What obstacles are there to the growth of emerging markets? “Round up the usual suspects,” advised Columbia University’s Frederic Mishkin at a January 11-12 Brookings-Wharton conference that focused on integrating emerging market countries in the global financial system. In response to Mishkin’s call, presenters looked at the role of property rights, bankruptcy law, standards and codes of best international practice, security market development, corporate governance, accounting standards, and bank regulation and supervision. Many also underscored how vital it is for emerging markets to be consistent in implementing the policies and the practices they choose to follow.
Environment for enterprises
A number of papers asked what steps are needed to bring the environment for enterprises in line with global standards. Reena Aggarwal from Georgetown University talked about a paradoxical situation in which emerging market economies thrive while their stock markets are in decline. She concluded that major enterprises in these emerging markets are increasingly bypassing local stock markets to list themselves on industrial country stock exchanges. But only the largest firms can do this, she said, so that the problems facing the remaining firms draw a great deal of attention.
Looking at corporate governance systems, Luis Zingales of the University of Chicago noted that the choice between a market-based “arm’s-length” approach and a relationship-based approach depends crucially on the underlying contracting system. In emerging markets, the arm’s-length model may not be optimal, he said, but it is likely to predominate in the long run, as it better accommodates international investors.
Corporate governance reform may be important, the World Bank’s Michael Pomerleano commented, but the risk of future crises will not be substantially reduced until public financial sector governance—especially that of monetary authorities—is also reformed. Governance failures in this area have played a key role in a number of recent crises, he said, citing the failure to take timely action to avoid the collapse of the Thai baht; the provision of emergency bank liquidity in Indonesia, much of which went to fund capital flight; and the hiding of foreign reserve losses prior to currency crises in Mexico and Korea.
When firms get into trouble, whether in a crisis environment or not, bankruptcy procedures become important, and potential creditors need to know what will happen. Clas Wihlborg from the University of Gothenburg surveyed international practice and concluded that creditor-oriented systems (the traditional U.K. practice) were effective, but so were debtor-oriented systems (the French approach, for example, makes maintaining employment a principal goal). What matters is enforcement and that all parties understand what will happen in the bankruptcy proceeding.
Ray Ball of the University of Chicago discussed the closely related issue of corporate accounting, looking at how well various systems provide information on firms’ balance sheets for the purpose of monitoring and at how well they capture changes—particularly losses—in the value of the firm. He drew an important difference between common law-based systems (the United Kingdom and the United States), which are run mainly for shareholders, and those based on code law (continental Europe), in which other stakeholders have important rights. Both systems, he said, provide adequate monitoring, but both fall short, in varying degrees, in terms of capturing changes in the value of firms. Christian Leuz of the Wharton School agreed that accounting and disclosure systems are deeply embedded in a country’s institutional framework. Consequently, he observed, traditional developing country systems, in which the concerned parties are limited to reasonably well informed insiders, may in fact be the best option for an environment with weak disclosure systems.
Ball emphasized that complementary reforms are indispensable for developing better accounting systems. Legal reforms, especially those that make management liable to shareholders for misrepresenting the condition of the firm, are essential for reliable accounting systems, he said. It is a waste of resources to focus on accounting standards where the supporting infrastructure is not in place, according to Ball. As an illustration, he discussed China, which has adopted International Accounting Standards (IAS), but where company accounts remain so poor that the credibility of IAS itself is threatened.
Role of local banks
While the conference addressed a wide range of topics, many participants singled out the crucial importance of the banking sector. As Mishkin emphasized, potential banking crises are a principal source of risk in emerging markets. Weak banks make it risky for the authorities to raise interest rates, thus limiting the tools available to defend against currency crises. This in itself can trigger a crisis that brings down the banks.
Improved banking regulation and supervision are critical to maintaining a sound banking system, and the World Bank’s Gerald Caprio presented new cross-country research assessing the features of supervisory systems that contribute to strong banking systems. The study concluded, most notably, that there is a strong positive link between state ownership of banks and the likelihood of a crisis. It also found a very robust link between the generosity of the deposit insurance system and bank fragility. While many of its conclusions were in line with earlier research, the comprehensive databases (see www.worldbank.org/-research/interest/data.htm) that the paper draws from provide a solid foundation for future research.
View from the practitioners
Each day’s discussion ended with a presentation from a speaker active in emerging markets. The first day, PIMCO Emerging Market Fund’s Mohamed El-Erian challenged the image of emerging markets as risky and highly volatile. Noting that the volatility of emerging markets’ security prices had declined over the past year, he pointed to a range of reasons why this was so, mentioning improved macroeconomic policies in the countries themselves, reduced participation by highly leveraged institutions, greater efforts at investor relations by borrowing countries, and a rapid response by the IMF when recent crises in Argentina and Turkey put the entire asset class at risk.
An especially positive factor in the declining volatility, he said, was the more active role played by borrowers. This greater activism ranged from conference calls with investors to increased provision of data (partly in response to IMF transparency initiatives) to greater sophistication on the part of countries’ debt managers in the timing of their market activity, including absorbing some of the volatility by actively trading in their own securities.
The second day ended with a session led by IMF First Deputy Managing Director Stanley Fischer, who discussed his views on exchange rate regimes and crisis prevention. On the former, Fischer noted that the major emerging market crises of the past few years had all involved the departure from a pegged exchange rate system, while similar countries with floating rate systems had had problems without crises. He said that this had led observers to focus on the so-called corner solutions of a free float or a hard peg. Nevertheless, he added, there is room for managed floats and other intermediate solutions, especially where countries are not open to international capital flows, and he referred the audience to his recent discussion of exchange rate regimes at the meetings of the American Economic Association (see IMF Survey, January 22, page 26).
On crisis prevention, Fischer called attention to progress in five areas: more candid surveillance by the IMF, especially with respect to countries’ vulnerabilities; introduction of the Financial Sector Assessment Program; work on developing and implementing standards and codes of good financial practice; increased transparency of the IMF itself; and introduction and reform of the IMF’s Contingent Credit Lines, which he expected would soon begin to be used by member countries.
The overarching question, said Fischer, was how to minimize the damage from vulnerabilities. Once a crisis occurs, there is a necessary choice between extending guarantees to the banking system or facing the collapse of the banking system. The IMF has supported a number of countries in recent crises when they took the first course. To those who worry about moral hazard created by guarantees, he said no country would allow an unneccessarily large recession simply to serve as a warning to investors, nor should it do so.
Correction: In the January 8 issue of the IMF Survey the reference to the IMF’s Data Quality Reference Site (DQRS) was incorrectly identified on page 12. The IMF’s DQRS is available at http://dsbb.IMF.org/dqrsindex.htm.
Ian S. McDonald
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