Benu Schneider, ODI
Robert Gray, HSBC.
Helmut Reisen, OECD Development Centre.
1. Robert Gray focused his presentation on the working of international capital and credit markets, policy mechanisms and gaps in institutional framework.
2. Capital flows to emerging market economies (EME) have declined significantly since 1997. For the fourth year in a row, banks will be net receivers rather than net disbursers of funds to emerging economies.
In Robert Gray's view, the following factors contributed to the decline in capital flows:
(i) the liquidity position of many EME has improved significantly since the Asian crisis;
(ii) declining interest rates in many EME have induced borrowers to favour domestic sources of finance over external sources.
3. Robert outlined possible measures to be taken in order to increase the scale and reduce the volatility of bank loans, equity and bond flows on the assumption that:
(i) given that long term and stable capital flows are more desirable than short term, volatile capital flows, EME should be willing to pay the premium required to attract long term finance;
(ii) portfolio equity flows are more desirable than bond flows or bank loans.
The most appropriate sources of development finance for low-income countries are multilateral lending, official aid and debt relief.
4. Robert Gray presented a defence for the role of banks in EMEs.
Considering the evolution in the composition of capital flows in recent years, traditional cross border lending has declined in importance. However, this does not reflect a diminished interest by banks in emerging economies. In Robert Gray's view, banks played a key-role in the recovery from the Asian crisis by providing short-term trade finance, enabling many of the worst affected countries (notably Thailand and Korea) to reverse their current account deficits. Moreover, banks still account for more than half of the private debt flows to middle-income countries, largely in the form of trade finance, inter-bank lines or other short term credit.
Timely voluntary standstills by commercial banks have been crucial in helping forestall a number of potential crises, as in the case of the recent episode in Turkey, or in Brazil and Korea previously. In the case of the latter country, in particular, negotiated extension of bank claims by 134 international banks made it possible for Korea to regain access to international capital markets in a timely fashion.
The gross amount of medium and long term lending by banks, although at a reduced level, is still large. Direct investment and acquisitions of local financial institutions have increased significantly: this is reflected in the level of outstanding claims in local currency lending by local affiliates of BIS-reporting banks in developing countries, which now amount to US$300bn compared to US$200bn at the end of 1997.
Commercial banks also support EME governments and/or central banks by providing private contingent credit lines. For example, such arrangements can provide a central bank with a form of insurance to protect the domestic banking system against a loss of foreign currency deposits. Such facilities should be a bigger part of the armoury of emerging markets borrowers. Credit rating agencies should place greater weight on the benefit of these facilities in their sovereign risk assessments.
It is argued that bank loans are a source of danger for emerging economies because of their short term nature. Certainly, a large part of bank lending is short term because it finances short term trade, but this component is likely to be self-liquidating. Banks have no practical or philosophical objections to lending on a medium term basis as long as they are properly rewarded for the greater risk with a higher margin.
Mr Gray also questioned proposals that focus on penalising banks and other short term lenders if a crisis develops (e.g. by incorporating an automatic rollover provision, or by mandating a standstill). Instead, a real contribution could be made if borrowers were given an incentive to achieve a proper liability structure, overcoming their reluctance to pay the higher margins required to secure longer maturities. Indeed, poor liability management was a key factor triggering the Asian crisis. On the other hand, other countries, like India, have successfully implemented regulations enforcing medium to long term maturity requirements for foreign borrowing by private and government sector borrowers.
(5) The total stock of outstanding international bonds issued by EME has increased fivefold since 1994, and the average maturity of bond finance lengthened from 5 to 10 years during the 1990s. By their nature, bonds are difficult to restructure in the event of a crisis. Bondholders have a significant information gap compared to banks. Moreover, while banks have multiple and frequently long term relationships with their borrowers, a bondholder's relationship with an issuer is usually limited to holding the issuer's bonds, with the options either to sell or hold the bond until maturity. Gray felt that some volume of emerging market bond borrowing by sub investment grade issuers might have been better carried out in the bank loan market. Risk of large scale sell-off would be lowered by the very different dynamic of the debtor/creditor relationship.
6. Summary of main recommendations.
(i) A mature financial system is an important precondition to capital account liberalisation. A strong domestic capital market is the best protection against volatile capital flows. Debt market development, strengthening of risk management and public sector governance are all important for financial stability.
(ii) Foreign investors should support this process by articulating the benefits of transparency and sound, safe and robust market infrastructure. Domestic capital markets should attract foreign lenders, such as pension funds and insurance companies, that are not as preoccupied with liquidity as investors with a shorter-term horizon such as hedge funds.
(iii) Regulatory or other constraints in foreign investment should be re-examined. Liberalisation of ceilings on insurance company and pension fund holdings of foreign equities in industrialised countries would be particularly beneficial. Also, countries could coordinate tax measures that would be developed to provide an incentive for long term emerging market investments.
(iv) Herding behaviour by bond investors should be avoided. Changes in credit ratings are a significant factor in fixed income investor behaviour. A downgrading can lead to sell-off by funds that are prohibited from holding sub-investment grade securities. It should be possible to devise a more flexible regime whereby a fund, rather than sell, would be required to complement any holding of sub-investment grade paper with a specified level of cash investments; a kind of capital adequacy measure.
Public sector guarantees could help bond issuers gain longer maturities in the international bond market and in local currency markets, so rendering bond flows more stable.
(v) Since banks are on the whole a relatively sophisticated and homogeneous group they may represent the best opportunity to develop a system of incentive that would result in counter-cyclical behaviour. For example, longer term co-financing between the official and private sectors could support the supply side better than at present. Contingent credit lines could be provided under the frame of so-called 'B loan' mechanisms, where a multilateral development bank acts as the lender of resort on behalf of a group of private sector banks. This structure has been very successful in acting as a catalyst for commercial bank and capital market financing for private sector projects in emerging markets. B loans leverage scarce public sector resources from multilateral development banks, bring local companies to international markets and thereby help create jobs and reduce poverty.
Mr Reisen initiated the discussion in the background of a theoretical and empirical analysis of the effects of private capital flows on economic growth and inequality.
7. From a theoretical perspective, capital inflows are predicted to finance either an existing foreign exchange gap or a saving-investment gap in developing countries (the "structural" dual-gap theory). While neoclassical theory, and the associated Solow growth model, posit that a poor country benefits from net inflows until the marginal productivity in its economy equals the world interest rate, the new, endogenous, growth theories claim that gross inflows convey positive externalities that offset diminishing returns to capital. A positive, long-term growth effect of capital is so restored. Moreover, international capital flows allow diversification of risk and the smoothening of consumption.
8. Generally, capital flows are associated with both benefits and risks, depending on the types of flows. Among benefits, capital inflows add to domestic savings allowing for higher investment, raise efficiency, and lower consumption risk. Capital flows entail risks, as they magnify distortions in the allocation of investment (credit booms), and are also subject to sudden stops, leading to bankruptcies, credit crunch, and increasing fiscal burden in the recipient economy.
Empirical studies show that FDI has shown distinctive positive effects: it can crowd in local investment, have positive spillover effects and be crisis resistant (however, such qualities are only associated with specific types of FDI).
Portfolio equity, on the other hand, lowers capital cost and facilitates reallocation, but it can add to asset price inflation and is also reversible (leading to high liquidity and transaction costs).
In contrast, debt flows have a consumption-smoothing role, but tend to be pro-cyclical and prone to sudden stops. Moreover, public guarantees might induce distortions in the allocation of debt flows.
A study conducted by M.Soto (OECD Technical Paper 160) on 44 middle-income countries over the period 1986-97, has shown that equity inflows have a positive effect on growth only in the case of countries with a level of bank capitalisation above 14%. If not, risk taking results intensified, leading to credit booms and bankruptcies.
9. Mr Reisen also presented some evidence about the effects of financial boom and bust cycles on poverty. During boom episodes in an undistorted economy, FDI greenfield raises labour demand and equipment of labour, with positive effects on the poor. On the other hand, portfolio flows, bank credit, and FDI M&A, raises demand for short-term inelastic assets, ensuing in a pro-rich wealth effect.
If there is a period of doubt about current account deficits, real exchange rates, or loan quality, the higher interest rates raise currency and default risks and deteriorate balance sheets. This to the benefit of savers. Labour is squeezed. In period of crisis, output losses rise, labour demand falls, as do the margins in the informal sector. Devaluation raises food and medicine prices. Bank failures induce lower social spending, higher public debt. The poor, in particular, bear the social burden of the crisis.
Mr Reisen concluded with the following suggestions for growth promotion and poverty reduction.
(i) Open up to equity inflows.
(ii) Maximise benefits from these:
- Educate people;
- Reduce distortions;
- Deepen stock markets;
- Abolish ownership limits.
(iii) Avoid premature opening up to bank credit flows, strengthen banking system first.
(iv) Beware of credit and spending booms.
- Enforce bank supervision;
- Avoid implicit incentives for short-term flows;
- Avoid exchange rate and any other 'guarantees'.
(v) Bank closures; owners' bail-in.
(vi) Microcredit availability.
11. The role of banks in pulling out funds from crisis-affected countries during 1997-8 has been emphasised, in contrast to the interpretation given by Mr Gray in his presentation.
12. In some cases, such as Japanese Banks, the turnaround in bank lending in East Asia was also related to the conditions in the financial sector in the home economy.
13. Access to finance has a different profile when viewed not in absolute numbers but relative to GDP. The difference in net capital flows to developing countries converges significantly among developing countries, if flows are measured as ratio to domestic GDP.
14. The need for a cost-benefit analysis of the composition of capital flows by developing countries.
15. FDI as measured by IIF may not be estimated correctly. Some increase in FDI flows is because of mergers and acquisitions, which is a temporary phenomenon.
16. On the issue of transparency it was pointed out that it was not enough that developing countries adopt international standards and make information available in a transparent fashion, but foreign institutional investors also need to be more transparent about the size and allocation of their portfolios. If a developing country had information on the share of portfolios earmarked for it and the time period in which this share would be reached, it can have a better idea of the expected capital flow which would enable it to better manage the capital flow.
For further information about some of the issues addressed by Mr Reisen, please see Helmut Reisen and Marcelo Soto, Why Foreign Capital Is Good for Post-Crisis Asia , International Politics and Society, 4/2000.
This event saw presentation on the working of international capital and credit markets, policy mechanisms and gaps in institutional framework; and the linkages between capital flows, growth and poverty.