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ECONOMIC AND SOCIAL COMMISSION FOR ASIA AND THE PACIFIC
Part Two of the Economic and Social Survey of Asia and the Pacific, 1999
Asia and the Pacific into the Twenty-first Century: Information Technology, Globalization, Economic Security and Development
VII. FINANCIAL FLOWS
ICT has a crucial role to play in the financial sector in at least three main areas: improving the range and efficiency of banking services available to customers, lowering costs and increasing the efficiency of capital markets, and allowing for more effective regulation of all types of financial markets and related transactions. The use of ICT enables a better delivery of banking services to both depositors and borrowers within a country and between countries. ICT has a central role in the operations of various capital markets such as stock markets, bond markets and foreign exchange markets, and it is intensively used by market organizers, market professionals and investors in these markets. ICT is also an essential tool for supervisory or regulatory bodies of these various markets at both national and international levels.
DOMESTIC BANKING SYSTEMS
The earliest commercial users of computerized systems were banks because of their daily repetitive-type operations. The computerization of banking operations in the developing countries in the Asian and Pacific region, such as the recording of deposits and withdrawals and the issuing of customer statements, started more than 20 years ago. There has been progressive computerization of other customer services such as reconciliation of inter-branch transactions of a bank using a LAN system, and preparation of management reports on accounts, calculation of interest received and paid, calculation of overdraft limits of customers, and other statistical reports, including those for the regulatory authorities. There has also been progress on the use of ICT to facilitate remittances and transactions between different banks and overseas transactions in foreign currencies. However, progress has been quite limited in practically all domestic banks in all developing economies of the region in the computerization of credit and risk assessments of clients and the processing of loans, whereas such use is at an advanced stage in major international banks. In this area, computerization can be very helpful in reducing the incidence of fraud and defaults.
In recent years, the use of automated teller machines has become significantly more wide-spread. ATM is an on-line system capable of reading ATM cards, verifying PIN numbers, counting and dispensing cash, and printing receipts. It is a prime example of financial service flexibility enhanced by ICT to allow customers to deposit and withdraw funds, check balances, pay for utilities, pay insurance premiums, or even settle equity transactions 24 hours a day throughout a country (or the world for some banks). The use of ATMs helps banks in reducing staff costs, speeding up transactions and providing a more convenient service for customers. ATMs started in urban areas and customers were restricted to using only proprietary ATMs. Now, in several countries, they are available in small cities and towns and there are interbank arrangements on the use of ATMs. These have been a significant source of income for many banks from the fees that they charge users.
In the early 1990s, the Asian Productivity Organization undertook a survey on the use of ICT in various sectors of selected Asian countries, including the banking sector.1 This report noted that, in Bangladesh, while almost every commercial bank and the central bank had computers, their use of the possible applications of ICT varied considerably. The most extensive use was by the large foreign banks such as the American Express Bank, with an emphasis on networks of computers to help with reducing costs and increasing the speed of settlement of transactions. All banks intended to extend the application of ICT to compiling statistical returns, payroll, provident funds, credit information, interbank clearing house activities, and so on. They recognized that ICT applications could help to spot fraud and reduce debt defaults. As many creditors tended to use the same collateral for loans from different banks, the banks had decided to share their databases on customer credits and liabilities to verify credit worthiness. On-line customer services also grew. The Central Bank used computers to collate and process the vast amounts of data collected from government agencies, commercial banks and other financial institutions. The output of that process was being used by the government in its formulation of monetary, fiscal and other related policies. This description applies to most of the developing countries in the region.
In Fiji, computers were used in the banks as early as the mid-1970s. Banks are now very ICT-oriented, with an emphasis on improving the efficiency of customer service and reducing queues at teller windows. The banking and financial sector in Hong Kong, China is very modern in its ICT applications, as befits its role as an international financial centre. In India, by contrast, the banks outside the main urban areas are still paper-oriented. According to a recent edict from the Vigilance Commission,2 there is an urgent need to introduce ICT into all banks to reduce the incidence of fraud. The Commission ordered that 70 per cent of all bank operations should be computer-based by the year 2000. Given the high costs of connectivity in the country, it has been suggested that satellites should be used to accomplish that goal. A large number of private software companies in India are ready to offer computerization automation to banks which wish to use it.
In Indonesia, the banking and financial institutions in urban areas are using computers for accounting activities of various sorts within each bank and for the settlement of interbank transactions, but it is not clear how much this has spread to more rural areas. In the Republic of Korea, ICT applications in the banking sector have a long history going back to the late 1960s. All banks had completed on-line savings accounts by 1977. Today, they are very up-to-date in the application of ICT. By 1988, customers of some banks could use cash dispensers or ATMs in any other bank in the network. As of 1992, there were 31 financial institutions in the network and the number of machines had risen to 9,720 from 1,192 in 1987. There is also an audio response service system, first installed in 1989, which allows customers to undertake certain banking transactions by telephone, as well as an electronic funds transfer system among a number of institutions. In 1991, selected banks started offering firm banking and home banking services. All these services have rapidly grown in the number of transactions completed and the number of financial firms participating.
In Singapore, the banking services available to customers are highly ICT-intensive. A grouping of seven major banks has been operating and further developing a network for electronic transfers between themselves and with their customers for the last decade or so. Home banking through the Internet started in 1997. In Thailand, considerable progress has been made in the use of ICT; a review of this progress was undertaken in 1997 and is summarized in box VII.1.
This cursory review shows that, while considerable progress has been made in the very useful application of ICT to the banking systems, there is still quite a way to go in many countries. Two other important considerations emerge. The realization is growing that the use of ICT can actively contribute to controlling fraud and debt default. Second, the increasing use of modern customer services such as ATMs can be affected by the costs of connectivity within a country. In some cases, banks have developed their own dedicated systems. The use of satellites to improve the spread of service in India is a novel approach.
A recent study on the spread of ATMs in the world reports that there were more than 700,000 machines in operation at the end of 1997 and that this figure should increase by almost 50 per cent over the following five years.3 The Asian and Pacific region was the largest market, with 245,000 machines installed, or 35 per cent of the world total. About 55 per cent of these were in Japan. Japan had the highest ATM density relative to population in the world at 1,080 ATMs per million inhabitants; the Republic of Korea was second at 791 machines per million persons and Singapore was sixth with a density of 547. In the forecasts to the year 2002, China is likely to become third on growth in the number of ATM installations, it is expected that India will have the highest rate at 652 per cent, China will grow at 275 per cent, Indonesia at 220 per cent and Thailand at 150 per cent.
A few developing countries of the region have started to use smart cards. For example, the Thai National Electronics and Computer Technology Centre, under the mandate of the National Information Technology Committee, has been working on developing an electronic commerce framework for Thailand that will encompass financial and payment issues. The Centre has led a group of volunteers, the Thailand Smart Card Working Group, in developing recommendations for smart card implementation in Thailand. Set up in February 1998, the working group has members from more than 50 government agencies, financial institutions, research and education institutes, and private companies. The working group believes in seamless smart card interoperability. It intends to propose a set of recommendations on standards for implementing smart card applications to the Thailand Industrial Standards Institute. It is also supporting cooperation among working group members to run a smart card pilot project that will demonstrate the usability of the recommendations.4 On-line debit service, ATM networks, cash cards and electronic settling of credit card payments have been progressively introduced in Singapore since 1986. Today, anyone in Singapore can get to school or the office, buy groceries or use a pay phone with a plastic card, a cash card, an ATM card, a prepaid card or a credit card. Telephone banking and using ATMs to buy shares or pay bills are routine, and the use of connections through the Internet is growing. The first electronic, Internet-based, billing service in Singapore was launched in November 1998 to allow customers to post bills and invoices through a secure Web site and for those billed to receive and pay their bills. The use of electronic banking services, including services which enable customers to do their banking and issue and pay bills through a touch-tone telephone, personal computer, videotex terminal or television have existed since the late 1980s in the developed countries, including Australia, Japan and New Zealand.
As discussed in chapter IV, the process of globalization has been realized to a large extent by the rise in capital flows of various forms, including through investment funds operating over the counter or through stock, bond or derivative markets. Advances in ICT have both supported and benefited from these developments in the financial sector. Although financial flows of loans, bonds and stocks may be small in relation to a developed country's total outward resource flows, they now represent a major source of funds for many developing countries, including several in the ESCAP region (see table VII.1).
Table VII.1 Annual average aggregate net long term resource flows to developing countries
Source: World Bank, Global Development Finance: Country Tables, (Washington DC, 1998).
The development of capital markets requires an increase in the intensity and dispersion of information among a wider group of market participants, both domestic and foreign (rather than just bank loan officers). For many countries with a small number of domestic participants, these include foreign banks and investment houses. The consequent flows of information rely heavily on the use of ICT. The application of ICT, coupled with the deregulation of banking and finance in the major industrial countries, has helped to establish a global market for finance. This has made it easier for the developing countries which are partners in using such technologies to access the global market for capital and credit. Increasingly rapid and efficient transmission of information has been a driving force not only behind larger and more mobile capital flows but also the decoupling of these flows from trade flows. As an illustration, cross-border transactions in bonds and equities in the major advanced countries grew from less than 10 per cent of GDP in 1980 to well over 100 per cent of GDP in 1995. Similarly, gross flows of portfolio investment and FBI in the advanced economies more than tripled between the first half of the 1980s and the first half of the 1990s.5 In addition, it is estimated that, on average, trade flows now account for only 10 per cent of the daily turnover on foreign exchange markets, the rest being accounted for by asset movements of various sorts. Several countries in the ESCAP region which adopted ICT relatively quickly have been active parties in this phenomenon.
In financial markets, the permeation of ICT can vary in both breadth and depth. Related to the type of capital market transaction, the relevant market-related systems can be divided into information systems, order routing systems, execution systems, and clearing and settlement systems.6 The extent of the automation of each of these has different rationales and implications for efficiency in the functioning of the market and the volume of transactions (that is, financial flows), as well as associated volatilities.
Because communication between the many participants in any capital market is very complex, there is a need for coordination mechanisms, and these create transaction costs. An exchange as a market organizer attempts to minimize these transaction costs by providing an appropriate transaction environment. The costs of provision of this service are charged by the market provider in the form of fees to market participants, including investors in financial markets. The impact of ICT on market coordination mechanisms can be divided into three parts.7 First, electronic communication allows for a faster, wider and less costly provision of information. Second, use of electronic technology allows the combining of different, formerly separated functions into a single one by avoiding media disruptions (for example, with such application a large number of market participants can send in their buying/selling orders simultaneously). Third, electronic brokerage cuts down on human interactions and reduces the role of middlemen. As a consequence, an increasing number of agents (including specialists and market makers) can be replaced by technology, providing a direct connection between partners in the original transaction. Ultimately, a computer exchange which electronically coordinates investors no longer requires human interaction at all, even in the price discovery (execution) process.8 Even in less advanced hybrid markets, the adoption of ICT lowers transaction costs,9 boosts efficiency10 of communication and improves coordination among the market participants.
With a significant reduction of communication costs, a tendency towards a centralization and integration of stock markets began to emerge. In the United States, for example, at the turn of the century, about 100 such markets existed. This number had declined to 35 by 1935, and to 15 by 1965. Today, only five regional exchanges and the New York Stock Exchange and the American Stock Exchange remain.11 In recent years, electronic trading has posed a direct threat to traditional floor-based trading, by reducing the latter's seat prices significantly.12 Indirectly, the threat of dual listing (that is, big corporations listing their stocks on more than one market simultaneously), together with the high fixed costs of modernizing electronic trading facilities, have encouraged a number of markets and exchanges to merge or at least cooperate closely. For example, the Philadelphia Stock Exchange proposed in mid-1998, and has agreed in principle, to join the American Stock Exchange and NASDAQ to enhance resources, state-of-the-art technologies and management strength to achieve a more efficient, transparent and low-cost market structure.13 A proposal is also under consideration to permit foreign stock markets with a significant number of American customers throughout the world, for example, the Sydney Futures Exchange, to set up electronic trading terminals in the United States.
In the Asian and Pacific region, the trend in the number of stock markets is in fact the opposite to that in developed countries, with a number of countries establishing their own stock markets over the last 10 years. Table VII.2 reports on the status of a sample of these markets. It is interesting to note that capitalization of many of these markets is small in terms of both absolute size and relative to the GDP of the country concerned. Only three economies have a capitalization larger than GDP (Malaysia; Hong Kong, China; and Singapore). Hong Kong, China and Singapore also serve as listing points for companies based in other countries. Six out of the 20 listed markets have a capitalization valued at over 50 per cent of GDP. In terms of number of enterprises raising money through the stock market, only Australia, India and Japan have more than 1,000 companies listed. The fact that practically all the developing economy markets are small implies that the prices of stocks on these markets are more easily subject to wide variations through the buying and selling of a relatively small number of stocks. For example, on the Jakarta market about 10 companies account for half of the market capitalization, and 80 per cent of market capitalization is related to only 45 companies. When these markets are open to foreign participation, which most are to some degree, they risk being overwhelmed by the activities of overseas institutional investors using amounts of funds which are small in comparison to their total portfolios.
Most of the stock markets in the region are intensive users of ICT for their operations and their reporting functions. Many are basically electronic markets. A few exchanges have now developed stock index futures to trade alongside their stocks. These are often seen as a good hedging vehicle for investors on the stock markets. The annex to this chapter and box VII.2 illustrate the progress made in this field and the experience to date.
There are very few bond markets in the region, and governments and enterprises from most countries continue to issue bonds on overseas markets denominated in foreign currencies. These bonds are then traded on developed country bond markets, which are themselves intensive users of ICT in order to attract a wide range of clients. The United States dollar has traditionally been the primary currency14 in which international issues of emerging market debt and bonds have been denominated. Reflecting market segmentation, this currency composition does not always correspond to the pattern of export earnings but is more aimed at satisfying groups of local investors - often retail ones in the developed countries.
Some foreign exchange hedging instruments exist within the international financial markets and demand has been growing for hedging exchange rate risk on emerging market investments. Since May 1995, the futures exchanges in New York and Chicago have offered a variety of products. For example, over-the-counter nondeliverable15 forward contracts in emerging market currencies are now available in both London and New York, with active trading in selected Asian currencies. Within the region, the markets of Hong Kong, China and Singapore also offer hedging instruments for New Taiwan dollars, Korean won, Philippine pesos, Indian rupees, Chinese yuan renminbi, and Vietnamese dong. The daily volumes are estimated to be between $500 million and $800 million, and are growing. Most markets offering foreign exchange hedging instruments are ICT-based, if not totally electronic, and further development of such hedging instruments within the region is likely to be based on modern electronic markets.
Volume of transactions
The enhancement of market intermediary functions by ICT has also encouraged a significantly larger number of matching quotes at lower transaction costs, contributing to the rapid growth in the volume of transactions.16 As a consequence, the share of trading accounted for by large financial institutions such as investment funds, pension funds or hedge funds has been increasing. Between 1975 and 1992, for example, the share of institutional trading at the New York Stock Exchange grew from 25 to 50 per cent of total trading.17 Since electronic or screen trading allows for anonymous trading, the relatively large institutional traders feel better protected against the strategic behaviour of the other market participants, who tend to observe their actions very carefully. Also, in normal circumstances, the use of the Internet may be levelling the playing field in the retail brokering of stocks, etc. by providing small investors with services previously reserved for corporate clients. However, such advice, combined with competitive pressures, technological developments and the relatively low level of investor sophistication, often provides little value added or can constrain these investors to be market followers.
In terms of globalization, the adoption of ICT has led to a significant increase in cross-border transactions of customized instruments through proprietary markets.18 Generally, financial markets may be divided into two types: exchanges and proprietary markets. Exchanges aim to organize a transaction arena so that members can experience financial gain. Owing to the privileges and rights provided exclusively for exchange members, it is not in the interest of any party involved to open the exchange to non-members. Proprietary trading systems, on the contrary, primarily aim to raise income by providing all potential customers with a transaction arena. This type of market has proved to be very innovative in taking advantage of ICT and accommodating an increasing volume of securities transactions. Proprietary markets have consequently become a key source of competition to the established exchanges by offering custom-made transaction services. Through the growing use of these trading systems, a large share of securities trading is across country borders. This type of competition has coincided with trends in reforms in some of the established exchanges. For example, on London's International Financial Futures and Options Exchange electronic trading was introduced for equity options in November 1998, and is to be introduced for all other contracts by mid-1999. Similarly, the Chicago Board of Trade is also considering a conversion of its "project A" to fully-fledged electronic trading.
Dramatic advances in computer and telecommunications technologies in recent years in the developed countries have enabled a broad unbundling of risks inherent in trading and investment activities through innovative financial engineering. For example, conventional financial instruments, common stocks and debt obligations have been combined with complex hybrid financial products (various exotic types of swaps and options) to allow risks to be reduced. This, however, also made these instruments very difficult to understand, and vulnerable to human mistakes. Thus, while the financial system as a whole has become much more efficient, the price-setting functions of the markets have also become increasingly sensitive to subtle changes in consumer choice and capital efficiencies.
One serious emerging problem with electronic exchanges of various sorts is how to regulate the abuse of privileged access to information or insider trading. This involves the use of private information to undertake trade and affect prices before a market is aware of a development. Its effects can be magnified when large traders are involved, such as block traders. In all trading, a healthy balance is needed between production and distribution of information and the legitimate use of the information gathered. This leads to the debate over transparency versus efficiency issues that continues to dominate modern financial market regulatory and supervisory frameworks. If, for example, block traders were required to report a trade immediately, they would not achieve the same price compared with discrete small trades, partly owing to the strategic actions of other market participants.19 They are understandably reluctant to report their trades immediately. As a solution to this problem, the market makers on the London Stock Exchange have been granted a time-span of 90 minutes to report their trade.20 This results in a loss of market transparency because of heterogeneously informed traders. The intricacies in the timing of pre- and post-trade reporting thus prove to be critical and can significantly influence the efficiency of a market. Similarly, there are conflicts of interest between the secrecy (with the associated abuses by money launderers) granted to private financial services providers in offshore financial centres (often the notional location of the headquarters of the hedge funds) in order to attract business and the desire to operate efficient and transparent financial markets.
One consequence of the adoption of ICT can be increased price variations, particularly in the extreme situation that the price discovery process is fully automated and when trading orders are large. This is because the use of ICT tends to amplify market reactions to news and shocks in terms of both speed and magnitude, raising the short-term variations in prices and volume of transactions, but not necessarily altering the underlying long-term trend. There are many examples of this phenomenon in commodity futures markets and stock exchanges, in particular. For example, in 1987, the stock market crash in the United States was partly attributed to programme trading. Programme trading on a stock exchange involves both the use of price change triggers to start the buying or selling of a stock automatically and the use of futures contracts to provide portfolio insurance for spot positions through quasi short sales. When a spot market dips, it will trigger a downward spiral as programme trading will profit from a further market slump. Non-programme market participants, on the other hand, misinterpret these automated reactions during the initial period of the spiral as fundamental shifts, causing these investors to follow while the market maker specialists do not have sufficient resources to provide liquidity support for the market. During the 1987 crash, the five-day settlement period also prevented investors from evaluating their true positions accurately, and the phones did not ring through when they tried to communicate with each other, exacerbating the panic and the depth of the crash even further.
Some of these shortcomings have already been rectified, particularly in the United States, through circuit-breakers, near real-time on-line clearing and settlement, and open lines of communication and networking. In the context of the developing countries in the ESCAP region, the side effects of ICT on economic and financial volatility and security remain critical, particularly in the aftermath of the recent financial crisis. As described in more detail in the annex, some exchanges, such as that of Thailand, have recently introduced floor and ceiling price limits to prevent excessive fluctuations in share values. These circuit-breakers suspend trading for a fixed period of time if the main index moves above or below a certain percentage value of the previous day's trading. Other exchanges, such as that in the Republic of Korea, have placed restrictions on the use of programme trading. Yet others, including Singapore, have kept a tighter rein on the financial sector, closely monitoring stock movements, and taken an increased role in supervising investment advisers and regulating unit trusts.
VOLATILITY IN EMERGING CAPITAL MARKETS
Emerging market volatility can be related to a number of factors: internal, external, real or imagined (speculative). Some of these factors are described below, based on recent developments in emerging markets.21 Volatility in equity markets, bond markets and foreign exchange markets can be calculated as the standard deviation of weekly changes in the logarithm of the respective variables over the preceding year, be they capital market prices, bond market total return indices or exchange rates. Figures VII.1 and VII.2 provide the results of these calculations for the period 1993 to 1997 for equity and bond markets. Despite a belief that capital markets in developing countries experience a higher degree of volatility in their performance indicators than do similar markets in developed countries, this is not necessarily true. Although some market volatility may be linked to an inadequate application of ICT, more use of which would increase the breadth and depth of the market, there is also the reverse argument that increased use of ICT has been a contributor to the volatility by making the market more easily accessible by local investors and by retail and institutional investors in other countries.
In fact, volatility in emerging equity markets rose steadily and significantly in 1994 in Latin America because of the Mexico crisis, levelled off in 1995 and declined dramatically during the course of 1996 and up to the end of May 1997. In Asia, volatility rose from 1.5 to 3 per cent in mid-1994 before returning to its previous low of 1.5 per cent in early 1997. This volatility in emerging equity markets was in contrast to that in the United States, where the volatility of the Standard & Poor's 500 rose consistently in 1996 and 1997. In fact, Asian emerging market volatility dropped below the volatility of the S&P 500 in October 1996. For 1996 and early 1997, as a whole, the rates of return on emerging equity markets rose and their volatility declined. The risk-adjusted rates of return therefore rose dramatically for both Asian and Latin American markets. Meanwhile, in the United States, both the share prices and volatility, as measured by the S&P 500, rose.22
In the bond markets, reflecting both shifts in perceptions of credit risk and the relatively lower liquidity of emerging debt issues, returns on emerging market debt have been considerably more volatile, as measured by the J.P. Morgan emerging markets bond index (EMBI), than those on mature market debt. Moreover, the strong correlation between the level and volatility of spreads, both rising and falling together, reflects shifts in uncertainty of credit risk over the period.23
The volatility in exchange rate markets became unprecedented as the Asian financial crisis struck. At the peak of the crisis, December 1997 - January 1998, the Indonesian rupiah and the Malaysian ringgit had depreciated by 81 and 46 per cent respectively, and the Thai baht and the Korean won by 55 per cent from their pre-crisis levels. Average volatility, as measured by the standard deviation of daily spot exchange rate changes for these currencies, increased by a factor of around 10 in the second half of 1997 compared with the same period of the previous year.
It is clear that volatility in emerging capital markets depends on objective internal and external factors as well as the changes in the perception of the market itself (whether based on fundamentals or speculation). It should be emphasized, however, that while ICT did and continues to contribute to volatility, it is not the only factor underlying observed market fluctuations. For example, financial market volatility has become increasingly pronounced in recent years, along with the trend towards liberalization. This liberalization was in turn facilitated by new applications of ICT which allow international fund transfers to take place in large volume and at great speeds. In general, the factors affecting emerging capital market volatility may be divided into seven groups: interest rates in industrial countries, investors' perception of risks/returns, economic fundamental-induced speculative attacks, the availability and use of hedging instruments, contagion effects, transparency, and other non-economic factors.
The period prior to the Asian crisis was characterized by record private capital inflows into emerging markets. These capital flows reflected a number of factors beyond the role of increased application of ICT mentioned above, in particular the higher yields in these markets relative to the low interest rates in advanced economies. The influx of capital contributed to the compression of the spreads across a wide range of emerging market credit instruments. The spreads on new bond issues, in particular, fell across the board, while maturities lengthened. Among various factors, it was found that sovereign spreads strongly correlated with United States interest rates from early 1993 through early 1996, with a slight lag of three to four months. It may be inferred that the low level of interest rates in the mature markets encouraged investors to transfer funds abroad to invest in emerging markets, such transfers being facilitated by the increased application of ICT. Almost coinciding with the trough in the United States interest rate cycle in November 1994, emerging market spreads also reached their historic low point in January 1995. This correlation continued through 1995, but became somewhat less robust in February 1996, when the average yield spreads on EMBI continued to decline while United States rates began to rise. As the federal fund rates rose further from the third week of March through mid-April, emerging market spreads also rose by around 120 basis points. Immediately prior to the beginning of Asian crisis in July, however, spreads fell by about 75 basis points through May 1997, before rising sharply again.
The second factor affecting emerging market volatility is the perception of investors regarding risks in these markets relative to the rates of return. The generally higher expected rates of return on equity in emerging markets relative to the mature markets have been related to higher price and return volatility. In the bond market, the market rally induced by the relatively cheaper cost of funds encouraged many from the emerging markets to switch to issuing bonds in place of syndicated bank lending. As spreads on new bond issues fell across the board, both existing borrowers and newcomers were attracted to the market to refinance outstanding liabilities on improved terms. In the secondary markets, spreads on emerging market debt, which had been declining since the peak in the spring of 1995 following the Mexican crisis, also continued to decline during 1996,24 raising returns on EMBI from 27 per cent in 1995 to 34 per cent during 1996. These returns were in contrast to sharp declines in returns in the mature markets, with returns on the J.P. Morgan government bond index for the United States dropping to 3.4 per cent in 1996 from a level of 17 per cent in 1995, and returns on the Merrill Lynch high-yield bond index (MLHY) of United States corporate bonds dropping from 20 to 11 per cent.25 By early 1997, as the spreads on emerging market debt reached their recent historic lows (of late 1993 and early 1994), investors' perception of the risk/return trade-off reached a pivotal point in terms of whether these yields had reached their lower limits in adequately compensating for risk. As bond yields fell in the first quarter of 1997, however, the trading volume continued to grow. Spreads then fluctuated until the last week of February 1997, when there was a turning point. Following the market turbulence in Hong Kong, China in late October 1997, spreads increased sharply, particularly as a consequence of international credit rating agencies' downgrading of various emerging sovereign risks. Debts of the Republic of Korea, for example, fell below investment grade, inducing certain institutional investors to cut back on their exposure to these countries. As emerging markets replaced their syndicated loans increasingly by issuing bonds, demand in the international syndicated loan market fell.26 Facilitated by low interest rates in industrial countries and competition among banks, strong credit supply began to exert downward pressures on pricing and weakened loan structures.
Owing to the lower degree of development in foreign exchange hedging markets, there are always concerns about pricing, whether investors are underpricing credit risk, especially in non-traditional sectors, and whether issuers are underestimating exchange rate risk. As the crisis struck, it became evident that interaction between unhedged currency exposures and weaknesses in the financial and corporate sector underscored the extreme fragility of the situation.
One important channel of contagion in the markets has been identified as the growing financial linkages among the Asian emerging markets, these linkages being facilitated by the use of ICT. For example, at the outset of the crisis, deterioration in the asset quality of banks of the Republic of Korea that had lent to a number of South-East Asian emerging markets led to the problems in the liquidity position of those financial institutions and undermined their own ability to cope with capital withdrawals by foreign creditor banks. As the crisis spread to the Republic of Korea in late October, financial institutions of the country began to liquidate these claims, this contributed to the second-round effect on the crisis in South-East Asia.
Within an economy, contagion effects can spread across various financial markets. The high volatility in Asian equity markets, for example, was closely related to the volatility in exchange markets and to uncertainty generated by potentially large exchange rate movements, given substantial amounts of unhedged foreign currency borrowings.
Significant spreads that persist, although with significant fluctuations, between emerging market sovereign debt and American corporate debt instruments can be at least partially attributed to differences in transparency. Since developed country corporations, in particular those in the United States, publish their balance sheets regularly and have a relatively clear legal framework for default and bankruptcy, in contrast to the situation in most developing countries of the region to date, the volatility of perceived credit risk for emerging market enterprises is likely to remain greater than that of American corporations. This affirms the need for greater transparency in developing economies.
This discussion illustrates that the application of ICT is fundamental to the development and growth of emerging markets. The use of ICT has exposed these markets to new groups of investors from around the world. Without this, the developing countries could not have had access to such large volumes of capital, but they were also vulnerable to the risks associated with withdrawal of the funds according to the perceptions and decisions of these investors.
INTERNATIONAL FINANCIAL SYSTEM AND THE USE OF ICT
Despite the advantage of easier access to capital that encouraged many countries to liberalize their trade and capital accounts, the Mexican crisis in late 1994 and the recent crisis in South and South-East Asia have raised concerns about the inherent stability of the international financial system. The financial structure, which has facilitated dramatic increases in productive capital flows, has also exhibited an enhanced capacity to create financial bubbles. The use of ICT has initiated a revolution, clouding the distinction between different types of financial markets and instruments, empowering financial institutions to devise and engage in new varieties of transactions that take advantage of opportunities made possible by the new technology itself, as well as those generated by the synergies and competition among financial activities and institutions.27 Rapid progress in computer and telecommunications technologies has enabled a broad unbundling of risks through innovative financial engineering. This not only allows market participants to isolate and manage risks more effectively, but also enables them to leverage their positions, increasing potential losses and gains relative to their equity, and raising their vulnerability to domino or contagion effects. It also makes the entire system more sensitive, increasingly threatened by the contagion effects through financial linkages and leveraging which arise from the use of derivatives. While the benefits of doing the right things become greater, so do the costs of making even minor mistakes. This can be illustrated dramatically by the enormous cost of adjustment required in the recent Asian crisis.
To avoid harsh market reactions to surprises, there arose the "golden rule" of transparency, which is seen as the key for modern management, economic success and rational behaviour of global markets.28 When there are deficiencies in the information available, the behaviour of creditors is interpreted as revealing important information about borrowers' creditworthiness. These interactions between different classes of creditors contribute to the dynamics of herding behaviour, whereby individual investors are significantly influenced by the actions of other investors. Improvements in the quality, timing and easy availability of information, requiring extensive use of ICT, are supposed to contribute to the reduction in volatility by encouraging a more rigorous assessment of risk. The faster reaction time, permitted by modern applications of ICT, has also accelerated the pace with which capital moves in response to the increasingly subtle differences among returns to investments, domestic and foreign. Thus, the recent financial crises to an important degree reflect a limited human capacity to cope with the vastly increased speed, volume and complexity of financial activities.
Although financial markets are still far from forming a single global market, the level of integration is high enough to strongly affect the conduct and effects of macroeconomic, regulatory and prudential policies in developing countries.29 At the macrolevel, the generalized increase in financial openness, facilitated by the use of ICT, has also made the management of the financial sector and monetary policy a very difficult task. In particular, as reflected in analyses of financial institutions seriously affected by the recent financial crisis in Asia, it has been found that an open capital account did increase the potential of these institutions to become insolvent. New and easier entry of financial institutions, including banks, granted under domestic liberalization processes can lead to a proliferation of financial institutions. Many of these did not have the requisite resources, experience or competence to operate on a sound actuarial basis or to be capable of carrying out satisfactory risk assessment of loans. They consequently accumulated unbalanced portfolios of assets and liabilities and an unsustainable volume of non-performing loans and eventually collapsed. The productive enterprises were also faced with a wider range of opportunities to raise finance but with more instability in costs, leading to concerns about their solvency.30
With floating exchange rates, national monetary authorities have greater independence in choosing their inflation objective.31 Although monetary policy is strongly influenced by international financial markets, increased financial market integration does not appear to have rendered it totally ineffective. Capital markets which are closely linked through increased openness facilitated by the use of ICT have, however, changed monetary transmission mechanisms by enhancing the role of the exchange rate. The greater independence implies greater responsibility under a more difficult environment, which does not necessarily correspond to less volatility or ensure greater security.
In addition to these fundamental effects, however, there are some artificial and perhaps even more harmful impacts that have arisen in modern financial markets, facilitated by ICT. During the Asian financial crisis, for example, hedge funds played an increasingly important role as an engine of contagion in global markets. With their concerted and colluded efforts, volatility can spread from one market to another rapidly and dramatically. This raises an important issue regarding the degree of transparency warranted in a country under speculative attack but also under pressure to reveal every bit of detailed information, which may increase its vulnerability to predatory hedge funds. Analogously, regulations and disclosure requirements of these funds have also become one of the prime issues under discussion in the current international financial reform efforts.
There has also been an increase in both competition and uncertainties that individual financial institutions themselves need to manage through ICT-intensive information, supervision and monitoring systems, while also using ICT to innovate new services or to improve the quality and efficiency of existing ones. In the context of the recent financial crisis in Asia, attempts have been made, with the assistance of multilateral financial institutions, to cope with this new environment. The measures undertaken include reforms in the regulatory and institutional framework of the banking and securities markets as well as improvements in accounting standards and transparency requirements. These reforms should help to increase the effectiveness of monetary policy and management of financial institutions by reengineering inter- and intra-banking transactional networks either in electronic or in physical forms. They require the application of ICT to establish a smooth functioning of financial markets through an effective operational framework for the mobilization of resources from the private sector, decentralization of foreign exchange operations, improved customer service and effective management of liquidity.
Contagion effects can be reduced by assuring the markets that there will be a supply of capital coming forth in the form of either liquidity provided by the lender of last resort or deposit insurance. Such measures, nevertheless, can have the effect of blunting market discipline by inducing moral hazard. This, in effect, is a central issue in the architecture of the future international financial system.32 Any reforms in this direction will rely on using ICT to monitor international capital flows closely to identify potential trouble spots, particularly with respect to short-term debt flows and exposures, in order to provide both regulators and market participants with a clearer basis for making their decisions.33
Given the continuous trend towards a new advanced technology-based international financial system, the levels of complexity within the current financial system are likely to increase even further. In such circumstances, it has been postulated that, in order to avoid prohibitive costs or uninformed interference in the market, government financial regulation is likely to be focused on performing oversight or monitoring functions.34 In the twenty-first century, such regulators will probably need to rely increasingly on private counterparty surveillance to achieve safety and soundness. This highlights the central role of information and ICT even further. Obviously, when well-informed investors are expected to bear the consequences of their own actions, they will seek accurate and reliable information and tend to use it to make better decisions.35 Access to reliable, comprehensive and timely information is perceived as essential, particularly by banking and financial institutions. Within the public sector, national and international policy makers will also need access to better information to guide their actions. This provides the rationale for additional disclosure and transparency rules and an increased application of ICT.
For this purpose, within the current reform efforts, IMF has established and maintained a dissemination standards bulletin board on the Internet, which posts information on the statistical practices of subscribers to the special data dissemination standard36 and on the general data dissemination system, where the focus is more on improvement in data quality. In addition, IMF and its members are also planning to promote wider use of public information notices, the publication of more letters of intent and policy framework papers underpinning Fund-supported programmes, and more information on and public evaluation of the Fund's operations and policies, with constant review of confidentiality.
Other proposals on measures to improve the architecture of the international financial system aim either to prevent crises before they occur or to reduce the scale of future crises.37 Several simultaneous attempts are currently being made to identify and disseminate international principles, standards and codes of best practice on monetary and fiscal policies, and auditing and accounting standards as a means to curtail domestic moral hazard in capital markets. Schemes are also being designed to strengthen the incentives for developing countries to meet these international standards, reinforced by official assistance to help these countries to develop their economic and financial infrastructure. In addition, the Bank of International Settlements is to examine the question of appropriate transparency and disclosure standards for private sector financial institutions involved in international capital flows, such as investment banks, hedge funds and other institutional investors.38 All of these proposals are likely to involve intensive and extensive use of ICT, especially those on accounting and disclosure standards for the collection and dissemination of information. This will require further improvements in the ICT application structures, in particular in central banks and other financial sector regulatory agencies.
In order to strengthen surveillance, IMF is also stepping up its efforts to monitor the financial sector, capital flows and the risks of reversal. It is developing a tiered response for countries that vary in the degrees by which their policies are off course so as to provide appropriate degrees of warning.39 This initiative will need to rely on applications of ICT between IMF and its members.
The crisis in Asia was largely induced by private sector debt and recent policy proposals have therefore been directed towards increasing private sector involvement in crisis prevention and resolution. Proposals have also been put forward regarding the enhancement of good governance and the prevention of corruption. Many of these envisage a role for non-governmental organizations, citizen's movements, transnational corporations, academia and the mass media.40 None of this will be feasible without intensive ICT use.
Thus, while in the financial area it is clear that increasing applications of ICT are a significant force behind recent problems, they are also a very important part of the solutions envisaged.
1 Asian Productivity Organization, National IT Strategies and Economic Development (Tokyo, 1996).
2 Central Vigilance Commission of India, Ordinance 1998, section 8(1)(h)/98(2), New Delhi, 27 November 1998.
3 Retail Banking Research Ltd., The Global ATM Market to 2002 (e-mail: email@example.com).
4 See "The roles of the National Electronics and Computer Technology Centre and the National Information Technology Committee on electronic commerce development in Thailand" by Thaweesak Koanantakool, Director, National Electronics and Computer Technology Centre, Ministry of Science, Technology and Environment, paper presented at the Expert Group Meeting of Trade Promotion Policy Experts, held at Bangkok on 2 and 3 December 1998.
5 IMF, World Economic Outlook (Washington DC, May 1997), p. 60.
6 United States General Accounting Office, Global Financial Markets (Washington DC, 1991), p. 4, cited in A. Picot, C. Bortenlaenger and H. Roehrl, 1995, "The automation of capital markets", Journal of Computer-Mediated Communication, 1 (3) <http://jcmc.hujl.ac.il> (15 July 1998).
7 T. Malone and others, 1987, "Electronic markets and electronic hierarchies: effects of information technology on market structure and corporate strategies", Communications of the ACM, 30 (6): 488-497; and A. Picot, 1986, "Transaktionskosten im Handel: zur Notwendigkeit einer flexiblen Strukturentwicklung in der Distribution", Der Betriebsberater, 13: 1-16, cited in Picot and others, "Automation".
8 The transformation function of price discovery through interaction of the market intermediaries (matching risks, time, place and information) is then supplied by a computer. Within this system, the computer independently quotes the spread in a market maker system, balances out order disequilibria in a hybrid system and assures, within the auction system, a deliberate making of the market for the provisioning of liquidity. (Cited in Picot and others, "Automation".)
9 The United States Cotton Exchange, for example, is undertaking a study on electronically trading United States government debt futures, partly because of competition and the need to reduce trading costs.
10 For example, when NASDAQ was introduced in 1971, the quotation from different market makers could be observed in real time on the screen. Therefore, transparency, reaction time and efficiency of the market greatly improved. See J. Hamilton, 1978, "Market place organization and market ability: NASDAQ, the stock exchange, and the national market system", Journal of Finance, 33: 478-503, cited in Picot and others, "Automation".
11 M. Blume and M. Goldstein, 1995, "On the integration of the US equity markets", University of Pennsylvania, working paper, cited in Picot and others, "Automation".
12 "Value of seats on the major exchanges declines", The New York Times, 12 June 1998.
13 "Philadelphia Exchange to join NASDAQ, AMEX", The Wall Street Journal, 10 June 1998.
14 The share of dollar issuance by all emerging market borrowers rose from 57 per cent in 1995 to 69 per cent in 1996, about the level that it was in the period 1990-1994, despite some shifts in currency composition across regions.
15 Settlement is usually in US dollars to bypass any exchange control imposed by authorities of the respective currencies.
16 For example, on 19 October 1998, Japanese securities companies began offering on-line trading services using the Internet (see "Japan seems ripe for on-line trading", International Herald Tribune, 22 October 1998). It was anticipated that the shift would cause lower trading fees and a dramatic increase in the number of Internet users (traders).
17 A block trade is defined at the New York Stock Exchange as greater than 10,000 shares. The figures are quoted from J. Shapiro, 1993, "US equity markets: a view of recent competition development", New York Stock Exchange working paper, cited in Picot and others, "Automation".
18 Picot and others, "Automation".
19 For example, in the context of the Asian crisis, the price of houses and properties would have declined earlier and more rapidly if the real estate agents had honestly informed all their potential customers that there was a glut in the market. Analogously, when a car dealer tells his potential customer of his unusually large stock, his customer's bargaining power is strengthened, resulting in a price reduction.
20 A. Rottenbacher, Die Zukunftsaussichten deutscher Boersen (Berlin, 1991), p. 37, cited in Picot and others, "Automation".
21 This section is based on IMF, International Capital Markets: Developments, Prospects, and Key Policy Issues (Washington DC, 1997), pp. 61-92; and World Bank, Global Development Finance (Washington DC, 1998), pp. 3-5.
22 As well as the higher volatility of returns, however, there are a number of other sources of risk in investing in emerging equity markets. These include inadequate accounting and disclosure practices, limited information, settlement and legal risks, and limited liquidity in some emerging markets.
23 As both spreads and volatility of emerging market debt declined, movements in the ratio of yields to volatility became more modest. After declining in early 1995, the ratio has fluctuated around a little less than one. It is important to note, however, that the ex post volatility of returns captures only market risk, and though this includes volatility in returns induced by changes in perceptions of credit risk, it does not capture the level of credit risk. The behaviour of such ratios for bonds with default risk can therefore be misleading.
24 Spreads refer to yield differentials relative to comparable government securities in that currency. Spreads in EMBI are relative to United States treasury bonds.
25 MLHY is an index of high-yield United States corporate bonds that are rated below investment grade. All of the sovereigns in EMBI were rated below investment grade during 1996.
26 This was reflected by the fact that significant amounts of loans were refinanced, accounting for almost a fifth of new syndications of medium-term and long-term loans in 1996.
27 Remarks made by Laurence H. Meyer before the Financial Institutions Practice Group, The Federalist Society, Washington DC, 12 November 1998.
28 Michel Camdessus, "Toward a new financial architecture for a globalized world", address to the Royal Institute of International Affairs, London, 8 May 1998.
29 IMF, World Economic Outlook (Washington DC, May 1997), p. 65.
30 For earlier discussions of this topic, see Survey 1995, chapter IV.
31 IMF, World Economic Outlook (Washington DC, May 1997), p. 66.
32 Lawrence H. Summers, "Building an international financial architecture for the twenty-first century", keynote address to the CATO Institute's 16th Annual Monetary Conference, Washington DC, 22 October 1998.
33 Stanley Fischer, "Economic crises and the financial sector", paper presented to the Conference on Deposit Insurance, Washington DC, 10 September 1998.
34 Remarks by Alan Greenspan on the structure of the international financial system at the Annual Meeting of the Securities Industry Association, Boca Raton, Florida, 5 November 1998.
35 Remarks by Robert E. Rubin on strengthening the architecture of the international financial system, at the Brookings Institution, 14 April 1998.
36 Including both gross and net reserves, as well as reserve-related liabilities and central bank derivative transactions and positions, together with external debt and data on banking and financial sector health. At mid-October 1998, there were 47 subscribers (developed and developing countries), of which 15 are linked to country data sites on the Internet.
37 See chapter I of the present volume for more details.
38 Declaration of G7 Finance Ministers and Central Bank Governors, 30 October 1998.
39 Michel Camdessus, "From the Asian crisis toward a new global architecture", address to the Parliamentary Assembly of the Council of Europe, Strasbourg, France, 23 June 1998.
40 Our Global Neighbourhood, report of the Commission on Global Governance, 1997 <http://www.cg.ch> (30 November 1998).