'Circuit breakers' luring investors

'Circuit breakers' luring investors

By C.J. de Koning

LONDON (JP): Foreign equity investors and foreign lenders to
countries like Thailand, Indonesia, South Korea, Russia and more
recently Brazil have recently been withdrawing their funds
individually and collectively on an unprecedented scale.

Such withdrawals have resulted in a steep depreciation of
currencies in the countries concerned, big hikes in local
currency interest rates, substantial drops in economic activity,
rapidly rising unemployment, bankruptcies and bank failures and
lower world commodities prices. The International Monetary Fund
(IMF) was called in to all these countries and IMF-sponsored
programs were put in place.

The withdrawal of capital from these countries resulted from
changes in perceived risk. For foreign investors and lenders,
three types of risk are attached to emerging markets.

* The first and foremost risk is the risk attached to the local
currency. Foreign investors bring foreign currency into countries
like Indonesia and they expect foreign currency in return. Risks
attached to the local currency arise both from the exchange rate
and the availability of foreign currency to meet any withdrawal
of investments.

* The second type of risk is the risk attached to the country's
political and economic environment. Is the country politically
stable? What type of business freedom does the government allow?
Does it interfere heavily in the business sector via state
companies and state banks? What is the state of the balance of
payments and international trade accounts? What taxes are levies?
Which interest rates apply and how are they likely to change? How
does the legal system work? What about corruption and collusion?

* The third type of risk is the "counter party" risk, which is
the risk that an individual company or a bank will be unable to
manage its affairs well within the emerging market. This type of
risk is actually the principal reason why foreign equity
investors choose or reject shares in any given company. The same
perception of risk determines whether or not foreign banks issue
loans to emerging market companies.

When the economic crisis broke in Indonesia in July 1997, all
evidence suggests that Indonesian companies made only minor
adjustments to the way they ran their affairs. Although companies
continued to work as efficiently as before, could the government?
Did the second type of risk -- the risk of substantial change in
government economic policy -- take on a greater probability of
occurring? The government introduced a managed floating exchange
rate regime in August 1997 and then went on to fully float the
currency before turning to the IMF in October 1997. However, this
was all in reaction to developments in the currency market and
not a major change in policy.

All indications point to the first type of risk,
currency risk, being prevalent in the Indonesian economy. Over a
six-month period, the rupiah dropped in value from Rp 2,450 per
U.S. dollar to nearly Rp 5,000 at the end of 1997, before going
on to fall even further in the course of 1998.

Foreign firms' perception of risks attached to the currency
were of the utmost importance. With approximately US$140 billion
in outstanding foreign debt -- 65 percent of all outstanding debt
in Indonesia -- and $50 billion in portfolio investment on the
Jakarta Stock Exchange at the end of June 1997 -- roughly half of
all investments -- foreign firms were a key player in the
Indonesian economy.

By withdrawing from the equities and lending markets in such
spectacular fashion, banks and individual investors were taking
entirely logical steps to protect themselves from a perceived
risk.

Collectively, however, it was economic and financial suicide.
Then, by pressing for the closure of local banks and drastic
increases in local interest rates, the IMF acted like it was
pouring petrol on a fire. These measures greatly increased the
risks attached to local companies and banks, compounding the
risks associated with the currency in that time of extreme
monetary turbulence.

Foreigners reacted predictably, racing to get out of the
Indonesian economy and liquidate their portfolios, pushing the
rupiah down to a record low of Rp 17,000 against the U.S. dollar
in January last year.

It seems clear that when individual portfolio risk management
decisions are not based on company performance, nor on government
performance, but on currency risk factors, then no "circuit
breakers" are currently available to stop the risks from feeding
on themselves. Collectively, everyone is a loser whether as an
equity investor, a lender or a borrower.

Of course, with hindsight, Indonesia could have measured and
reported the level of foreign currency borrowings more
accurately. A better maturity profile of all foreign currency
debt should have been available, and not restricted solely to
government debt. Improvements could have been made in the process
of settling foreign debt by centralizing all foreign currency
debt payments via a central credit clearing organization.

All these measures would have helped, but the most promising
"circuit breaker" might not come from the borrower's side, but
rather from the lenders and investors themselves.

The objective of a "circuit breaker" is to collectively manage
the risk of lending and equity portfolios held by overseas
parties in a manner which -- when needed -- slows down or
accelerates the funds made available to, for example, the
Indonesian economy as a whole, but not necessarily to the same
borrower.

There are two possible "circuit breakers" which could be
implemented, one for international lenders, the other for foreign
equity investors. For international lenders, a possible "circuit
breaker" would be an instrument set up by central banks in
developed countries.

They could, under the guidance of the Bank for International
Settlements (BIS) and with assistance from the IMF, decide upon a
scheme of reserve requirements for loans and off-balance country
risk items in emerging market countries. The percentage of
reserves which must be kept at a central bank would depend on the
perceived risk attached to the nation involved, and could be
changed over time as the country evolves. A BIS panel of experts
could recommend the applicable percentage, with an agreement
between central banks then put in place to ensure that all accept
and enforce this percentage in all banks under their supervision.
In this way, a level playing field would be maintained for all
banks in the developed world.

Over time, the "circuit breaker" would serve two main
purposes.

The first would be related to supply and demand for funds in a
developing country. The growth rate and sheer size of the world's
lending institutions' capacity to lend far exceeds the capacity
of individual developing countries to borrow.

When a developing country's collective loan portfolio grows or
risks increase, the risk premium attached to that country must
rise to reflect that change.

However, individual risk decisions evolve over time and no
single institution can foresee what others are planning to do.
The last lender changes the collective loan portfolio risk, and
so the individual risk premium may therefore be no reflection of
the actual risks incurred, especially as many premiums are fixed
for a number of years.

It would not be difficult to include a clause in loan
agreements stating that when banks in developed countries are
faced with increased reserve requirements, the costs of such
regulation could be passed on to the borrower.

Collectively this leads to the debtor country borrowing less,
and paying more, for the whole loan portfolio, correctly
reflecting the change in risks. Application of this risk premium
system shifts the collective risk management of the loan
portfolio towards the borrower's ability to borrow rather than
the lender's willingness and ability to lend.

This instrument also serves to allow reserves built up in the
central banks of developed countries to serve as the "second line
of defense" for developing country exchange rates, after
developing countries have use their own foreign exchange
reserves.

This second line of defense could be used, for example, when a
developing country enters into a cooperation agreement with the
IMF. The increased potential buffer already reduces the risk of
illiquidity in the developing country's foreign exchange market
and thereby reduces the potential for currency volatility, thus
reducing collective cross border loan portfolio risks.

The "circuit breaker" can do its work when speculators or
irrational collective behavior threaten the economy of a
developing country. More orderly adjustments can then be made
over time in co-operation with the IMF.

The second type of "circuit breaker" would help foreign equity
investors, whose non-corporate risk is basically currency risk.

A developing country government could remove currency risk by
guaranteeing to repurchase proceeds from the sale of shares at
the official middle exchange rate on the day of purchase. The
guarantee should stretch no further than the original amount
invested, so as not to cover profits made, nor to share losses.

An independent "guarantee corporation" run by an independent
auditing firm could operated this mechanism, with the necessary
financial resources provided by the host government. In this
case, the program would initially cover 100 percent of the
currency risk or the equities purchased. Gradually, the
percentage could be lowered and varied to suit the influx of
foreign funds into the local equity market.

Both "circuit breakers" provide the opportunity to turn
emerging markets around, something which would also benefit the
developed world. Therefore, individual foreign lenders and
investors should collectively be induced to come to the
conclusion: "Start the economy, I want to get in."

The writer is a former country manager of ABN AMRO in
Indonesia. He currently works for ABN AMRO of London. The article
was written in a private capacity.