From: glevy@PRATT.EDU
Date: Fri Jun 29 2007 - 10:31:26 EDT
via Antonio Pagliarone
Global Finance Today: Deja Vu?
C.P. Chandrasekhar
The nature of financial integration of developing countries with their
developed counterparts has been radically transformed over the last four
years. Evidence collated by the World Bank's annual report for 2007 on
Global Development Finance, reveal a number of features of the new
scenario that have far-reaching implications.
The first of these is an acceleration of financial flows to developing
countries (Chart 1) precisely during the years when as a group they have
been characterised by rising surpluses on their current account. Total
flows touched a record estimated 600 billion in 2006, having risen by 19
per cent on top of an average growth of 40 per cent during the three
previous years. Relative to the GDP of these countries, total flows, at
5.1 per cent, are at levels they touched at the time of the East Asian
financial crisis in 1997.
A second feature is the acceleration of the long term tendency for private
flows to dominate over official (bilateral and multilateral) flows.
Private debt and equity inflows, which had risen by 50 per cent a year
over the three years ending 2005, increased a further 17 per cent in 2006
to touch a record $647 billion (Chart 2). On the other hand net official
lending has in fact declined over the last two years. One factor
accounting for this is the failure of the G-7 to match promises of a
substantial hike in aid disbursements beyond what the retirement of the
debt of few heavily indebted poor countries ensures. The other is that the
more developed among the developing countries have chose to make advance
repayments of debt owed to official creditors, especially the IMF and the
World Bank. Overall, principal repayments to official creditors exceeded
disbursements by $70 billion in 2005 and $75 billion in 2006. In the event
there has been a reverse flow of capital to the World Bank and the IMF,
which is threatening the viability and influence of these institutions,
especially the latter. However, the increase in private flows has more
than matched the reverse flows to official creditors.
The third feature is that the dominance of private flows has meant that
both equity and debt flows to developing countries have risen rapidly,
with the surge being greater in the case of the former. Net private debt
and equity flows to developing countries have risen from a little less
that $170 billion in 2002 to close to $647 billion in 2006, an almost
four-fold increase over a four-year period. While net private equity
flows, that rose from $163 billion to $419 billion dominated the surge,
net private debt flows too increased rapidly. Bond issues rose from $10.4
billion to $49.3 billion and borrowing from international banks from $2.3
billion to a huge $112.2 billion. What is more, net short-term debt,
outflows of which tend to trigger financial crises, has risen from around
half a billion in 2002 to $72 billion in 2006.
The fourth feature, which is a corollary of these developments, is that
there is a high degree of concentration of flows to developing countries,
implying excess exposure in a few countries. Ten countries (out of 135)
accounted for 60 per cent of all borrowing during 2002-04, and that
proportion has risen subsequently to touch three-fourths in 2006. In the
portfolio equity market, flows to developing countries were directed at
acquiring a share in equity either through the secondary market or by
buying into initial public offers (IPOs). IPOs dominated in 2006,
accounting for $53 billion of the $96 billion inflow. But here too there
were signs of concentration. Four of the 10 largest IPOs were by Chinese
companies, accounting for two-thirds of total IPO value. Another 3 of
those 10 were by Russian companies, accounting for an additional 22 per
cent of IPO value.
A fifth feature is that despite this rapid rise in developing country
exposure, with that exposure being excessively concentrated in a few
countries, the market is still overtly optimistic. Ratings upgrades
dominate downgrades in the bond market. And bond market spreads are at
unusual lows. This optimism indicates that risk assessments are
pro-cyclical, underestimating risk when investments are booming, and
overestimating risks when markets turn downwards. But two consequences are
the herding of investors in developing country markets and their
willingness to invest in a larger volume of money in risky, unrated
instruments.
Finally, the rapid rise in capital flows to developing countries at a time
when many of them are recording large current account surpluses has
substantially increased their foreign exchange reserves and triggered a
flow of capital out of developing countries. This outflow takes three
forms: (i) investment of reserves in safe and low-return instruments such
as US Treasury Bills; (ii) financing of asset acquisition to support the
growing presence of leading developing country firms in global commodity
markets; and (iii) financial investments in and lending to other
developing countries, resulting in the South-South flow of capital. These
trends together suggest that developing countries are still largely
restricted to the low return or high risk segments of global capital flow.
This is the cost they bear to meet the requirements of ensuring balance in
the global balance of payments.
These features of the current global financial scenario can be interpreted
in two ways. One is in the direction taken by the World Bank. It admits,
on the one hand, that "the probability of a turn in the credit cycle" has
risen and that a "key challenge facing developing countries is to manage
the transition by taking pre-emptive measures aimed at lessening the risk
of a sharp, unexpected reversal in capital flows". On the other, it
downplays the dangers involved by arguing that the surge in capital flows
"speaks well for the resiliency of developing economies and for the
ability of international financial markets to manage risks."
An alternative view would be that many emerging market economies that
attract a disproportionate share of these capital flows, are fast
approaching a situation where they are vulnerable to financial crises,
with the current scenario incorporating features that could make these
crises more intense. What is more, it appears that prudential norms, risk
management techniques and disclosure requirements put in place as part of
the so-called "new international financial architecture" seem inadequate
to foreclose a build up of this kind. This is not surprising, since
garnering large and quick profits rather than minimising risks seems to be
the dominant requirement of financial institutions from the developed
countries.
The current situation is the inevitable result of expanding the space for
financial capital through dilution or elimination of regulation. Financial
liberalisation has ensured that since the late 1970s, the newly discovered
"emerging markets" among developing countries have been the new frontier
for profiteering by global financial institutions. Awash with the
liquidity derived from the surpluses earned by oil exporters and the
savings accumulated by the generation of baby-boomers in the West, banks,
investment funds and pension funds were looking to new avenues for
lucrative investments. The role of financial intermediaries was one of
dressing up developing countries that were hitherto "untouchables" as
lucrative destinations for financial capital. And financial innovation
consisted in not just identifying instruments that could carry such
investments, but derivatives that could help hedge against the risk
associated with rushing into uncharted territory.
The process began when developing countries were still reeling under the
effects of declining non-fuel commodity prices and rising oil prices,
which had left gaping holes in the current account of their balance of
payments. The new found interest of global finance offered developing
country governments an opportunity to finance that gap, even if it meant
offering high returns to foreign financial investors. It was this
conflation of interests of developing country governments and financial
institutions from the developed countries that led up to the debt crisis
of the 1980s and the financial crises of the 1990s, including those that
began with the East Asian crises in 1997.
One consequence of the 1997 crisis was a sharp decline in lending to
developing countries. But this did not mean a decline in capital flows.
Rather, encouraged by the post-crisis deflation in asset prices in
emerging markets and the sharp devaluation of their currencies, foreign
direct investment kept flowing into developing countries to acquire assets
at rock bottom prices when measured in hard currencies. While net debt
flows to developing countries declined from $53.1 billion in 1998 to just
$1.2 billion in 2000, net FDI flows remained more or less stable at around
$170 billion a year.
Since 2002, when growth accelerated or remained high in China and India
and commodity prices rose sharply in the case of oil and metals and
moderately in the case of agriculture, this lull in capital flows has
given way to a surge. Besides the features noted above, three kinds of
developments have accompanied this surge. First, the growing importance of
unregulated hedge funds looking for abnormal returns in portfolio equity
markets, which renders activity in those markets highly speculative and
opaque. Second, the rapid increase in investments by "private equity"
firms - investing largely in unlisted equity - in corporations in
developing countries. The size of each of these investments is such that
they are identified as foreign "direct" investments, even though their
objective is speculative. The evidence on the controversial role played by
these firms in the developed countries indicates that their activity too
is extremely opaque. Third, the revival once again of the global market
for developing country debt, driven this time by private corporate
borrowing in the syndicated loan market. Since this new surge in credit
rides on a wave of securitisation that transfers the risk associated with
such lending to pension and mutual funds among others, accumulating risk
does not serve as a deterrent on banks creating such credit.
There are a number of implications of these tendencies. To start with, the
risk associated with the current surge in capital flows can be and is much
greater than was true during previous episodes involving a similar surge.
Moreover, the surge is accompanied by the growing acquisition of assets in
developing countries outside the stock market with objectives that are
largely speculative, so that a sell-off, if it occurs, would be far more
widespread. And the persistence of the herd instinct has meant that the
surge in fixed and portfolio investment flows has resulted in a revival of
credit flows that is unbridled since it is accompanied by risk-mitigation
techniques that transfer risk to those who are least equipped to assess
them. Unfortunately, all of this occurs in an environment in which the
target of both investment and debt flows is the private sector, which
makes it difficult for governments that have liberalised financial
regulation to control such flows. In sum, the risks associated with the
current surge in capital flows are far greater than emerges from the World
Bank's rather sanguine assessment of the possible fall-out of the ongoing
transformation of global financial flows. A turn in the investment cycle,
with far-reaching implications, is real and imminent.
June 14, 2007.
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