Impacts of Mexican crisis (2)

By J.E. Ismael

This is the second of two articles based on a paper presented at the 30th Southeast Asia Central Bank Governors Conference held in Manila recently.

MANILA: As emerging markets recover, the recovery of new issuance debt markets and the new issuance equity markets may take different paths. Debt markets provide a fixed return to investors focused on the credit attributes of the issuer and the economic rate of return. Equity markets for new issues are relatively more dependent on broader market attributes, including purchasers' sentiments and selectivity.

The events in Mexico and the implications for other nations have distinct parallels in the United States "junk" bond market or high yield bond market. In the early to mid-1980s, a very large market for high yield debt developed in the U.S. (debts rated lower than BBB-by Standard & Poor's or Baa3 by Moody's).

The fund managers, institutions and individuals purchasing these debt issues were relatively credit insensitive and reacted to the attractive yields of the securities offered. Following the collapse of the U.S. savings institutions, which were major purchasers, and withdrawals from high yield mutual funds, issuance in the U.S. markets went from a high of US$31.9 billion in 1986 to virtually no new issues in 1990 and 1991.

As more sophisticated institutions and individuals subsequently entered these markets as purchasers, the U.S. high yield market recovered in 1992 and 1993, with a total of $72.7 billion in new issues in 1993, more than double the highest year in the 1980s. More recent purchasers are much more knowledgeable about credit analysis, and U.S. high yield issues have recently been better structured than those issued in the 1980s.

Just as the U.S. high yield markets recovered, but with a strong credit bias, so will the debt of sovereign and corporate credits in emerging markets. In the first quarter of 1995, Eurobonds of Latin American issuers totaled $100 million, in contrast to $6.5 million in the first quarter of 1994. The total issuance represented two $50 million issues of Brazilian companies with strong credit characteristics.

An interesting fallout of the Mexican crisis is the institutional changes that have occurred as a result of the portfolio losses in emerging markets. Many of the U.S. institutions have reorganized and placed their emerging markets fixed income activities under the management of their high yield groups.

High yield investors and hedge funds, who are now also emerging markets investors, today have significant experience with debts of troubled companies in the U.S., Canada and the United Kingdom. They are relatively less experienced in other countries. They have grown accustomed to legal systems with a developed body of law providing an orderly recovery on distressed investments.

These investors are beginning to gain experience in Mexico and are discovering that Mexican banks and Mexican investors have little or no confidence that their legal system will provide an appropriate recovery of their original investment. Often, the investors with the most experience in a troubled situation are those best able to make new investments as the situation recovers. Their investment decisions will be strongly affected by their newly found experience with the legal system in dealing with troubled credits.

Apart from the inherent fundamentals of a corporation or sovereign issuer (i.e. market position, financial capacity, cash flow or balance of current account and trade), confidence in the legal system and transparency are important elements of credit analysis. Those issuers least affected by the Mexican crisis tended to be among the most transparent.

The Latin American countries to first recover from the hangover of the tequila effect will be those whose investors best understand and have the most confidence in recovering their investments. It is heartening to note that Mexico has changed its practice of delayed reporting of current balances and now discloses those balances on a timely basis.

Capital investments security is beneficial in increasing liquidity in the debt and equity markets and creating added value in the financial services industry. On the negative side, global developments, such as stock market performance, interest rates and exchange rates, influence investors' funds flows more volatile and presents various policy challenges in dealing with this new environment.

The first policy challenge relates to the destabilizing effects of large inflows, and the problems these create for monetary management. The management of these flows requires greater flexibility in the use of monetary instruments in order to manage inflows and anticipate the outflows. The second challenge is the interest rate policy required to control inflation. This must be developed, taking into account the interest rate environment in the respective reserve currency countries.

Finally, the most important challenge is the need for monetary authorities to recognize the transient nature of large reserve accumulations as investors are attracted to a country, and the consequences as investor sentiment changes. Basing the exchange rate on these short-term flows could lead to sudden depreciation when the funds flow out. Inevitably, the resulting volatile exchange rate movements would deter long-term investors.

Taking these policy challenges into account, the effects of a Mexican type crisis can likely be very short-lived as we have seen in Southeast Asia and Hong Kong. For two to three days, the fund managers reacted hastily to the Mexican crisis, which caused the Asian currency and share markets to come under pressure.

While I acknowledge that capital flows can be volatile, we should not quickly generalize that all developing countries' emerging capital markets will be equally vulnerable to sudden changes in investor sentiment. Countries which are prepared to simultaneously implement preventive measures, sound monetary management and other macroeconomic policies designed to create a stable environment will avoid or minimize the contagion effects of a Mexican type crisis.

The short-term loss of foreign exchange may actually yield more sustained long-term benefits to the extent that the reversal of short-term capital flows has evoked a policy response aimed at strengthening macroeconomic fundamentals and accelerating structural reforms. At a recent International Monetary Fund Board discussion, I introduced the concept of "good" and "bad" external deficits. Good external deficits are those characterized by permanent capital which develop the internal economy. Bad deficits are not self sustaining and, in extreme cases in this new world of monetary-security, can create monetary crises, as in the case of Mexico.

During the Mexican crisis, several countries in Asia were able to test their "crisis management" abilities. The strength of their "real" reserves position allowed authorities greater certainty in implementing monetary policies to control inflation despite the exodus of speculative capital. Nevertheless, Asia was fortunate in that its markets stabilized quickly, although the weaknesses in the Asian economies are very different and less threatening than those in Latin America. It is difficult to predict whether the contagion effects would be contained in another similar episode because fund managers, faced with liquidity crises due to fund redemptions by shareholders, invariably sell their most liquid securities first.

To help avoid a future crisis, central banks need better monitoring and control systems. They need to better understand the underlying volatility in their currency and securities held by foreigners. This would include intelligence on the types of institutions that hold external debt. Based on this review, central banks would need to reassess the risk associated with potential outflows, which may cause them to rethink their prudent levels of foreign reserves.

The lessons from the Mexican crisis emphasize the need for authorities to be stricter in promoting and maintaining orderly foreign exchange markets. But foremost, there is a need to establish and maintain sound monetary policies, practice fiscal prudence and present an attractive transparent investment climate, which promotes confidence for investors.

The other most notable monetary event of this past year is the dramatic rise of the yen. This even has much broader implications for the Asian countries than for the rest of the emerging markets in that much of our Asian countries' debts are in yen. We have the unfortunate dual problem of deteriorating dollar denominated revenued with rising yen loans. Rather than approach this dramatic increase on a coordinated basis, Germany, Japan and the U.S. have each gone their separate ways and pursued courses of action aimed at addressing domestic policy issues.

While this appears on the surface to have no direct relationship to the Mexican crisis, the underlying causes of both problems are identical. The U.S. has experienced an erosion in the confidence of global holders of securities. The implications for the U.S. are far less stark than for Mexico, simply because the U.S. external debts are held in its own currency. Much like Mexico, the U.S. can solve the problem of confidence by getting its own house in order. A number of observers have suggested that the U.S. raise interest rates to strengthen the dollar. This alone will not restore confidence in investors. The U.S. must solve the problem of its twin deficits: the trade deficit and the budget deficit.

Although the U.S. is generally viewed as transparent, in this situation transparency alone does not solve the problems. Transparency does not go so far as to view the future. No one knows to what extent future political pressure and election exigencies will prevent the U.S. from adopting fiscal and monetary policies sufficient to strengthen the dollar or even prevent further erosion. If the U.S. does not restore investor confidence, further appreciation of the yen may result, with still greater problems in servicing yen debt for our Asian countries.

The original strength of the yen was caused by over-tight monetary conditions in Japan. What Japan will be obliged to do under the current circumstances is to pursue easy money and credit policies for some time. Unfortunately, the emergency package announced by the Japanese government early April failed to reverse the yen's appreciation.

Therefore, more expansionary policies are needed and the quickest way to achieve this is to increase public sector spending significantly. More write-offs of bad loans and bank mergers should be encouraged now that the bubble economy of the late 1980s is a long way away. Furthermore, the Japanese authorities will need to come to grips with and accept that the demand for yen as a reserve currency has increased. Therefore, sporadic intervention is likely to prove less effective than broad-based yen sales, which will not be inflationary if they are merely parked in reserves.

Dr. J.E. Ismael is Executive Director of the International Monetary Fund, Washington D.C. He was previously the Director of Bank of Indonesia and lecturer on International Monetary Developments at University of Indonesia, Jakarta.

Window A: During the Mexican crisis, several countries in Asia were able to test their "crisis management" abilities.

Window B: The lessons from the Mexican crisis emphasize the need for authorities to be stricter in promoting and maintaining orderly foreign exchange markets.