Viewpoint7 The World Bank February 1996 Note No.70 Emerging Markets and Financial Volatility-Beyond Mexico GaryL. Perlin In the wake of the Mexican financial crisis, too ket volatility that in large part caused the much attention has been given to what was hap- globalization of financial markets in the first pening in emerging economies and too little to place. Until the 1970s, most international capi- what was changing in financial markets. Easily tal flows were fairly steady, passing through forgotten now is that within weeks of the Mexi- banks as a means of settling underlying trade can devaluation in December 1994, the unprec- in goods and services. Then oil price inflation, edented power of financial markets was twice budget and trade deficits, and a variety of demonstrated, and with equal drama, in the speculative bubbles appeared. The U.S. Fed- downfall of Orange County, California, and of eral Reserve abandoned its policy of targeting the venerable Barings Bank. Such events sug- stable interest rates and announced that the . - .. , jf gest that emerging market investors and bor- best remedy for these ills was to steady growth rowers must derive lessons not only from their in the supply of money. This policy shift set own experience but also from the broader off unprecedented worldwide interest rate - -.-/~f changes in market structure and behavior. swings to accompany already volatile exchange rates. As interest rate targets dropped, economic What are these changes? First, much of the capital volatility was transformed into financial asset flowing to emerging markets is now in the form volatility, and the markets responded. of bonds and portfolio equity investment. Sec- ond, investors managing these flows are attracted Rather than following trade, growing pools of to high-risk, high-return opportunities and are savings, increasingly managed by sophisticated, less patient than the foreign direct investors or competitive institutions, began to flow across banks that emerging market governments may borders in search of much higher returns or, for have been more used to dealing with. Third, the fainter of heart, portfolio diversification. These these investors have no way of communicating flows increased as nominal interest rates in the their patience level to policymakers other than United States fell through the mid-1980s. Finan- by exit. And fourth, high information costs tend cial deregulation was embraced as a way to free to concentrate these flows in "hot" countries and institutions to deal with the volatility that threat- lead investors to rely on a few knowledgeable ened their access to funds or their ability to di- observers to signal when their returns are at versify into new businesses and markets. And risk, adding to the potential volatility. These new technologies allowed investors and inter- changes require a new perspective and new fi- mediaries to complete transactions quickly and nancial management capacity in both the pub- securely. Communications and information en- lic and the private sector. gineers made it possible to talk, trade, and settle across borders and time zones. Meanwhile, a new Origins of volatility class of financial engineers developed security structures and derivatives that enabled investors "Putting the financial genie back in the bottle" to build intemational exposure-and to affect in- by simply restricting the flow of capital, as some ternational market levels-without ever leaving suggest, is not an option. Why? Because vola- their home market. Then it was only a matter of tility predated the flows. It was, ironically, mar- time before global capital discovered-and in Financial Sector Development Department . Vice Presidency for Finance and Private Sector Development kw Emerging Markets and Financial Volatility-Beyond Mexico some senses created-the "emerging markets." What has changed? And in the early 1990s, investors who had mas- tered the art of seeking out returns and diversifi- Capital need not always be crossing borders in cation wherever they could were quick to record flows for it to be "global," nor can we ex- recognize the opportunities in the newly liberal- pect investment flows to expand in an uninter- ized economies in Latin America, East and South- rupted fashion. Still, capital flows now result from east Asia, the Middle East, and even Central Europe. deliberate locational decisions by investors and borrowers who have considered global alterna- An unstoppable virtuous cycle had begun, or so tives. Flows will slow from time to time. Indeed, the thinking went. Growing pools of savings in after tripling from an average US$50 billion a year aging industrial countries would continue to find in 1989-91 to US$159 billion in 1993, investment superior investment returns by building expo- flows to developing countries rose by only 5 per- sure to faster-growing developing countries. In cent to US$167 billion in 1994 and by some esti- turn, the integration of these countries with world mates fell by up to 20 percent in 1995. ... highly quantitative managers The question now is, how does volatility affect emerging market investors, borrowers, and the intentionally create exposure-typically market itself? To answer this, it is important to note the dramatic shifts in the composition of representing a small share of assets investment in developing countries since it ex- ploded during the early 1990s. These flows are -to high-risk, high-return classes of not "stodgy" old bank loans. Commercial bank loans have fallen sharply-from more than 20 investments. Taken together, such percent of total capital flows to developing coun- tries in the late 1980s to less than 4 percent in the investments can make up a large share past four years. Limited by balance sheet capac- ity and banks' new focus on fee-generating busi- of lightly capitalized markets, ness, bank loans and syndications have given way to securities issues. Bonds reach a much reinforcing the markets volatility. broader range of investors, many of whose po- tentially longer-term and less-leveraged liabilities financial markets would assure a level of con- are well suited to bond assets. These investors nectivity and discipline that would prevent the are also willing to bear risks because of their kind of economic backsliding that had earlier ability to diversify portfolios and their perceived soured such investments. It was presumed that ability to trade assets actively when conditions newly powerful capital market forces would de- appear to shift. mand great discipline on the part of borrowers, with investors able to sell their holdings and refuse Capital flows to developing countries in the form to invest again. After the loan failures of the 1970s of debt securities reached 25 percent (or US$42 and 1980s, when many commercial banks, try- billion) in 1993. But bonds are not the only fi- ing to bail themselves out, threw good money nancial market instrument being traded. Dynamic after bad in lending to long-time customers, capi- equity portfolio investments have grown from tal markets were expected to reduce volatility low levels to nearly another quarter of capital and its underlying conditions. But as things have flows. These portfolios interact with increasingly turned out, the information content of the capi- well-developed stock markets. Or investors can tal flows and the discipline they could instill in trade them without ever leaving the comfort of borrowers were both overestimated. And, as the their home market by using American or global Mexican experience shows, volatility was too depository receipts, which represent interests in often-and at great risk-simply assumed away. emerging market companies. Not all equity investments are held in trading reflected quickly in market prices, which are in portfolios, of course. In fact, nearly half the capi- turn affected by the relatively large number of tal flows to developing countries represent di- investors whose decisions are linked to price rect foreign investment (like that in plant and performance. Prices are therefore more likely equipment) by strategically minded global cor- to rise or fall precipitously. The trouble is that porations. Still, some US$65 billion of capital- the markets have no easy way to transmit their about 30 percent more than the total annual time-bound expectations and their ongoing judg- investment flows just five years ago-has flowed ments to borrowers. As long as prices are high, in each of the past few years to developing coun- both investors and borrowers tend to presume tries in the form of bonds and portfolio equity that all is on track. Neither pays enough atten- investments. tion to fundamentals. Investors believe that oth- ers will want to buy their stakes when it is time The profile of these investments is decidedly to take profits. And borrowers draw from the less patient than that of the direct foreign in- price charts and their success stories a sense vestment whose presence in part attracts them. The new investors appreciate volatility. Their . the messagefrom investors was not often highly quantitative managers intentionally wt create exposure-typically representing a small that all was well. It was simnply that share of assets-to high-risk, high-return classes of investments. Taken together, such investments they would give Mexico another can make up a large share of lightly capitalized markets, reinforcing the markets' volatility. And chance-ais long as it absorbed more emerging markets are well suited to the new investors. Newly opened economies present op- of the market risk portunities for windfall gains at the same time that they are steering through the uncharted wa- that their job is done. By the time it becomes ters of adjustment (which occasionally turn wind- clear that not enough has been done to support falls into waterfalls). Moreover, the performance long-term investments, there is little or no mar- of many firms in the emerging economies is tied gin left for completing the task. to the fate of their market. This phenomenon, along with the high information and transaction Economic management implications costs of dealing in a wide variety of equity and debt instruments, can lead to holdings concen- In view of the benefits of financial integration- trated in a few countries or companies, again increased trade, more uniform market rates (ad- adding to volatility. For example, during the justed for risk and inflation), and a higher 1990s, 84 percent of private capital flows to de- potential for growth-investors and developing veloping countries have gone to just twelve country capital importers both must understand countries, with nearly 30 percent going to China how the other responds to financial volatility. and about 13 percent to Mexico. Trouble in one of these countries cannot but have a major im- So how should investors adapt? Recent experi- pact on the market as a whole. ence suggests that investors might be well served to ignore traditional counsel against 'fighting Financial market investors compensate for their the tape" and begin to rely less on market trends lack of intimate knowledge of-and long-term as a guide to investment strategy. Developed relationships with-the countries and compa- markets in which trend analysis is used enjoy nies in which they invest with hair triggers on relatively complete information flows and are their investments. They count on other, more populated by a wide variety of investors with knowledgeable observers to signal when returns different objectives and time horizons. In thin- are in jeopardy. They expect such signals to be ner and more crisis-prone emerging markets, Emerging Markets and Financial Volatility-Beyond Mexico investors should consider the underlying fun- when trade deficits balloon, growth remains damentals for the countries and companies- anemic, banking weakness reflects poor invest- not only policies and the commitment and ability ment performance, and the political will to com- to implement them, but also the ability to man- plete the reform is lacking. age in the wake of financial volatility. Investors' reaction to conditions in Mexico There is already broad agreement on the impor- throughout 1994 and 1995 was, of course, the tance of better-quality information on the funda- extreme case. As the markets there began to pla- mental condition of economies into which global teau, competitive investment yields rose and in- funds are flowing. But this is not a panacea, nor vestors became wary. Outflows were stemmed will it improve the situation immediately. It might by offering higher returns and through financial even slow capital flows down for a while. Some engineering that lowered investors' risks. But the investors will be deterred by the information they message from investors was not that all was well. receive or by the difficulty of determining how It was simply that they would give Mexico an- others in the market will respond to such data. other chance-as long as it absorbed more of And it might take time for existing or prospec- the market risk. Even if this was recognized in tive investors to reclassify their emerging market Mexico as well as outside, it was not clear that assets away from the most high-risk, high-return the Mexicans were granted enough time or room categories, while in the short run they could to fix the economy to meet market expectations, choose to reduce their portfolio exposure to all nor could they easily change those expectations. developing country securities. Clearly, officials must learn to manage the eco- nomic fundamentals that it is in their power to The countries on the receiving end of global affect, to inform investors of their progress, and open forem intended to capital flows, meanwhile, face substantial risk to listen carefully to the feedback that the mar- encourage dissemina- along with high opportunity. The cost of avoid- ket offers. Market jitters do not necessarily re- tion of and debate on ing financial integration is unacceptably high. quire fundamental rethinking, nor does market ideas, innovations, and best practices for But integration is not costless; in the early stages euphoria suggest that necessary reforms can be expanding the private of economic and financial reform, it can intro- postponed. But the stakes are rising, and the win- sector. The views duce a potential for higher financial volatility. dow of opportunity for action is shrinking. published are those of the authors and should That is why some countries have deliberately not be attributed to the curbed investment inflows during long periods Like other international financial institutions, the World Bank or any of its of adjustment. But not all have found this World Bank too must reconsider its role in the affiliated organizations. Nor do any of the con- tradeoff attractive. Some attempt to integrate wake of volatile global capital flows. Strategic clusions represent quickly into global financial markets even if their advice and financial support can no longer be official policy of the local markets are not yet developed to global offered in a market vacuum. The message of World Bank or of ls standards. This leads to a pattern of events that market flows must feed into Bank operations, or the countries they by now has been repeated in several countries, and the Bank must try to improve the informa- represent. notably in Latin America but also in such coun- tion content of its advice to client countries. Fi- Comments are welcome. tries as Turkey. In the typical scenario, economic nally, while the Bank's need to address long-run Please call the FPD adjustment is led by tight-money policies aimed fundamentals is increasingly important, so too is Note line to leave a at reducing chronic inflation. This generates sub- the need to help client countries improve their message (202-458-1 111) or contact Suzanne stantial inflows of foreign funds and heavy re- capacity to anticipate, avoid, and manage the Smith, editor, Room patriation of overseas holdings. Success in this crises of volatility that can accompany economic G8105, The World Bank, phase, however, does not necessarily signal a liberalization and financial integration. 1818 H Street, NW, Washington, D.C. 20433, capacity in the economy to absorb investment or Internet address flows. Countries that have "suffered" such a sur- Gary Perlin, Director, Financial Sector Develop- ssmith7r3woridbank.org. feit of capital inflows relative to their ability to nient Department (appointed Vice President and @Printed on recycled deploy them in a fully productive way find that Treasurer of the World Bank, effective March paper. international markets continue investing even 1996)