Chapter

IV: Issues in Market Re-Entry

Author(s):
International Monetary Fund
Published Date:
January 1992
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Several issues have been raised by the recent experience with market re-entry by a number of developing countries. These include the expansion of the investor base, the role of reforms of developing country financial markets, and steps taken to graduate new bank lending from provisioning requirements where creditworthiness has improved.

Expanding the Investor Base

In the early phase of the re-entry process, returning flight capital was reportedly by far the largest source of capital for Latin American countries.49 Knowledgeable about the region and attracted by the high yields paid on initial placements, Latin American investors were at the forefront of the investment boom in U.S.-dollar-denominated Latin American securities.50 In the second stage, specialized mutual funds and individual investors attracted by high yields reportedly joined flight capital investors, as Latin American securities replaced U.S. “junk” bonds as the high-yield segment in international portfolios. A recent survey reveals that the share of the international portfolios of institutional investors placed in emerging developing country markets increased from 2.5 percent in 1989 to 7.5 percent in 1990, and further to 9.5 percent in 1991.51

Over the past year, interest has broadened to include mainstream institutional investors (money managers, pension funds, mutual funds, insurance companies, and finance companies). These investors have become increasingly aware of the attractive returns and risk diversification potential of investments in emerging markets, particularly as U.S. short-term interest rates have fallen to low levels. Market participants report that these investors have concentrated on the most liquid and least risky sectors, particularly collateralized bonds issued in the context of bank debt restructuring operations and well-known Mexican issues. Beyond this, these investors’ interest to date has led more to research and exploratory investment than to actual investment on a significant scale.

Notwithstanding the recent broadening in the range of investors, the investor base for LDC securities (particularly Latin American) probably still consists largely of flight capital, individual investors, and global investment funds. Although no firm figures are available, market participants estimate that about 60–70 percent of investment in Latin American instruments has come from flight capital, and 20–25 percent from high-yield investors and investment funds. Market observers consider that mainstream institutional investors such as insurance companies, pension funds, and nondedicated mutual funds may now account for up to 5 percent of total investments in Latin American securities.

Portfolio flows to emerging markets also seem to have a distinct geographical pattern. According to a recent survey, the booming stock exchanges in Latin America received 36 percent of the funds invested in emerging markets in 1991, more than double the 16 percent committed in 1990.52 The share of emerging markets in East Asia declined to 34 percent in 1991, from 68 percent in 1990. Commitments to emerging markets in Southern and Eastern Europe dropped 3 percentage points to 8 percent of the total, while investment in South Asia more than tripled, from 5 percent to 18 percent.

Flows to Latin America seem to originate mainly in the United States and from Latin flight capital. Investors in Europe focus on Eastern European, Middle Eastern, and African opportunities, while flows to Asian emerging markets come substantially from Far Eastern financial centers. These patterns generally follow traditional political and economic linkages. There is, however, some evidence of diversification of the funding base over the past year, particularly by Latin American issuers, which have placed about $1.8 billion in the Austrian schilling, Canadian dollar, ECU, French franc, peseta, and sterling markets in 1991 and in the first half of 1992. These were generally debut issues by a developing country entity.

On the whole, European investor interest in developing country securities remains mainly restricted to the deutsche mark sector. In Germany, commercial banks play a central role in distributing bond issues to domestic retail customers. Retail customers rely on their banks to apply quality control, and banks strive to maintain customer confidence by avoiding bond defaults. In this context, German banks have generally avoided issuing or marketing securities from countries where bank debt packages have not yet been finalized. The yen sector represents about 13 percent of recent borrowing by developing countries in the international bond market; it is also mainly focused on nonrestructuring countries, with recent Samurai issues by Hungary and Turkey, and by Chinese public-sector companies.

The gradual expansion in the investor base has been associated with improvements in the ratings assigned by the main rating agencies (Table 11). Three developing countries have received investment-grade credit ratings thus far in 1992. In April 1992, Standard and Poor’s (S&P) assigned a first-time rating of BBB to Turkey, an investment-grade rating that facilitated Turkey’s entry into the “Samurai” and “Yankee” markets; in July 1992, S&P gave Indonesia an investment-grade rating (BBB−). And in August 1992, S&P assigned Chile a BBB rating, making it the first Latin American country to achieve investment-grade status. In other developments, in January 1992, Moody’s assigned a first-time rating of Bal (just below investment grade) to Statni Banka Ceskoslovenska, the Czech and Slovak Federal Republic’s Central Bank.53 In July 1992, Moody’s upgraded Argentina to B1 from B3, based on its assessment that administrative and regulatory controls were being dismantled and that fiscal policy had strengthened considerably.

Table 11.Credit Ratings of Developing Country Borrowers1
Moody's RatingS&P RatingRecent Changes
KoreaA1A+
ThailandA2A−Moody's placed ratings on credit watch.
MalaysiaA3AS&P upgraded rating from A- in July 1991.
Hong KongA3A
ChileNRBBBS&P assigned a BBB rating in August 1992.
ChinaBaa1BBBS&P assigned a BBB rating in February 1992.
TurkeyBaa3BBBFirst-time rating assigned by S&P in April 1992.
IndonesiaNRBBB−S&P assigned first-time rating in July 1992.
Czech and SlovakBa1NRMoody's assigned first-time Federal Republic rating in January 1992. The rating was placed under review in July 1992.
HungaryBa1BB+S&P assigned first-time rating in April 1992.
VenezuelaBa1BBS&P upgraded sovereign rating from B+ in July
(Floating-rate notes)Ba1NR1991. Moody's upgraded from Ba3 in August
(Conversion bonds)Ba1NR1991, assigned to Venezuelan Brady bonds.
(Par and discount bonds)Ba2NR
IndiaBa2BB+Moody's lowered the rating from Baa3 in June 1991; S&P affirmed long-term rating previously placed on credit watch.
MexicoBa2BB+S&P assigned first-time rating in July 1992.
(Pemex)Ba2BB+
(Brady bonds)Ba3BB+
ArgentinaB1NRMoody's upgraded sovereign rating from B3 in July 1992
BrazilB2NR

Ranked in descending order according to rating. Ratings by Standard and Poor’s and Moody’s Investor Service. The ratings are ranked from highest to lowest as follows:

Moody’sS&P
Investment gradeAaa, Aa, A, BaaAAA, AA+, AA, AA‒, A+, A, A–, BBB+, BBB, BBB–
Noninvestment gradeBa, BBB+, BB, BB‒, B+, B, B–
Default gradeCaa, Ca, C, DCCC+, CCC, CCC‒, CC, C

In addition, numbers from 1 (highest) to 3 are often attached to differentiate borrowers within a given grade.

Ranked in descending order according to rating. Ratings by Standard and Poor’s and Moody’s Investor Service. The ratings are ranked from highest to lowest as follows:

Moody’sS&P
Investment gradeAaa, Aa, A, BaaAAA, AA+, AA, AA‒, A+, A, A–, BBB+, BBB, BBB–
Noninvestment gradeBa, BBB+, BB, BB‒, B+, B, B–
Default gradeCaa, Ca, C, DCCC+, CCC, CCC‒, CC, C

In addition, numbers from 1 (highest) to 3 are often attached to differentiate borrowers within a given grade.

The importance attached to credit ratings varies among markets. Such ratings probably play the largest role in the United States, where investors—in particular, pension funds—rely heavily on them. To these investors, credit ratings reduce the cost of gathering and analyzing information for individual issues and are important benchmarks in portfolio allocation. In contrast, European investors have tended to base their decisions largely on name recognition, which tends to limit these investors’ demand for developing country assets. In Japan, the authorities use credit ratings to provide quality control in the domestic market.54 In some cases, however, the market has reacted more quickly to changes in a country’s prospects than the agencies. For example, as mentioned above, terms and conditions obtained for recent issues by Mexican public-sector borrowers (including the recent Yankee issue) are already comparable with those of low-rated, investment-grade borrowers.

In sum, the investor base is gradually broadening, both functionally and geographically. The fledgling participation of mainstream institutional and retail investors may presage a potentially significant widening of the investor base for developing country securities. This process needs to be nurtured by borrowing countries themselves. In this regard, consolidation of progress toward economic and political stability is clearly the key factor, with a crucial step being the achievement of investment-grade credit ratings to foster larger-scale involvement of mainstream institutional and retail investors. In addition, as discussed in the following section, it will be important to persevere with domestic market reforms to increase the attractiveness of developing country securities to foreign investors.

The Role of Domestic Market Reforms

Domestic market reforms that have contributed to the gradual restoration of access to voluntary financing for developing countries have included

  • stock market reforms and associated regulatory changes;
  • increased opportunities for investors through privatization;
  • banking sector reforms affecting the level and structure of interest rates and the allocation of credit among sectors or types of borrowers; and
  • tax policy changes to encourage the use of equity financing by commercial enterprises.

Countries have also taken steps to encourage foreign direct and portfolio equity investment (as discussed more thoroughly in Chapter V). These structural reforms—combined with a markedly improved macroeconomic environment—have enhanced the attractiveness of domestic assets to foreign investors and have increased incentives for domestic firms to seek financing in securities markets. Although a number of countries made significant progress in this regard between late 1988 and early 1992, in many areas such reforms represent only the beginning of long processes of liberalizing domestic economies.

Increasing the Efficiency of Market Trading Systems

Stock market reforms have been critical in attracting foreign investor interest by improving the efficiency of price determination mechanisms, reducing costs of intermediation, and providing liquidity to holders of securities. The Brazilian stock exchanges, for example, eliminated their exclusive broker system in 1991, moving closer to the auction system of the New York Stock Exchange. In Argentina, stock brokerage commissions have been deregulated and exchange fees cut in half. In India, a number of measures were taken recently to make it more attractive for brokers to serve small investors. An over-the-counter (OTC) exchange was also launched in late 1990, while the Bombay Stock Exchange is being linked to the Frankfurt Stock Exchange partly to attract nonresident Indians and foreign investors. Moreover, the Credit Rating Information Service of India has set up an information company with foreign collaboration to provide a range of financial information services based on published data. In Nigeria, a central clearing system has been established to improve settlement and delivery performance. Similarly, Hungary has taken steps to bolster interest in the Budapest Stock Exchange and to broaden the range of issues traded.

With the opening of exchanges in Shanghai and in the special economic zone of Shenzhen, capital market reforms have gathered pace in China. Foreign investment through mutual funds has been encouraged by authorizations to issue $400 million in special “category B” shares, U.S.-dollar-denominated shares in, for example, joint ventures.55 New stock exchanges have also been launched recently in Ghana, Hungary, Mauritius, Mongolia, Namibia, Poland, and Uganda. Meanwhile, 14 Asian stock exchanges have formed the East Asian and Oceanic Stock Exchanges Federation (EAOSEF) to facilitate the development of securities markets of member countries through exchange of information and mutual assistance.56 The three existing stock exchanges in the Caribbean—located in Barbados, Jamaica, and Trinidad and Tobago—started cross-listing and cross-trading securities in 1991.

Regulatory Structures in Emerging Markets

Poor accounting standards, lack of timely and adequate information on company and market developments, complicated intercompany accounting, and insider trading are frequently cited as impediments to foreign investment in developing countries. The development of appropriate regulatory oversight is perceived by potential investors as critical. A variety of regulatory structures have evolved in both developed and emerging markets that depend on the stage of market development and on the extent to which specialized firms perform the functions of broker, dealer, or investment banker 57

In general, developing countries are gradually moving toward regulatory systems based on delegating regulatory responsibilities to stock exchanges or other self-regulatory organizations and strengthening government oversight of markets. This phenomenon is observable in all three areas of regulation: (1) disclosure, accounting, and listing standards for new issues; (2) regulation of market practitioners through registration and prudential standards; and (3) secondary market trading activities, including surveillance and enforcement. For example, in India, the Securities and Exchange Board was recently granted an autonomous status to provide investor protection, prohibit insider trading, promote the development of the capital market, and simultaneously register and regulate the working of intermediaries. The budget for 1992/93 abolished the practice of government control over capital issues and pricing; companies are now allowed to approach the market directly, provided the issues conform to published guidelines relating to disclosures and investor protection. Important regulatory reforms have also occurred in Argentina, where the Comision Nacional de Valores has introduced new controls on insider trading and market manipulation and has tightened accounting and disclosure standards.

Privatizations

Privatization programs broaden the range of quality financial assets in developing countries. In addition, by signaling potential improvements in economic efficiency, they can also promise higher rates of return on investment. As a result, successful programs have often attracted foreign capital. In Mexico, the Government sold more than half its holdings in Telmex in 1991 through international offering of shares to investors in the United States, Europe, and Asia. Over 70 percent of the Mexican economy is now open to full foreign ownership without prior approval. In addition, Argentina, Brazil, Chile, and Venezuela have undertaken extensive privatization programs and liberalized foreign constraints on foreign investment.

Privatization has also gathered momentum in Eastern Europe. Following a record level of selloffs in 1991, Hungary launched a new initiative to improve conditions for investors by ploughing back privatization proceeds into special funds designed to reduce political and business risks. In Poland, about two thirds of privatizations occurred through direct sales, mainly to foreign investors. Czechoslovakia has also sold enterprises directly; such sales have been responsible for the bulk of foreign investment inflows since 1991.

Other Reforms

In many developing countries, interest rate and credit allocation policies have traditionally aimed at making inexpensive financing available through domestic banking channels. Such policies discouraged the issue of equities and bonds by private or public enterprises. Moreover, public enterprises in a number of developing countries typically received additional funding directly from government budgetary appropriations, from low-interest loans from state-owned banks or development finance institutions, or from loans raised abroad under government guarantee. These financial policies served to limit opportunities for involvement by foreign investors. Comprehensive financial-sector reform programs adopted recently in many countries have reversed this situation by freeing interest rates and limiting administered lending operations. This has encouraged domestic companies to seek domestic or foreign financing on market-related terms.

Tax reforms in re-entrant countries have also promoted development of equity markets by reducing existing distortions and impediments that formerly favored debt financing. Capital gains taxes, for example, have been reduced to encourage family holders to sell part of their holdings, and fiscal measures have been adopted to lower the effective cost of equity issues. In addition, many developing countries have established special tax incentives for public registration and quotation to offset disincentives arising from increased disclosure and imposed tax compliance. These incentives include lower tax rates, temporary tax holidays, and preferential accelerated depreciation allowances for publicly listed companies.

Graduation from Provisioning Requirements

Following the emergence of the debt crisis in 1982, bank supervisors in the main creditor countries reviewed the adequacy of regulatory practices under their national jurisdictions. Although the regulatory procedures adopted varied among major creditor countries, the common aim was to promote an increase in loan-loss reserves by commercial banks against exposure to countries experiencing debt-servicing difficulties.58 Strengthened regulatory practices were supplemented by stock market pressure on commercial banks, where higher provisioning was considered synonymous with financial resilience. As a result, by 1990 commercial banks in most jurisdictions had raised their provisioning levels relative to exposure to countries with debt-servicing difficulties to 50 percent or more, and in some cases to well above levels requested by regulatory guidelines (Table A16). This high level of provisioning facilitated bank participation in debt restructuring packages completed over the past three years.

As described in Chapter III, market re-entry by a number of heavily indebted countries has involved the regaining of access to international securities markets. New bank lending, however, has been far more limited. Indeed, there have been concerns that regulatory frameworks may have deterred new bank lending even after the creditworthiness of such countries improved. This section reviews how regulatory practices in creditor countries apply to new commercial bank lending to developing countries. It describes recent steps in creditor countries to adapt provisioning requirements in response to a changing environment.

Once its creditworthiness improves, a country may obtain new bank lending with reduced or no provisioning requirements in several ways. Regulatory requirements in a number of creditor countries give banks a fair degree of flexibility in setting provisioning levels by country and by asset type. This is particularly the case in Germany, where banks are not constrained by official regulations on provisioning, but are required to make provisioning decisions individually in consultation with bank auditors. Even in countries with mandatory provisioning systems, certain forms of loans—for example, short-term trade lines, interbank facilities, and cofinancing with international financial institutions—may be exempt from provisioning requirements. Moreover, secured medium-term lending may be subject to lower provisioning requirements on a case-by-case basis, depending on the structure of enhancements.

For unsecured medium-term loans, in most regulatory regimes, provisions would be required on new exposure to countries included on a specified list. A country may be “graduated” from this provisioning basket according to various criteria that differ by creditor country: (1) a periodic reassessment; (2) a clear demonstration of renewed market access by the country; and (3) the passage of time since the last rescheduling.

Periodic Reassessment

In the United States, an interagency committee of federal bank regulatory authorities (ICERC) meets three times a year to review the allocation of countries among seven risk categories, and to evaluate the status of countries requiring mandatory reserves (ATRRs). For countries with value-impaired claims, a reduction in the mandated level of provisions can only be achieved after a sustained improvement in the country’s debt-service management. To date, ATRRs have not been reduced in any case. For new loans, however, ATRRs have not always been required, provided that an adequate debt-servicing track record has been established (normally, a year of full debt-service payments).

In the United Kingdom, the matrix system of the Bank of England allows for an improvement in creditworthiness to reduce the indicative provisioning range. In particular, a country that has improved economic performance through an economic adjustment program and debt restructuring is likely to receive a lower score in the grading system. If the score is low enough, the Bank may remove the country entirely from its matrix. This has occurred in the past year in the cases of Chile and South Africa.

A semiannual assessment is undertaken in the Netherlands jointly by bankers and regulators, with the appropriate level of provisioning adjusted as needed. In France, a debtor country may be removed from the provisioning basket if banks consistently decide to reduce their provisions against the country. In recognition of a systematic reduction of bank provisions against particular countries, the authorities decided during the past year to remove three countries—Chile, Indonesia, and South Africa—from the basket. To the extent that removal of exposure to these countries from the provisioning basket raises bank provisions relative to exposure above 60 percent (the maximum amount of provisions that are tax deductible), banks will be required to reverse tax benefits previously obtained over a five-year period.

Market Access

The Canadian regulatory system takes into account renewed market access. Although a country is automatically removed from the provisioning basket five years after the last restructuring of commercial bank debt, the time period can be reduced to two years if the country demonstrates an ability to raise new medium- and long-term funds on a voluntary, unsecured basis on the international capital markets. On this basis, Mexico has been removed from the provisioning basket, while Chile and Venezuela are expected to qualify for removal by December 1992.

Passage of Time

In Japan, passage of time remains the prevailing standard for graduation. The indicative provisioning level applies to exposure to countries that have concluded a rescheduling agreement within the last five years. Similarly in Belgium, countries remain in the provisioning basket if they have not observed the original terms of their loan contracts within a five-year period.

Graduation from regulatory provisioning does not necessarily imply that banks would increase unsecured medium-term loans to developing countries that were regaining market access. In many creditor countries—for example, Canada, the United Kingdom, and the United States—actual provisioning by the banks is well above that indicated by the regulatory authorities. Moreover, in Germany, regulatory requirements do not act as a disincentive for new lending, because provisioning levels are determined by the banks. There is, however, little evidence to date that banks in these countries have been more inclined to resume general purpose lending to market re-entrants than banks in other countries.

Nevertheless, while respecting the need to maintain prudential standards, regulatory guidance should be sufficiently responsive to improved circumstances so as not to preclude a gradual resumption of bank lending in appropriate circumstances. Recent measures undertaken by a number of countries represent steps in this direction. Consideration could be given to some further revisions in regulatory frameworks. First, in certain regimes there would seem to be scope to allow more flexibility in setting provisions by asset type, taking into account payment history, extent of security, and other factors. In particular, short-term trade-related claims and interbank credits are likely to carry a lower risk than unsecured medium- and long-term loans. Project lending, where special arrangements are made to provide additional security, could also be reviewed on a case-by-case basis. Second, countries that review provisioning standards only after a lengthy period could make more frequent assessments, which would allow a closer tracking of a country’s debt service and policy implementation record. Third, more weight might be given to the great divergence in macroeconomic and structural policies across countries in varying provisioning requirements across individual cases, rather than applying a general requirement to an entire group.

49Detailed quantitative information is not available on the composition of the investor base for these countries’ securities. The discussion here is based mainly on market reports and interviews with market participants.
50The structure of the investor pool and the role of Latin American flight capital in the early phases of market re-entry were discussed in Private Market Financing for Developing Countries (Washington: IMF, December 1991), Chapter IV.
51See Kleiman International Consultants, “1991 Emerging Markets Survey” (1991).
52See Kleiman International Consultants, “1991 Emerging Markets Survey” (1991).
53In view of subsequent political uncertainties, this rating was placed under review in July 1992.
54Private Market Financing for Developing Countries (Washington: IMF, December 1991).
55“B shares” can be owned by foreigners only, but they are afforded the same right of ownership as “A shares,” which are reserved for Chinese nationals. In China, a share entitles the owner to a dividend distribution, but not to a right to influence the operations of the company.
56The Federation includes the stock exchanges of Tokyo, Osaka, Seoul, Taipei, Hong Kong, Manila, Makati, Jakarta, Surabaya, Singapore, Kuala Lumpur, and Bangkok. Its agenda includes the development of a common system of clearance and settlement, and the promotion of cross-listing of shares.
57Case studies conducted by the IFC concluded that differences among institutional structures are less important determinants of the functioning and depth of security markets than other factors, such as the level of economic development and laws and regulations. For more discussion of recent trends in securities markets regulations, see Chuppe, Terry M., and Atkin, Michael, “Regulation of Securities Markets: Some Recent Trends and Their Implications for Emerging Markets,” Working Paper (Washington: International Finance Corporation, January 1992).
58For further information on specific regulatory treatment in creditor countries, see International Capital Markets: Developments and Prospects (Washington: IMF, April 1990), Chapter V, and Hay, Jonathan and Nirmaljit, Paul, “Regulation and Taxation of Commercial Banks During the International Debt Crisis,” World Bank Technical Paper No. 158 (Washington: World Bank, 1991).

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