'Circuit breakers' luring investors<\/p>\n
By C.J. de Koning<\/p>\n
LONDON (JP): Foreign equity investors and foreign lenders to
\ncountries like Thailand, Indonesia, South Korea, Russia and more
\nrecently Brazil have recently been withdrawing their funds
\nindividually and collectively on an unprecedented scale.<\/p>\n
Such withdrawals have resulted in a steep depreciation of
\ncurrencies in the countries concerned, big hikes in local
\ncurrency interest rates, substantial drops in economic activity,
\nrapidly rising unemployment, bankruptcies and bank failures and
\nlower world commodities prices. The International Monetary Fund
\n(IMF) was called in to all these countries and IMF-sponsored
\nprograms were put in place.<\/p>\n
The withdrawal of capital from these countries resulted from
\nchanges in perceived risk. For foreign investors and lenders,
\nthree types of risk are attached to emerging markets.<\/p>\n
* The first and foremost risk is the risk attached to the local
\ncurrency. Foreign investors bring foreign currency into countries
\nlike Indonesia and they expect foreign currency in return. Risks
\nattached to the local currency arise both from the exchange rate
\nand the availability of foreign currency to meet any withdrawal
\nof investments.<\/p>\n
* The second type of risk is the risk attached to the country's
\npolitical and economic environment. Is the country politically
\nstable? What type of business freedom does the government allow?
\nDoes it interfere heavily in the business sector via state
\ncompanies and state banks? What is the state of the balance of
\npayments and international trade accounts? What taxes are levies?
\nWhich interest rates apply and how are they likely to change? How
\ndoes the legal system work? What about corruption and collusion?<\/p>\n
* The third type of risk is the \"counter party\" risk, which is
\nthe risk that an individual company or a bank will be unable to
\nmanage its affairs well within the emerging market. This type of
\nrisk is actually the principal reason why foreign equity
\ninvestors choose or reject shares in any given company. The same
\nperception of risk determines whether or not foreign banks issue
\nloans to emerging market companies.<\/p>\n
When the economic crisis broke in Indonesia in July 1997, all
\nevidence suggests that Indonesian companies made only minor
\nadjustments to the way they ran their affairs. Although companies
\ncontinued to work as efficiently as before, could the government?
\nDid the second type of risk -- the risk of substantial change in
\ngovernment economic policy -- take on a greater probability of
\noccurring? The government introduced a managed floating exchange
\nrate regime in August 1997 and then went on to fully float the
\ncurrency before turning to the IMF in October 1997. However, this
\nwas all in reaction to developments in the currency market and
\nnot a major change in policy.<\/p>\n
All indications point to the first type of risk,
\ncurrency risk, being prevalent in the Indonesian economy. Over a
\nsix-month period, the rupiah dropped in value from Rp 2,450 per
\nU.S. dollar to nearly Rp 5,000 at the end of 1997, before going
\non to fall even further in the course of 1998.<\/p>\n
Foreign firms' perception of risks attached to the currency
\nwere of the utmost importance. With approximately US$140 billion
\nin outstanding foreign debt -- 65 percent of all outstanding debt
\nin Indonesia -- and $50 billion in portfolio investment on the
\nJakarta Stock Exchange at the end of June 1997 -- roughly half of
\nall investments -- foreign firms were a key player in the
\nIndonesian economy.<\/p>\n
By withdrawing from the equities and lending markets in such
\nspectacular fashion, banks and individual investors were taking
\nentirely logical steps to protect themselves from a perceived
\nrisk.<\/p>\n
Collectively, however, it was economic and financial suicide.
\nThen, by pressing for the closure of local banks and drastic
\nincreases in local interest rates, the IMF acted like it was
\npouring petrol on a fire. These measures greatly increased the
\nrisks attached to local companies and banks, compounding the
\nrisks associated with the currency in that time of extreme
\nmonetary turbulence.<\/p>\n
Foreigners reacted predictably, racing to get out of the
\nIndonesian economy and liquidate their portfolios, pushing the
\nrupiah down to a record low of Rp 17,000 against the U.S. dollar
\nin January last year.<\/p>\n
It seems clear that when individual portfolio risk management
\ndecisions are not based on company performance, nor on government
\nperformance, but on currency risk factors, then no \"circuit
\nbreakers\" are currently available to stop the risks from feeding
\non themselves. Collectively, everyone is a loser whether as an
\nequity investor, a lender or a borrower.<\/p>\n
Of course, with hindsight, Indonesia could have measured and
\nreported the level of foreign currency borrowings more
\naccurately. A better maturity profile of all foreign currency
\ndebt should have been available, and not restricted solely to
\ngovernment debt. Improvements could have been made in the process
\nof settling foreign debt by centralizing all foreign currency
\ndebt payments via a central credit clearing organization.<\/p>\n
All these measures would have helped, but the most promising
\n\"circuit breaker\" might not come from the borrower's side, but
\nrather from the lenders and investors themselves.<\/p>\n
The objective of a \"circuit breaker\" is to collectively manage
\nthe risk of lending and equity portfolios held by overseas
\nparties in a manner which -- when needed -- slows down or
\naccelerates the funds made available to, for example, the
\nIndonesian economy as a whole, but not necessarily to the same
\nborrower.<\/p>\n
There are two possible \"circuit breakers\" which could be
\nimplemented, one for international lenders, the other for foreign
\nequity investors. For international lenders, a possible \"circuit
\nbreaker\" would be an instrument set up by central banks in
\ndeveloped countries.<\/p>\n
They could, under the guidance of the Bank for International
\nSettlements (BIS) and with assistance from the IMF, decide upon a
\nscheme of reserve requirements for loans and off-balance country
\nrisk items in emerging market countries. The percentage of
\nreserves which must be kept at a central bank would depend on the
\nperceived risk attached to the nation involved, and could be
\nchanged over time as the country evolves. A BIS panel of experts
\ncould recommend the applicable percentage, with an agreement
\nbetween central banks then put in place to ensure that all accept
\nand enforce this percentage in all banks under their supervision.
\nIn this way, a level playing field would be maintained for all
\nbanks in the developed world.<\/p>\n
Over time, the \"circuit breaker\" would serve two main
\npurposes.<\/p>\n
The first would be related to supply and demand for funds in a
\ndeveloping country. The growth rate and sheer size of the world's
\nlending institutions' capacity to lend far exceeds the capacity
\nof individual developing countries to borrow.<\/p>\n
When a developing country's collective loan portfolio grows or
\nrisks increase, the risk premium attached to that country must
\nrise to reflect that change.<\/p>\n
However, individual risk decisions evolve over time and no
\nsingle institution can foresee what others are planning to do.
\nThe last lender changes the collective loan portfolio risk, and
\nso the individual risk premium may therefore be no reflection of
\nthe actual risks incurred, especially as many premiums are fixed
\nfor a number of years.<\/p>\n
It would not be difficult to include a clause in loan
\nagreements stating that when banks in developed countries are
\nfaced with increased reserve requirements, the costs of such
\nregulation could be passed on to the borrower.<\/p>\n
Collectively this leads to the debtor country borrowing less,
\nand paying more, for the whole loan portfolio, correctly
\nreflecting the change in risks. Application of this risk premium
\nsystem shifts the collective risk management of the loan
\nportfolio towards the borrower's ability to borrow rather than
\nthe lender's willingness and ability to lend.<\/p>\n
This instrument also serves to allow reserves built up in the
\ncentral banks of developed countries to serve as the \"second line
\nof defense\" for developing country exchange rates, after
\ndeveloping countries have use their own foreign exchange
\nreserves.<\/p>\n
This second line of defense could be used, for example, when a
\ndeveloping country enters into a cooperation agreement with the
\nIMF. The increased potential buffer already reduces the risk of
\nilliquidity in the developing country's foreign exchange market
\nand thereby reduces the potential for currency volatility, thus
\nreducing collective cross border loan portfolio risks.<\/p>\n
The \"circuit breaker\" can do its work when speculators or
\nirrational collective behavior threaten the economy of a
\ndeveloping country. More orderly adjustments can then be made
\nover time in co-operation with the IMF.<\/p>\n
The second type of \"circuit breaker\" would help foreign equity
\ninvestors, whose non-corporate risk is basically currency risk.<\/p>\n
A developing country government could remove currency risk by
\nguaranteeing to repurchase proceeds from the sale of shares at
\nthe official middle exchange rate on the day of purchase. The
\nguarantee should stretch no further than the original amount
\ninvested, so as not to cover profits made, nor to share losses.<\/p>\n
An independent \"guarantee corporation\" run by an independent
\nauditing firm could operated this mechanism, with the necessary
\nfinancial resources provided by the host government. In this
\ncase, the program would initially cover 100 percent of the
\ncurrency risk or the equities purchased. Gradually, the
\npercentage could be lowered and varied to suit the influx of
\nforeign funds into the local equity market.<\/p>\n
Both \"circuit breakers\" provide the opportunity to turn
\nemerging markets around, something which would also benefit the
\ndeveloped world. Therefore, individual foreign lenders and
\ninvestors should collectively be induced to come to the
\nconclusion: \"Start the economy, I want to get in.\"<\/p>\n
The writer is a former country manager of ABN AMRO in
\nIndonesia. He currently works for ABN AMRO of London. The article
\nwas written in a private capacity.<\/p>",
"url": "https:\/\/jawawa.id\/newsitem\/circuit-breakers-luring-investors-1447893297",
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