CHAPTER III International Capital Markets
- International Monetary Fund
- Published Date:
- September 1998
In their annual review of developments in international capital markets, conducted in July 1997 shortly after the eruption of the financial crisis in Thailand, Executive Directors engaged in a wide-ranging discussion of mature and emerging capital markets and banking systems. They also assessed the implications of European Economic and Monetary Union for international capital markets. Directors discussed at length developments in emerging markets, strategies for dealing with speculative attacks, and approaches to more effective management of sovereign external liabilities. Later in the fiscal year, in March 1998, the Board examined the role of hedge funds and institutional investors both in connection with the Asian crisis and, more generally, in a world of increasingly integrated capital markets.6
Mature Capital Markets
Directors noted the narrowing of interest rate differentials among the mature economies and attributed this to several causes, including fiscal consolidation, reductions in inflation rates, and increased competition in international banking markets. Directors also saw the continued convergence of interest rates as a sign that markets expected a broad EMU to begin on January 1, 1999, As to a second major trend in the mature markets—the continued sharp advances in equity prices, particularly in the United States—many Directors felt that the relatively high valuations of stocks rested on investor expectations of continued strong growth in corporate earnings and relatively low inflation rates. Although diverse views were expressed about the implications of conventional market indicators, many Directors were concerned about the potential for corrections in some equity markets and the possible negative impact of such corrections, especially in emerging equity markets. Directors urged careful monitoring of stock markets in the United States and other economies.
Banking in Mature Markets
Directors noted that the banking systems in some mature markets had been highly profitable during the preceding 12 months, while others continued to be affected by high levels of nonperforming loans. They discussed the difficulties in ensuring effective financial supervision created by financial deregulation and globalization and noted that, as distinctions between banks and other financial institutions had blurred, a growing number of countries had moved toward consolidating supervision over a broad range of financial institutions into one agency.
Structural Aspects of EMU
Directors viewed the creation of EMU as an important international financial event that was likely to foster the creation of EMU-wide financial markets, benefit European banking systems, and lead to a more efficient European payments system. Although some consolidation and restructuring of banking systems was generally seen as inevitable, several Directors cited the diverse situations of banking systems among European countries. Some stressed the importance of taking into account the performance of all types of financial institutions, such as savings, post office, and cooperative banks, in assessing the efficiency of the European banking system. Market-based solutions were seen as desirable for addressing banking sector problems. Some Directors cautioned that regulatory practices, local market power, rigid labor practices, and public ownership structures could delay the required adjustments. A number of Directors cautioned against both the fiscal costs and the moral hazard that might be associated with public interventions for addressing the problems of the more seriously troubled financial institutions.
Directors noted the growing integration of many emerging markets into the global financial system, as evidenced by the record level of private capital flows to these countries in 1996. The scale of such flows reflected improvements in the economic fundamentals in many recipients, the growing international diversification of institutional investor portfolios, and the increased ability of investors to search for higher yields. Directors expressed concern, however, that interest rate spreads on emerging market bonds and syndicated loans might have been bid too low and that many of these investors might not be fully cognizant of the credit risks they faced. Some Directors also thought that the low level of emerging market spreads might reflect investor expectations that systemically important emerging markets would receive official assistance that would allow them to avoid debt-service interruptions. To avoid moral hazard, several Directors cited the need to dispel the notion that the IMF would step in to bail out creditors.
Speculative Attacks and Exchange Rate Regimes
Executive Directors noted that the events in Thailand and neighboring foreign exchange markets had—as during the Mexican and European exchange rate mechanism crises—again demonstrated that the growing integration of financial markets meant that perceived macroeconomic uncertainties and structural weaknesses were more likely to generate large-scale speculative pressures on rigidly managed exchange rate arrangements than on flexible regimes. Many Directors argued that an inflexible exchange rate system could be sustained only if actively supported by strong macroeconomic policies and a sound financial system able to withstand sharp and sometimes sustained increases in interest rates to defend against speculative pressures.
The first line of defense against speculative attack must be sound macroeconomic policies. Directors stressed. When economic fundamentals were broadly correct, the authorities could mount a graduated defense based, first, on sterilized foreign exchange intervention and then, if necessary, unsterilized intervention, allowing short-term domestic interest rates to rise. Even in situations where the cost of maintaining high interest rates was considered excessive, Directors saw only a limited, short-term role for capital controls designed to limit the access of speculators to domestic credit. Such measures, they felt, should be used only in crisis situations to buy time to undertake corrective policies and should not be seen as a substitute for necessary reforms. Some Directors also emphasized that exchange restrictions that discriminated between domestic and foreign residents were inappropriate.
In discussing the appropriateness of fixed exchange rates, a few Directors drew attention to the choice of the peg currency and whether this should be based on the currency composition of trade flows or of external borrowing. Many Directors underscored the importance of moving to more flexible exchange rate systems in the face of sustained market pressures. Some also felt that allowing for more exchange rate flexibility would reduce the need to build up foreign exchange reserves and mitigate the problems in sterilizing sizable capital inflows and the associated cost (see also Chapter VI).
Banking in Emerging Markets
Directors commended the progress made in improving the health of banking systems in several countries but observed that significant problems remained in some others. Several Directors noted that investor concerns about potential vulnerabilities in the banking systems of some Asian emerging markets had contributed to instability in foreign exchange markets. Concerns about the impact of the Thai devaluation echoed similar concerns raised in 1995 in the context of the Mexican financial crisis. Both episodes had underscored the importance of sound risk management and prudential regulation in emerging market banking systems.
Managing Sovereign External Liabilities
Directors stressed the importance of improving the emerging market countries’ management of sovereign external liabilities (both gross and net). They generally viewed foreign currency borrowing as necessary for complementing domestic debt instruments, broadening the investor base, and establishing international benchmarks. But they cautioned that such borrowing should be guided by strategic debt-management considerations—namely, the ability to generate corresponding foreign currency revenues—and not be driven by short-term fiscal savings. Cost considerations should be based on the hedged (risk-adjusted) cost for a country. The debt-management strategy should incorporate clear guidelines on currency composition and maturity structure and should take into account foreign borrowing by the private sector, especially by commercial banks. Directors noted the risks and constraints that a large stock of short-term foreign currency debt could impose on macroeconomic policies; they referred to the unfolding Asian turmoil as a clear example of what could occur.
Greater policy transparency and accountability of debt managers in managing foreign assets and liabilities were generally viewed as enhancing the ability to manage exposures to external shocks. In this regard, many Directors highlighted the potential merits of a separate debt-management agency with expertise and experience in risk-management techniques. They also underscored the need for coordination and consistency between such an agency and the monetary and fiscal authorities.
Hedge Funds and Financial Market Dynamics
As a point of departure for their March 1998 discussion on hedge funds, Directors noted that detailed information on these funds was limited. As private investment pools, hedge funds were not subject to most of the reporting and disclosure requirements applicable to banks and mutual funds. More fundamentally, it was difficult to demarcate clearly the boundaries of the hedge fund industry from other institutional investors, or to generalize about its activities given the great diversity of investment strategies pursued by fund managers. Still, several commercial services gathered information on the industry. Excluding “funds of funds” (funds made up of smaller funds), such estimates suggested that hedge fund capital was in the neighborhood of $100 billion as of the third quarter of 1997. Of that, some $25 billion was in the hands of so-called macro funds, that is, funds that take large unhedged positions on changes in global economic conditions and typically leverage their capital through borrowing by a factor of 4 to 7. The remainder was managed by so-called relative value funds that take bets on the relative prices of closely related securities and are less exposed to economic fluctuations; they tend to be more highly leveraged than macro funds. By contrast, the capital of such other institutional investors as investment and commercial banks exceeded $20 trillion in the mature markets alone.
Against this background. Directors differed on the impact of hedge funds on market dynamics. While agreeing that hedge fund capital represented only a fraction of liquidity in global financial markets, several Directors emphasized that highly leveraged hedge funds could take large positions in the smaller emerging markets. They also noted the relative freedom and flexibility of hedge fund activities. Some Directors argued that hedge funds encouraged herding behavior among investors. Others saw only limited evidence that hedge funds contributed significantly to herding and noted their potential role as contrarians or stabilizing speculators.
Hedge Funds and the Asian Crisis
Directors differed on the extent of the involvement of hedge funds in the Asian crisis. Several saw no clear evidence that hedge funds took short positions against Asian currencies any earlier than other investors, or that their trades were necessarily a signal for other investors. Directors noted that while hedge funds had large short positions on the Thai baht, the same did not appear to have been true for Asian currencies in general. Because some governments and central banks limited the ability of offshore counterparties to borrow domestic currency from onshore banks, other investors with better access to the domestic broker market might have acted as market leaders. The entire constellation of institutional investors, and not merely hedge funds, in the Board’s view, had played a role in the market fluctuations of 1997.
A few Directors felt that hedge funds had played a more important role in the crisis than indicated by the staff paper on hedge funds.7 They argued that hedge funds at times had a strong effect on asset prices, particularly in light of the relative size of their positions in specific markets. Directors generally agreed, however, that the events in Asia highlighted the need for policy makers to pursue sound and prudent macroeconomic policies that were transparent to markets in order to protect their economies against sharp market volatility and speculation. In particular, they recommended avoiding offering one-way bets in the form of inconsistent policies and indefensible currency pegs; maintaining strong, well-regulated, and competitive financial systems; and providing timely and comprehensive information to the public about government policy and private sector financial conditions. While recognizing the role of better information in curbing herd behavior, several Directors cautioned that disclosing market-sensitive information could on occasion trigger or worsen market volatility.
Board members expressed diverse views on whether hedge funds should be subject to additional regulatory and disclosure requirements. Some argued that, given the scant evidence of market failure associated specifically with hedge funds, the case for new regulations was slim. Some other Directors, however, indicated that further options needed to be explored to render hedge fund operations more transparent and assure officials and market participants that hedge funds were not dominating or manipulating markets.
A number of Directors warned that hedge funds were only one part of the larger constellation of institutional investors, so that, to convey useful information, any system of detailed portfolio and position reporting would also have to encompass, among others, commercial banks, investment banks, insurance companies, and pension funds. It was also noted that reporting systems were more difficult to implement in an over-the-counter environment, such as the foreign exchange market, than on organized exchanges. Moreover, to be totally effective, reporting requirements would have to be applied by all countries Otherwise, market participants who regarded reporting as onerous would simply book their transactions offshore.