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Eliot Kalter Assistant Director International Capital Markets Dept

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Presentation on theme: "Eliot Kalter Assistant Director International Capital Markets Dept"— Presentation transcript:

1 Structural Changes in the World Financial System: The Impact on Local Financial Markets
Eliot Kalter Assistant Director International Capital Markets Dept International Monetary Fund March 28, 2004

2 I. Introduction This presentation examines structural shifts in world financial markets to better understand forces at work impacting the EMCs access to capital. Focus on the dramatic shift in the investor base for capital flows to EMCs and the impact on local capital markets. This analysis is based on the Global Financial Stability Reports (GFSR) of the International Monetary Fund.

3 II. Emerging Market Capital Flows
Growing Role of Debt Financing and FDI

4 Total External Financing to EMCs
Since 1990, private capital flows, led by bond and equity financing, have far exceeded official loans and grants to become the dominant source of external financing to EMC’s. Bond financing to emerging market countries started to decline following the Asia crisis but is now rebounding. Cross-border bank loans are now insignificant in net terms. Total external financing to EMC’s Table 1. page 36 march 2004 GFSR Since 1990, private capital flows have far exceeded official loans and grants to become the dominant source of external financing to EMC’s. Debt financing—cross-border bank lending and bond financing—to emerging market countries started to decline following the Asia crisis, with net debt-creating flows falling from an inflow of over $100 billion in 1995 to net amortizations in 2001–02. Bank loans contracted sharply and in net terms have been negative since 1999 while bond issuance remained an important source of external financing The declining trend in total private external financing for emerging market countries was reversed in 2003

5 FDI flows to EMCs fell in 2003, continuing the downward trend that began in 2000.
Private Flows to Emerging Market Economies (In billions of US dollars) Chart 2.x. bottom page 41 march 2004 GFSR FDI flows to EMC’s fell in 2003, continuing the downward trend that began in 2000. However, the decline was smaller than in the previous year and was more than accounted for by reduced FDI in Brazil and the EU accession countries The outlook for FDI is expected to improve further in 2004 reflecting the improving growth prospects of the global economy. FDI-now the most important net flow for all regions Equity portfolio flows have been more cyclical in nature and linked with developments in mature markets

6 Foreign Direct Investment to EMCs
Foreign direct investment (FDI) to emerging market countries remains resilient but varies greatly by region. Geographic Distribution of FDI Flows (In percent of total) Foreign direct investment to EMC’s Chart 2.x. top page 41 march 2004 GFSR FDI to emerging market countries has been more resilient but has also declined in recent years, owing in large part to a sharp reduction in flows to Latin America and reduced privatizations of state-owned assets in the service sector. Nevertheless, FDI has remained at substantial levels.

7 FDI prospects dependent on 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. FDI prospects dependent on country-specific factors Results from a recently completed survey conducted by a working group of the Capital Markets Consultative Group (see CMCG, September 2003) emphasize the importance of regional economic, structural and institutional factors on influencing FDI prospects. The direct investors participating in that working group reported that there was no large-scale withdrawal from Latin America and that the effect on FDI from the Argentina crisis was concentrated in the banking and utilities sectors. The CMCG report also notes that FDI in emerging market countries is increasingly being undertaken to service domestic demand in the host country, which highlights the importance of large markets and promising growth prospects. Consequently, emerging market countries with good governance practices and improving infrastructure and institutions are likely to secure greater amounts of FDI.

8 III. Institutional Investors in Emerging Markets
Growing Role of Cross-Over and Local Investors

9 Changing Market Share of Emerging Market Investors (In percent)
Changes in the Composition of the Investor base GFSR September 2003 page 108 Graph Sharp drop in participation of cross-boarder banks that has contributed to the securitization of international finance. Increased participation of mature market nonbank institutional investors such as pension funds and insurance companies. Relative decline in “dedicated” investor: an investor whose performance is measured against an emerging market asset benchmark Relative increase in “crossover” investors: performance is not measured against any emerging market benchmark Rapid growth of local emerging market nonbank institutional investors such as pension funds, mutual funds, and life insurance companies

10 Mature Market Investor Base: Underlying Factors for the Changing Composition
The dramatic shift in the investor base began with the restructuring of bank debts to Brady bonds in the early 1990’s. Increased risk aversion by banks. Ongoing shift in business strategies of many money center banks. Strong risk-adjusted returns of emerging securities have led international institutional investors to make a strategic allocation to EM asset class Underlying Factors for the Changing Composition of Investor Base Supply consideration This trend began with the restructuring of bank debts to Brady bonds in the early 1990’s, together with the liberalization of investment in equity markets. Bradies have slowly been restructured with less expensive Eurobonds, with EMC’s entering a more sophisticated phase of managing their liabilities. Increased Risk Aversion by banks and hedge funds; weak balance sheets and earnings in home markets contributed to the retrenchment; crises have led to a reassessment and re-pricing of risk Ongoing shift in business strategies of many money center banks First, Japanese banks post-Asia crisis; more recently, European banks Greater emphasis on fee-based businesses Shrinking of traditional syndicated loan markets

11 Emerging Market Investment Base: Parallel Growing Role of Institutional Investors
Moving toward mature market investor base 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. B. Emerging Market Investors Changing Composition of Investor base 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[1] projects that by 2015, most pension systems in EMC’s will reach the industrial country average of percent of GDP assets under management. [1] Garcia Cantera et al, 2001, “Private Pension Funds in Latin America”, equity research: Latin America,

12 IV. Implications of Increased Role of Institutional Investors
Growing Demands and Incentives for Developing Local Capital Markets

13 Growing Role of Local Institutional Investors
Positive 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. Consequences Benefits Local EMC institutional investors are a steady source of demand for both local-currency and foreign currency denominated emerging market assets The growth of assets under management of local institutional investors is contributing to the development of local securities markets

14 Growing Role of Mature Market Institutional Investors
Positive force for development of local markets Internationalization of mature market institutional investor 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.

15 Forces for Reform and Stability
The corresponding securitization of the stock of emerging market claims aids the process of greater fungibility and tradability. Contributes to increased transparency regarding country risk perceptions. Finally, the availability of more timely and comprehensive information, along with the growth of hedging opportunities, enables the providers of capital to better manage their sovereign risk exposure. The corresponding secular securitization of the stock of EM claims implies greater fungibility and tradability. Contributes to better transparency regarding changes in perceptions of country risk. Finally, the availability of more timely and comprehensive information, along with the growth of the credit default swap market, enables the providers of capital to better manage their sovereign risk exposure.

16 EMCs Growing Use of Local Capital Markets
In turn, EMC’s are re-evaluating the risks of external borrowing. Many EMCs are developing local securities markets to facilitate the management of financial risks associated with external financial markets. EMC Sovereigns are increasingly depending on local markets for new financing while using external markets for liability management purposes. EMC corporates are relying on domestic capital markets to reduce exchange rate risk and take advantage of lower risk-adjusted rates. Demand considerations EMC’s are re-evaluating the risks of external borrowing Sovereigns are increasingly financing their debt in local markets, albeit in some cases linked to foreign exchange The desire and ability to reduce external debt by many large issuers has kept supply down

17 V. Recent Trends in Local Securities Markets
The Growth of Local Bond Markets

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19 Recent Trends in Local Securities Markets
To what extent have local bond markets begun to provide an alternative source of funding? There has been substantial progress in the development of government bond markets, but progress has been somewhat slower in corporate bond markets Emerging local bond markets have grown considerably over the last decade and now are roughly 35 percent of GDP. Domestic bank lending continues to be the dominant source of corporate financing, accounting for 70 percent of total domestic and international funding. Recent Trends in Local Securities Markets Emerging local bond markets have grown considerably over the last decade, but they are still much smaller than bond markets in the G-7 countries. Emerging local bond markets are roughly 36 percent of GDP (see Table 1). There are regional differences in how rapidly the markets have developed. In Asia, the growth of local bond issuance has been driven by the need to recapitalize banking systems. The lack of bank credit has also contributed to some increase in corporate bond issuance, not just in Asia but also in Latin America. In the latter region, the rapid growth of local institutional investors has driven the growth of local bond markets, together with large refinancing needs of the corporate sector in a difficult external environment. There has been substantial progress in the development of government bond markets, but progress has been somewhat slower in corporate bond markets The use of the equity market as a serious alternative source of financing for emerging market corporates really began in earnest in the early to mid-1990s. The importance of the stock market as a source of funding for corporates in emerging markets has become more volatile as a result of a string of financial crises, starting with Mexico in 1995, Asia during 1997–98, Russia in 1998, Brazil in 1999, and in more recent years, Turkey and Argentina.

20 Recent Trends in Local Securities Markets
Nevertheless, domestic corporate bond issuance rose from an annual average of $11 billion in in to $110 billion in Domestic corporate bond issues rose from 3 percent of total funding in to close to 20 percent of total funding in International issues on bonds, equities, and syndicated loans by the corporate sector accounted for 10 percent of total funding in compared with 2 of total funding in While international corporate bond issues where about equivalent to domestic corporate bond issues in , they were on tenth of domestic issues in

21 Recent Trends in Local Securities Markets
There are regional differences in how rapidly the markets have developed. In Asia, the growth of local bond issuance has been driven by the need to recapitalize banking systems. The lack of bank credit has also contributed to some increase in corporate bond issuance, not just in Asia but also in Latin America. In Latin America, the rapid growth of local institutional investors has driven the growth of local bond markets, together with large refinancing needs of the corporate sector in a difficult external environment.

22 V. Potential Costs of New Investor Base
Vulnerability to Shifts in Investor Confidence and Developmental Challenge

23 Vulnerability to Shifts in Market Confidence
EMC market: Unanswered questions regarding 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). EMC market: unanswered questions regarding 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. [1] Mohamed El-Erian, PIMCO Emerging Markets Watch, “The Capital Flows Transition” March 2003.

24 Potential Vulnerabilities
The increase in cross-over investors 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. The increase in cross-over investors could go either way. Have exhibited susceptibility to developments in competing and complementary asset classes--may sell off EMC bonds due to influences from other asset classes However, they also have broadened the investor base, moving investors’ focus from narrow benchmarks toward blended benchmarks that combine emerging market securities with more established products.[1] Also, increasingly cross-over investors are ultimately pension funds and insurance companies, that are likely to be long-term investors

25 EMC’s Financial Markets Lack Depth and Liquidity
Many EMC’s are not in the position to respond to the increased pension fund demand with sufficient volume and diversity of securities, without the issuers of the paper running dangerous financial policies. Lack of investor sophistication and excessive market regulations are creating important challenges for the efficiency and stability of local markets. Development of some EMC’s financial markets is hampered by small markets that prohibit sufficient economies of scale. Could result in inappropriate investment decisions and encourage increased public and private debt. Risks It is not clear whether the EMC’s could respond to the increased pension fund demand with sufficient volume and diversity of securities, without the issuers of the paper running dangerous financial policies. Lack of investor sophistication and captured market and excessive market regulations are creating important challenges for the efficiency and stability of local markets Could result in inappropriate investment decisions and encourage increased public and private debt

26 Need for Comprehensive Plan to develop Domestic Securities markets
A major challenge is the mismatch between the growth of domestic institutional investors and less developed domestic securities market Domestic institutional investors require size, liquidity and variety of instruments Require improved market infrastructure, including a liquid secondary market and good clearing and settlement system Underdevelopment of corporate bond markets

27 Risks of Current Market Conditions: Underlying Vulnerabilities are Masked
Emerging Market Debt: Average Cross-Correlations, 2002–04 EMBI+ Dispersion of Returns (In percent) Risks Charts on page 34 March 2004 GFSR There is a risk that the US yield curve could increase rapidly, triggering a widening of spreads in mature and emerging markets with an unwinding of leveraged positions. An unexpectedly sharp increase in underlying U.S. treasury yields could trigger a widening of credit spreads on EMC bonds. While improved EMC spreads have reflected improved fundamentals, they also reflect the existing ample global liquidity Recent evidence of the market reacting sharply to the possibility of a tightening in U.S. monetary policy . Underlying vulnerabilities of many EMC’s have been masked by favorable external financing environment Countries with high public debt levels and volatile debt structures would be most at risk. The cost of the increased public debt levels will increase as monetary conditions tighten.

28 VI. Policy Implications for EMCs of Increased Role of Institutional Investors

29 Implement Strong Macroeconomic Policy:
To reduce spreads, lower vulnerability to sharp swings in investor sentiment, and global liquidity conditions. To attract FDI. To prevent an unsustainable demand for public debt in an environment where available financing, particularly of domestic debt, may become increasingly available. V. Policy Implications for EMC’s of Increased Role of Institutional Investors Implement Strong Macroeconomic Policy To reduce spreads; lower vulnerability to sharp swings in investor sentiment and global liquidity conditions To attract FDI To prevent an unsustainable demand for public debt in an environment where available financing, particularly of domestic debt, may become increasingly available

30 Deepen Domestic Capital Markets and Improve Regulatory Framework
Institutional investors are particularly sensitive to market infrastructure, transparency and disclosure issues. Development of good clearance and settlement systems and liquid secondary markets for debt instruments could attract international institutional investors. Deepen Domestic Capital Markets and Improve Regulatory Framework Institutional investors are particularly sensitive to market infrastructure, transparency and disclosure issues Development of good clearance and settlement systems and liquid secondary markets for debt instruments could attract international institutional investors

31 Reduce Market Restrictions
Adequate diversification of domestic institutions’ portfolios may require a further sizable increase in the funds allocated to foreign securities. Reduce market restrictions Adequate diversification of domestic institutions’ portfolios may require a further sizable increase in the funds allocated to foreign securities.

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

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

34 Additional Steps are Required to Develop Local Markets
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 markets and derivatives markets are critical in developing corporate bond markets. Other Selected Policy Issues While the development of market infrastructure, institutional investors, and transparency are uncontroversial steps, countries’ experience and the arguments behind some other aspects of the development of local securities markets (the “grey areas”) are less clear cut. Indexed Bonds: The development of indexed bonds, in particular inflation indexed (or inflation linked, IL) bonds, has contributed to the development of local bond markets—especially in high inflation emerging markets. The issuance of dollar-linked debt in local markets compounds the problem that most emerging markets cannot issue international bonds denominated in their own currencies, the so-called “original sin problem.”

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

36 Sequencing Broadly speaking, a comparison of different types of financial systems, and their evolution over time, is a complex issue and there are no simple answers to what would be an optimal development strategy. Some analysts suggest that it may be optimal to develop first a deep local debt market before opening up the capital account. An example is Australia. The potential benefits of developing local markets in isolation from international markets have to be weighed against traditional arguments against capital controls (such as misallocation of resources, increased costs of funding, and evasion)

37 Local securities markets remain highly segmented in most regions, and a number of measures would have to be undertaken to develop fully integrated, regional markets. In Asia, for example, analysts note that, besides the removal of controls and harmonization of taxes, several institutional aspects of bond markets—such as contracts, underwriting, and settlement conditions—would have to be standardized to some extent before a pan-Asian market could be created. The Asia Bond Market Initiative started in 2003 is a broad umbrella covering many areas of bond market development. Market infrastructure is receiving particular attention, including: creating new securitized instruments, credit guarantee mechanisms, settlement regulations, local and regional credit agencies, and technical assistance coordination.


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