'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.