Signs of improvement, also reassessment of risks

by Chakravarthi Raghavan

Geneva, 14 June -- While the global financial markets have shown signs of improvement during the first quarter of 1999, the global reassessment of risks (in the wake of the Russian default and the Brazilian crisis) has had a lasting influence, says the Bank of International Settlements in its second quarterly review of the International Banking and Financial Market developments.

Despite some retreat, credit spreads, liquidity premia and volatility all remained well above their pre-Russian crisis levels.

Fears of a possible loss of confidence in the US currency have dissipated, as buoyant US growth gave rise to anticipation of higher interest rates. But the initial enthusiasm of investors for the euro rapidly waned owing to the weakness of economic activity in euro area.

The volume of announced international debt securities surged by 58% in the first quarter of 1999, reaching an all time high of $415 billion. The launch of the euro in January was evidently a factor, with a large number of borrowers seeking to create benchmarks.

In contrast, the volume of international syndicated loan facilities dropped from $225 billion in the fourth quarter of 1998 to $156 billion in the first quarter of 1999. The heavy capital-raising activity of banks seems to have been due less to a desire to expand than to strengthen balance sheets.

There has also been a growing use of short-term credit lines, which are less capital intensive and are not included in the BIS data on announcements.

Under the Basle capital requirements (now under revision to meet criticism), the short-term exposure of banks carries less capital adequacy requirements than medium- or long-term. Credit lines are generally viewed as an exposure only when funds are drawn upon them.

The more detailed BIS data on international banking activity for the last quarter of 1998 shows a $100 billion drop in the outstanding loans of banks to non-bank customers inside the BIS reporting area - which includes major financial centres, supporting other evidence that banks contributed to the overall market reversal.

This, BIS says, shows the high degree of inter-dependence between bank lending and strategies pursued by non-bank investors.

There was an even larger withdrawal of international deposits by some non-banking sources - about $120 billion -- showing how the abrupt reappraisal of global exposures in the wake of the Russian debt moratorium and the debacle of the Long Term Capital Management (LTCM) hedge-fund hindered international bank intermediation.

In the international banking market, the total volume of international syndicated loan facilities in the first quarter of 1999 declined substantially to $156 billion - from the $225 billion in the 4th quarter of 1998. Pricing conditions tightened for all categories of borrowers -with the weighted average spreads for developing country borrowers, for which transactions fell to a low of $6 billion, being above 375 basis points (and even developed country borrowers about 175 basis points.)

The detailed banking statistics for the fourth quarter of 1998 shows the extent of reappraisal in global exposures in the wake of the Russian debt moratorium and the LTCM debacle.

Despite some easing of credit squeeze faced by emerging market borrowers, there was an absolute decline of $65 billion in stock of international bank credit outstanding - the first recorded decline since 1992.

Non-bank entities inside the BIS reporting area bore the brunt of this adjustment, with a drop in claims of $70 billion - including cross-border claims and local claims in foreign exchange. The credit lines to such customers were also cut by $100 billion, but partly offset by securities purchases of $22 billion. There has also been some anecdotal evidence that the banks pared their credit lines to their own non-bank subsidiaries in the Caribbean centres.

But there was also a sharper decline of $119 billion in deposits from the same source - suggesting that the disruption in international bank intermediation in the fourth quarter was as much due to reduced ability of banks to attract funds as to their own reluctance to extend risks.

These developments put into broader perspective the decision of monetary authorities to inject liquidity.

Discussing the impact of the suggestion for "bailing-in" of private creditors, that is of private creditors and bond holders sharing the losses in future debt restructuring, the BIS notes that the emerging market bonds were affected in the first quarter of 1999 by the possibility of debt restructuring.

This was a reaction to the reported suggestion of the Paris Club and the IMF that Pakistan include outstanding international bonds in the restructuring of its external debt. The perception of market participants that major creditor countries were increasingly in agreement on the principle that private credits share in losses of future debt rescheduling and fears that such a principle might be applied to the Russian securities led to a wider sell-off in emerging market bonds.

Press reports show that the Paris Club (of official creditors) would now insist on a comparability of terms from all creditors - official and private - on all types of instruments, loans and bonds. Eurobonds have no seniority to other debt obligations, but in practice they have enjoyed a privileged status and have been excluded from rescheduling.

The idea of "bailing-in" bondholders in sovereign debt rescheduling was addressed in a 1996 report by a working group of G-10 countries, which argued against the presumption that any type of debt would be exempt from payment suspension or restructuring, and suggested a market-led process to develop contractual provisions to facilitate cooperation between private creditors and debtors.

This issue was further pursued in the Willard Group (of 22 developed and developing countries) as part of the efforts at restructuring the global financial system.

There has been a belief in official sectors that the preferential treatment given to eurobonds has created pricing distortions, leading to excessive debt accumulation in certain countries, and raising the issue of moral hazard for private investors.

But there are currently no mechanisms for orderly restructuring of international bonds. Thus a default by Pakistan on such bonds would have a number of implications, the BIS notes. The inclusion of bonds in restructuring could trigger a series of cross-default clauses (whereby default on one obligation by a borrower triggers automatically a default or acceleration clause in other debts). Investors could attempt to pursue their claims in courts.

Conducting a bond rescheduling would also be difficult since it would require the agreement of a large number of holders of individual bearer securities.

Bailing-in would thus require introduction of new contractual provisions to reduce the incentive for a small number of bond- holders to disrupt, delay or prevent agreement.

Fearful of losses on emerging market bonds and reduced revenues in the business sector, intermediaries have been opposed to the idea, arguing that private sector bail-in would only lead to a drying up of funds. Debtor countries too have been concerned that the risk premia on their international securities could increase, and thus reduce their access to external finance.

However, those advocating reform have noted that before the Asian crisis the risk premia were too low, encouraging an unsustainable buildup of debt.

"If the removal of perceived immunity of international bonds were to result in a better pricing of risk, debt accumulation might be less subject to bubble-type growth and financial stability might be improved to the actual benefit of creditors and debtors," BIS says. (SUNS4456)

The above article first appeared in the South-North Development Monitor (SUNS) of which Chakravarthi Raghavan is the Chief Editor.

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