1 Structural Changes in the World Financial System: The Impact on Local Financial Markets Eliot...

11

Structural Changes in Structural Changes in the World Financial the World Financial System: The Impact on System: The Impact on Local Financial MarketsLocal Financial Markets

Eliot KalterEliot KalterAssistant DirectorAssistant DirectorInternational Capital Markets DeptInternational Capital Markets DeptInternational Monetary FundInternational Monetary Fund

March 28, 2004March 28, 2004

22

I.I. IntroductionIntroduction

This presentation examines structural This presentation examines structural shifts in world financial markets to shifts in world financial markets to better understand forces at work better understand forces at work impacting the EMCs access to capital.impacting the EMCs access to capital.

Focus on the dramatic shift in the Focus on the dramatic shift in the investor base for capital flows to EMCs investor base for capital flows to EMCs and the impact on local capital markets.and the impact on local capital markets.

This analysis is based on the Global This analysis is based on the Global Financial Stability Reports (GFSR) of the Financial Stability Reports (GFSR) of the International Monetary Fund.International Monetary Fund.

33

II. Emerging Market II. Emerging Market Capital FlowsCapital Flows

Growing Role of Debt Growing Role of Debt Financing and FDIFinancing and FDI

44

Total Total External External Financing to Financing to EMCsEMCs Since 1990, private Since 1990, private

capital flows, led by capital flows, led by bond and equity bond and equity financing, have far financing, have far exceeded official exceeded official loans and grants to loans and grants to become the dominant become the dominant source of external source of external financing to EMC’s.financing to EMC’s.

Bond financing to Bond financing to emerging market emerging market countries started to countries started to decline following the decline following the Asia crisis but is now Asia crisis but is now rebounding.rebounding.

Cross-border bank Cross-border bank loans are now loans are now insignificant in net insignificant in net terms.terms.

55

FDI flows to EMCs fell in 2003, FDI flows to EMCs fell in 2003, continuing the downward trend continuing the downward trend that began in 2000.that began in 2000.

Figure 2.x. Private Flows to Emerging Market Economies(In billions of U.S. dollars)

-50

0

50

100

150

200

1990 1991 1992 1993 1993 1995 1996 1997 1998 1999 2000 2001 2002 2003

-50

0

50

100

150

200

Inward FDIFlows

Private DebtFlows

Private Flows to Emerging Market EconomiesPrivate Flows to Emerging Market Economies(In billions of US dollars)(In billions of US dollars)

66

Foreign Direct Foreign Direct Investment to EMCsInvestment to EMCs Foreign direct Foreign direct

investment (FDI) investment (FDI) to emerging to emerging market market countries countries remains resilient remains resilient but varies but varies greatly by greatly by region.region.

Figure 2.x. Geographic Distribution of FDI Flows(In percent of total)

0

10

20

30

40

50

60

70

Jan-90 Jan-91 Jan-92 Jan-93 Jan-94 Jan-95 Jan-96 Jan-97 Jan-98 Jan-99 Jan-00 Jan-01 Jan-02

0

10

20

30

40

50

60

70

East andSouth Asia Latin

America

Europe andCentral Asia

Middle Eastand Africa

Geographic Distribution of FDI FlowsGeographic Distribution of FDI Flows(In percent of total)(In percent of total)

77

FDI prospects dependent on FDI prospects dependent on country-specific factors.country-specific factors.

– Results from a recently completed survey conducted by a working group of the Capital Markets Consultative Group emphasize the importance of regional economic, structural and institutional factors on influencing FDI prospects.

– The direct investors reported that there is no large-scale withdrawal from Latin America and that the effect on FDI from the Argentina crisis concentrated in the banking and utilities sectors.

– Consequently, EMCs with good governance, infrastructure and institutions are likely to secure greater amounts of FDI.

88

Growing Role of Cross-Over Growing Role of Cross-Over and Local Investorsand Local Investors

III.III. Institutional Institutional Investors in Investors in Emerging MarketsEmerging Markets

99

Changing Market Share of Emerging Market Changing Market Share of Emerging Market InvestorsInvestors(In percent)(In percent)

0102030405060708090

100

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002

Cross over

Hedge funds

Dedicated EM funds

Locals

Distressed players

Commercial Banks

1010

Mature Market Investor Base: Mature Market Investor Base: Underlying Factors for the Underlying Factors for the Changing CompositionChanging Composition The dramatic shift in the investor base began The dramatic shift in the investor base began

with the restructuring of bank debts to Brady with the restructuring of bank debts to Brady bonds in the early 1990’s.bonds in the early 1990’s.

Increased risk aversion by banks.Increased risk aversion by banks. Ongoing shift in business strategies of many Ongoing shift in business strategies of many

money center banks.money center banks. Strong risk-adjusted returns of emerging Strong risk-adjusted returns of emerging

securities have led international institutional securities have led international institutional investors to make a strategic allocation to EM investors to make a strategic allocation to EM asset classasset class

1111

Emerging Market Investment Emerging Market Investment Base: Parallel Growing Role of Base: Parallel Growing Role of Institutional Investors Institutional Investors Moving toward mature market investor Moving toward mature market investor

basebase– Institutional investors assets under

management are growing rapidly in most EMC’s, with the enactment of pension fund reforms and the growing popularity of mutual funds.

– Salomon Smith Barney projects that by 2015, most pension systems in EMC’s will reach the industrial country average of 25–30 percent of GDP assets under management.

1212

IV. Implications of IV. Implications of Increased Role of Increased Role of Institutional InvestorsInstitutional Investors

Growing Demands and Growing Demands and Incentives for Developing Incentives for Developing Local Capital MarketsLocal Capital Markets

1313

Growing Role of Local Growing Role of Local Institutional Investors Institutional Investors

Positive force for development of local marketsPositive force for development of local markets

The growth of assets under management of local institutional investors is contributing to the development of local securities markets.

Local EMC institutional investors are a steady source of demand for both local-currency and foreign currency denominated emerging market assets.

The long-term liability structure of institutional investors allows them to invest in longer-term securities markets.

1414

Growing Role of Mature Market Growing Role of Mature Market Institutional Investors Institutional Investors

Positive force for development of local marketsPositive force for development of local markets

Internationalization of mature market institutional Internationalization of mature market institutional investor requirements to local marketsinvestor requirements to local markets

The balance sheet treatment of claims on EMCs shifts to a more market-to-market approach.

Pressure to establish markets in the EMCs that are sufficiently liquid to allow market-to-market.

1515

Forces for Reform and Forces for Reform and StabilityStability

The corresponding securitization of the stock The corresponding securitization of the stock of emerging market claims aids the process of emerging market claims aids the process of greater fungibility and tradability. of greater fungibility and tradability.

Contributes to increased transparency Contributes to increased transparency regarding country risk perceptions.regarding country risk perceptions.

Finally, the availability of more timely and Finally, the availability of more timely and comprehensive information, along with the comprehensive information, along with the growth of hedging opportunities, enables the growth of hedging opportunities, enables the providers of capital to better manage their providers of capital to better manage their sovereign risk exposure.sovereign risk exposure.

1616

EMCs Growing Use of EMCs Growing Use of Local Capital MarketsLocal Capital Markets

In turn, EMC’s are re-evaluating the risks In turn, EMC’s are re-evaluating the risks of external borrowing.of external borrowing.

Many EMCs are developing local securities markets to Many EMCs are developing local securities markets to facilitate the management of financial risks associated facilitate the management of financial risks associated with external financial markets.with external financial markets.

EMC Sovereigns are increasingly depending on local EMC Sovereigns are increasingly depending on local markets for new financing while using external markets for new financing while using external markets for liability management purposes.markets for liability management purposes.

EMC corporates are relying on domestic capital EMC corporates are relying on domestic capital markets to reduce exchange rate risk and take markets to reduce exchange rate risk and take advantage of lower risk-adjusted rates.advantage of lower risk-adjusted rates.

1717

V. Recent Trends in V. Recent Trends in Local Securities Local Securities MarketsMarkets

The Growth of Local Bond The Growth of Local Bond MarketsMarkets

18

Private Sector(In billions of U.S. dollars)

1997 1998 1999 2000 2001 2002 2003 1998-2002

Emerging markets 1 343.43 243.47 727.05 571.58 480.61 505.17 732.73 2,871.31Domestic 241.11 196.44 666.75 478.26 413.25 465.75 676.30 2,461.57

Equities 37.28 32.70 592.96 185.59 205.74 16.65 51.23 1,070.92Bonds 11.17 11.70 10.47 98.01 114.47 116.86 106.92 362.67Bank loans 192.67 152.05 63.32 194.67 93.04 332.25 518.15 1,027.99

International 102.32 47.03 60.30 93.32 67.35 39.42 56.43 409.74Equities 18.42 5.59 15.76 31.90 8.81 11.01 16.14 91.48Bonds 41.63 19.86 22.15 21.84 30.90 7.48 19.96 143.86Bank loans 42.27 21.59 22.39 39.59 27.64 20.93 20.32 174.40

Asia 207.30 156.80 770.00 460.93 428.72 482.14 590.21 2,505.88Domestic 154.87 144.69 743.13 405.68 385.38 458.23 555.92 2,291.98

Equities 28.11 16.69 585.07 180.74 197.49 15.46 44.12 1,023.55Bonds 0.00 0.00 0.82 42.66 53.57 70.31 64.53 167.36Bank loans 126.75 128.00 157.24 182.28 134.33 372.47 447.26 1,101.07


Central Europe 5.51 23.14 2.91 6.76 15.34 20.68 39.60 74.34Domestic -0.14 18.09 -1.29 1.77 12.26 17.74 31.73 48.43

Equities 1.31 6.60 3.35 1.29 0.95 0.20 6.84 13.69Bonds 0.50 0.28 0.33 0.17 0.32 1.46 2.41 3.07Bank loans -1.95 11.21 -4.97 0.31 10.99 16.07 22.48 31.67


Latin America 130.63 63.54 -45.86 103.89 36.54 2.35 102.92 291.09Domestic 86.38 33.66 -75.09 70.81 15.62 -10.22 88.65 121.16

Equities 7.86 9.41 4.55 3.56 7.31 0.99 0.28 33.68Bonds 10.66 11.42 9.32 55.17 60.58 45.09 39.97 192.24Bank loans 67.86 12.84 -88.95 12.08 -52.28 -56.29 48.40 -104.75


Sources: Dealogic; IMF, International Financial Statistics; S&P EMDB; and Hong Kong Monetary Authorities. 1 Emerging markets: China, Hong Kong SAR, Malaysia, Singapore, South Korea, Thailand, Argentina, Brazil, Chile, Mexico, Czech Republic, Hungary, and Poland.

1919

Recent Trends in Local Recent Trends in Local Securities MarketsSecurities Markets

To what extent have local bond markets To what extent have local bond markets begun to provide an alternative source of begun to provide an alternative source of funding?funding?

There has been substantial progress in the development There has been substantial progress in the development of government bond markets, but progress has been of government bond markets, but progress has been somewhat slower in corporate bond markets somewhat slower in corporate bond markets

Emerging local bond markets have grown considerably Emerging local bond markets have grown considerably over the last decade and now are roughly 35 percent of over the last decade and now are roughly 35 percent of GDP.GDP.

Domestic bank lending continues to be the dominant Domestic bank lending continues to be the dominant source of corporate financing, accounting for 70 percent of source of corporate financing, accounting for 70 percent of total domestic and international funding.total domestic and international funding.

2020

Nevertheless, domestic corporate bond issuance rose Nevertheless, domestic corporate bond issuance rose from an annual average of $11 billion in in 1997-99 to from an annual average of $11 billion in in 1997-99 to $110 billion in 2002-03.$110 billion in 2002-03.

Domestic corporate bond issues rose from 3 percent Domestic corporate bond issues rose from 3 percent of total funding in 1997-99 to close to 20 percent of of total funding in 1997-99 to close to 20 percent of total funding in 2002-03.total funding in 2002-03.

International issues on bonds, equities, and International issues on bonds, equities, and syndicated loans by the corporate sector accounted syndicated loans by the corporate sector accounted for 10 percent of total funding in 1997-99 compared for 10 percent of total funding in 1997-99 compared with 2 of total funding in 2002-03.with 2 of total funding in 2002-03.

While international corporate bond issues where While international corporate bond issues where about equivalent to domestic corporate bond issues in about equivalent to domestic corporate bond issues in 1997-99, they were on tenth of domestic issues in 1997-99, they were on tenth of domestic issues in 2002-03 2002-03


2121


There are regional differences in how rapidly the There are regional differences in how rapidly the markets have developed. markets have developed.

In Asia, the growth of local bond issuance has In Asia, the growth of local bond issuance has been driven by the need to recapitalize banking been driven by the need to recapitalize banking systems. The lack of bank credit has also systems. The lack of bank credit has also contributed to some increase in corporate bond contributed to some increase in corporate bond issuance, not just in Asia but also in Latin issuance, not just in Asia but also in Latin America.America.

In Latin America, the rapid growth of local In Latin America, the rapid growth of local institutional investors has driven the growth of institutional investors has driven the growth of local bond markets, together with large local bond markets, together with large refinancing needs of the corporate sector in a refinancing needs of the corporate sector in a difficult external environment.difficult external environment.

2222

V. Potential Costs of V. Potential Costs of New Investor BaseNew Investor Base

Vulnerability to Shifts in Vulnerability to Shifts in Investor Confidence and Investor Confidence and Developmental ChallengeDevelopmental Challenge

2323

Vulnerability to Shifts in Vulnerability to Shifts in Market ConfidenceMarket Confidence EMC market: Unanswered questions EMC market: Unanswered questions

regarding market stabilityregarding market stability– The size of assets under control of non-bank

institutional investors dwarfs the size of emerging markets or capital flows to EMC.

– Thus, even a modest shift in the assets held by these institutional investors in EMC assets would lead to substantial capital flows.

– Hedge fund holdings can be driven by short-term goals (less leverage but wider holdings).

2424

Potential VulnerabilitiesPotential Vulnerabilities

The increase in cross-over investors The increase in cross-over investors could go either way.could go either way.– The investor base has been broadened,

moving investors’ focus from narrow benchmarks toward blended benchmarks that combine emerging market securities with more established products.

– Also, increasingly cross-over investors are ultimately pension funds and insurance companies, that are likely to be long-term investors.

2525

EMC’s Financial Markets EMC’s Financial Markets Lack Depth and LiquidityLack Depth and Liquidity

Many EMC’s are not in the position to respond to Many EMC’s are not in the position to respond to the increased pension fund demand with the increased pension fund demand with sufficient volume and diversity of securities, sufficient volume and diversity of securities, without the issuers of the paper running without the issuers of the paper running dangerous financial policies.dangerous financial policies.

Lack of investor sophistication and excessive Lack of investor sophistication and excessive market regulations are creating important market regulations are creating important challenges for the efficiency and stability of local challenges for the efficiency and stability of local markets.markets.

Development of some EMC’s financial markets is Development of some EMC’s financial markets is hampered by small markets that prohibit hampered by small markets that prohibit sufficient economies of scale.sufficient economies of scale.

Could result in inappropriate investment decisions Could result in inappropriate investment decisions and encourage increased public and private debt.and encourage increased public and private debt.

2626

Need for Comprehensive Need for Comprehensive Plan to develop Domestic Plan to develop Domestic Securities marketsSecurities markets A major challenge is the mismatch A major challenge is the mismatch

between the growth of domestic between the growth of domestic institutional investors and less institutional investors and less developed domestic securities marketdeveloped domestic securities market

Domestic institutional investors require Domestic institutional investors require size, liquidity and variety of instrumentssize, liquidity and variety of instruments

Require improved market infrastructure, Require improved market infrastructure, including a liquid secondary market and including a liquid secondary market and good clearing and settlement systemgood clearing and settlement system

Underdevelopment of corporate bond Underdevelopment of corporate bond marketsmarkets

2727

Risks of Current Market Conditions: Risks of Current Market Conditions: Underlying Vulnerabilities are Underlying Vulnerabilities are MaskedMasked

Emerging Market Debt: Average Cross-Correlations, 2002-2004

0

0.1

0.2

0.3

0.4

0.5

Jan-02 Apr-02 Jul-02 Oct-02 Jan-03 Apr-03 Jul-03 Oct-03 Jan-04

Sources: J.P. Morgan Chase; and IMF staff estimates.Note: 30-day moving simple average across all pair-wise return correlations of 20 constituents included in the of the EMBI Global.

0

2

4

6

8

10

12

14

16

18

Jan-02 Apr-02 Jul-02 Oct-02 Jan-03 Apr-03 Jul-03 Oct-03 Jan-04

Emerging Market Debt: Average Emerging Market Debt: Average Cross-Correlations, 2002–04Cross-Correlations, 2002–04

EMBI+ Dispersion of ReturnsEMBI+ Dispersion of Returns(In percent)(In percent)

2828

VI. Policy Implications VI. Policy Implications for EMCs of for EMCs of Increased Role of Increased Role of Institutional Institutional InvestorsInvestors

2929

Implement Strong Implement Strong Macroeconomic Policy:Macroeconomic Policy: To reduce spreads, lower vulnerability To reduce spreads, lower vulnerability

to sharp swings in investor sentiment, to sharp swings in investor sentiment, and global liquidity conditions.and global liquidity conditions.

To attract FDI.To attract FDI. To prevent an unsustainable demand To prevent an unsustainable demand

for public debt in an environment for public debt in an environment where available financing, particularly where available financing, particularly of domestic debt, may become of domestic debt, may become increasingly available.increasingly available.

3030

Deepen Domestic Capital Deepen Domestic Capital Markets and Improve Markets and Improve Regulatory FrameworkRegulatory Framework Institutional investors are Institutional investors are

particularly sensitive to market particularly sensitive to market infrastructure, transparency and infrastructure, transparency and disclosure issues.disclosure issues.

Development of good clearance and Development of good clearance and settlement systems and liquid settlement systems and liquid secondary markets for debt secondary markets for debt instruments could attract instruments could attract international institutional investors.international institutional investors.

3131

Reduce Market Reduce Market RestrictionsRestrictions

Adequate diversification of Adequate diversification of domestic institutions’ portfolios domestic institutions’ portfolios may require a further sizable may require a further sizable increase in the funds allocated to increase in the funds allocated to foreign securities.foreign securities.

3232

Market CommunicationMarket Communication

Investor relations programs can Investor relations programs can be particularly useful both in be particularly useful both in terms of communicating terms of communicating improved EMC conditions and in improved EMC conditions and in gauging the potential segments gauging the potential segments of the investor base.of the investor base.

3333

Public Liability Public Liability ManagementManagement

EMC public sector should take EMC public sector should take advantage of current market advantage of current market conditions by prudent liability conditions by prudent liability management to improve the management to improve the structure of existing domestic and structure of existing domestic and external debt (lower costs and external debt (lower costs and increase maturity).increase maturity).

3434

Additional Steps are Additional Steps are Required to Develop Local Required to Develop Local MarketsMarkets

– The development of indexed bonds, in particular inflation indexed bonds, has contributed to the development of local bond markets—especially in high inflation emerging markets.

– The development of well-functioning money The development of well-functioning money markets and derivatives markets are critical markets and derivatives markets are critical in developing corporate bond markets.in developing corporate bond markets.

3535

Credit Risk PricingCredit Risk Pricing

Market participants regard the Market participants regard the lack of sophistication in pricing lack of sophistication in pricing credit risk as a major constraint credit risk as a major constraint to the growth of emerging to the growth of emerging corporate bond markets. corporate bond markets. Development of a credit culture Development of a credit culture takes timetakes time..

3636

SequencingSequencing

Broadly speaking, a comparison of different types Broadly speaking, a comparison of different types of financial systems, and their evolution over time, of financial systems, and their evolution over time, is a complex issue and there are no simple is a complex issue and there are no simple answers to what would be an optimal development answers to what would be an optimal development strategy.strategy.

Some analysts suggest that it may be optimal to Some analysts suggest that it may be optimal to develop first a deep local debt market before develop first a deep local debt market before opening up the capital account. An example is opening up the capital account. An example is Australia. The potential benefits of developing local Australia. The potential benefits of developing local markets in isolation from international markets markets in isolation from international markets have to be weighed against traditional arguments have to be weighed against traditional arguments against capital controls (such as misallocation of against capital controls (such as misallocation of resources, increased costs of funding, and evasion)resources, increased costs of funding, and evasion)

3737

Local securities markets remain highly Local securities markets remain highly segmented in most regions, and a number of segmented in most regions, and a number of measures would have to be undertaken to measures would have to be undertaken to develop fully integrated, regional markets.develop fully integrated, regional markets.

In Asia, for example, analysts note that, besides In Asia, for example, analysts note that, besides the removal of controls and harmonization of the removal of controls and harmonization of taxes, several institutional aspects of bond taxes, several institutional aspects of bond markets—such as contracts, underwriting, and markets—such as contracts, underwriting, and settlement conditions—would have to be settlement conditions—would have to be standardized to some extent before a pan-Asian standardized to some extent before a pan-Asian market could be created.market could be created.

The Asia Bond Market Initiative started in 2003 is The Asia Bond Market Initiative started in 2003 is a broad umbrella covering many areas of bond a broad umbrella covering many areas of bond market development. Market infrastructure is market development. Market infrastructure is receiving particular attention, including: creating receiving particular attention, including: creating new securitized instruments, credit guarantee new securitized instruments, credit guarantee mechanisms, settlement regulations, local and mechanisms, settlement regulations, local and regional credit agencies, and technical assistance regional credit agencies, and technical assistance coordination.coordination.

1 Structural Changes in the World Financial System: The Impact on Local Financial Markets Eliot...

Documents

Transcript of 1 Structural Changes in the World Financial System: The Impact on Local Financial Markets Eliot...