Poverty and Development Division
last updated : 20 December 1999
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.
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.
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