From Rich to Poor: A Plan for Stabilizing Investment Markets in Developing Countries

by Michael J. Johnston and Peter Wilamoski for the Caux Round Table. Compliments of the Papousy Endowed Chair in Business Ethics at Southern New Hampshire University.

IV. An Agenda for Investment Reform

The lessons of the Asian crisis suggests policy reforms that should reduce the probability of future financial crises and limit the domestic and international economic impact of any crisis that should occur. These reforms include policy changes by the capital-importing countries that will lessen the probability of a crisis along with changes in how the international financial system responds to crises.

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Reforms, which lessen the frequency or degree of crisis, ultimately provide an atmosphere for healthier public markets. But, since the crises may arise from imprudent capital outflows from wealthy nations, reforms are needed as well in the investment decision-making of source markets for capital. Text Box: What capital importing countries ??can do??

Text Box: What capital importing countries ??can do??

Macroeconomic policy played a key role in creating the Asian financial crises. Along with weak regulation and government guarantees of financial liabilities, macroeconomic policy contributed to large capital inflows that encouraged risky investment and generated a boom-bust cycle. Preventing future financial crises will require new policies aimed at preventing the boom-bust cycles that characterized the Asian crisis. Following are suggestions for change that have emerged from the debate on reform.

1. Strengthen Capital Controls

The search for new policies has led respected free-trade economists to question free trade in capital (Bagwahti,1998), and led others (Krugman, 1998) to suggest that nations subject to volatile capital flows consider imposing capital controls. Capital controls have traditionally been aimed at capital outflows. While such controls are no solution to the structural problems producing capital flight, they do limit the negative economic consequences of outflows in the short run. They do this by breaking the link between foreign capital flows and domestic interest rates, freeing the country to pursue policies that promote economic growth and health for firms and banks. Controls have tried to encourage longer-term inflows and limit volatile short-term inflows. For some years, Chile has taxed short-term inflows by requiring foreign investors to maintain a nonremunerated deposit at the central bank. But Chile is about to remove these restrictions.

An alternative, market-based solution to controlling capital flows is for countries to improve the prudential regulatory framework of the financial system and to pay more attention to the speed and sequencing of future capital account liberalization. This is the view held by IMF and the G7. Their views on appropriate regulation of the financial system are presented next.

2. Improve Transparency of Financial Information

In order to avoid the market imbalances that contribute to a crisis, participants in the markets must have a clear perception of the risk of their investments and value them at a price that is appropriate for that risk. Proper evaluation of risk is possible only if there is transparency in financial information. Transparency refers to "a process by which information about existing conditions, decisions, and actions is made accessible, visible and understandable."[2] A lack of transparency is the outcome of government failing to provide the regulatory institutions and standards necessary to ensure the collection and dissemination of information used to evaluate risk, or the failure of enforcement actions to insure compliance. Improved transparency reduces the probability and size of a crisis by (a) encouraging macroeconomic policy adjustments to begin earlier, and (b) helping market participants differentiate between borrowers. The World Bank Report on the International Financial Architecture (1999) suggests that policies to improve private sector transparency should address five elements:

Timeliness. Policies should encourage firms to publish comprehensive financial statements on a periodic and timely basis.
Completeness. Financial statements should properly reflect assets, liabilities, revenues and costs, as well as off-balance-sheet and related-party transactions.
Consistency. Methodologies should be applied consistently over time.
Risk Management. Firms should disclose the strategies used to manage risks.
Audit and control processes. Firms should have effective systems of internal control and have statements reviewed by an independent auditor.

3. Bolster Corporate Governance

The need to reassure foreign investors is just one reason why corporate governance in host countries must be improved. According to the World Bank, good corporate governance means that directors and managers act in the best interests of all investors. Most times, eliminating multiple classes of shareholders is a good and simple solution. Typical failings of weak corporate governance are concentrated ownership and poor protection of minority shareholder rights. These weaknesses allow corporate insiders to hide the fundamental soundness of their investments from capital sources--be they bond holders, banks or outside equity holders. To ensure that firms protect the interests of outside investors, the World Bank recommends that emerging market governments take the following steps:[3]

1. These countries must establish a mechanism for corporate takeovers and eliminate governance procedures that prevent them.

2. They should put in place legal protections that vest as much decision making power as possible in shareholders. An example is a one-share-one-vote rule.

3. State involvement in the financial sector (state banks, guaranteed loans) that favor specific industries and businesses must be eliminated. Because of the lack of accountability to creditors, state directed financing may lead to poor investment decisions.

4. These countries should allow foreign competition for corporate financing. This competition will force domestic financiers to improve valuation and risk techniques in order to survive.

4. Discourage short-term capital flows

The IMF (1995), the World Bank (1997) and the BIS (1995) have all recognized to one degree or another, that measures undertaken "by recipient governments to discourage short-term capital flows may play a positive role if they are part of a package of policy measures that lead to sound macroeconomic fundamentals." Little has been said, however, about complementary actions that can be taken by source nations of capital to regulate potentially volatile flows. Griffith-Jones (1997) examines what role nations that provide capital to developing markets might play into stabilizing capital flows.[8] Why might source nations of portfolio capital choose to regulate capital outflows? Griffith-Jones suggests that "source countries need to take measures to discourage potentially unstable short-term capital flows coming from them" in order to avoid having to become a lender of last resort.

5. Strengthen Bank Regulation

Banks in host countries played a considerable role in recent international financial crises. What part can these banks play in smoothing out the irregularities of international investment?

Equity markets in emerging countries are both a weathervane and a residual of other capital flows. Equity investors need assurance that the banking sector and other lending sectors will not face the same degree of crisis in the next economic downturn. Liberalization of domestic financial markets and the capital account without strengthening the regulatory framework under which they operate, left East Asian banks facing competition from less-regulated domestic non-bank financial institutions and foreign banks. This competition lowered their franchise value and induced them to undertake more risky investment strategies.

A number of factors contributed to inappropriate risk-taking in loan making and seeking:

First, the governments of these countries provided insurance guarantees to the financial sector and implicit guarantees to the corporate sector. These guarantees led banks to take on greater risk since they did not bear its full cost- a classic example of moral hazard. [4]
Second, capital requirements were too low for the level of risk in the banks’ loan portfolios. This induced banks to over-lend to sectors such as real estate.
Finally, access to foreign capital created a lending boom that strained the financial sector's capacity to properly screen and assess the riskiness of borrowers and projects.

The last point is important. Studies show that financial liberalization contributed to credit growth across the Asia nations between two and six times as high as GDP growth. During the initial stages of the lending boom, rising profits made it easier to lend without adequately assessing the risks of doing so. The credit boom led the financial sector to over expose itself to risky sectors such as real estate; in Thailand, 20% of total loans were to the property sector where growth in office space was exceeded by rising vacancy rates.

What form should reform of the banking sector take? The ideas for reform being produced by the IMF, the World Bank and other concerned parities suggest that while safety-nets must be in place to reduce the risk of a systemic crisis, the level of protection should be limited so that financiers do not assume that government stands ready to absorb their losses, i.e., the incidence of moral hazard must be reduced. Because of the limited skill set of bank management in developing nations, reforms should rely more on market-imposed discipline and improving incentives for prudent banking, and less on regulation to restrain excessive risk taking. Such a strategy would include:

1. raising capital adequacy standards;

2. increasing the financial and personal liability of managers and directors;

3. introducing a tier of uninsured subordinated debt for individual banks to increase the incentives for private monitoring of banks; and

4. require banks to publish key information such as credit ratings.

Additional reforms that would improve the overall efficiency of the banking sectors of these countries, making them healthier and more competitive include:

5. privatizing government owned banks;

6. reducing the government's direct involvement in allocating credit and in providing guarantees to commercial enterprises so as to enhance market-oriented banking behavior;

7. more stringent limits on the concentration of risks, such as limits on exposure to real estate loans; and

8. setting up a formal deposit insurance scheme that limits the level of insurance, charging risk-weighted deposit insurance premiums, and mutual liability for banks

These reforms limit future moral hazard by writing off bad debt against the capital of shareholders, ensuring that those who benefited from risky behavior bear a significant part of the cost of restructuring. In addition, insolvent and poorly regulated banks, protected by insurance, need to be shut down to prevent a continuing misallocation of resources as banks lend to insolvent debtors to recoup earlier losses.

Asian crisis nations are already attempting to strengthen prudential regulation and supervision of their banking sector. Reforms include tightening up loan classification and provisioning requirements as well as improving disclosure and accounting standards. Financial restructuring agencies have been created (Indonesian Bank Restructuring Agency, Korean Financial Supervisory Commission, Thai Financial Sector Restructuring Authority) to liquidate and consolidate failing institutions.

6. Re-regulate bankruptcy

Bankruptcy laws should maximize the growth and income potential of firms that appear able to recover their cost of capital but liquidate nonviable ones. In addition, bankruptcy laws need to create incentives to abide by future contracts by penalizing debtors for resorting to bankruptcy. While reforms are being made, current bankruptcy laws in developing nations are often antiquated, poorly enforced and open to political corruption. [5] Reforms are being introduced that (a) strengthen the ability of courts to approve reorganization rather than just liquidation, (b) improve transparency and efficiency in proceedings, and (c) provide training to judges and administrators. [6]

In a systemic crisis, however, individual bankruptcy proceedings may be insufficient to resolve a panic. A pre-arranged orderly collective workout agreement, it is suggested, would minimize the real costs resulting from delays in reaching a reorganization agreement. Real costs include foregone investment opportunities and grab races between creditors that force individual borrowers into liquidation even when it is in the interest of all creditors to keep the borrowing enterprise afloat. In a systemic economic crisis, even well managed firms that would be viable under normal economic conditions can become insolvent because of decreasing demand, depreciation and interest rate hikes. Without a coordinated approach to debt relief, a case-by-case treatment of firms facing default during crisis could lead to the liquidation of firms that would normally be profitable.

An orderly workout arrangement would follow the same principles as a bankruptcy framework. It would provide for the inclusion of a collective action clause, a standstill on debt servicing (to stop the outflow and stabilize the currency), a provision for interim financing, and a system for debt reduction and debt-to-equity conversions. A related proposal by Buiter-Sibert (1999) to deal with national liquidity crises involves including a three-month debt-rollover option in all foreign currency denominated obligations, both private and sovereign. To prevent borrowers from exercising the option lightly, their proposal calls for nations to pay a penalty rate for invoking the rollover option. The debt-rollover provision works like temporary suspensions of convertibility that banks are allowed. A bank suspension, or roll-over in the international setting, gives debtors time to solve liquidity crunches that undermine investor confidence, and thereby avoid the costs of a run that leads to their closure.

Several agreements reached since the onset of the crisis attest to the usefulness of workout arrangements. In January of 1998, external creditor banks reached a $24 billion rescheduling of short-term debt owed by Korean banks, converting it to government guaranteed loans with maturities of one to three years. In the months following the agreement, Korea's task was made easier by the small number of bank debtors and creditors, which eased coordination. In Indonesia, however, $65 billion of foreign debt was owed by thousands of corporations. Even when debt is owed by private-sector firms, it may be necessary to arrange a debt standstill and rollovers on a country basis to prevent further financial panic. The orderly workout arranged there in June of 1998 provided an incentive for voluntary debt restructuring through a government guarantee of foreign exchange for debt service at a fixed rate. [7]

There are a number of objections to bailing in the private sector through orderly-workout agreements (Eichengreen, 1999):

The first objection is that these agreements are not necessary to inhibit moral-hazard induced lending; in the Mexico and Asian crisis, creditors suffered large losses in stock, bond and real estate markets in spite of official assistance.
A second objection is the difficulty in developing an effective framework in nations where financial markets are more developed. The Korean agreement was relatively easy because creditors and debtors were mostly banks. When financial markets offer more options to raise capital, creditors are likely to be more heterogeneous, making the range of agreements necessary problematic. The addition of bail-in clauses also raises the costs of funds to emerging-market borrowers.
Finally, and maybe most importantly, anticipation by the market that a nation intends to activate provisions for an orderly workout or rollover can lead creditors to bail-out ahead of time, creating the very crisis policy makers are trying to prevent.

Nevertheless, the merits of orderly-workout procedures in reducing real costs to the private sector, as well as the cost of official assistance, has led The Economist (1999) to suggest "the prospect of an orderly re-negotiation rather than a messy default might actually make some bonds more attractive." Text Box: What the international financial system ??can do??

The International Monetary Fund came under criticism on two fronts regarding the Asian crisis. First, IMF agreements with the crisis nations appear to have made their economic conditions worse, adding to capital flight and economic hardship. Second, IMF arrangements permitted international financial markets to exhibit volatility, herd behavior, and contagion.

Tighten lender of last resort policies

One aspect of the debate revolves around the tradeoff between preventing panic by providing a lender of last resort and the moral hazard it would induce. A lender of last resort prevents systemic risk arising from a country's default on private or sovereign debt that could undermine the liquidity or solvency of creditor nation banking systems. The case for a lender of last resort is also made based on the need to prevent the effects of contagion that might occur when an attack on one nation's currency spreads to other countries’ currencies even when fundamentals are sound.

The problem with formal lender of last resort or ad hoc rescue packages is that they create moral hazard among developing country governments (who lose the incentive to implement reforms), local financial institutions and companies, and international lenders who expect their risky behavior to be bailed out. To minimize moral hazard, a lender of last resort must have a supervisory role in implementing reform that reduces incentives for excessive risk taking.

In the current post-crisis environment, neither the mandate nor resources are there for the IMF to play the role of lender of last resort. In fact, its own proposals call for the IMF to play a lesser role in the future. IMF financial assistance during the Asia crisis was between five and seven times each country's normal fund allocation for most countries, and in the case of Korea, 1900 percent of its quota. The IMF has suggested limiting assistance to each country to 300 percent of its quota on a cumulative basis.

Alternatives to a lender of last resort include (a) private market agreements that guarantee liquidity, and (b) the establishment of rules regarding debtor-creditor negotiations that allow rollovers, maturity extensions, and debt reduction. The latter has become known as "bailing in the private sector". Bailing in the private sector contains elements of crisis prevention and resolution:

1. First, an "orderly workout arrangement", by establishing rules for negotiating debt relief during a financial crisis ahead of time, shifts part of the financial burden back to investors, eliminating a source of moral hazard that has encouraged risky lending.

2. Second, the establishment of rules that lead to debt roll-overs and maturity extensions lowers one cost of financial crisis: a "disorderly workout" where risky borrowers provoke a creditor grab race and liquidation. Radelet and Sachs (1998) argue that the Asian financial crisis was the result of a financial panic and a disorderly workout. It is suggested that an orderly work-out agreement with provision for the rollover of debt could have led to a quicker resolution of the crisis at a smaller real cost (Buiter-Siebert, 1999; Eichengreen, 1999). The solutions offered for bailing in the private sector include reforming bankruptcy laws and establishing a mechanism for orderly debt workouts.

Text Box: What investing nations ??can do?? If recipient nations are unable to restrain capital inflows, which overwhelm the nation’s ability to assimilate them and a financial crisis results, the source nation may be forced to act as a lender of last resort to protect its own investors, and prevent the spread of crisis to other nations. To discourage risky investment in the expectation that there will be a bail-out if things go wrong, “source countries will need to impose some additional regulatory and or disclosure restrictions on institutional investors, to help avoid excessive surges of easily reversible capital inflows to emerging markets.”

1. Tighten bank supervision

Bank regulators in developed countries need to be more vigilant about the concentration of loans with their country’s banks. Not only should source country banks not overly concentrate their loan portfolios in a geographic region, but source country banks should not be overly dominant in a region. For instance, in the Asian crisis, Japanese banks were the dominant lender in Southeast Asia. When that region entered crisis, it simultaneously created a crisis for the lending Japanese banks and curtailed their ability to proceed in an orderly fashion to provide workouts.

2. Provide better liquidity

One suggestion to stabilize capital flows from developed to developing markets employs the same strategies used to promote confidence in banks: the provision of liquidity. Legislation adopted in 1991 already gives U.S. securities markets access to a lender of last resort. Enacted in response to the 1987 and 1989 market declines, the legislation permits the securities industry to borrow from the Federal Reserve Banks using corporate stocks and bonds, as well U.S government securities, as collateral. Access to this liquidity during a financial crisis would permit mutual funds to meet the redemption demands of their shareholders without having to liquidate their positions in emerging market assets under attack.

In order to compete with banks, the mutual fund industry markets their shares as virtually payable on demand. While mutual funds are required to redeem shares within a 7-day period, next day redemption is standard practice. At the same time, funds that sell positions face three-day settlement, creating a need for liquidity. The seriousness of liquidity needs are obvious from a survey, which revealed that 40% of mutual fund shareholders would sell some or all of their shares in equity funds if the market fell by 15% or more (Kinsella, WSJ, 1996), and in turn exacerbate price declines. The potential for redemption of this magnitude might lead to an expansion of a crisis in a particular emerging market nation to other emerging markets as funds seek cash to meet redemption needs.

Any arrangement portfolio investors develop to mitigate the pressures placed on them to meet fund redemptions following a crisis will benefit emerging markets. Several solutions to the liquidity needs of mutual funds have been suggested. One solution offered is entirely market based. It utilizes a "fund of funds" approach to provide access to liquidity. Mutual funds would buy shares in an umbrella fund whose assets cannot be sold to the public. The “fund of funds” would invest in highly liquid money market instruments available, which could be sold to redeem the shares of mutual funds attempting to meet the liquidity demands of their shareholders. To meet extreme situations, the “fund of funds” can buy the shares of mutual funds that had exhausted their redemptions. The problem with a market based fund of funds solution is that in the event of a crisis that affects all funds, there is no guarantee that shares can be redeemed without losses. As a result, the ability of the approach to stabilize public confidence and limit redemptions that push prices further down, is limited.

Another approach involves extending the Federal Reserve’s ability to provide liquidity to banks that lend to mutual funds. In order to mitigate lending decisions based on the knowledge that risks are insured, “it would seem reasonable to require that some portion of mutual funds’ cash reserves be placed in the form of interest-bearing deposits in commercial banks as a prudential capital charge.” The creation of a capital charge on mutual funds to ensure defined sources of liquidity would also remove the distortion that gives mutual funds an advantage over banks in attracting savings. While a capital charge would lower earnings to mutual funds that do not currently maintain adequate cash reserves, such industry wide standards would raise investor confidence and attract more funds in the long-run. And by introducing to mutual funds the concept of risk-weighting, already a part of banking, capital charges would reduce volatility, and limit the volatility of exchange rates that bring about the capital flight. So, while investors would earn slightly lower returns, they would be compensated by smaller volatility of returns.

3. Introduce risk-weighted capital charges

The introduction of a risk-weighted capital charge, as developed agencies such as the IMF and BIS use, would lead to charges that would vary with the macroeconomic risk of different nations. And as a result, mutual funds would need to perform risk analysis, taking into account critical country ratios such as: current account to GDP, external debt to GDP, and the maturity structure of debt. Firms would find it more profitable to invest in countries with relatively stable macro-economic conditions. As macroeconomic conditions deteriorated in a nation, investment would decline, and force an early-correction of macro-policy. As policy and conditions improved, investment from firms conducting risk analysis would resume.

4. Fashion creative investment covenants

Those things that might stabilize portfolio flows from institutional investors could be even more effective in stemming a crisis caused by financial panic, given that most foreign portfolio investment currently comes from institutional funds. One proposal to do so could originate from beneficial owners,' pension funds, etc. -- individually or together -- instructing the advisor or manager of their assets, to ignore the results of the investments in countries in crisis for a period of time. Something akin to this occurred during the Japanese “bubble economy” of the late 1980s and early 1990s. Several large pension funds instructed their managers to, for example, cut in half the benchmark weighting of the Japanese stock market. In effect, this instruction relieved the manager from the pressure of investing heavily in what was generally perceived, at least temporarily, as an overvalued market.

Investment covenants like this could be adopted in reverse with developing markets. If, for example, a financial crisis were to develop in one or more developing countries, institutional investors could instruct their managers to ignore results from other developing countries which are considered to be fundamentally sound, at least for a period of time. So if Mexico and Brazil have adopted reforms, and if their situations seem to be healthy in the main, managers of foreign portfolio investments would feel no performance pressure to sell those investments for fear of having a sympathetic decline with the problem countries. And simultaneously, and for the duration of the “blackout” period, the corresponding country indices would be excluded from the benchmark.

Russell 20/20, a group of institutional investors and managers active in foreign portfolio investment, is systematically grading developing countries on their progress toward financial reform. These evaluations might be used to help distinguish which countries might be exempted from measuring results versus benchmarks during crisis. Those countries so exempted would, in effect, be rewarded for their reforms by having less selling pressure in their markets during a financial panic not of their making. After the exemption period was over, the managers might even have found it beneficial to have purchased investments in those markets if prices had declined during the crisis, because from some point before the crisis to some point after the crisis the results within those markets would be included.

5. Foster better disclosure

While proposals for emerging markets to improve transparency are numerous, and their merits obvious, there are fewer calls for better reciprocal disclosure by the source of funds, financial institutions such as mutual funds. A strong case can be made for greater transparency on the part of financial institutions whose investors are not protected by deposit insurance. Disclosure of the nature of risk (is capital at stake, how variable are returns, what are measures of total risk, market risk and risk adjusted performance?) is likely to cause fund managers to adopt more conservative investment strategies. While greater awareness of risk could lead to a reduction in emerging markets investment, its long-run implication would be more stable capital flows. With investors better informed of risks, they are less likely to rush in and out of developing nations.

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