option premiums—as the U.S. Federal Reserve did for the Y2K period. He warned that what may be ahead are fewer, but bigger, crises.
What you see is what you get—except in the new financial system, Peter Garber of Deutsche Bank Group cautioned. Risk monitoring that focuses solely on on balance sheet data may miss out on half the story. Derivatives, he noted, are an ideal means to circumvent prudential regulations, because accounting systems do not keep pace with rapidly innovated financial market instruments and are nearly obsolete for balance of payments data. On-balance-sheet data, Garber suggested, create an “optical illusion” that may mask the real implications of major shifts in capital flows. Without a fuller idea of what players in the market are doing and why, it will be extremely difficult to measure a country’s potential susceptibility to major capital flow reversals and to gauge what is driving reversals and what appropriate short- and long-term responses should be, Garber said.
In a concluding presentation, Richard Portes of the London School of Business noted that recent crises and several large bailouts have prompted a number of proposals that in effect seek to abolish the IMF and end big bailouts. The recommendations seem to harken back to a golden age when creditor agencies resolved crises neatly and without moral hazard. But this golden age never was, he said. Before the IMF existed, defaults took years to resolve, and it “was not nice.” Large bailouts, he stressed, can be avoided only when credible alternatives are in place.
He suggested that bondholder committees and collective-action clauses offered more plausible alternatives. Bondholder committees could mitigate information problems, establish procedures, create peer pressure, and facilitate side payments. Collective-action clauses could provide for qualified voting majorities, and sharing and nonacceleration agreements. There has been resistance in various quarters, Portes noted, but if the world is serious about reform, these proposals offer more realistic solutions.