Chapter 3. International Capital Markets
- International Monetary Fund
- Published Date:
- September 1999
At the end of July 1998, Executive Directors conducted their annual review of developments in, and prospects for, international capital markets. At that time, the financial crises in emerging markets had been largely confined to Asia. Soon afterward, the outbreak of the debt crisis in Russia and, later, the near-collapse of a highly leveraged hedge fund, Long-Term Capital Management, ushered in another period of unusual financial turbulence, escalating fears that the economic slowdown might continue to widen and deepen in 1999.
Consequently, in mid-December 1998, the Board discussed an update of the fall World Economic Outlook assessment, as well as updated developments in international capital markets, their impact, and their implications for financial sector and stabilization policies4 (see also Chapters 2 and 5).
At their July 1998 discussion of capital markets, Directors emphasized the lessons from the Asian crisis, the risks and challenges facing policymakers, and issues raised by the then-forthcoming introduction of the euro.
Asian Crisis and Other Emerging Market Developments
Directors viewed the deep-seated problems in banking systems and financial sectors—including weak supervisory and regulatory systems, poor internal risk management, and governance problems—as significant factors, although not the only ones, that had led to the Asian crisis. Several felt that inadequate domestic market discipline, owing to the availability of extensive national safety nets, had encouraged excessive risk taking in a number of countries. The financial sector weaknesses implied that the large capital inflows before the crisis had not been efficiently intermediated and—together with excessive reliance on formal or informal exchange rate pegs—had led to significant unhedged exposures to currency and interest rate risk, liquidity mismatches, and poor credit quality.
Regarding the role of different investors during the crisis, attempts by domestic agents to hedge or unwind unhedged currency exposures—as well as, in some cases, capital flight—had been an important source of pressure in exchange markets; Directors differed, however, about the role that international investors and hedge funds had played. The Board noted that the very large exchange rate depreciations during the crisis had been exacerbated by an especially perverse set of market dynamics related to the drying up of liquidity in foreign exchange markets, growing counterparty risk, and interactions with weak domestic financial institutions. Several Directors noted that the extent of spillovers and contagion across countries did not appear to be fully accounted for by the growing trade and financial linkages between countries. Several Board members suggested that contagion had been aggravated by deficiencies in information and a lack of transparency that made it difficult for investors to discriminate among emerging markets, contributing to the severity of the market reaction after the crisis had begun.
A number of Executive Directors noted that the Asian crisis raised fundamental questions about the functioning of international capital markets. The capital inflows before the crisis had created enormous difficulties for emerging market policymakers, given the size of the inflows and the potential for sharp reversals when sentiment changed. Some Directors felt the Asian crisis was as much a reflection of weaknesses in international investor behavior as of problems in the emerging markets. Some considered that the sharp decline in nominal interest rates in mature markets had stimulated the search by global investors for higher yields.
In this regard, a number of Board members noted, as an important feature of the crisis, cross-border interbank lending—especially at short maturities—which had facilitated capital inflows and posed new challenges for managing risk. A number of Directors supported changes to bank capital requirements that would better reflect the risks of short-term interbank lending. Some underscored the need to find ways to improve the pricing of risks by foreign creditors and called for better supervision of creditor banks.
Several Directors noted that key international credit-rating agencies had failed to foresee the Asian crisis and then aggravated it when they subsequently moved to sharply lower the credit ratings of countries. A number of others, however, indicated that these agencies were not alone in failing to see the crisis coming, or in missing the extent of the vulnerabilities in the Asian crisis countries. Notwithstanding these concerns, Directors felt it was inevitable that the trend toward increased capital account liberalization would continue. Most believed that a certain degree of volatility was unavoidable; policymakers had to work to make their economies more resilient to the shocks that did occur and had to give much greater attention to ensure the orderly and well-sequenced liberalization of the external capital accounts.
The Board pointed to a number of lessons that national authorities should take from the Asian crisis. Most important was that weak financial policies and systems could overwhelm sound macroeconomic policies. A number of Directors suggested that exchange rate flexibility could play a key role both in helping to adjust to capital inflows and in encouraging appropriate hedging. Some Directors reiterated that the timing of exiting from an exchange rate peg was crucial. In particular, the risks of switching to a flexible system in the midst of the crisis were higher when banking, financial, and corporate sectors were weak. A few Directors argued that other options in the context of the Asian crisis might have been to adjust the exchange rate within the framework of the existing anchor or to move to another nominal anchor.
The Board agreed that strengthening banking sector supervision and infrastructures, including through the adoption of the principles set out by the Basle Committee, was key to avoiding future crises. Some Directors favored Chilean-type taxes on short-term capital inflows as a prudential measure applying to both bank and nonbank sectors. Several others, however, considered that, while such controls had helped discourage potentially destabilizing short-term flows in certain cases, they tended to lose effectiveness over time. Such controls had, however, helped gain time for countries in the process of building up their supervisory frameworks and strengthening market discipline. In any event, controls on short-term capital inflows should not be considered a substitute for strong fundamentals, including the requisite banking sector reforms. Some Directors pointed to the important role of foreign direct investment as a more stable source of financing. And several Board members commended efforts by a number of countries to facilitate the development of local capital markets, especially bond markets, to reduce the importance of banks in intermediating capital flows.
On the issue of moral hazard, some Directors agreed that the prospect of IMF support had probably not been a consideration in lenders’ and borrowers’ decisions prior to the Asian crisis. Several Board members noted, however, that the provision of IMF support, together with government guarantees on external liabilities, could have affected the behavior of market participants. In this context, they called for measures to minimize moral hazard, including by involving the private sector early on, to bring about a fair burden sharing between the private and public sectors.
With respect to then-recent developments in the emerging markets, the Board was concerned about the sharp output declines in the Asian crisis countries and the continued fragility of private market financing provided to the emerging markets. Directors agreed that the priority for the Asian crisis countries was to accelerate financial and corporate restructuring, including providing adequate bankruptcy procedures; this could be facilitated in some cases by the judicious use of public funds to recapitalize weak but viable financial institutions. More generally, the Board urged policymakers in the emerging market countries to continue their efforts to reduce their vulnerabilities to external shocks, including through addressing domestic macroeconomic and financial weaknesses and, in the case of commodity exporters, adjusting appropriately to the softness in commodity prices.
Mature Market Countries
The continued weaknesses in a number of emerging markets, especially in Asia, contrasted sharply with the relatively favorable performance of many of the industrial countries. Most Directors felt that the performance of the industrial countries in North America and Europe (as of the July 1998 discussion) reflected strong macroeconomic conditions and policies in many of these countries, generally low and stable inflation, and manageable exposures of many banking systems to the Asian emerging markets in crisis. Moreover, several industrial countries had benefited to some extent from the favorable inflation implications of lower commodity prices and weaker Asian economic activity. On the other hand, growing domestic weaknesses in Japan had been worsened by—and were contributing to—the Asian crisis, given close trading and financial linkages with the Asian emerging markets.
The Board welcomed the growing confidence in the then-forthcoming successful launch of the euro at the beginning of 1999, and the high degree of macroeconomic convergence achieved by the 11 countries that were to make up the initial euro area. This was seen as contributing importantly to intra-European exchange rate stability and the effective convergence of long-term interest rates at low levels.
A number of not-insignificant risks in the mature economies, however, made the outlook uncertain. Most notable, Japan’s failure to address decisively its financial sector problems had contributed to domestic economic weakness, downward pressure on the Japanese yen, and adverse spillovers, in particular, to neighboring emerging markets and the world economy. Directors therefore strongly urged the Japanese administration to move quickly to address the long-standing weaknesses in the banking sector through a rigorous accounting of the size of the bad loan problem, recapitalization and restructuring of viable banks, and improvements in the prudential framework to ensure that any use of public funds in assisting the banking sector would result in a sustained improvement in the safety and profitability of the banking system. A number of Board members noted that Japan’s “Big Bang” reforms underscored the urgency of action, since the reforms would place additional pressure on banks and contribute to further downward pressure on the yen by making it easier for Japanese savings to be invested abroad.
A number of Directors were concerned about the risk of a significant correction in the then-high equity valuations in the United States, particularly in view of the apparent slowdown in U.S. earnings growth, the likelihood of further fallout from Asia, and the possibility of an increase in U.S. interest rates. Most Directors believed that the strong economic fundamentals in the United States—together with improvements in the financial market infrastructure since the 1987 stock market crash—meant that a modest correction would be manageable from a domestic perspective. They expressed concern, however, about spillovers, especially to emerging equity markets, and possible adverse implications for confidence in the then-unsettled global environment.
The European Economic and Monetary Union process had highlighted a number of supervisory and regulatory issues for the European countries that were also, to varying degrees, faced by other countries. The acceleration of financial sector restructuring likely to be facilitated by the introduction of the euro would pose a number of challenges for European policymakers. Directors expressed a range of views on the preparations for crisis management within EMU and, in particular, on lender-of-last-resort support. Some noted that such support was the responsibility of national authorities. Others thought it was essential for a central bank, and, in particular, for the European Central Bank, to be lender of last resort, and for it to play a central role in coordinating supervision across pan-European institutions and markets. Some Directors also pointed to the importance of such financial safety nets as deposit insurance schemes and liquidity consortia. Some Directors acknowledged, by referring to the European System of Central Banks (ESCB) Statute, that the ESCB had the tools necessary to fulfill a liquidity support role and could step in to provide liquidity if and when needed. Some supported the IMF staff’s suggestion that it was important to clarify further the sharing of responsibilities between the ECB and national central banks and the flow of information between national supervisory bodies and the ECB.
The Board welcomed the ongoing efforts in multilateral forums and in many mature market countries to improve supervision and regulation through improvements in accounting and disclosure; clearer understandings on the responsibilities of “home” and “host” supervisors; and an increased focus on consolidated, risk-based supervision, such as the Basle Committee’s guidelines on market risk capital requirements for banks, issued on January 1, 1998.
The Board concluded by noting that developments since its last review of international capital markets had underscored the importance of timely and comprehensive IMF surveillance of international financial markets.
At the Executive Board’s December 1998 interim assessment—an update of the summer assessment of international capital market developments and fall World Economic Outlook—Directors considered the possible causes of the financial market turbulence, its likely impact on the global economy, and the implications for financial sector and stabilization policies. They emphasized the triggering role of Russia’s unilateral debt restructuring, which was followed by a number of sharp global market corrections, a broad-based reassessment of the risks associated with emerging market investments, and a large-scale portfolio rebalancing across the full range of financial markets. The Board focused on the turbulence in mature markets; the widening of interest rate spreads after a period of unusual compression; the effects on highly leveraged investment positions; the heightened concern about a lack of liquidity in some of the world’s deepest financial markets; and the sharp correction in the yen-dollar exchange rate in early October 1998.
Although a measure of calm had returned to financial markets since mid-October, the Board stressed the wide margin of uncertainty about the significance of the turmoil, in particular its implications for economic activity. Several Directors saw reason to expect that the turbulence would have only a limited economic impact. They emphasized the rapid rebound in equity markets in most industrial countries, reductions in bond spreads for most creditworthy borrowers and the ability of corporate borrowers to draw on bank credit lines after the contraction in the U.S. commercial paper market, and a lack of evidence of a credit crunch in Europe. Directors were also encouraged by further declines in interest rates in the Asian crisis countries and by evidence of some renewed access for emerging market economies with stronger economic fundamentals to global financial markets.
On the other hand, many Board members were deeply concerned by signs that the crisis could have more long-lasting effects, especially for emerging market economies. Among the most important of these were a widening of yield spreads, increased selling pressures in equity markets, and indications of renewed capital outflows. Some of these were in reaction to delays in implementing the needed fiscal reform in Brazil.
Factors Behind Markets’ Response
In light of the severity of the then-recent turbulence, the Board identified several elements that helped explain the markets’ reassessment of risks and, together with the rebalancing of mature market portfolios, the disproportionately severe market reactions in response to disturbances of relatively limited magnitude:
- The Russian unilateral debt restructuring challenged underlying assumptions of many investors about the risk of sovereign default. Several Directors commented that the Russian experience had served to change perceptions of risk by demonstrating to markets that official support would not be disbursed unless economic policy requirements were met.
- Highly leveraged investment exposures in both emerging and mature markets had to be rapidly unwound or hedged as risks were reassessed. The subsequent rapid liquidation into falling markets added to the intensity of selling pressure.
- A large number of the world’s leading commercial and investment banks—and not just hedge funds—were involved in the kind of highly leveraged investment positions that were vulnerable to the unexpected widening of interest rate spreads.
- Risk management models used by these institutions did not prevent the buildup, and modern portfolio management appears to have worsened the unwinding, of these leveraged financial positions. A disorderly unwinding and deleveraging of Long-Term Capital Management’s portfolio would have posed additional systemic risks in international financial markets, which justified the role of the U.S. authorities in helping organize a private sector rescue operation. Several Directors noted that the reassessment of risk and portfolio adjustments were, in and of themselves, broadly appropriate, reflecting in large part a correction of the previous underestimation of risks of certain investments, in mature as well as in emerging markets. The concern, rather, was the speed and breadth with which the adjustments had occurred and the systemic risks they posed to financial markets and economic growth.
Directors underscored the limitations of private risk and portfolio management, banking supervision, and financial market surveillance in the face of rapid globalization of financial markets and increasing financial innovation. They identified, as a source of systemic concern, the apparent lack of understanding by both private and official market participants of the growing financial imbalances and vulnerabilities in the run-up to the events during August–October 1998. Several Directors questioned whether models of risk management were capable of adequate warnings and safeguards against low-probability but high-cost events, such as those that had shaken global markets in 1998. They observed that the international financial system itself, including the highly integrated nature of institutions and markets and their linking within and across national boundaries, contributed to the turbulence and unpredictability of financial market risks. Some Directors concluded that management control systems and practices within financial institutions would have to be reassessed and risk models subjected to more stress testing, to cope better with the risks inherent in modern financial markets.
Role of Public Policy
The Board also considered the role of public policy, especially as financial vulnerabilities had been allowed to accumulate until it was too late to prevent their adverse consequences. Directors called for urgent consideration, as a critical element in efforts to strengthen the architecture of the international financial system and domestic financial sectors, of possible measures to reduce the systemic risk associated with financial market turbulence. Such measures included stricter capital requirements for off-balance-sheet activities, a reexamination of the adequacy of current prudential supervision and regulation of the largely unregulated hedge fund industry and other highly leveraged institutional investors, and stronger oversight of bank lending to hedge funds.
Several Directors called for a further discussion of the systemic impact of highly leveraged positions of financial institutions generally. To reduce the systemic dangers posed by high-risk operations of hedge funds and other large financial institutions, stronger efforts were also needed on the supply side. Private financial institutions, with the help of supervising authorities, had to address the shortcomings in private risk and portfolio analysis and management, and the international community had to strengthen its efforts on financial supervision and regulation and financial market surveillance in the mature economies to better identify and prevent the emergence of systemic risks. Directors generally thought that financial supervision and regulation could be enhanced only if national supervisors had more information and analysis on the buildup of balance-sheet and off-balance-sheet positions, leverage, and both the aggregate amount and distribution of risk taking in national and international markets.
Some Directors also stressed that the August–October 1998 episode of market turbulence underscored yet again the importance of capital account liberalization being orderly and well-sequenced—and preceded or accompanied by the establishment of effective prudential regulations and supervision. Market-based measures to discourage excessive short-term inflows and encourage foreign direct investment might also be desirable in the liberalization process. Pointing to the risks arising from increasingly volatile and large capital flows, Directors called for an effective system to manage and monitor them.