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1 Structural Changes in the World Financial System: The Impact on Local Financial Markets Eliot Kalter Assistant Director International Capital Markets.

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Presentation on theme: "1 Structural Changes in the World Financial System: The Impact on Local Financial Markets Eliot Kalter Assistant Director International Capital Markets."— Presentation transcript:

1 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 2 I.Introduction This presentation examines structural shifts in world financial markets to better understand forces at work impacting the EMCs access to capital. 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. 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. This analysis is based on the Global Financial Stability Reports (GFSR) of the International Monetary Fund.

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

4 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 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 EMCs. Bond financing to emerging market countries started to decline following the Asia crisis but is now rebounding. 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. Cross-border bank loans are now insignificant in net terms.

5 5 FDI flows to EMCs fell in 2003, continuing the downward trend that began in Private Flows to Emerging Market Economies (In billions of US dollars)

6 6 Foreign Direct Investment to EMCs Foreign direct investment (FDI) to emerging market countries remains resilient but varies greatly by region. Foreign direct investment (FDI) to emerging market countries remains resilient but varies greatly by region. Geographic Distribution of FDI Flows (In percent of total)

7 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.

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

9 9 Changing Market Share of Emerging Market Investors (In percent)

10 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 1990s. The dramatic shift in the investor base began with the restructuring of bank debts to Brady bonds in the early 1990s. Increased risk aversion by banks. Increased risk aversion by banks. Ongoing shift in business strategies of many money center 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 Strong risk-adjusted returns of emerging securities have led international institutional investors to make a strategic allocation to EM asset class

11 11 Emerging Market Investment Base: Parallel Growing Role of Institutional Investors Moving toward mature market investor base Moving toward mature market investor base – –Institutional investors assets under management are growing rapidly in most EMCs, 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 EMCs will reach the industrial country average of 25–30 percent of GDP assets under management.

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

13 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.

14 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 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 15 Forces for Reform and Stability The corresponding securitization of the stock of emerging market claims aids the process of greater fungibility and tradability. 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. 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. 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.

16 16 EMCs Growing Use of Local Capital Markets In turn, EMCs 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. 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 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. EMC corporates are relying on domestic capital markets to reduce exchange rate risk and take advantage of lower risk- adjusted rates.

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

18 18

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

20 20 Nevertheless, domestic corporate bond issuance rose from an annual average of $11 billion in in to $110 billion in 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 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 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 While international corporate bond issues where about equivalent to domestic corporate bond issues in , they were on tenth of domestic issues in Recent Trends in Local Securities Markets

21 21 Recent Trends in Local Securities Markets There are regional differences in how rapidly the markets have developed. 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 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. 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 22 V. Potential Costs of New Investor Base Vulnerability to Shifts in Investor Confidence and Developmental Challenge

23 23 Vulnerability to Shifts in Market Confidence EMC market: Unanswered questions regarding market stability 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).

24 24 Potential Vulnerabilities The increase in cross-over investors could go either way. 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.

25 25 EMCs Financial Markets Lack Depth and Liquidity Many EMCs 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. Many EMCs 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. Lack of investor sophistication and excessive market regulations are creating important challenges for the efficiency and stability of local markets. Development of some EMCs financial markets is hampered by small markets that prohibit sufficient economies of scale. Development of some EMCs 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. Could result in inappropriate investment decisions and encourage increased public and private debt.

26 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 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 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 Require improved market infrastructure, including a liquid secondary market and good clearing and settlement system Underdevelopment of corporate bond markets Underdevelopment of corporate bond markets

27 27 Risks of Current Market Conditions: Underlying Vulnerabilities are Masked Emerging Market Debt: Average Cross-Correlations, 2002–04 EMBI+ Dispersion of Returns (In percent)

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

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

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

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

32 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. 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 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). 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 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 marketsespecially in high inflation emerging markets. –The development of well-functioning money markets and derivatives markets are critical in developing corporate bond markets.

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