SUNS 4298 Friday 9 October 1998



FINANCE: TNC INVESTORS BEMOAN LOSS OF IMF-G7 "MORAL SUPPORT"

Geneva, 8 Oct (Chakravarthi Raghavan) -- Transnational investors (of all kinds of capital, long- medium- and short-term flows) of industrial countries, who used to preach the virtues of governments keeping their hands off the economy are now beginning to bemoan that they can no longer rely on the "moral support" of the International Monetary Fund and the G-7 treasuries.

The rules of the game have changed, emerging market countries with liberal capital markets may be an endangered species, convertibility risk is back with a vengeance in the aftermath of
the collapse of the Russian markets and Malaysian exchange and capital controls, and unilateral debt restructuring is now on the policy agenda, say the Deutsche Bank Research writers (whose views are acknowledged to be reflecting the views of the bank).

The article shows how the benefits of globalization are to be paid by the costs to developing and transition economies and how easily bankers expect their state and countries to save them, and how glibly they can talk of "adjustment" by debtor countries of downturn of GDP by five percent or more - involving hardship to the people to ensure protection of foreigners rights.

Writing on "Capital flows from Emerging Markets in a Closing Environment," researchers David Folkerts-Landus and Peter Gerber, bemoan that the "moral support" of the IMF and G-7 Treasuries on which previously investors had relied on (to be able to collect debts and investments) has faded in the new environment. The official attitudes have swung against the investor with the invocation of moral hazard, demands for exposure of position-taking by entities that have fallen outside the usual regulatory purview, and the proposed use of "prudential regulations" to impose additional capital burdens on loans to "speculators".

But the "moral hazard" problem cannot be cheaply exorcised, and in a "marking to market universe", the price realignments that such an event causes will cause bankruptcies to erupt in unsuspected places, "as the recent bailout of a major hedge fund (a reference to the US Long Term Capital Management LP) indicates."

"Withdrawal of industrial country fiscal support from the international lender of last resort business only throws the problem into the laps of industrial country money printers," says the article.

The article notes that the casualties in the global financial crisis continue to mount. In 1997 phase, Thailand, Indonesia and korea suffered large exchange rate depreciation, banking crises, debt restructuring and sharp recessions or even near depression. Malaysia has faced large depreciation, a troubled banking sector and a recession, and has walled itself behind capital controls.
Russia has had a ruble collapse, moratorium on cross-border payments a banking crisis, a forced debt restructuring and a "resurrection of the Communists." South Africa, as of 21 September,
has come under occasional attack, its stock market having fallen by 22% and the rand sliding by 20% against the dollar in 1998. Stock markets in Latin America have fallen by an average of 36%, with Brazil the focus of the attack, while the Mexican peso has depreciated by 22 percent.

There has been a reversal of private capital imports into Asian countries, and the remaining major strongholds of stability - China, Hong Kong, Brazil and Argentina - have now experienced virulent attacks and large stock market declines - with the possibility of the Chinese renmimbi devaluation or a Brazilian debt restructuring.

The view is equally depressed for market participants in emerging markets - with some claiming that extreme volatility, and increased credit and transfer risk have threatened continued existence of
entire emerging market asset class. Asset allocation by fund managers to emerging markets will not happen automatically; large funds may withdraw their attention and staff; dedicated funds have
already closed along with specialized proprietary trading units in banks, and staff will tend to be laid off in large numbers.

After the collapse of the Russian markets and Malaysian controls, classes of risk hitherto assigned low probability have suddenly become prominent - inconvertibility, forced restructuring of debt,
or even expropriation have now become more likely, leading to a general distrust of emerging markets. Presence in a market has become a corner decision and compensation offered for staying has proven inadequate. Thus the Russian crisis was visited almost immediately on Latin America, which until then was the only emerging market region relatively intact.

The writers complain that the use of forced, unilateral restructuring of debt as in Russia, and the non-convertibility in Malaysia, has only drawn "mild reproval" from the multilaterals or the G-7

The combination of the increased probability of transfer risk or forced restructuring and modern methods of risk control through value added at risk (the Basle guidelines formula) and marking to
market constitutes an explosive mixture that the Russian default has detonated.

Modern risk control methods, pushed heavily by the BIS and national regulatory authorities are "liquidity hungry" and trigger heavy demands for cash, collateral and capital on a systemic level when asset prices move significantly. Such methods have now created a clear tension between the thrust of prudential regulation of industrial country supervisors and the lender of last resort
responsibility of G-7 authorities. How this tension is resolved will determine the dynamics of the unwinding global crisis.

While debt restructuring itself is not new, it has been unilateral in the Russian case. Along with ruble devaluation, it means foreign currency investments in countries likely to experience financing
gaps in their fiscal or bop accounts may now be subject to restructuring, voluntarily if possible, forced if necessary.

In previous restructuring, when a country ran into payments problems, it might have imposed a moratorium on payments to creditors, then under IMF auspices would negotiate a restructuring,
possibly including an IMF program, which would provide some assurance that fiscal, monetary and other reforms (which involve domestic belt-tightening to repay foreign creditors) might generate
sufficient revenue to repay the restructured debt. As a standard outcome, the debt restructuring policy of the Russian authorities would have been a reasonable decision - given the lack of positive
market response to the IMF program announced July 13.

"But it was the unilateral and punitive nature of the conversion that rang alarms. Foreign investors have concluded that they are fair game as the most visible taxable targets and sources of locked
in finance, and restructuring can at least make up the financing gap in under-funded stabilization programs."

[A footnote brings out that the Deutsche Bank and JP Morgan had been providing advice to the Russians on debt restructuring and the discussions had been constructive - calling for pushing out the debt service payment, some of the new restructure would be inconvertible to reduce pressure on exchange rate, and domestic and foreign holders of debt to be treated equally. It complains that
the new government provided liquidity to the Russian banks (but not to foreign banks).

[A recent article by Andrew Cornford of UNCTAD has noted that while WTO/GATS negotiators were advised that their actions for BOP reasons would be covered by GATS and powers under prudential
regulations, the liquidity by central banks (as lender of last resort) to domestic but not foreign banks may be challenged as violation of national treatment at the WTO - and would mean finance ministers would be second guessed at the WTO by panels!]

In the new calculus, says the article, there is no longer a marginal calculus of return adjustments to compensate for higher risks. If an investor keeps funds in a country for high returns, they may now be used as evidence that the investment was speculative and ought to be expropriated partly in restructuring. As a result higher yields might attract capital flight.

"Such a dramatic exorcism of moral hazard has reaped the whirlwind of forcing emerging market asset class to depend more heavily on official finance, reminiscent of the post-war styled control
regimes."

The traditional motivation for an adjustment program is to minimise the transmission, to other countries, of disturbance caused by unsustainable BOP. Programs were designed to cause the least disruptive adjustment - with some inevitable decline in domestic activity.

But with the opening of free flow of capital, the size of the current account imbalances that came to be regarded as sustainable grew larger because of increasing growth rates, as did the current
account imbalances themselves. The size of the adjustments also became larger, requiring a turn around in the current account balance by 5% of GDP.

Even worse, a sudden withdrawal of a large fraction of the stock of foreign claims on a country was now possible. The means to prevent an excessive misallocation of capital in the adjustment process
came from the IMF, the World Bank and regional development banks,bilateral official lending and concerted restructuring.

But with open capital markets these resources became insufficient and the adjustments required in the problem countries have been much greater than in the past.

The original motivation of the IMF to push for opening of current accounts was to assure that payments problems would not be used as an excuse to distort trade. But since there is "not intellectual difference" between efficiency gains from freely trading goods across space and continued time, it was natural to extend the goal to opening the capital account. But the global spread of the Asia crisis has revived the intellectual respectability of controls among policy makers and academics, the authors note.

But at a Third World Network seminar last week, financial expert Prof Jan Kregel said that if there are to be multilateral rules for investments and capital account convertibility, the equivalent of
payments problems not being used to restrict trade and thus depressing global demand, would be that hosts of foreign funds should be able to continue to receive funds (in the event of an imbalance) and holders of funds should be forced to keep them in the country, despite the reduction in returns.

The problem, the Deutsche Bank publication says, has increased as crisis rolled around from country to country, and official funds grew even tighter and private lenders more reluctant to make
rollovers.

[To meet this problem, the UNCTAD Trade and Development Report has suggested the IMF lending into arrears, and countries unilaterally adopting a standstill on debt repayments, subject to later approval by an independent panel, similar to the WTO safeguard provisions. The US-sponsored Group of 22 has endorsed the idea of "lending into arrears", but silent on actions by debtor countries. Without the IMF having funds, or printing money via say SDRs, it is at best a
half-solution that will not work.]

A raft of new programs has left the IMF short of funds, and some countries have received money on the basis that they were "too big to fail".

It would be necessary to confront this moral hazard problem, the writer concede, but when is the question. If the problem were suddenly dispatched by imposing a serious loss on investors, it
would cause an eruption in countries that has received the "moral hazard" inflows, exacerbate the crisis and emphasize the lack of funds.

Asserting the principle in Russia was probably the best place - its creditors were widely scattered, unlikely to have a systemic effect on bank capital, its trade connections to the rest of the world
likewise small, and a commodity exporter and consumer goods importer.

Thus, the dynamics of the emerging market crisis made Russia into a watershed country. Once an expropriation commenced, there was no way any manager of emerging market funds could ignore the cross-border problem. And the rush out of domestic emerging market debt became an avalanche.

"The myth that there were really very viable domestic currencies in emerging markets without capital controls and IMF backing was destroyed. Investors in Latin America absorbed the lesson much faster than the official sector that had taught it."

As a result, the reaction has hit Brazil and other Latin American countries.

Ofcourse Brazil is not Russia, and there has been some guarded optimism that Brazil would maintain the programmed exchange rate through the Presidential election, and thereafter to implement quickly the reforms proposed by President Cordoso. But in the new environment, international markets now require much more yield to hold emerging market domestic debt.

By now state-of-the-art risk management systems have been installed in the major international financial institutions. Of these the most developed is the Value-At-Risk (VAR) methodology for
controlling market risk. The value at risk is the size of the loss associated with a specific, small probability level if the asset vector is held for a given number of days. The capital that a firm
must hold against this is set as a positive function of the VAR.

This automatically imposes a hedging and netting vision on asset management. Thus if an investor buys Russian shares, it can hedge by selling Brazilian shares. If Russian shares are illiquid and the
investor wants to close a Russian position, it can approximate this shift by shorting Brazilian shares.

This management methodology, endorsed by industrial country regulators, is the primary source of the contagion effect of the crisis. A volatility event in one country automatically generates
an upward re-estimate of credit and market risk in a correlated country, triggering automatic margin calls and tightening of credit lines -- "in short the mechanism by which rhetoric about unified
global markets are realised in practice".
Thus, bizarre operations connecting otherwise disconnected securities markets are not the response of panicked green screen traders arbitrarily driving economics from a good to bad
equilibrium. Rather they work with relentless predictability and under the seal of approval of supervisors of main financial centres.

"Contagion is the other side of the coin of risk control in industrial countries. Credit and currency control events are poison for such systems of market risk management... If funds cannot be
moved across borders easily or if a piece of a portfolio defaults, then VAR technology falls apart. Positions must be regarded from a gross, not a net position, with considerable higher capital costs
that may be justified by the risk-return tradeoff of a given security."

The article appears though to imply that the ease and "market" mechanisms of industrial countries need to be paid for by the peoples of developing and transition economies bearing these costs
of open capital movements as an aspect of the valhalla of globalization.