The vulnerability of emerging markets to shocks: what has changed since the mid-1990s?

Speech by Malcolm D Knight, General Manager of the BIS, at the Toronto Centre Executive Forum, 9 November 2004.

It is a pleasure to be back in Toronto to talk to this group about a subject of great significance: the ability of emerging market economies to cope with shocks. I hardly need to remind this audience of the huge costs of the successive waves of financial turmoil that began with the Mexican crisis in 1994-95, hit Thailand and Korea in 1997, followed by the Russian debt default and the Turkish and Argentine crises. Several of these events led to financial losses well in excess of 10% of national income in the affected country. And each crisis exposed weaknesses in the financial system - weaknesses that accentuated the severity of the economic downturns that ensued. These countries, and many others, have learnt the hard way that the robustness of financial systems is crucial to sustained economic growth and stability.

The desire to limit both the incidence and the effects of financial crises provided a major impetus for the establishment of the Toronto Centre. Its key aim was - and is - to help financial supervisors and regulators around the world strengthen their leadership skills. Such skills are critical to the implementation of sound international standards, including those being developed by the Basel-based groups such as the Basel Committee on Banking Supervision and the International Association of Insurance Supervisors. And the BIS's Financial Stability Institute is also taking a leading role in disseminating these standards. As well, in recent years both the International Monetary Fund and the World Bank have accorded the assessment of the effectiveness and stability of financial systems a higher profile in their own work. In short, the health of financial systems in developed and emerging market economies alike has certainly commanded the attention of the international community during much of the past decade. It is then reasonable to ask: what has been achieved? Where are the vulnerabilities that still need attention? I would like to outline my reflections on these two questions.

What has been achieved?

The most visible achievement has been improved macroeconomic stability - so often a precondition for financial stability. Monetary policies have been more consistently directed towards ensuring nominal stability, with a number of emerging market economies adopting inflation targeting. The fruits of this orientation are already clear: inflation rates in 2003 were the lowest recorded since at least the 1960s. Fiscal deficits have also fallen appreciably in key emerging economies since the late 1990s. And exchange rate regimes have become more flexible: in the decade to 2003, according to a recent IMF assessment, more than half of the group of emerging market economies adopted more flexible exchange rate regimes.

The second achievement is that standards and codes of good practice in financial markets have been taken more and more seriously by those responsible for their implementation in emerging markets. When these efforts were initiated in the late-1990s, they often met with a sceptical or even hostile reception. Moving from general principles to specific content inevitably took time. Even as recently as 2000, an IMF review found many shortfalls in the implementation of the Basel Core Principles for Effective Banking Supervision. A 2002 update continued to reveal a worrying lack of progress. But the most recent assessments have been more favourable. The energy that has recently gone into the adoption of the Basel Core Principles, and with which preparations are being made for the implementation of Basel II, reflects the growing conviction amongst most key decision-makers that improving supervisory practices is very much in their own long-term interests. It is striking that over 90% of banking assets in the developing world are expected to be covered by Basel II arrangements, with most of that coverage scheduled to be in place by 2010.¹

A third achievement has been the greater opening of local banking markets to international competition. Between 1990 and 2002, the typical foreign share of the banking system (as measured by the share of bank assets owned by foreign-controlled banks) increased from virtually nothing to around half in eastern Europe and Latin America, and stayed flat at roughly one quarter in Asia. Some of the opening to external competition has perhaps been driven at a pace that has been uncomfortable. And there are indeed difficult challenges involved, including the complexities of cross-border tax rules, the interaction between different legal and regulatory codes, and the uneasy sharing of responsibility for supervision and crisis management between home and host supervisor. Nonetheless, the implications for stability are mostly favourable. A recent Working Group of the Committee on the Global Financial System² - in which several developing countries were represented - reached the conclusion that the entry of foreign banks into emerging market financial systems did indeed bring many benefits: improved management and technical skills; greater capital backing for the risk-taking of financial intermediation than local institutions can muster; and greater diversity in the channels of intermediation.

Finally, local currency bond markets have begun to develop. Bond markets have expanded rapidly in many Asian economies - with the volume outstanding now the equivalent of almost 50% of area GDP. Liquidity in secondary markets is still quite limited, but there has been progress. Even in Latin America, local currency markets are beginning to take root again: for instance, Mexico and Chile have made great progress in developing long-term local currency bond markets. For emerging markets as a whole, nearly 90% of the increase in debt securities now reflects domestic issuance rather than international issuance. At the same time, lending by foreign banks has shifted from largely dollar-denominated cross-border loans to local currency loans through local affiliates. These developments have considerably reduced the currency mismatches which left so many countries vulnerable in the 1990s.

Hence a great deal has been achieved. And these efforts have been accompanied by much better economic performance. According to the latest IMF projections, growth in the developing world this year will be around 6½% - the highest rate of growth for over 30 years. Asia, central Europe, Latin America and even Africa are all growing faster than in the recent past. But this success should not lead us to overlook key weaknesses that remain. Let me outline some that seem important to me.

What still needs further work?

First there are a couple of medium-term issues related to macroeconomic stability that require attention. One is that further reductions in fiscal deficits are still needed in key emerging market economies because public sector debt ratios are still too high or are still rising in some countries. Even though fiscal policies have been tightened in recent years, Asian and Latin American public debt ratios are now about 20 percentage points of GDP higher than they were in 1997, partly because of the cost of financial system restructuring. Many emerging market economies are therefore quite vulnerable to future increases in interest rates, whether associated with changes in global interest rates or a widening of emerging market interest rate spreads. In addition, unusually high commodity prices make underlying fiscal positions in some exporting countries look healthier than they actually are. I need not remind a Canadian audience that a combination of higher interest rates and falling commodity prices can be extremely uncomfortable.
Also relevant to macroeconomic stability is the sheer size of foreign exchange reserve accumulation by Asian central banks - more than $650 billion over the last three and a half years. Such massive intervention may have contained currency appreciation, but could well create problems in the future. Persistent currency undervaluation can lead to over-investment in activities that would not be viable at a realistic exchange rate. Prolonged and large-scale intervention tends to increase domestic liquidity - and eventually excessive monetary and credit expansion becomes inevitable. And you know the dangers - unsustainable credit booms and inflated equity or property prices, with obvious macroeconomic and financial system risks.

The second broad area that requires attention is related to major changes in the orientation of the banking systems in emerging markets. Up until the mid-1990s, banks lent primarily to governments or to corporations. Very little was lent to households. This has changed radically in the past few years. Consumer credit to households in several countries has been growing rapidly - at around 20% per annum in real terms for at least the last two years. The cumulative growth in real credit to households between 2000 and 2004 (comparing first quarter with first quarter) was 50% in Asia and more than 150% in central and eastern Europe. Any rapid expansion by financial institutions into new areas inevitably involves confronting unfamiliar risks. The greater leverage of the household sector is itself risky - especially when primed by very low interest rates as at present. The recent experience of the Korean credit card industry provides a notable illustration of the risks of fast penetration of new technologies into an inexperienced consumer market by inexperienced financial institutions with inadequate systems. Thus from both a macroeconomic perspective and a financial stability perspective, there are issues to watch.

The third area is the social/political/legal infrastructure, which still impedes the development of resilient financial systems in many emerging market countries. These aspects are no less important for being intangible. So let me give a few illustrations. One is that the legal code in many countries does not provide sufficient clarity with respect to property rights in many types of financial contract. For example, the inability to enforce collateral claims predictably has prevented the development of a conventional mortgage market in many countries. Initial reviews by the IMF and World Bank of the observance of international standards and codes have found significant weaknesses in insolvency law. Inadequate training, ineffective regulation to prevent corruption and the exercise of undue political influence are among the problems identified. Another is the continued lack of effective transparency and disclosure - traditions of secrecy, the existence of favoured groups in society and so on militate against giving full rein to the power of information. For investors in corporate or government bonds, and banks extending loans to customers, proper credit risk assessment is impossible without good quality information. Yet surveys by various organisations continue to rank emerging markets well behind developed markets in terms of effective, accurate and timely disclosure.

Fourth, much still needs to be done in developing expertise/understanding/skills at grass-roots level - both in banks and in supervisory agencies. Let me take the example of credit risk management - which is of course at the heart of the Basel II reform.

Effective credit risk assessment is fundamental in banking. And it is an especially important skill in emerging market situations where credit ratings and traded security prices are less available as additional information for credit risk managers. In many countries there are very limited data on default histories. Even if there were data, calculating the key variables of Basel II - default probabilities, loss given default and so on - would not provide a good guide to the current situation, because the economic environment in which banks operate has changed so much since the mid-1990s. In fact, Basel II expects banks to assess those parameters on the basis of a long period of time, preferably through a full economic cycle. In such circumstances, the skills of credit risk managers are very important.

Default probabilities and loss given default are terms used in the context of Basel II's Pillar one, the minimum capital requirements. Basel II, however, is more than just its Pillar 1. It is based on three pillars. An important innovation of Basel II is the incorporation of supervisory review into the international framework. This is the second Pillar. It is critical that the minimum capital requirements set out in the first Pillar be accompanied by a robust implementation of a supervisory review process, including efforts by banks to assess their capital adequacy. This is expected to result in bankers and regulators engaging in more focused discussions of risk management. Pillar 2 recognises that national supervisors may have different ways of entering into such discussions and accordingly it provides flexibility to accommodate this.

The third Pillar - market discipline - is based on enhanced bank transparency. It should enable markets to reward banks that take responsible approaches to risk management and penalise those that do not. The Basel Committee aims to encourage market discipline by requiring a set of disclosures which will allow market participants to assess key pieces of information about a bank's risks. Pillar 3 follows the "menu of options" utilised in Pillar 1. Under this approach, banks would be required to disclose information relevant to the approach(es) used in the measuring of capital requirements and on the basis of materiality. This makes Pillar 3 sensitive to disclosure of material information that is relevant to the markets and should minimise the burden placed on smaller banks.

To cope with all these challenges, banks in emerging markets do appear to devote proportionately more staff to the risk management function, and have more frequent internal reporting of credit risks. Even so, the quality of the overall credit risk management process in emerging markets is still judged by the rating agencies to be somewhat weaker than in developed markets.

The implementation of Basel II should help to improve this situation. Basel II builds on advances in quantifying credit risk. Over time, bankers and supervisors in many countries will gain experience in managing credit risk in a more rigorous fashion. The capability of the front line staff who will be asked to operate the new policy arrangements is admittedly an issue. The IMF and World Bank have indeed expressed concerns. But such worries are not new. People learn by doing things that are at first unfamiliar and by making mistakes. There are few shortcuts to the development of human capital - personal experience matters, and experience only accumulates slowly. Yet some judicious acceleration is surely possible. I am sure that institutions such as the Toronto Centre and the Financial Stability Institute can help such acceleration. The Toronto Centre is well placed to assist the leaders in financial sector supervision and regulation to craft strategies for implementing global standards. A key contribution of all organisations providing assistance to supervisors and regulators is giving these individuals the chance to learn from the experience of others, and to interact with others at similar and different stages of development. Given the importance of the contribution that well-designed and well-implemented financial system policies can make to society's welfare by containing the risks of instability, these opportunities to learn need to be grasped with both hands.

Let me close my remarks by saying that good progress is now being made on making financial systems more resilient to shocks. I am confident that the Toronto Centre can continue to contribute to this work. But it would be only prudent to recall that progress is very recent and that present conditions in the world economy are rather favourable for most emerging markets. At some point, these conditions will become less favourable. Current conditions therefore provide a window of opportunity to accelerate the process of making financial systems more robust. Better to take corrective measures when real incomes are rising than in a recession. We have, in the Basel Core Principles, other standards and codes and the Basel II arrangements, excellent foundations on which to build.

¹ Financial Stability Institute Occasional Paper No 4, July 2004.

² Foreign direct investment in the financial sector of emerging market economies, CGFS Working Group Report, 22 March 2004.