The Hindu Business Line : The return of the debt spiral

As the world marks the completion of a decade after the 1997 financial crises, evidence mounts that global financial fragility is on the increase, argue C.P. Chandrasekhar and Jayati Ghosh. In particular, new instruments and new players in credit markets have triggered a credit spiral, increased risk and rendered such risk more systemic.

July 2007 marks the completion of a decade since the Southeast Asian financial crisis. The East Asian crisis of 1997, whose effects are still visible, focused attention on the dangers associated with a world dominated by fluid finance. There were a number of features of the global financial system that were starkly revealed in the course of that crisis and in the innumerable analyses that have followed it.

What the crisis revealed

First, all talk of efficiency of financial markets notwithstanding, the structure of the financial system appeared to be such that banks and financial institutions were not merely prone to overexposure in individual markets, but to exposure reflective of unsound financial practices.

A combination of moral hazard generated by implicit guarantees, the herd instinct characteristic of imperfect financial markets, and the competitive thrust for speculative gains on funds garnered from profit-hungry investors, all resulted in a situation where lending to, and financial investments in, particular countries continued well after there was evidence that high-risk exposure had exceeded warranted limits.

Second, a sudden and whimsical turnaround in flows can set off currency speculation in the host country which can have extremely severe consequences for the exchange rate.

Third, since the surge in capital flows occurs in the wake of financial liberalisation in the host country, which dissociates the right to access and use foreign exchange from the responsibility to earn foreign exchange to meet future foreign currency commitments, much of the flow is directed to the private sector.

Finally, the East Asian crisis brought home the fact that external debt remained a major determinant of external vulnerability in developing countries.

During the early 1990s, when a surge in foreign direct and portfolio investment flows increased developing-country access to international liquidity, excessive external borrowing, of the kind which led up to the debt crises of the 1980s, was seen as being an increasingly unlikely phenomenon, especially in the more developed of the developing countries.

There were three reasons provided to buttress this argument. First, that capital flows needed to finance current account deficits were increasingly available in non-debt forms such as portfolio and direct investments. Second, that debt financing was predominantly resorted to by governments, which in the wake of the debt crisis had been forced to restructure their finances and reduce the quantum of deficit financing, especially that based on external borrowing. Finally, that banks which had over-exposed themselves in a few developing countries and had burnt their fingers, were now far more prudent and cautious when lending to such countries, including their governments. Thus, it was argued, a combination of supply- and demand-side factors had made debt-crisis a thing of the past.

The crisis in Southeast Asia challenged this complacence. It is now widely accepted that the excessive accumulation of debt, especially short-term debt, served as the trigger for the collapse of confidence that resulted in massive capital outflows and currency depreciation.

Surge in inflows

Even if we take developing countries as a group, private long-term debt inflows registered a three-fold increase from $18.6 billion in 1991 to $60 billion in 1995 and rose further to touch $100.3 and $105.3 billion respectively in 1996 and 1997.

Short-term inflows also registered a similar increase between 1991 and 1995, and only tapered off thereafter as lenders became increasingly wary of rolling short-term funds because of the massive accumulation of debt. Thus debt remained a prominent source of external finance in the 1990s as well.

This was even more true of the five crisis countries (Indonesia, South Korea, Malaysia, the Philippines and Thailand) in Southeast Asia. In 1996, on the eve of the crisis, these countries accounted for more than a fifth of total long-term resource flows to developing countries and more than half of short-term flows. All of them registered sharp increases in their debt levels and debt-GDP ratios between 1994 and 1997. And though absolute debt levels declined in 1998, the contraction in GDP resulted in a sharp increase in debt-GDP ratios.

Not surprisingly, in the years immediately following the crisis, the flow of private non-guaranteed debt to developing countries as a group stagnated in 2000 and registered a marginal decline in the subsequent two years to 2002. With governments wanting to discourage debt-dependence, and creditors wary of lending any further, even public and publicly guaranteed debt from private creditors registered a sharp decline during those years. These trends once again led to the conclusion that the global financial system, reformed in the aftermath of the crisis, was adjusting in two ways: It was reducing over-exposure in the crisis countries by redirecting credit to countries were exposure was lower. It was also shifting the pattern of capital flows away from credit to investments in equity, in the form of portfolio or direct investments in developing countries.

Short-lived shift

But to the extent that this shift occurred, it appears to have been short-lived. Matters seem to have changed dramatically over the last four years. The flow of non-guaranteed debt from private sources into developing countries has increased by 250 per cent over the four years ending 2006, or at a scorching pace of 28 per cent compound per annum.

Simultaneously, developing-country governments too seem to have overcome their fear of debt, with public or publicly guaranteed debt from private creditors having risen by more than 150 per cent or growing at a compound rate of around 11 per cent annum (Charts 1 and 2). In sum, creditors appear willing to lend and debtors willing to borrow, resulting in an aggregate scenario that spells debt dependence of a much larger magnitude than preceded the 1997 crisis.

There has been some change in composition by source as well. While in the immediate aftermath of the 1997 crisis, the relatively small inflow of debt was on account of bond issues by developing countries, with bank credit collapsing and turning negative, in more recent years there has been a revival of bank credit. In terms of target, as was happening at the time of the crisis, there is a sharp shift in borrowing, away from the public to the private sector. The World Bank’s report on Global Development Finance 2007 suggests that the corporate share of external debt has risen from less than one-fifth of the total in the late 1990s to more than one-half in 2006.

What is disturbing is the extreme concentration of these flows, with a growing and now substantial share of it flowing to Europe and Central Asia. In 2006, 57 per cent of flows of private non-guaranteed debt went to this region while East Asia and the Pacific received 14 per cent and Latina America and the Caribbean 19 per cent (Chart 3). Just 10 countries accounted for three-fourths of all borrowing in 2006, a sharp increase from the already high 60 per cent average during 2002-04. What is more, the evidence points to a growing share of lending to banks in developing countries, interested in exploiting the lower interest rates in international as opposed to domestic markets. Loan commitments to the banking sector totalled $32 billion in 2006, which exceeded commitments to the oil and gas sector, a traditional leader.

Decline in credit quality

Finally, there has been a decline in credit quality accompanying these developments. To quote the Global Development Finance Report: “As private debt flows swell, riskier borrowers may be taking a larger share of the market. T he share of bonds issued by unrated (sovereign and corporate) borrowers rose from 10 per cent in 2000 to 37 per cent in 2006, and the share of unsecured loans in total bank lending rose from 50 per cent in 2002 to almost 80 per cent in 2006.” The point to note, however, is that despite these disconcerting trends creditor confidence is at a high. The average spread between interest rates charged on developing country loan commitments and the benchmark LIBOR fell from more than 200 basis points in 2002 to 125 in 2006 and the average loan maturities have become longer. An inevitable conclusion from this evidence is that creditors are not pricing risk adequately and taking it into account when determining exposures. One explanation could be that creditor profiles have changed significantly, with the entry of intermediaries such as hedge funds and other less risk-averse entities into the credit market. The other could be that the process of securitisation and the growing presence of credit derivatives allow for the pooling and transfer of risk to entities that are less capable of assessing them.

This implies that those making decisions to lend are less concerned about the implications of such exposure and more with the returns lending would provide.

These two aspects are in fact related. Securitisation essentially involves transforming illiquid, poorly-saleable credit assets into more liquid assets that can be traded in capital markets, by pooling credit assets of different kinds and embedding their values in representative securities. A buyer of these securities, pays a part of the price, carries part of the risk and obtains part of the returns from exposures by the original lender in many markets.

Emergence of credit derivatives

What is important is that with the emergence of credit derivatives, credit assets become tradable. This allows those looking for quick or early profits to operate in this area. But it also attracts the speculator looking for such assets in order to place bets on how markets and interest rate differentials would move.

The demand for derivatives rises, and therefore the need to create these assets by either extending further credit or creating derivatives linked to other derivatives, or “derivatives-squared”.

Once credit becomes a tradable asset class, it attracts new investors. Till recently, other than banks, the major players in the credit business were pension funds and insurers. But with equities proving to be inadequately remunerative investments, banks increasingly geared to creating new instruments based on debt, and credit derivatives offering liquid credit instruments, new players have emerged as investors —hedge funds and pension funds — and new operators — specialised credit funds and mangers of collateralised debt obligations — have emerged as providers of instruments.

According to figures reported by the Financial Times (March 13, 2007): “The outstanding notional volume of credit derivatives contracts has doubled every year since the start of this decade to reach $26,000 billion in the midd le of last year. This has led many traditional credit investors to rethink their strategies. But above all, it has triggered a sharp increase in the number and scale of credit-focused hedge funds. In 1990, according to Hedge Fund Research, hedge funds focused on fixed income strategies accounted for just over 3 per cent of the $39 billion of assets under management in the industry. By the end of last year, a more varied array of credit-related strategies accounted for almost 7.5 per cent of a $1,400 billion industry — and that does not include convertible bond arbitrage. Similarly, the volume of assets under management in fixed-income arbitrage strategies alone, which seek to exploit price differences between related bonds and rely heavily on derivatives, has leapt from $5.8 billion in 2001 to $41 billion at the end of 2006, according to HFR.”

Increased risk

It must be noted that the growing ability to transfer risk by no means implies that the risk goes away. Rather it increases risk for a number of reasons.

First, since the “original” lender plans to transfer risk through securitisation, and the sellers of credit insurance or purchasers of derivatives are often not capable of assessing risk fully, the riskiness of assets in play only increases.

Second, since the conversion of credit assets into tradable securities increases demand for such securities, there is an inherent dynamic in the system to increase the volume of credit. This results in growing exposures, and inasmuch as the creation of these exposures depends on the availability of willing borrowers, there is a tendency for exposures to be concentrated among profligate borrowers.

Third, since risk is distributed more widely than before, including to poorly informed investors, there is likely to be substantial delays in adjusting to heightened risk.

And, finally, the current level of risk is not merely higher than before, but “systemic” to a far greater extent.

In sum, a decade after the 1997 crisis and after much discussion about the creation of a new financial architecture, the world seems to have returned to a situation of vulnerability. But in today’s world, where knowledge is seen as resting precisely with those that generate risk, such diagnoses are never taken seriously, till a crisis actually erupts.

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