I Introduction and Overview

International Monetary Fund
Published Date:
September 1999
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The period since last year’s International Capital Markets report has witnessed some of the most severe financial market turbulence in the postwar period. The effects of the Asian financial crisis were initially felt mainly within the region, and the negative spillovers to other emerging markets and to most of the advanced countries outside the region were short lived.1 Indeed, through mid-1998 other emerging markets, including in Latin America and Europe, generally maintained access to international capital markets at relatively favorable terms, and some of the Asian crisis countries saw a pickup in inflows.2 At the same time, equity markets in most of the advanced countries continued to record strong gains—reaching record valuations; levels of leverage in advanced countries’ financial systems remained high; and confidence was generally strong.

During 1998, however, the situation began to deteriorate as weakening commodity prices, deeper-than-expected output declines in the Asian crisis economies, and continued difficulties in Japan conspired to produce an increasingly negative perception of the global outlook. Russia’s decision in August to unilaterally restructure its domestic debt and allow the ruble to depreciate triggered a far-reaching reassessment of risk. Reflecting the associated portfolio rebalancing and deleveraging, credit and liquidity spreads in key mature markets widened sharply—more than reversing the compression over the preceding several years; liquidity almost dried up in some of the deepest capital markets in the world following the near-collapse of the hedge fund Long-Term Capital Management (LTCM); and the dollar-yen exchange rate experienced its largest one-day movement since the collapse of the Bretton Woods system. The effects of the turbulence on the emerging markets were dramatic: spreads on external debt widened sharply, international lending effectively dried up, and the more vulnerable economies in Latin America began to be brought into the crisis.

Timely action by a number of central banks and the international community were successful in staving off the risk of a global crisis, and financial markets in the advanced countries began to stabilize toward the end of 1998. Moreover, even though sentiment began to deteriorate again early this year when Brazil gave up its defense of its currency after several months of pressure, the spillovers to other countries were surprisingly short lived and the negative effects on Brazil less than had been feared. These muted responses were pivotal in avoiding another round of international financial turmoil. In the event, the economic climate began to improve as it became clear that growth in the U.S. economy remained surprisingly robust, Japan began to take important measures to stabilize its economy and address its banking sector problems, and the Asian crisis economies showed signs of recovery. Notwithstanding these favorable developments, conditions in financial markets remain fragile, as evidenced by continued high levels of volatility, high spreads on emerging market external debt, and capital flows to the emerging markets that are running well below the rates during the boom years.

The turbulence over the last few years has raised questions about the market dynamics of the “new” increasingly integrated and securitized international capital markets, including the boom-bust swings in international capital flows, the speed and severity with which disturbances spill over across countries, and the market dynamics (magnification effects) associated with high levels of leverage. Recent International Capital Markets reports and World Economic Outlooks have extensively covered many of these issues, which are also being considered in the context of the IMF Executive Board’s work program. Following a review and assessment of recent developments in capital market and banking systems, this year’s International Capital Markets report addresses a number of specific features of international capital market dynamics, including the systemic and other issues posed by highly leveraged institutions and activities; the nonstandard policy responses some emerging markets have taken when faced with extreme external pressures; and the performance of the major credit rating agencies during the recent financial crises.

Chapter II provides a comprehensive assessment of recent developments and trends in the mature financial markets and identifies key risks and uncertainties in the outlook. Beyond the turbulence in international capital markets, the mature financial markets were influenced significantly over the last year by continued sharp differences in macroeconomic performance and policies across the major advanced countries, notably the continued strong performance of the U.S. economy vis-à-vis Europe and Japan; spillovers from problems in the emerging markets, especially to banking systems; and the global shift toward a low-inflation environment. On the structural side, important factors have included the further progress toward European financial integration with the successful launch of the euro, Japan’s initiation of a program to address its financial sector problems, and stepped-up mergers and acquisitions within and between major banking systems. Notwithstanding the recent improved global situation, there are a number of risks related to the sustainability of current configuration of asset prices, especially in the United States, potential vulnerabilities in the major banking systems of the advanced countries, and the possibility of increased uncertainty in the lead-up to the Y2K (Year 2000) transition.

Chapter III reviews and assesses recent developments in the emerging markets with particular focus on how they have been affected by the global turbulence. After declining in 1997 for the first time this decade, private market financing for the emerging markets fell dramatically in 1998, with much of the decline in the latter half of the year in the wake of the international turbulence. With the notable exception of foreign direct investment, all categories of private inflows fell sharply with significant further retrenchments in bank lending. Many regions shared in the cutbacks, with the Asian crisis countries becoming net capital exporters as they began to build up reserves following sharp declines during the crisis. In response to the tightening and cutback of external financing, emerging markets adopted a number of innovative approaches to accessing international capital markets, but generally only the highest quality borrowers have been successful, in some instances supported by official guarantees. Not surprisingly, the tight external financing conditions have placed strains on emerging markets, with effects varying according to underlying vulnerabilities, including dependence on short-term external funding, the strength of banking and corporate sectors, and progress in improving financial sector resilience. Notwithstanding a rally in emerging markets early this year, external financing for many emerging market borrowers remains weak.

In the immediate aftermath of last year’s turbulence in international financial markets, the World Economic Outlook and International Capital Markets: In-term Assessment3 identified several weaknesses in private risk management, bank supervision, and financial markets surveillance that had been intended to provide key lines of defense against systemic risk. Subsequently, in the wake of the LTCM episode, recommendations have been made by both official and private groups in a number of countries to address these weaknesses. Against the background of deepseated and ongoing changes in global financial markets, Chapter IV considers a number of conjunctural factors, such as abundant global liquidity and the search for yield in competitive financial sectors, that may have contributed to unsustainable levels of leverage in key financial centers, as well as the factors underlying the market dynamics set in train by the increase in risk aversion following the Russian crisis. High and unchecked levels of leverage have not only raised important systemic issues but have also been a source of concern for a number of countries that believe their markets have been pushed around by the large and concentrated positions taken by a number of highly leveraged institutions (HLIs). An appendix to Chapter IV addresses the impact of HLIs on small and medium-sized countries.

The evolving role of emerging markets in the new financial system is discussed in Chapter V. A number of emerging markets have recently responded to extreme financial pressures through relatively nonstandard approaches, taking into account developments in the instruments used—and high leverage employed—by some international investors. Included among these nonstandard approaches have been the interventions last year by the Hong Kong Monetary Authority (HKMA) in domestic equity and derivative markets to deal with concerns about a “double play” by highly leveraged speculators, the adoption by Malaysia of controls on capital outflows to provide greater domestic monetary independence and effectively close down the offshore market in its currency, and interventions by Brazil in its external debt market.

As capital markets become a major source of funding, major credit rating agencies have been assuming an increasingly important role in providing standardized assessments of the credit risks associated with emerging market investments. Although the major credit rating agencies identified weaknesses in the financial systems of a number of Asian countries before the crisis, the maintenance of investment-grade ratings for many countries and the subsequent sharp downgrades during the crisis have been seen by some observers as imparting a pro-cyclical element, exacerbating herding behavior before the crisis and contributing to the massive turnaround in capital flows. Against this background, the report reviews in Chapter V the credit rating experience during the Asian crisis and considers steps the major rating agencies are taking to address weaknesses revealed by the episode. The recent Basel Committee proposals to base banks’ capital risk weights on external credit ratings add importance to rating agencies’ current efforts to strengthen the rating process, and could help dampen the boom-bust cycles in international capital flows, lock in some of the recent shift away from bank lending and toward portfolio flows, and facilitate a better pricing of risk.

1The term “emerging markets” as used in this report is substantially broader than that used in other contexts and includes the IMF’s World Economic Outlook classifications of “developing countries,” “countries in transition,” and the advanced economies of Hong Kong Special Administrative Region (SAR) of China, Israel, Korea, Singapore, and Taiwan Province of China.
2Here, and in what follows, Korea, Malaysia, the Philippines, Thailand, and Indonesia are characterized as the Asian crisis economies. In view of the large number of Asian countries seriously affected by the regional turmoil, the identification of crisis countries is necessarily somewhat arbitrary.
3International Monetary Fund World Economic Outlook and International Capital Markets: Interim Assessment (Washington, December 1998).

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