After some of the most severe financial turbulence in post-World War II history in 1998, the global financial system is pursuing a still fragile recovery and beginning to turn its attention to implementing the lessons learned from the crises of the past year. The IMF’s annual survey of global markets, International Capital Markets: Developments, Prospects, and Policy Issues, notes that timely action by a number of central banks and the international community defused a potential global crisis and that relative stability returned to financial markets in 1999. Significant risks remain, however—notably those associated with the ongoing global reappraisal of risk. In the mature markets, there are questions about U.S. equity prices and the sustainability of a strong dollar. In emerging markets, risks arise from the size of the investor base, which, despite some rebound in “quality” markets, remains relatively small; the level and structure of external financing; and cutbacks in external debt markets.
The IMF’s yearly report on capital markets, which is based on staff discussions with private market participants as well as national authorities, also spotlights key issues in market behavior. The recent crises pointed to critical weaknesses in private risk management, bank supervision, and financial market surveillance. The 1999 report addresses the need to better manage global finance and gain a deeper understanding of the ramifications of high levels of leverage for systemic risk.
In a September 8 press conference on the report’s findings, Charles Adams, Assistant Director of the IMF Research Department and head of the staff team that prepared the report, also notes that the study specifically examines how small and medium-sized capital markets have been affected by the turbulence and how nonstandard policy interventions have been employed in Brazil, Hong Kong SAR, and Malaysia to cope with the crisis. Given the increasingly important role of major credit-rating agencies in determining market access, the IMF took a closer look at these agencies, Adams explains, both to gain a more in-depth understanding of how these agencies worked and to determine what lessons they were drawing from the crisis of 1998.
Over the past year, according to the report, the behavior of mature markets continued to be shaped by sharply divergent macroeconomic performances and policies—notably, the strong performance of the U.S. economy and the negative or low growth recorded in Japan and Europe. Mature markets were also affected by emerging market spillovers to banking systems and a low-inflation environment. On the structural side, a number of important steps took place, principally the successful launch of the euro, Japan’s steps to address its financial sector problems, and stepped-up mergers and acquisitions among major banks.
But notwithstanding a return to greater stability and crucial structural changes, significant risks persist. A key risk is the possibility of a large correction in the U.S. equity market. Uncertainty about the outlook for corporate earnings, the advanced stage of the U.S. business cycle, and the recent reversal of the decline in U.S. interest rates all underscore the potential for a substantial correction, the study cautions. Also, in the absence of comprehensive information about the extent of leverage in the major financial systems, the vulnerability of these systems—and emerging market systems—to a correction may be considerable.
Also of potential concern, the report notes, are a sudden—and sharp—weakening of the dollar (with the related risk of exchange rate volatility and spillovers to other markets) and risks related to the Y2K problem. In the run-up to the millennium, market liquidity and the willingness to bear risk may decline, and liquidity “may command an increasing premium,” the study suggests. A fairly wide range of market reactions is conceivable, including an extreme flight to cash and large cutbacks in emerging market exposure. The study commends financial institutions for the emphasis they have recently given to contingency planning.
Despite access largely restricted to sovereign issuers and a still shrunken investor base, the first half of 1999 saw a pickup in emerging market asset prices. Overall external financing for emerging market borrowers remains weak, however. Offsetting improved macroeconomic conditions, particularly in Asia, are a number of risks. Chief among them is the prospect of tighter monetary conditions in the United States. Such a tightening has traditionally been accompanied by a slowdown in capital flows to emerging markets and wider interest rate spreads on emerging market securities. Similarly, a sharp adjustment in equity prices in mature markets, such as the United States, could strongly, and negatively, affect emerging equity markets.
The report also highlights concerns about the corporate sector, where restructuring efforts in a number of Asian countries are moving slowly, if at all, and the position of Latin American corporate sectors is deteriorating in line with the economic slowdown there. Another concern is the decision, by some investment banks, to shut down their emerging market trading desks, with attendant declines in investors and liquidity, and increased asset price volatility.
Managing global finance
The three lines of defense against systemic risk—market discipline, prudential supervision and regulation, and macroprudential surveillance—failed to prevent excessive leverage in 1998 and have been the focus of subsequent reform efforts. The new proposals stress the need to tighten bank controls on their exposure to hedge funds and increase significantly the amount of information that financial institutions, including hedge funds, provide to their counterparties and to the markets.
The IMF study welcomes these steps but emphasizes the important challenges that remain. In particular, it urges that attention be given to the absence of an analytical framework to determine when leverage reaches unsustainable levels; the need to develop incentives to improve risk management in private firms; and the importance of improving both the types and the frequency of market information.
In the area of macroprudential oversight, the report cites the need to monitor global liquidity more closely, explore the synergies between prudential macrosurveil-lance and supervision of individual financial institutions, and improve regulators’ understanding of risk control mechanisms within firms. Another question in need of greater attention, according to the report, is whether firms’ heavy reliance on modern risk management practices may be exacerbating financial turbulence.
The systemic issues raised by highly leveraged institutions and activities are currently the subject of a number of international studies, including one by the Financial Stability Forum. The staff report argues that systemic issues can be addressed through significant enhancements in market discipline, supported by improved disclosure and transparency, more rigorous creditor and country assessments of exposure, and stronger private risk management and control systems. But further work needs to be done, it contends, on the impact of the activities of highly leveraged institutions on small and medium-sized countries.
Nonstandard policy responses
In the face of extreme financial pressures, some countries last year opted for nonstandard policy responses. The Hong Kong Monetary Authority intervened in domestic equity and derivative markets to address concerns about a “double play” by highly leveraged speculators; Malaysia implemented capital controls to bolster its domestic monetary independence and effectively halt offshore operations in its currency; and Brazil intervened in its external debt market.
Malaysia, as Donald J. Mathieson, chief of the IMF’s Emerging Markets Study Division, notes at the press conference, had a very high ratio of corporate bank debt to GDP and the corporate sector was thus highly sensitive to interest rate changes. Malaysian authorities used capital controls in part to segment domestic and international financial markets and to allow them to sustain lower interest rates. The controls also were implemented after most of the external pressures had been felt and, as a result, were never fully tested. It is difficult to speculate on how effective they would have been in a period of intense pressure, Mathieson notes, but the study finds no significant evasion for the period they were in force.
The authorities also pursued several key reforms—particularly in banking and the corporate sector—that improved the country’s economic situation.
As capital markets have taken on a larger role in funding, major credit-rating agencies have assumed a key task in providing standardized assessment of credit risks. These agencies identified weak financial systems in a number of Asian countries before the crisis, but the report argues that the maintenance of investment-grade ratings for many countries and the sharp downgrades during the crisis contributed to the procyclical nature of capital flows.
Major rating agencies are now moving to strengthen their analyses, and the Basel Committee proposals, which base banks’ capital risk weights on external credit rating, lend even more urgency to their efforts. A more effective rating process could help moderate the boom-bust cycles that have characterized international capital flows.
The IMF study concludes that lessons from 1998’s extraordinary turbulence have given shape to a long and ambitious agenda for the public and private sectors. While financial crises will never be eliminated, the report suggests that these efforts can help reduce the frequency and severity of financial crises and help ensure that all countries—including emerging markets—participate in capital markets without exposure to high risks.
Copies of International Capital Markets: Developments, Prospects, and Policy Issues, by an IMF staff team led by Charles Adams, Donald J. Mathieson, and Garry Schinasi, are available for $36.00 ($25.00 academic rate) from IMF Publication Services. See page 297 for ordering information. The full text of the September 8 press conference is available on the IMF’s website: http://www.imf.org.