TWN Info Service on Finance and Development (Nov07/03)
7 November 2007
JUST as the world was recalling the 1997 Asian financial crisis on its 10th anniversary, evidence was accumulating that the global financial system was once again vulnerable. The extent of vulnerability was driven home by the simultaneous collapse of stock indices in the world’s leading financial markets on 27 July, including those in so-called ‘emerging markets’ in developing countries.
fact that a crisis in the
is an analysis of the cause and global effects of the crisis in the
Entanglement and Emerging Markets
as the world was recalling the 1997 Asian financial crisis on its 10th
anniversary, evidence was accumulating that the global financial system
was once again vulnerable. The extent of vulnerability was driven home
by the simultaneous collapse of stock indices in the world’s leading
financial markets on 27 July, including those in so-called ‘emerging
markets’ in developing countries. What is disconcerting is that this
synchronised collapse of markets was not the result of developments
in each of the countries where these markets were located. Rather, the
source of the problem was a crisis brewing in the housing finance market
these ripple effects is the financial entanglement which results from
the layered financial structure, the ‘innovative’ financial products
and the inadequate financial regulation associated with the increasingly
liberalised and globalised financial system in most countries. Few deny
that the sub-prime housing loan market in the
What needs to be understood, however, is that the problem is largely a supply-side creation driven by factors such as easy liquidity and lower interest rates. Utilising these circumstances, mortgage brokers attracted clients by relaxing income documentation requirements or offering grace periods with lower interest rates, on the completion of which higher rates kick in. As a result, the share of such sub-prime loans in all mortgages rose sharply. Estimates vary, but according to one by Inside Mortgage Finance quoted by the New York Times, sub-prime loans touched US$600 billion in 2006, or 20% of the total as compared with just 5% in 2001.
The increase in this type of credit occurred because of the complex nature of current-day finance that allows an array of agents to earn lucrative returns even while transferring the risk associated with the investments that offer those returns. Mortgage brokers seek out and find willing borrowers for a fee, taking on excess risk in search of volumes. Mortgage lenders finance these mortgages not with the intention of garnering the interest and amortisation flows associated with such lending, but because they can sell these mortgages to Wall Street banks.
The Wall Street banks buy these mortgages because they can bundle assets with varying returns to create securities or collateralised debt obligations, involving tranches with differing probabilities of default and differential protection against losses. They charge hefty fees for structuring these products and valuing them with complex mathematical models, before selling them to a range of investors such as banks, mutual funds, pension funds and insurance companies. These entities in turn can then create a portfolio involving varying degrees of risk and different streams of future cash flows linked to the original mortgage. To boot, there are firms like the unregulated hedge funds which make speculative investments in derivatives of various kinds in search of high returns for their high-net-worth investors. Needless to say, institutions at every level are not fully rid of risks but those risks are shared and rest in large measure with the final investors in the chain.
structure is relatively stable so long as defaults are a small proportion
of the total. But as the share of sub-prime mortgages in the total rises
and the proportion of defaults increases, the bottom of the barrel gives
and all assets turn illiquid. Rising foreclosures affect property prices
and saleability adversely as foreclosed assets are put up for sale at
a time when credit is squeezed because lenders turn wary. And securities
built on these mortgages turn illiquid because there are few buyers
for assets whose values are opaque since there is no ready market for
them. The net result is a situation of a kind where a leading Wall Street
bank like Bear Stearns has to declare that investments in two funds
it created linked to mortgage-backed securities were worthless. The
investors themselves have to sell off other assets to rebalance their
portfolios, sending ripples into markets such as those in developing
countries that have little to do with the
problem is not restricted to the Wall Street banks. For example, in
early August, the French bank BNP Paribas suspended withdrawals from
three of its funds exposed to the mortgage-backed securities market.
The bank reportedly attributed its decision to ‘the complete evaporation
of liquidity in certain market segments’, which constrained it from
meeting withdrawal demands that could have turned into a run on the
fund. Other cases included that of Dusseldorf-based IKB bank, which
through offshore front company Rhineland Funding had invested as much
as $17.5 billion in asset-backed securities. As the value of its assets
Entanglement also makes nonsense of the theory that a complex financial system with multiple institutions, securitisation, proliferating instruments and global reach is safer because of the fact that it spreads risk. This was illustrated by the example of IKB referred to above. Banks wanting to reduce the risk they carry, resort to securitisation to transfer this risk. But institutions created by the banks themselves, linked to them in today’s more universalised banking system or leveraged with bank finance, often buy these instruments created to transfer risk. In the event, as The Economist (11 August 2007) recently put it, ‘banks (that) have shown risk out of the front door by selling loans, only... let it return through the back door.’ This, it notes, is what exactly transpires in the relationship between the three major prime broking firms – Goldman Sachs, Morgan Stanley and Bear Stearns – that offer prime broking services, including loans, to highly leveraged institutions like hedge funds. The bailout of Long Term Capital Management in 1998 was necessitated because of entanglement of this kind involving all the leading merchant banks.
Investments by banks, pension funds and mutual funds are driven by the search for high and quick returns in a world of excess liquidity. In deciding to make investments on structured products intermediated at different levels, these institutions, ill-equipped to judge the true value and riskiness of these assets, rely on rating agencies. But these ratings have turned out to be unreliable and pro-cyclical, serving as erroneous and belatedly corrected signals. Noting that ‘in a matter of weeks thousands of portions of sub-prime debt issued as recently as 2005 and 2006 have had their ratings slashed’, The Economist (11 August 2007) argued that investors should not have trusted the original ratings because ‘the rating agencies were earning huge fees for providing favourable judgments’. What is more, even when there is no deception involved, rating agencies themselves are not equipped to assess these products and rely on information and models provided by the creators of the products themselves. Once an asset is rated there is much reluctance to downgrade it, because it would raise doubts about related ratings as well as trigger a sell-off that affects prices of related securities that may warrant further downgrades.
Emerging Market Exposure
The problem is that if these factors result in the accumulation of doubtful assets by investors such as banks, pension funds and mutual funds, any downturn spreads the effects into markets where these institutions have made unrelated investments. In fact, institutions overexposed to complex structured products whose valuation is difficult are saddled with relatively illiquid assets. If any development leads to liquidity problems they are forced to sell off their most liquid assets such as shares bought in booming emerging markets. The effect that this can have on those markets would be all the greater the larger is the exposure of these institutions in these markets.
this is precisely what has been happening in most emerging markets including
What is more, there is a high degree of concentration of these flows to developing countries, implying excess exposure in a few countries. Ten countries (out of 135) accounted for 60% of all borrowing during 2002-04, and that proportion has risen subsequently to touch three-fourths in 2006. In the portfolio equity market, flows to developing countries were directed at acquiring a share in equity either through the secondary market or by buying into initial public offers (IPOs). IPOs dominated in 2006, accounting for $53 billion of the $96 billion inflow. But here too there were signs of concentration. Four of the 10 largest IPOs were by Chinese companies, accounting for two-thirds of total IPO value. Another three of those 10 were by Russian companies, accounting for an additional 22% of IPO value.
Despite this rapid rise in emerging-market exposure, with that exposure being excessively concentrated in a few countries, the market is still overtly optimistic. Ratings upgrades dominate downgrades in the bond market. And bond market spreads are at unusual lows. This optimism indicates that risk assessments are pro-cyclical, underestimating risk when investments are booming, and overestimating risk when markets turn downwards. But two consequences are the herding of investors in developing-country markets and their willingness to invest a larger volume of money in risky, unrated instruments. When liquidity problems arise, even for reasons unrelated to these markets themselves or the countries in which they are located, these investments are quickly unwound precisely because those markets are still liquid, and a collapse of the kind seen in end-July ensues. It hardly bears stating that a collapse that is in the form of a mere ‘correction’ can soon turn into a full-fledged crisis.
is another reason why such a danger exists. Surges in capital flows
to developing countries tend to increase the incentives to invest in
these markets. Consider the case of
Another change in recent times seems to be a huge increase in commercial borrowing by private-sector firms. With caps on external commercial borrowing relaxed and interest rates ruling higher in the domestic market, Indian firms seem to be taking the syndicated-loan route to borrow money abroad at relatively lower interest rates to finance their operations, investments and acquisitions. Net medium-term and long-term borrowing increased from $1 billion in 2005 to $13 billion in 2006, or by a huge $12 billion.
consequence of these flows is excess availability of foreign exchange,
galloping rise in reserve levels reflects the effort being made by the
Reserve Bank of India (RBI) -
more recently the rupee has been gaining in strength, despite the RBI’s
efforts as reflected in the sharp increase in reserves. This occurs
not because the RBI has not made an effort to prevent such appreciation.
The RBI has indeed been intervening vigorously in foreign-exchange markets,
resulting in a sharp increase in the reserve of foreign-exchange assets
it holds. The problem seems to be that the inflow of foreign exchange
appreciation incentivises foreign investment, inasmuch as investors
not merely benefit from the high rupee returns available in
There are a number of implications of these tendencies that have at their core the phenomenon of financial entanglement. To start with, the risk associated with the current surge in capital flows to developing countries can be and is much greater than was true during previous episodes involving a similar surge. Moreover, the surge is accompanied by the growing acquisition of assets in developing countries outside the stock market with objectives that are largely speculative, so that a sell-off, if it occurs, would be far more widespread. And the persistence of the herd instinct has meant that the surge in fixed and portfolio investment flows has resulted in a revival of credit flows that is unbridled since it is accompanied by risk-mitigation techniques that transfer risk to those who are least equipped to assess them. Unfortunately, all of this occurs in an environment in which the target of both investment and debt flows is the private sector, which makes it difficult for governments that have liberalised financial regulation to control such flows.
consequence of this large and concentrated flow of capital is that when
assets have to be retrenched by financial firms because of developments
in any component of their portfolio, a few emerging markets can become
the sites of that sell-off. This partly explains why stock exchanges
in emerging markets have turned bearish and volatile in recent weeks,
primarily because of the ripple effects of the sub-prime mortgage crisis
There are many lessons that are once again being driven home by these developments that are of particular significance for developing countries that are rapidly liberalising their financial systems. First, excess liquidity in a loosely controlled financial system provides the basis for speculative and unsound financial practices, such as excessive sub-prime lending that increases fragility.
Second, such practices are encouraged by the ‘financial innovation’ that liberalisation triggers, which increases the number of layers of intermediation and allows firms to transfer risk. As a result, those who create risky ‘products’ in the first instance are less worried about the risk involved than they should be.
Third, as the product moves up the financial chain, investors are less sure about the risk and value of these products than they should be, rendering even low-risk, first-stage tranches prone to value loss. Fourth, this inadequate knowledge appears to be true even of the rating agencies on whose ratings investors rely, resulting in erroneous ratings and belated rating downgrades. This implies that as and when a rating downgrade does occur, the asset turns worthless, since there is nobody willing to buy into the asset.
Fifth, new forms of self-regulation appear to be poor substitutes for more rigorous control, since the current crisis originates in a country whose financial sector is considered the most sophisticated, well regulated and transparent and serves as a model for others reforming their financial sectors. And finally, financial globalisation and entanglement imply that countries that have more open and integrated financial systems are prone to contagion effects, even if the virus originates in remote locations and markets. These are lessons that must inform policy in these so-called emerging markets.
Chandrasekhar is a Professor at the Centre for Economic Studies and