(the New York University Salomon Center Series on Financial Markets and Institutions 2) Timothy J. Kehoe (Auth.), Richard M. Levich (Eds.)-Emerging Market Capital Flows_ Proceedings of a Conference He

EMERGING MARKET CAPITAL FLOWS
The New York University Salomon Center Series

on Financial Markets and Institutions
VOLUME 2
The titles published in this series are listed at the end of this volume.
EMERGING MARKET
CAPITAL FLOWS
Proceedings of a Conference held at the Stern
School of Business, New York University on
May 23-24, 1996
Edited by
RICHARD M. LEVICH
Stern School of Business

New York University
S'f'ER:N.
Leonard N. Stern School of Business ,
Springer Science+Business Media, B.V.

A C.I.P. Catalogue record for this book is available from the Library of Congress
ISBN 978-1-4613-7841-9 ISBN 978-1-4615-6197-2 (eBook)

DOI 10.1007/978-1-4615-6197-2
Printed on acid-free paper
All Rights Reserved

1998 Springer Science+ Business Media Dordrecht
Originally published by Kluwer Academic Publishers in 1998
Softcover reprint of the hardcover 1st edition 1998
No part of the material protected by this copyright notice may be reproduced or
utilized in any form or by any means, electronic or mechanical,
induding photocopying, recording Of by any information storage and
retrieval system, without written permission from the copyright owner.
Table of contents
Acknowledgments . ix
Introduction
Richard M. Levich Xl
Part I The history of emerging markets: what have we learned? 1

1. Can debt crises be prevented?
Timothy J. Kehoe. . . . . . . . . . . . . . 3
2. Dealing with capital inflows: Mexico and Chile compared
Andres Velasco and Pablo Cabezas. . . . . . . . . 23
3. International lending in the long run: motives and manage-
ment
Barry Eichengreen . . . . . . . . . . . . . . 49
Discussion:
Philip Suttle. . . 75
Michael P. Dooley 79
Part II. Returns on emerging market equities 83

4. Rethinking emerging market equities
Roy C. Smith and Ingo Walter . . 85
5. The behavior of emerging market returns
Geert Bekaert, Charles B. Erb, Campbell R. Harvey and
Tadas E. Viskanta. . . . . . . . . . . . . . . 107
6. Cross-listing, segmentation and foreign ownership restrictions
Ian Domowitz, Jack Glen and Ananth Madhavan 175
Discussion:
William N. Goetzmann and Philippe Jorion' 193
Stijn Claessens . . 199
Rene Garcia. . . 207
Vihang R. Errunza 211
Part III. Integration of emerging markets and international equity

markets . . . . . . . . . . . . . . . . . . 217
7. Determinants of emerging market correlations
Holger C. Wolf. . . ...... . 219
v
vi Table of contents
8. A Markov switching model of market integration

Robert E. Cumby and Anya Khanthavit . 237
9. External financing in emerging markets: an analysis of
market responses
Kishore Tandon 259
10. Political risk in emerging and developed markets
Robin L. Diamonte, John M. Liew, and Ross L. Stevens 277
Part IV. Lending on 'fixed' terms in emerging markets: bank lending

and sovereign debt. . . . . . . . . . . . . . . 291
11. Cross-border emerging-market bank lending
Peter Aerni and Georg Junge. . . . . . . . . . . 293
12. Hedging the interest rate risk of Bradys: the case of
Argentinian fixed and floating-rate bonds
Dong-Hyun Ahn, Jacob Boudoukh, Matthew Richardson,
and Robert F. Whitelaw . . . . . . . . 307
13. Country and currency risk premia: evidence from the
Mexican sovereign debt market 1993-1994
Ian Domowitz, Jack Glen, and Ananth Madhavan . 319
14. Emerging-market debt: practical portfolio considerations
Robert J. Bernstein and John A. Penicook, Jr.. . . . 335
Discussion:
Kenneth Rogoff 371
Martin D. Evans 375
Richard Cantor 381
Lawrence Goodman 385
Part V. Topics in corporate debt and emerging markets. 389

15. Emerging-market corporate bonds - a scoring system
Edward I. Altman, John Hartzell and Matthew Peck 391
16. Proposal for a new bankruptcy procedure in emerging mar-
kets
Oliver Hart, Raphael La Porta Drago, Florencio Lopez-de-
Silanes and John More . . . . . . . . . . . . . 401
Discussion:
Gordon M. Bodnar . 421
William J. Chambers. 425
Lemma W. Senbet 433
List of contributors 443
Index . . . . . 461
List of contributors
P. AERNI c.B. ERB

University of Basel First Chicago Investment
Management Co.
D.H.AHN
University of North Carolina, V.R. ERRUNZA
Chapel HilI McGill University
E.1. ALTMAN M.D. EVANS
New York University Georgetown University
G. BEKAERT R. GARCIA
Stanford University University of Montreal
R.I. BERNSTEIN J. GLEN
Brinson Associates International Finance Corporation
G.M. BODNAR W.N. GOETZMAN
The Wharton School Yale University
J. BOUDOUKH L. GOODMAN
New York University Salomon Brothers Inc.
P.CABEZAS
O.HART
New York University
Harvard University
R. CANTOR
J. HARTZELL
Federal Reserve Bank of New York
Salomon Brothers Inc.
W.I. CHAMBERS
Standard & Poors C. HARVEY
Duke University
S. CLAESSENS
World Bank P. JORION
University of California at Irvine
R.E. CUMBY
Georgetown University G. JUNGE
Swiss Bank Corporation
R.L. DIAMONTE
GTE Investment Management T.J. KEHOE
University of Minnesota
I. DOMOWITZ
Northwestern University A. KHANTHAVIT
Thammasat University (Bangkok)
M.P. DOOLEY
University of California at J.M. LIEW
Santa Cruz Goldman Sachs
B. EICHENGREEN R. LA PORTA DRAGO
University of California at Berkeley Harvard University
Vll
viii List of contributors
R.M. LEVICH R.C. SMITH

New York University New York University
F. LOPEZ-DE-SALINAS R.L. STEVENS
Harvard University Goldman Sachs
A. MADHAVAN P. SUTTLE
University of Southern California J.P. Morgan
J. MOORE K. TANDON
London School of Economics City University of New York
T.E. VISKANTA
M. PECK
First Chicago Investment
Management Co.
J.A. PENICOOK, Jr. A. VELASCO
Brinson Partners, Inc. New York University
M. RICHARDSON I. WALTER
New York University New York University
K. ROGOFF R.F. WHITELAW
Princeton University New York University
L.W. SENBET H.C. WOLF
University of Maryland New York University
Acknowledgements
This volume presents the proceedings of a conference held at the Stern School
of Business, New York University on May 23-24, 1996. It is a pleasure to
thank Edward Altman and Jianping Mei for their assistance in planning the
conference, and also to thank Ingo Walter, the Director of the NYU Salomon
Center, for encouraging us to undertake this conference. We also thank Brinson
Partners, Inc. and Salomon Brothers Inc for their financial sponsorship of the
conference. Thanks are also due to Mary Jaffier who efficiently handled the
numerous administrative arrangements for the conference. Finally, we thank
the authors of the papers and the discussants for contributing their energy to
this project, and bearing with us until the completion of this conference volume.
IX
RICHARD M. LEVICH
New York University
Introduction
In a little over one decade, the spread of market-oriented policies has turned
the once so-called lesser developed countries into emerging markets. In 1982,
the 32 developing country stock markets surveyed by the International Finance
Corporation had a market capitalization of $67 billion representing about
2.5% of world market capitalization. By the end of 1995, the market capitaliza-
tion of emerging stock markets had grown 28-fold, exceeding $1.9 trillion or
10.7% of world equity market capitalization.
Many forces have been responsible for the tremendous growth in emerging
markets. Trends toward market-oriented policies that permit private ownership
of economic activities, such as public utilities and telecommunications, are part
of the explanation. Corporate restructuring, following the debt crisis of the
early 1980s, has permitted many emerging-market companies to gain interna-
tional competitiveness. And an essential condition, a basic sea-change in eco-
nomic policy has opened up many emerging markets to international investors.
The growth in emerging markets has been accompanied by volatility in
individual markets, and a sector-wide shock in 1995 after the meltdown in the
Mexican Bolsa and Mexican peso. This experience led some economists to
question the economic fundamentals underlying emerging markets, suggesting
instead that the surge in emerging-market capital flows was the sign of a
speculative asset bubble - the sort of fad, or mania that cannot be sustained.
At the same time, other economists argued that emerging markets were a fully
credible and permanent element of international capital markets, albeit a sector
with special risk considerations.
Emerging-market capital flows continue to be the subject of intense discus-
sion around the world among investors, academics, and policymakers. This
book examines the issues of emerging-market capital flows from several distinct
perspectives. The research papers in this volume address a number of related
questions about emerging markets, including:
What have we learned from the history of emerging-market capital flows
with respect to market performance, stability and impact on economic
growth?
What are the return characteristics of emerging-market equities and how
do they affect capital flows? How do emerging-market risks and diversifica-
tion opportunities change over time?
What are the benefits of international cross-listing of securities?
How closely are emerging and developed equity markets integrated?
What are the impacts of political risk in emerging markets?
Xl
xii Introduction
How should we determine the pricing of emerging-market bank loans and

sovereign debt? What is the relationship between emerging-market debt and
equity flows?
How should we determine the credit ratings of emerging market corporate
debt? Are the procedures for bankruptcy in emerging markets adequate, or
are they in need of reform?
How will emerging markets cope with rising or volatile capital flows? What
are the prospects for emerging markets over the remainder of this century?
This book is divided into five parts. The papers in Part I focus on the recent
history of emerging markets. Timothy Kehoe examines the macroeconomic
foundations of debt crises in order to analyze the determinants of debt crises
and to assess whether crises can be prevented or predicted. Andres Velasco
and Pablo Cabezas analyze how the policies toward capital inflows in
Mexico and Chile effected macroeconomic conditions in each country, and the
severity of each country's experience with debt crises. Barry Eichengreen takes
a longer-term perspective on the ongoing role of lending in international
development, and how both borrowing and lending countries can cope with
their inescapable capital market linkages.
In Part II, we present several papers that investigate the pattern of equity
market returns in emerging markets. Ingo Walter and Roy Smith offer an
overview of the performance of emerging-market equity risk and returns in
comparison to developed country markets. Geert Bekaert, Charles Erb,
Campbell Harvey and Tadas Viskanta contribute an in-depth analysis of the
pattern of returns, and the statistical distribution of returns in emerging equity
markets. The authors suggest that emerging-market returns are more variable
and harbor additional elements of risks than are typical of developed equity
markets. Ian Domowitz, Jack Glen and Ananth Madhavan examine the extent
to which cross-listing of securities can help to overcome barriers that would
otherwise segment emerging markets from developed equity markets.
In Part III, our attention turns toward the integration of global equity
markets. Returns across emerging markets could be correlated because they
are exposed to similar fundamental macroeconomic factors, or because of
market sentiment that drives investors into (or out of) all emerging markets
as if by contagion. Holger Wolf investigates these sources of correlation among
emerging-market returns and finds that there is only a small role for contagion
effects. Robert Cumby and Anya Khanthavit model the relationship among
three emerging equity markets (Thailand, Taiwan, and Korea) as a Markov
process, whereby market integration is allowed to switch between a low
co-variance regimen and a high covariance regime. The authors find some
support for the model, yet it appears that equity returns in these markets are
too high to be consistent with a simple capital asset pricing model in an
integrated world equity market.
Kishore Tandon investigates another aspect of integration, namely whether
companies whose stocks are cross-listed enjoy better access to debt markets
through the Eurobond market. And finally, Robin Diamonte, John Liew and
Introduction xiii
Ross Stevens analyze the relationship between political risk variables and
returns in emerging equity markets.
In Part IV, we turn to examine lending to emerging markets through bank
lending and sovereign debt issues. Peter Aerni and Georg Junge survey the
developments in cross-border bank lending to emerging markets. The pricing
and hedging of interest rate risk inherent in Brady bonds is analyzed in a paper
by Jacob Boudoukh, Matthew Richardson, and Robert Whitelaw. Estimates
of the country and currency risk premia represented in Mexican sovereign debt
are the focus of a paper by Ian Domowitz, Jack Glen and Ananth Madhavan.
And Robert Bernstein and John Penicook explore the practical aspects of
portfolio investment in emerging-market debt securities.
Finally, in Part V we present two papers dealing with aspects of corporate
debt in emerging markets. Edward Altman, John Hartzell, and Matthew Peck
analyze the methods for assessing risk ratings on corporate debt from emerging
markets. And Oliver Hart, Raphael La Porta Drago, Florencio Lopez-de-
Salinas, and John Moore describe an alternative, market-based approach to
bankruptcy proceedings in emerging markets, and assess the pros and cons of
their approach relative to existing bankruptcy procedures.
This conference volume, in the tradition of the New York University
Salomon Center, presents original thematic papers written by academic, govern-
ment, and industry observers of emerging markets around the world, with
discussants drawn from international banking and securities practitioners and
government regulators. We hope that this book offers the reader a valuable
window on the economic and financial research and policies issues that effect
this important, fast growing segment of the global financial market.
PART ONE
The history of emerging markets:

What have we learned?
TIMOTHY J. KEHOE
Department of Economics. University of Minnesota
1. Can debt crises be prevented?*
INTRODUCTION
The financial crisis in Mexico in late 1994 and early 1995 came as a surprise
to most observers, not so much because there was a major devaluation of the
peso, but because the aftermath of this devaluation left the Mexican financial
system and economy in a crisis from which it only in 1996, more than a year
later, started to recover. The conventional wisdom, as presented by, for example,
Dornbusch and Werner (1994), was that a devaluation was exactly what Mexico
needed to spur exports and growth. Instead, the devaluation occurred more or
less simultaneously with (and perhaps touched off) a debt crisis in which the
Mexican government found itself unable to roll over its debt. Fears of a default
of one sort or another totally paralyzed the economy in late December 1994
and January 1995. An explanation of the Mexican crisis that focuses on
Mexico's government debt has a puzzling aspect, however: in 1994 Mexico had
a very low ratio of government debt to national product by international
standards (see Table 1).
Table 1. Debt/GDP percentages for selected countries
1990 1991 1992 1993 1994
Mexico 55.2 45.8 35.1 35.0 37.4

Belgium 130.7 132.6 134.4 141.3 140.1
France 40.4 41.1 45.6 52.9 56.8
Germany 43.4 42.7 47.3 51.8 54.6
Greece 77.7 81.7 88.6 117.1 119.8
Italy 100.5 103.9 111.4 120.2 122.6
Spain 48.7 49.9 53.0 59.4 63.5
Source: International Monetary Fund and Organization for Economic Cooperation and
Development.
* The research reported here has been supported by a grant from the Air Force Office of
Scientific Research, Air Force Materiel Command, USAF, under grant number F49620-94-1-0461.
The US government is authorized to reproduce and distribute reprints for government purposes
not withstanding any copyright notation thereon. The views expressed herein are those of the
author and not necessarily those of the Air Force Office of Scientific Research or the US government.
3
R. Levich (ed.), Emerging Market Capital Flows, 3-22.
< 1998 Kluwer Academic Publishers.
4 T.J. Kehoe
This paper traces the events in 1994 that left Mexico vulnerable to a debt
crisis - the steady conversion of government debt into short-term, dollar-
indexed tesobonos. This conversion seems to have been the result of an
agreement, both implicit and explicit, between the Mexican government and
members of the international financial community.
The paper also proposes a theoretical framework, based on a model devel-
oped by Cole and Kehoe (1996b), for identifying situations in which a debt
crisis can occur. The essential feature of this framework is that there is an
interval of levels of government debt, called the crisis zone, which depends
heavily on the maturity structure of the debt, for which a crisis can occur.
Furthermore, the framework formalizes the idea of 'herd behavior' of investors
often discussed in the popular press: investors feared that Mexico would be
unable to honor its commitments on government bonds becoming due. This
made these investors unwilling to purchase new bonds. Since these fears were
widespread, Mexico was unable to sell new bonds and, consequently, was in a
position where default of some sort seemed inevitable. This situation then
justified the expectations that Mexico would be unable to honor its commit-
ments. Had these expectations not been present, however, no crisis would have
occurred.
This theoretical framework suggests an accounting methodology for calculat-
ing the size of the crisis zone. Identifying situations in which debt crises can
occur potentially goes a long way towards eliminating the possibility of such
a crisis, since governments would then face strong pressures from financial
markets to stay out of the crisis zone. The theoretical framework also suggests
a significant potential role for an international lender oflast resort which would
sharply limit the possibility of debt crises in a manner similar to that in which
a central bank can limit the possibility of runs on private domestic banks. As
recent banking crises in such countries as Japan and the USA have illustrated,
however, it is essential that a central bank serve as regulator as well as lender
of last resort. Similarly, any international agency that would serve as lender of
last resort should be willing to provide this service only at the price of being
able to regulate government financial policy.
OVERVIEW OF THE MEXICAN FINANCIAL CRISIS
What went wrong in Mexico in 1994 was a combination of an unprecedented

sequence of shocks to the Mexican political and economic system together
with government policies that treated these shocks as transitory. It is easy now
to identify these policies as errors. If a less adverse sequence of political and
economic shocks had buffeted Mexico in 1994, however, these policies would
probably now be regarded as successes.
In 1994, faced with political instability, a dramatic increase in short-term
US interest rates, upcoming elections, a fragile domestic banking sector, and
plummeting foreign portfolio investment, the administration of President
Can debt crises be prevented? 5
Carlos Salinas de Gortari made two decisions that resulted in the financial
crisis: first, it allowed the Mexican peso only a small devaluation (a nominal
12%) against the US dollar over the course of the year, and in maintaining
the value of the peso, without adjusting its monetary policy, it lost most of
Mexico's foreign reserves. Second, as the Salinas administration refinanced
Mexico's government debt during 1994, it allowed the debt to become mostly
short-term and dollar-indexed.
The combination of these two decisions left Mexico open to a speculative
attack, when investors realized that the Banco de Mexico did not have enough
reserves to continue supporting the peso, and shortly afterwards, a 'bank run',
when bond holders realized that the Banco de Mexico did not have enough
reserves to meet the payments becoming due on the dollar-indexed debt.
In 1994, as it had in 1992 and 1993, Mexico ran a large current account
deficit. What changed in 1994 was the level of foreign portfolio investment
(Figure 1). 1994 was a difficult year politically for Mexico: there was an uprising
in Chiapas in January; the presidential candidate of the ruling Partido
Revolucionario Institutional (PRI), Luis Donaldo Colosio Murrieta, was assassi-
nated in March; the Secretary of the Interior, Jorge Carpizo McGregor, who
had been encharged with ensuring honest elections in August, threatened to
resign in June; the Secretary General of the PRI, Jose Francisco Ruiz Massieu,
was assassinated in September; Ruiz Massieu's brother Mario resigned as
assistant attorney general in November, charging a high-level coverup of the
35,---------------------------------------------------------,
30
DIRECT PLUS
PORTFOLIO INVESTMENT ___ "
25
,
<I> 20
,
~
0'5
ui
::i
~
II) '0
"Of-'9-e-,-+-'-98-2-+-'-98-3-+---'984---">-'98-5-+--'98-6-+-'9-87-+-'-98-8-+-'-98-9-+---'990-i--'99-'-+-":"'9":"92-+--:-'99:::3::-+-:'994:::-:-'
Figure 1. Foreign investment in Mexico.

Source: IMF, Balance of Payments Statistical Yearbook, various issues.
6 T.1. Kehoe
assassination within the PRI; and there were threats of new uprisings in Chiapas
in November and December.
The political uncertainty generated by these events, combined with rising
interest rates that made the USA a more attractive investment target, resulted
in a substantial drop in foreign investment: foreign portfolio investment in
Mexico fell from US$ 28.4 billion in 1993 to US$ 8.2 billion in 1994. (It is
worth noting, however, that foreign direct investment actually rose from
US$ 4.9 billion to US$ 8.0 billion.)
Perhaps even more significantly, there were presidential elections in August,
with the new president, Ernesto Zedillo Ponce de Leon who had replaced
Colosio as the PRI candidate, taking office in December. The change of
government was, as it has been every 6 years in Mexico since 1928, a time of
great uncertainty. At the end of each of the previous three administrations -
in 1976, 1982, and in 1987 - there had been large devaluations. Mexicans and
foreign investors had come to associate ends of presidential terms with
devaluations.
In the face of the drop in foreign investment, the Salinas administration
continued to maintain the value of the peso against the dollar. There were
good reasons to do so, at least during the first half of 1994. A series of social
pacts negotiated between leaders of government, business, and labor had, since
1987, set a policy of a maximum allowable rate of depreciation of the peso
against the dollar. This policy had resulted in a decline in the rate of inflation
in Mexico from 159.2% in 1987 to 7.1 % in 1994. At the same time real wages,
which had fallen sharply following the 1982 financial crisis, rose by more than
20% between 1987 and 1994.
To the extent to which the Salinas administration believed that the shocks
that buffeted Mexico in 1994 were transitory, it was justified in selling the
Banco de Mexico's foreign reserves to insulate Mexico from these shocks. At
the same time that Mexicans and foreigners were selling pesos for dollars, the
Banco de Mexico was sterilizing by reissuing the pesos. This policy was designed
to promote a stable money supply and interest rates. With elections due in
August, it is easy to understand why these sorts of policies were attractive
during the first three-quarters of 1994.
Policy judgements often involve calculated risks, and poor judgements are
far easier to identify if there is a run of bad luck than if there is not. As political
shocks continued to hit Mexico during the fall of 1994, foreign reserves fell to
dangerously low levels. November was a crucial month: it was in November
that foreign reserves fell below the Mexican monetary base, and on
November 18 alone the Banco de Mexico had to sell US$ 1.7 billion to maintain
the value of the peso.
MONETARY POLICY AND THE LOSS OF RESERVES
Figure 2 traces out the behavior of foreign reserves held by the Banco de
Mexico during 1994. It is worth noting that the Banco de Mexico made
~r-------~~------------------------------------------.
25
DEC JAN FEB MAR APR MAY JUN JUI. AUG SEP OCT NOV DEC
1993 1994
Figure 2. Mexican international reserves. December 1993-December 1994" .

Daily data.
Source: Mancera, Wall Street Journal, 31 January 1995.
significant interventions in the peso/dollar markets only during six, relatively

brief periods: 19 January-ll February, following Mexico's entry into NAFTA,
when despite the uprising in Chiapas, the Banco de Mexico had to buy US$ 4.2
billion to keep the value of the peso down; 25 March-21 April, following the
Colosio assassination, when it had to sell US$ 10.4 billion to keep the value
of the peso up; 23 June-12 July, during the uncertainty over the Carpizo
resignation, when it sold US$ 2.7 billion; 14-23 November, during Mario Ruiz
Massieu's allegations of a coverup of his brother's assassination, when it sold
US$ 3.6 billion; 15-19 December, during threats of a new uprising in Chiapas,
when it sold US$ 1.8 billion; and 20-21 December, during the first stage of the
devaluation, when it sold US$ 4.6 billion. During these six periods the Banco
de Mexico intervened on a total of 53 days. During all of the rest of 1994 the
Banco de Mexico only intervened on 18 days, selling a total of US$ 1.2 billion.
(All of these data are taken from Banco de Mexico, 1995.)
Figure 3 illustrates the response of monetary policy to the decline in reserves:
the Banco de Mexico sterilized, in January and February, by contracting
domestic credit to keep the money supply down as it sold pesos for dollars,
and, later, by expanding domestic credit to keep the money supply up as it
bought pesos with dollars. This policy helped insulate the Mexican domestic
economy, in particular the banking industry, from a sharp decline in the money
supply that would have otherwise resulted from the drop in foreign portfolio
investment. In 1994, the Mexican banking industry, which had expanded rapidly
following its privatization in 1991, was in fragile condition: non-performing
loans had risen from 2.3% of total loans in 1990 to 9.5% by the end of 1994.
One way in which the Banco de Mexico expanded domestic credit during
1994 was through loans to the seven national development banks, pricipally,
Nacional Financiera (NAFIN), which makes loans to small- and medium-sized
8 T.J. Kehoe
1ro,~--------------------------------------------------------,
~---------~,~----------------------~-
140
MONEY SUPPlY (M1)

120
;,-...-- ....
," --,
........ " "
,,
....
\ RESERVES
~---.---.---.---.--- '"
40
MONETARY BASE
20
o
"
D lot lot A S N D
1993 1994
Figure 3. Mexican international reserves vs. money supply. December 1993-December 1994.
Source: Secretaria de Hacienda y Credito Publico.
enterprises; Banco Nacional de Comercio Exterior (BANCOMEXT), which

finances foreign trade activities; and Banco Nacional de Obras y Servicios
Publicos (BANCOBRAS), which finances state and municipal projects.
Between 1992 and 1994 the development banks' credit outstanding rose from
2.5% of Mexican GDP to 4.0%.
In retrospect, Mexican monetary policy during 1994 can be viewed as a
calculated gamble: the Salinas administration reacted to the shocks that led to
falls in foreign portfolio investment as though each shock was the last that
would occur. In particular, it ran down foreign reserves in an effort to keep
both the exchange rate and the domestic money supply constant. Unfortunately,
the shocks kept occuring and, absent a sharp tightening of monetary policy in
the fall of 1994, Mexico was eventually forced to let the peso devalue.
DEBT MANAGEMENT AND THE DEBT CRISIS
Mexican government debt can be divided into two broad categories: domestic
and external. This division has nothing to do with who holds the debt; rather
it depends on where it is sold. Domestic debt is sold at auctions held by the
Banco de Mexico, while external debt is sold abroad. The debt crisis was
caused by a run on domestic debt. Although yields on such external debt
instruments as Brady bonds increased sharply on secondary markets during
the crisis, Mexican external debt has a long maturity structure. The immediate
danger of default was the result of the short maturity structure of the domes-
tic debt.
Table 2 traces the evolution of composition of Mexican domestic government
debt during 1994. There were four types of debt instruments: certificados de fa
tesoreria de fa federaci6n (cetes), peso-denominated bonds with maturities of
28,91, 182,364, and 728 days; tesobonos, dollar-indexed bonds with maturities
of91, 182, and 364 days; bonos de desarrollo (bondes), peso-denominated bonds
with maturities of 1, 2, and 10 years; and ajustabonos, inflation-indexed, peso-
denominated bonds with maturities of 3 and 5 years.
Following the assassination of Colosio in March, the Mexican government
steadily converted its domestic debt from peso-denominated cetes, bondes and
ajustabonos into dollar-indexed tesobonos, as depicted in Figure 4. In the second
week of March 1994, due to uncertainty about the situation in Chiapas and a
possible independent presidential campaign by Manuel Camacho Solis, who
had been edged out as the PRI candidate by Colosio, the peso had begun to
fall against the dollar. The assassination accelerated this fall, and the peso
moved from the bottom to the top of its trading band, devaluing by almost
8% over a month. This drop in the value of the peso led to a sharp increase
in Mexican interest rates with a resulting drop in the prices of Mexican bonds
and equities. According to Torres and Vogel (1994), much of this movement
into tesobonos was the result of discussions between representations of the
Weston Forum, a group of New York investment funds, and officials of the
Mexican Finance Secretariat and the Banco de Mexico.
To understand the importance of the move of Mexican debt into tesobonos,
it is worth understanding how these bonds worked. Tesobonos were sold by
the Banco de Mexico in weekly auctions. The Banco received bids in US
Table 2. Outstanding domestic government debt in Mexico 1994 (billion $US)*
Month Cetes Tesobonos Bondes Ajustabonos Total
January 24.07 2.43 5.22 10.82 42.54

February 26.68 2.57 5.35 10.63 45.23
March 22.04 4.10 4.07 9.64 39.85
April 13.06 10.15 2.19 8.64 34.04
May 13.61 11.94 2.11 8.23 35.89
June 12.47 12.99 2.32 7.69 35.47
July 10.34 16.40 2.04 6.83 35.61
August 9.40 19.47 1.36 6.24 36.47
September 9.15 18.69 2.00 5.94 35.78
October 9.35 17.55 1.82 5.46 34.18
November 7.34 18.62 1.14 5.22 32.32
December 3.94 21.55 0.58 3.31 29.38
Source: Banco de Mexico (1995) and International Monteary Fund, International Financial
Statistics, various issues.
Market values converted to $US (in the case of cetes, bondes and ajustabonos) using the exchange
rate at the end of the month.
10 T.]. Kehoe
~r------------------------------------------------------'
35
PESO DENOMINATED BONDS
., ....
....., , ,
,,
.... _.. RESERVES '"
,,
,
.. --- .. _--
10
TESOBONOS
D M A M A s o N D
11193 1994
Figure 4. Mexican international reserves vs. Government bonds. December 1993-December 1994.
dollars at 9:30 am on Tuesdays. An 11:00 am fix of the peso--dollar exchange

rate determined the peso value of those bids. On Thursdays payments and
deliveries were made. Tesobonos were sold in maturities that were multiples of
7 days, but most were 91-day bonds. The weekly calendar for settlements was
the same as that for sales: the peso value of maturity debt was determined by
the 11:00 am Tuesday fix, and payments were made on Thursdays.
The movement away from peso-denominated debt into dollar-indexed debt
helped to shield debt holders from exchange rate risk. It also allowed the
Mexican government to borrow at substantially lower interest rates, as shown
in Figure 5. The movement in the composition of the debt had two adverse
effects on Mexican government finances, however: it exposed the government
to far more exchange rate risk, and it sharply reduced the already short maturity
structure of the debt (see Table 3).
Following the 20-22 December devaluation, rumors abounded that the
Mexican government would impose dual exchange rates, paying off tesobonos
at an official rate lower than the market rate. It did not take too long a memory
to recall that the Mexican government had resorted to similar policies during
the 1982 financial crisis. The tesobono auctions of 27 December, 3 January and
10 January were complete failures: the Banco de Mexico was able to sell only
US$ 143 million worth of bonds out of US$ 1.5 billion offered.
In retrospect, it is difficult to rationalize Mexican debt management during
1994. The policy of converting peso-dominated debt into dollar-indexed debt
exposed the Mexican government to substantial exchange rate risk. This policy
M,--------------------------------------
30
25
MEXICAN 91 OA Y CETES
~~----
'0 MeXICAN 364 DAY TESOSONOS ./ I
I.4EXICAN 91 CAY TESOSONC>S / ..... - - - / -

~ ~-------------..- - - - ; '
- ~- -- -- .".. - - - - - ......... - ~- - - - - - ..~ - - ... '" -- - --
5 ----,-,_/~--.... 1/ _ _ _ _ _ _- - - - - - - -
_ _ _ _ _ _ _ _ _ ..~----.-.------~ T.sILLS
______ ____ __
....
o~~~ ~ ~ ~~
D J A A o D
.993
Figure 5. Interest rates Mexican-US Government bonds. December 1993-December 1994.

Source: Bloomberg Financial Market.
Table 3. Average maturity of domestic government debt in Mexico 1994 (days)
Month Cetes Tesobonos Bondes Ajustabonos Average*
January 161.1 72.5 317.6 740.8 322.7

February 168.7 82.1 317.5 772.5 323.3
March 164.3 87.5 299.8 809.6 326.3
April 150.3 71.6 266.8 856.9 313.7
May 155.2 125.1 248.0 865.9 313.6
June 156.7 120.5 208.8 878.4 303.3
July 158.8 136.4 213.4 880.6 290.1
August 156.7 155.9 249.9 896.8 286.4
September 149.4 155.8 171.0 881.2 275.4
October 146.0 166.5 172.1 837.7 268.4
November 144.3 158.2 191.9 838.9 266.2
December 147.0 138.4 176.0 841.3 219.5

* Weighted average using weights from Table 2.
made sense only if the Mexican government had private information that the
risk of devaluation was lower than financial markets thought that it was. The
sale of tesobonos demonstrated a confidence on the part of the government
that later events proved unjustified and that, in any case, financial markets did
not share.
12 T.J. Kehoe
MODELING SELF-FULFILLING DEBT CRISES
Cole and Kehoe (1996b) present a formal model that captures the intuition
that the Mexican debt crisis was self-fulfilling in the sense that the failure of
the government's auctions of new debt put the government into a position
where default seemed inevitable, thereby justifying the panic that led to the
failure of the auctions. This model and relevant results are described in the
appendix.
The model has three types of actors: domestic consumers, who make con-
sumption and investment decisions; foreign investors, who purchase govern-
ment debt and are risk neutral, reflecting the small size of the country relative
to world capital markets; and a government, which taxes, spends on public
goods, offers new bonds for sale, and decides whether or not to honor commit-
ments on old bonds. The central actor in the model is the government. Cole
and Kehoe (1996b) model the government as benevolent in that it seeks to
maximize the welfare of the domestic consumers; they show, however, how it
is also possible to model the government as more impatient than consumers
or international investors. The welfare of consumers and governments depends
both on private consumption and on provision of the public good.
The government cannot commit to repaying its debt; all of the actors know
that the government resolves its maximization problem every period. If the
expected present value of defaulting exceeds that of repaying old debt, the
government will default. If the government defaults, the country is subject to
a penalty that results in a decline in domestic productivity. This penalty reflects,
for example, the large distortion created by the imposition of dual exchange
rates. In the model, for some levels of government debt, a crisis can occur
depending on the realization of a random event that is extrinsic to the funda-
mentals of the model, a sunspot variable. An unfavorable realization of this
sunspot variable can lead to a panic in which the international investors are
unwilling to purchase new government debt. This panic is rational if the failure
of the new debt auction puts the government in a situation where it prefers to
default. At the same time, however, the panic is somewhat arbitrary because a
favorable realization of the sunspot variable would not lead to a panic, the
government would be able to sell its new debt, and no crisis would occur.
In this model a self-fulfilling crisis is possible if the government would choose
to default if no new borrowing were possible, but would choose to honor its
commitments if new borrowing were possible. Cole and Kehoe (1996b) show
that, if a crisis is possible, the probability of its occurence is arbitrary: for any
probability of an unfavorable realization of the sunspot variable, there is a
different equilibrium. Although Cole and Kehoe model the crisis as dependent
on a sunspot variable, it is also possible to model it as dependent on a random
event connected to the fundamentals, such as a political shock. The essential
point is that there are multiple equilibria: there is an equilibrium in which the
shock touches off a crisis and there is an equilibrium in which it does not.
The crucial insight of the model is that the government finds itself in a far
different position if it cannot sell its new bonds than if it can. If the level of
government debt is low compared with its ability to raise revenue, however,
these positions are not very different: the government will choose to repay its
debt and to avoid the default penalty whether or not new borrowing is possible.
Similarly, if the maturity structure of the debt is long enough, these positions
are not very different: with government debt of long maturity little new borrow-
ing is needed in anyone period. Figure 6 depicts the size of the crisis zone for
a simple model described in the appendix that has been calibrated to match
the general features of the Mexican economy in 1994. For levels of the debt
too high, a crisis occurs immediately; for low levels of the debt, no crisis is
possible; and, for intermediate levels of the debt - levels in the crisis zone - a
crisis can occur with fairly arbitrary probability. Notice how fast the crisis zone
shrinks as the maturity of the debt increases. For a variety of reasons not
explained by the model, bonds with a short maturity may be less risky than
those with a long maturity if the maturity structure itself is constant.
Nevertheless, one lesson that can be drawn from the model, a lesson that
financial markets did not seem to understand in 1994, is that letting the whole
maturity structure shorten is very risky.
Although the Cole-Kehoe model is only a simple first step at modeling
events like the Mexican financial crisis, it provides a framework that may
eventually be capable of identifying countries in danger of a crisis like that
which hit Mexico in 1994-95. A country is in danger of a crisis if the amount
~O.8
'a"
i
a:: 0.6
~
'&
1
-10.4
0.2
0~0----~----+---~-----+4----~5-----6~---+-----r----~--~10
Average Maturity of the Government Debt in Years
Figure 6. Average maturity of the debt and the crisis zone.

14 T.J. Kehoe
of government debt becoming due during, say, one quarter is large compared
with its ability to raise taxes or to cut expenditures and compared to its foreign
reserves. It is worth noting that a government might find itself in danger of a
self-fulfilling debt crisis even though it would have no problem meeting the
interest payments on its debt, or even in eventually reducing this debt to a
level below the crisis zone. In terms of the literature on bank runs, the govern-
ment may be illiquid even though it is solvent.
AN INTERNATIONAL LENDER OF LAST RESORT?
The first step towards resolving the Mexican debt crisis was taken on 31 January
1995, when US President Bill Clinton announced a US$ 48.8 billion loan
package put together primarly by the US Exchange Rate Stabilization Fund,
the International Monetary Fund, and the Bank for International Settlements.
It was not until 9 March, however, that the Zedillo administration was able
to put together a complete economic plan for the year. Essential features of
the economic program enacted in Mexico during January-March included a
rapid opening of the banking sector to foreign competition and foreign owner-
ship, an increase in taxes, and measures to aid domestic banks left in precarious
positions by the devaluation. In general, the period from late December through
early March was a period of great uncertainty and economic paralysis in
Mexico.
It is plausible that most ofthe uncertainty and paralysis that afflicted Mexico
in early 1995 could have been eliminated if the loan package had been made
available, say, a month earlier. This has led commentators like Eichengreen
and Portes (1995) and Sachs (1995) to propose international institutional
mechanisms for dealing with crises like that in Mexico. An international lender
of last resort conceivably would have prevented the run on Mexican govern-
ment debt and allowed the Mexican economy to recover very quickly after the
December devaluation.
A crucial question, of course is, When does a lender of last resort lend? It
is one thing to lend to support a budget deficit or to support an exchange rate
that is subject to repeated speCUlative attacks. It is another thing to lend to
stop a run on government debt. Much the same as Bagehot (1873) proposed
a lender of last resort to eliminate domestic bank runs, an international lender
of last resort could, by its very existence, eliminate the possibility of a crisis
like the Mexican crisis: international investors, knowing that the government
has access to an international lender of last resort, would not find it rational
to panic. As shown in the appendix, an international lender of last resort can
eliminate the possibility of a crisis in the Cole-Kehoe model.
It is worth recalling Bagehot's conditions for a central bank to provide
credit to an illiquid domestic bank: the domestic bank should be solvent; it
should provide good collateral; and there should be a penalty interest rate. All
of these three features were present in the Mexican crisis and its subsequent
resolution: the debt service on Mexican government debt was very small in
relation to Mexican government revenue; the Mexican government was able
to use its oil export revenues as collateral; and the loan package involved
substantially higher interest rates than those the Mexican government was
paying before the crisis. (See US General Accounting Office 1996 for details
on the agreements.)
The concept of international lender of last resort is one deserving more
attention. It is worth making two related observations, however: First, serving
as lender of last resort without regulating creates a potential moral hazard
problem. Governments will undertake riskier policies if they know that an
international lender of last resort stands ready to bail them out. Second, an
international lender of last resort indirectly inherits much of the responsibilities
of the domestic central bank in serving as lender of last resort to domestic
commercial banks. A country like Mexico in 1994 and 1995, with a fragile
domestic banking system, will use its monetary and debt management policies
to insulate these banks from unfavorable shocks. To properly regulate a central
bank, an international lender of last resort needs to make sure that the central
bank is properly regulating domestic commercial banks.
ApPENDIX
The Model
This section lays out the model utilized by Cole and Kehoe (1996b) to analyze
the 1994-95 Mexican debt crisis. There is a single good in each period,
t = 0,1, .... This good can either be consumed or be saved as capital.
Production utilizes capital and implicitly, inelastically supplied labor. There
are three types of people in the model: domestic consumers, international
investors, and the government. We describe each in turn.
There is a continuum with measure one of identical, infinitely lived domestic
consumers. The consumers' utility function is
co
E L P'(c, + v(g,}}
'=0
where Ct is private consumption and gt is government consumption. We assume
that 0 < P< 1 and that v is continuously differentiable, concave, and monotoni-
cally increasing. The consumer's budget constraint is
Ct + kt+ 1 - k t :$; (1 - (J}(IX,f(k t ) - (jk t )

Here IX t is a productivity factor that depends on whether or not the government
has ever defaulted; (j, O:$; (j ~ 1, is the depreciation factor; (J, 0 < (J < 1, is the
constant proportional tax on domestic income; and f is a continuously
16 T.J. Kehoe
differentiable, concave, and monotonically increasing production function. Each

consumer is endowed with ko units of capital in period 0.
Cole and Kehoe (1996a) explore a model in which domestic consumers have
a more general, concave utility of consumption and in which they can borrow
from, and lend to, the international investors. The assumption of risk neutrality
of consumers greatly simplifies the modeling of consumer behavior. For exam-
ple, it allows us to neglect the possibility of borrowing and lending without
loss of generality.
There is also a continuum with measure one of identical, infinitely lived
international investors. These investors are risk neutral and have the utility
function
,=0
The assumption of risk neutrality of investors captures the idea that the
domestic economy is small compared to world financial markets. Each investor
is endowed with x units of the consumption good in each period and faces the
budget constraint
x, + q,bt +1:::; X + Ztbt.

Here qt is the price paid for one-period government bonds that pay bt +1 in
period t+l if Zt+l=l, but pay if Zt+l=O; ZtE(O, I} is the government's
default decision. We can choose the endowment x to be large enough that we
can ignore corner solutions to the investor's utility maximization problem.
Initially, each investor holds bo units of government debt. There is a constraint
b,+ 1 ~ - A, where A can be chosen large enough so that it rules out Ponzi
schemes but does not otherwise bind in equilibrium.
There is a single government. In every period it chooses its new borrowing
level, B t +1 ; whether or not to default on its old debt, Zt; and the level of
government consumption, gt. If the government defaults by setting Zt = 0, then
productivity drops from OCt = 1 to OCt = oc < 1 from period t onward. In period 0,
the government debt is Bo = boo
The government is benevolent in that its objective is to maximize the welfare
of domestic consumers. Its budget constraint is
gt + ZtBt :::; ()(oc,f(k t ) - t5k t } + qtBt + 1
We do not need to impose a borrowing constraint on the government to rule
out Ponzi schemes because, if the government tries to sell too much new debt
B t +1, the price qt falls to zero. That the tax rate is constant captures the idea
that changes in tax policy occur much more slowly than do debt crises.
In each period there is an exogenous sunspot variable (t, whose value is
realized. This variable is independently distributed on the interval [0, 1]. In
the next section we describe equilibria where, if the level of government debt
B t is above some crucial level and (t is below another crucial level, then
international investors are not willing to buy new government debt and the
price of this debt is ql = O. This unwillingness to buy government debt creates
new debt, it chooses to default. If 'I

a self-fulfilling debt crisis in the sense that, since the government cannot sell
is above the crucial level, however,
international investors lend to the government and no default occurs. The
possibility of a debt crisis depends on the level of government debt: if BI is
below the crucial level, then investors know that the government will not
default, whether or not they buy the new debt; they therefore buy the new debt.
The timing of actions within each period is important to the presentation
of the model:
'I is realized, and the aggregate state is Sl = (BI' Ktl 0(/-1' 'I)'
The government, taking the price schedule qr = q(sl' B1+ 1 } as given,
chooses BI + 1
The international investors, taking qr as given, choose whether to purchase
Br+ 1
The government chooses whether or not to default, Zr, and how much to
consume, gr'
The consumers, taking 0(1 as given, choose Ct and k t + I; in equilibrium
kr+1 = K r+ l
The essential aspect of the timing is that it enables the government to issue
new debt before retiring the old debt while having a maturity of one period
on the debt. The need to roll over old debt into new is what drives the crucial
results. A worthwhile extension of the model would be to have longer maturity
debt that is only partially rolled over in any period and some stock of reserves
with which the government pays old debt becoming due, but this would
complicate the analysis.
Concept of equilibria and central results
Cole and Kehoe (1996b) carefully define a recursive equilibrium for their model.
The crucial elements of this definition are policy functions that describe the
optimal actions for each actor given the actions of other actors that have
already occurred and taking into account the optimal responses that will follow.
For the domestic consumers, there is an optimal consumption policy Ct and
an optimal investment policy kl + l . Each is a function of the aggregate state
variable St = (Btl K t , at-I> 'I)' the individual holdings of capital entering the
period kl (which in equilibrium is, of course, equal to the aggregate capital
stock K r), and the actions that have already occurred in the period relevant
for the consumer's decision in the current period or for the determination of
the aggregate state in the subsequent period, B1 + 1 , gtl and ZI' Thus, consumers
actions are determined by the policy functions
Cr = c(sr' k t , B 1 + 1 , gr, Zt)
kr+ 1 = k'(sr, kr' Br+ I, gr, Zt}

18 T.J. Kehoe
The .consumer's investment policy determines the evolution of the aggregate

capital stock:
K t +1 = k'(st, K t , B t +1,gt, Zt),

but the distinction between kt+ 1 and Kt+ 1 is necessary so that individual
consumers do not think they can influence the aggregate state, thereby manipu-
lating the government and the international investors.
The behavior of the international investors is easy to summarize because
they are competitive and risk neutral. The investors purchase the bonds Bt + 1
offered by the government as long as the price of these bonds satisfies
q(St, Bt+ d = PEz(St+ 1, B'(St+d, q(St+ 1, B'(St+1))),

in other words, as long as the expected gross return on these bonds is liP.
Here z(St' Bt+ 1, qt) is the government's optimal default policy still to be specified.
The price function q(St' B t + d summarizes the behavior of the international
investors.
The government is the only strategic actor in the model. After it has observed
the actions of the bankers, which are summarized in the price qt, it chooses
whether or not to default, Zt, which in turn determines the level of government
spending, gt, and the level of productivity, at. This choice is given by the policy
functions, Zt = z(St' Bt+1' qt) and gt = g(St' Bt+1' qt). The state of the government
when it chooses B t is simply the aggregate state St. It knows, however, what

the price q(St, Bt+d and its own optimizing choices g(St' B t +1, q(s" B t +1 and

z(St' Bt+1' q(St' B t +1 will be later. It also knows the effects that its actions will
have on the price of the bonds q" on the productivity parameter a" and on
the consumers' consumption and investment decisions Ct and k t + 1
't
Cole and Kehoe (1996b) demonstrate that there is always an equilibrium in
which agents ignore the realizations of the sunspot variable as long as the
government prefers to repay its debt by setting Zt = 1. Furthermore, this equilib-
rium is stationary in that it satisfies Bt = B, Ct = cn and kt = k n , where
(1- lJ)(f'(kn) - <5) = 1/P-1
cn = (1 - lJ)(/(kn ) - <5kn).
To calculate the maximum level of debt for which the government prefers to
repay its debt, we need to calculate the levels of consumption and investment
that will take place if there is a default:
(1 - lJ)(rxf'(kd) - <5) = liP - 1

cd(k) = (1 - lJ)(rx/(k) - <5k) - ~ + k.
Notice that, if there is a default, investment adjusts immediately to the station-
ary level kd, but capital and consumption take one period to adjust because
the initial capital stock k is not necessarily equal to k d
For the government to prefer not to default it must satisfy the constraint
that the utility of not defaulting is greater than or equal to that of defaulting:
[en + v(9(f(kn) - Jkn) - (1 - P)B)]/( 1 - p)
~ ed(kn) + v(9(rxf(kn) - Jkn) + PB)

+ p[ed(kd) + v(9(rxf(kd) - Jkd))]/( 1 - Pl.
Cole and Kehoe (1996b) refer to this constraint as the participation constraint.
(They also show that an equilibrium without default may be possible even
when this constraint is violated if the government reduces its debt immediately;
this case is not very interesting, however, because there is no explanation of
how the government could start with a level of debt high enough to violate
the constraint.)
The government is in a very different position if it is not able to borrow
from the international investors because qt = O. In this case it is optimal for
the government to default if the utility of not defaulting is less than that of
defaulting:
en + v(9(f(kn) - bkn) - B) + PEen + v(9(f(k n) - bk"))]/( 1 - P)

< ed(kn) + v(9(rxf(kn) - bkn)) + p[ed(kd) + v(9(rxfkd) - bkd))/(1- p).
Cole and Kehoe (1996b) refer to this condition as the no-lending continuation
condition. If it is not satisfied, then it is not rational for the international
investors to refuse to lend to the government.
The central result obtained by Cole and Kehoe (1996b) is, that, if both the
participation constraint and the no-lending continuation condition are satisfied,
then there are equilibria where default occurs with probability 1t for any
o< 1t < 1 as long as B t + 1 remains in the interval where both of these conditions
are satisfied. In particular, if Ct < 1t a. crisis occurs, but if Ct ~ 1t it does not. Cole
and Kehoe refer to this interval as the crisis zone. Actually, the crisis zone
shrinks as it increases because that maximum level of debt that satisfies partici-
pation constraint falls. As long as there is a nonempty crisis zone for 1t = 0,
however, then it is possible to show that there are levels of the debt for which
a crisis occurs, at least in the first period, with probability 1t for any 0 < 1t < 1.
As long as Bt+l remains in the crisis zone qt satisfies qt = P(1-1t) and
kt+l = k" and et = e" where
(1- 9)[( 1 -1t + 1trx)f'(k") - b] = liP - 1
e" = (1 - 9)(f(k") - Jk").
Optimal government behavior is not necessarily stationary, however. In particu-

lar, for some levels of initial debt it is optimal for the government to run the
debt down over time to leave the crisis zone.
20 T.J. Kehoe
A calibrated model and a lender of last resort
Cole and Kehoe (1996b) present a model designed to capture, in a stylized

way, the situation in which Mexico found itself in late 1994. In this example a
period is two-thirds of a year. This period length is chosen to match the average
maturity of the Mexican government's short-term (that is, domestic) debt as
shown in Table 3. The utility function for the consumers and the government
is
00
E L 0.97'(c, + log(g,)).
,=0
The discount factor of 0.97 corresponds to a yearly discount factor of 0.955
(=0.97 3/2 ), which implies a yearly yield of 0.047 (=0.955- 1 -1) on risk-free
bonds - to be thought of as US Treasury bills. If we set the probability of
default to be 1t = 0.02, then the yearly yield on Mexican government bonds -
to be thought of as tesobonos - would be 0.079 (=[(0.97)(0.98)r 3/2 -1).
Consequently, there would be a 3% risk premium on the Mexican government
bonds. These numbers roughly match the average yields on 90-day US T-bills
and 91-day tesobonos during 1994 (see Figure 5).
The choice of the funtional form v(g) = log(g) is somewhat arbitrary. In
comparison with a function that displays more curvature, such as v(g) = - g- 1,
this function allows the government a fair amount of substitutability in govern-
ment consumption over time. This, in turn, allows the government flexibility
in reducing its expenditure to be able to payoff old debt in the event of no
lending. Consequently, setting v(g) equal to log (g) rather than to - g -1 increases
the upper level of the debt for which no crisis can occur. The main point of
the model is to show that crises can occur for fairly low levels of debt, however,
and our choice of v(g) biases, if anything, the results against crises.
The technology is given by the feasibility constraint
c, + g, + k'+1 - 0.95k, + z,B, ~ 2k?4 + Q,B'+I'
The choice of b = 0.05 corresponds to a yearly depreciation rate of 0.074
(= 1 - 0.95 3/2 ). The capital share 0.4 is lower than that found in Mexico's
national income and product accounts, but the published numbers include
income of self-employed workers in capital income. The constant in the pro-
duction function is a scaling factor that only influences the results because the
utility function c + log (g) is not homothetic.
If consumers expect default to occur nest period with probability 1t = 0.02,
they set k'+1 = k" where k" solves
(1- 0)[(0.98 + 0.21X)0.8(k,,)-0.6 - 0.05] = 1/0.09 - 1.
Setting 0 = 0.2 and IX = 0.95 - which implies that Mexico would incur a perma-
nent drop in productivity of 5% if it were to default - we obtain a capital
stock of k" = 39.04 and a yearly GDP of (3/2)2(k")0.4 = 12.99, for a capital/
output ratio of 3.00. The investment/GDP ratio is 0.05k"/(2(k,,)0.4) = 0.23
(Banco de Mexico 1995, p.206, reports a ratio of 0.22 in Mexico in 1994).

Government revenues as a fraction ofGDP are 0.2(2(k,,)O.4 - 0.5k")/(2(k"f4) =
0.15 (Banco de Mexico 1995, p. 237, reports a figure of 0.17).
A crucial parameter of the model is the initial value of government, Bo.
Choosing this parameter is complicated by the different types of debt obliga-
tions that Mexico had outstanding in 1994 and by the devaluation at the end
of 1994 that sharply lowered the value of GDP compared to those obligations
that were indexed to, or denominated in, US dollars. For the sake of discussion,
we set B o = 2 for a debt/GDP ratio of 0.15, which is on the low side.
The crisis zone for this model includes all initial government debt levels in
the interval 1.32 < Bo ~ 8.49, which are debt levels between 0.10 and 0.65 as
fractions ofGDP. For all debt levels in this zone it is optimal for the government
to run the debt down and out of the zone, although this process can take up
to 15 periods, which corresponds to 10 years. Furthermore, Cole and Kehoe
(1996b) show that, if the government is more impatient than domestic consum-
ers and international investors in that it has a discount factor y < p, it may be
optimal for the government to increase its debt even when it is in the crisis
zone. Specifically, when y = 0.93, which corresponds to an annual discount
factor of 0.90 = (0.93 3 / 2 ), it is optimal for the government to increase its debt
for all levels greater than 2.21 (0.17 as a fraction of GDP). This process
continues up to the upper limit of the crisis zone, which falls to 4.29 (0.33 as
a fraction of GDP) because all actors now understand that the government is
more impatient. (The lower limit of the crisis zone also falls, but only slightly.)
Cole and Kehoe (1996b) consider the case of government debt whose matu-
rity is more than one period and show that as the maturity of this debt increases
the crisis zone shrinks. This makes intuitive sense because, with debt of long
maturity, the government needs to do little new borrowing in any given period,
and consequently there is little difference between the situation where new
borrowing is possible and that where it is not.
Let us consider another way of eliminating the possibility of self-fulfilling
debt crisis. Suppose that there is a lender of last resort that stands ready to
lend to the government at an interest rate r z. liP - 1. To receive this loan the
government must be solvent in that it must prefer to repay any borrowing
from the lender of last resort. Given a maturing debt of B, the government can
smooth its consumption by setting its debt with the lender of last resort so
that
8(f(kn) - bkn) - (1- P) = 8(f(kn) - bkn) - B + D

= 8(f(kn) - bkn) - rD.
In other words, the government sets D = PB initially and thereafter pays the
debt service rD. The constraint that the government be solvent is
[en + v(O (j(kn) - bkn) - rD)J/( 1 - P) > cd(kn) + v(8(rxj(k") - bk" + D)
+ P[cd(kd) + v(8(rxj(kd) - bkd))]/( 1 - P).
22 T.J. Kehoe
If f = liP - 1, then this constraint is just the participation constraint: There is

no crisis zone, and by its mere existence a lender of last resort can prevent a
crisis and therefore never needs to make loans, at least in this simple model. If
f> liP -1, however, there is still a small crisis zone, where the government
would choose to refinance its debt at the low interest rate liP - 1, but not at
the high interest rate f. It would then be the responsibility of the lender of last
resort as a regulator to make sure that the government stays out of this
crisis zone.
The analysis of this model suggests directions for future research. One
obvious direction, already mentioned, would be to allow government debt
instruments of various maturities and government reserves. Another would be
to incorporate stochastic shocks to the production function so that the govern-
ment might face some probability of finding itself in violation of the participa-
tion constraint. In this case the distinction between insolvency and illiquidity
would be crucial, and the lender of last resort would need to be able to monitor
the government's finances enough to make the distinction.
REFERENCES
Bagehot, Walter (1873). Lombard Street: A Description of the Money Market. New York: Scribner,
Armstrong.
Banco de Mexico (1995). Informe Anua11994. Mexico: Banco de Mexico.
Cole, Harold L. and Timothy J. Kehoe (1996a). Self-Fulfilling Debt Crisis and Capital Flight,
in progress.
Cole, Harold L. and Timothy J. Kehoe (1996b). A self-fulfilling model of Mexico's 1994-95 debt
crisis, Journal of International Economics, 41,309-30.
Dornbusch, Rudiger and Alejandro Werner (1994). Mexico: stabilization, reform, and no growth,
Brookings Papers on Economic Activity, I, 253-297.
Eichengreen, Barry and Richard Portes (1995). Crisis? What Crisis? Orderly Workoutsfor Sovereign
Debtors. London: Centre for Economic Policy Research.
Sachs, Jeffrey (1995). Do We Need an International Lender of Last Resort? Harvard University,
unpublished manuscript.
Torres, Craig and Thomas T. Vogel (1994). Market forces: some mutual funds wield growing clout
in developing nations. Wall Street Journal, 14, June, 1.
US General Accounting Office (1996). Mexico's Financial Crisis: Origins, Awareness, Assistance,
and Initial Efforts to Recover. Washington: US G.A.O.
ANDRES VELASCO! and PABLO CABEZAS 2
1 New York University and NBER 2 New York University
2. Dealing with capital inflows:

Mexico and Chile compared
INTRODUCTION
Starting in the late 1980s, and as a response to the economic slowdown and
the fall in interest rates in industrialized economies, private capital returned to
Latin America. Tens of billions of dollars started pouring in, with the flow to
some countries exceeding the records set during the petro-dollar euphoria of
the late 1970s. Policy makers in Latin America welcomed this at first. Foreign
capital could finance much needed imports and investment, reigniting growth
after years of stagnation. Perhaps, thanks to the newly arrived dollars, the 'lost
decade' of the 1980s would be finally over.
But the capital inflow soon created problems. The incoming money tended
to strengthen Latin American currencies to the point where many new exporting
firms (an important creation of the trade reforms of the 1970s and 1980s) found
it difficult to compete abroad. External deficits, not a bad thing in themselves,
tended to grow beyond what prudence dictated. Banks had to recycle the funds
domestically, sometimes over-extending themselves into risky areas such as
real estate and consumer credit.
Optimists minimized the extent of such dangers. With reformed governments
running fiscal surpluses, they stressed, private firms were doing the borrowing.
Capital arrived to finance productive investment, not government-owned white
elephants. Currency appreciation was simply a sign of growing productivity
and economic strength. Nothing could possibly be wrong with this.
Since the Mexican meltdown of December 1994, the tone of this debate has
changed. What most of Latin America learned in the early 1980s has been
rediscovered recently: foreign capital can leave just as quickly as it arrived.
Debt-led expansion can easily turn into financial panic. As a result, the
'Washington consensus' no longer claims that "the more foreign capital, the
merrier." Spokesmen for institutions as venerable as the IMF and the US
Treasury have endorsed arbitrary rules of thumb, arguing that any current
account deficit (and the accompanying capital inflow) over 3% of GDP is
dangerous. Economists with solid neoclassical training have found themselves
defending mild forms of capital controls. Heterodoxies that seemed long
discredited are suddenly back in fashion.
23
1998 Kluwer Academic Publishers.
24 A. Velasco and P. Cabezas
What are the proper lessons from Latin America's most recent boom and
(in some places) bust cycle? This paper revisits the debate over the consequences
of capital inflows and the appropriate policy response to them by comparing
the experience of Chile and Mexico. These countries are interesting for two
reasons. The first is that, thanks to their strong record of economic reforms,
both countries have been the most successful in the region in earning the
confidence of foreign investors. Table 1 shows that, relative to the size of the
economy, capital inflows were especially high for Chile and Mexico. For Chile,
during the period 1990-1994, capital inflows averaged more than 6.7% of
GOP. In the Mexican case, net capital inflows averaged 6.2% of GOP during
the same period. Other Latin American economies also experienced some
capital inflows, but not of the same magnitude received by Chile or Mexico:
for the period 1990-1994, Argentina received inflows that averaged 1.2% of
GOP, while Brazil's capital inflows averaged 1.8% of GOP.
The second is that both countries differed substantially in their policy
response to the capital inflows. As is well known, Mexico embraced foreign
capital warmly (skeptics will say that, given the size of external deficits, it had
no choice), while Chile has endeavored to keep it at arms' length. But neither
country is run by wild-eyed populists taking advantage of the inflows to embark
on an unsustainable fiscal expansion, nor by grim-faced bureaucrats denouncing
the evils of foreign investment and closing the door to all inflows. On the
Table 1.
Reserves
Trade Current Capital
balance account account (flow) (stock)
Chile (shares of GDP)

1987 6.4 -4.2 4.5 0.3 12.5
1988 9.7 -1.0 3.9 2.9 13.8
1989 5.9 -2.5 4.3 1.8 13.6
1990 4.4 -1.8 9.6 7.8 21.2
1991 4.9 0.3 3.3 3.6 22.0
1992 1.9 -1.7 7.5 5.8 23.7
1993 -2.2 -4.6 5.9 1.3 22.0
1994 1.4 0.0 7.6 7.6 29.1
Mexico (shares of PIB)

1987 5.7 2.7 -0.1 2.5 7.3
1988 1.6 -1.7 -2.0 -3.7 3.3
1989 0.2 -2.8 2.7 -0.1 3.5
1990 -0.4 -3.0 3.9 0.9 4.5
1991 -2.8 -5.1 7.9 2.8 6.9
1992 -5.3 -7.3 7.8 0.5 6.3
1993 -4.1 -6.4 8.3 1.9 7.7
1994 -5.5 -8.6 2.9 -5.7 1.9
Source: Balance of Payments Statistics, IMF.

Mexico and Chile compared 25
contrary, both countries have often been hailed as paragons of sound macro-
management. Insofar as Mexico's and Chile's policy stances have differed, they
have differed in respects about which 'reasonable people can disagree'. That is
why they provide especially fertile ground for extracting useful policy lessons.
What do (or should) policy makers worry about when contemplating the
possible effects of large-scale capital inflows? Any shopping list, influenced not
only by recent events, but also by the experience of Latin America in the early
1980s, must include the following:
Real exchange rate appreciation, which might be especially costly if it has
to be reversed under conditions of hysteresis.
Loss of control over monetary aggregates in cases where a fixed exchange
rate policy is pursued.
Volatility of flows, which may cause unexpected and sharp required swings
in the current account.
Intermediation of the flows through the domestic banking system, which
might give rise to a spurt of high-risk lending and sow the seeds of an
eventual banking crisis.
Of course, many well-known caveats are applicable. Real exchange rate
appreciation may well be an equilibrium phenomenon (a response to reform-
induced productivity changes, for instance) and not something for policy makers
to agonize over; loss of control of the money supply may be a good thing, in
that it brings with it monetary discipline; some of the consequences of volatility
are hedged in today's financial markets; potential banking instability may be
the result of poor regulation or outright fraud, not the capital inflows them-
selves. Nonetheless, the recent experience, not just of Mexico, but of countries
such as Argentina, Brazil and the Philippines, suggests that these concerns may
be real indeed.
Policy makers' worries can be tackled by an array of possible measures.
Choices made in the following areas are particularly important in determining
how the capital inflows will affect the macroeconomy:
The exchange rate regime, and the choice among fixing, flexing, crawling,
or some combination of these.
The extent of sterilization, and the effects sterilization has both on the
exchange rate and on fiscal accounts.
Other supporting measures, especially fiscal policy, which can be especially
important in limiting real appreciation and moderating the external deficit.
Capital controls of one kind or another.
In what follows we review the Chilean and Mexican experience in the light
of these policy issues and the policy responses they elicited. The next section
is largely descriptive, in that it summarizes the macroeconomic environment
in each country and the size and nature of the capital inflows it received. The
following three sections deal, in a more analytical vein, with policy options in
the areas of exchange rates, money, debt management, bank behavior and
capital controls. A final section concludes and offers some policy suggestions.
CHILE AND MEXICO: TWO STAR PERFORMERS?
Chile and Mexico were often seen from the outside as 'twin' economies: two
highly market-oriented economies that had liberalized internal and external
markets, both went through successful stabilization, deregulation and privatiza-
tion of state owned enterprises. These similarities, however, can obscure other
very fundamental differences. Some of these differences became extremely
important when the countries had to confront the capital inflow, and later
outflow, of the 1990s.
A first contrast has to do with the timing and maturity of the reforms. While
Chile implemented a first wave of structural reforms (trade and fiscal) in the
mid-1970s and a second (further privatization and deregulation) in the
mid-1980s, Mexico only started its reforms by 1983 and some of the most
important ones (deregulation, trade) were in fact delayed until after 1987. This
meant that by the 1990s most of the initial cost of the reforms were for Chile
a thing of the past, and the country was poised to begin enjoying their growth
and efficiency benefits. In Mexico, by contrast, the painful part of the process
is still under way, and growth has been very slow in coming. The numbers are
telling: while Chile enjoyed an average rate of growth of 7.1 % from 1988 to
1994, Mexico displayed a barely acceptable average of 2.8% per annum for
the same period (Table 2). Chilean economic growth was also reflected in an
enormous increase in employment. Unemployment rates came down from an
average of 22% for 1980-1985 to a comfortable 4% during 1993 and 6.2%
during 1994. Mexico's unemployment figures are notoriously unreliable, but
there is evidence of substantial unemployment and especially underemployment
during the period. There was greater similarity between the two countries in
the trajectory of wages. Together with the decrease in the unemployment rate,
in Chile real wages showed a steady recovery, increasing 24% between 1988
and 1994, while in Mexico real wages increased by slightly more than 25%
(Table 3).
A second difference is that in Chile inflation stabilization was achieved in
the late 1970s, while in the early 1990s Mexico was still undergoing the effects
Table 2. Gross domestic product (annual growth rates)
Chile Mexico
1988 7.3 1.2

1989 9.9 3.3
1990 3.3 4.5
1991 7.3 3.6
1992 11.0 2.8
1993 6.3 0.7
1994 4.3 3.5
Source: IFS, IMF, Chilean 1992-1994 figures come from new revisions made by Chilean Central
Bank.
Table 3. Real wages (annual growth rates)
Chile Mexico
1986 2.1 -13.1

1987 -0.2 4.0
1988 6.6 -2.1
1989 2.0 13.6
1990 1.9 4.0
1991 5.0 6.4
1992 4.6 2.0
1993 304 -1.2
1994 4.7 -0.9
Source: IFS, IMF and Banco Central de Chile.
Table 4. Inflation (annual averages)
Chile (%) Mexico (%)
1986 19.5 87.3

1987 2004 130.8
1988 15.3 114.3
1989 16.2 20.1
1990 26.6 26.6
1991 22.0 22.7
1992 15.6 15.5
1993 12.1 9.7
1994 12.0 6.9
Source: IFS, IMF.
of the stabilization program undertaken late in 1987. As a result, it is hard to

decide whether some of the problems of the period, particularly exchange rate
overvaluation and a current account deficit, were caused by the exchange-rate
based stabilization, the capital inflows, or some combination of both. Regardless
of timing, both countries' success in terms of inflation-fighting was impressive.
Mexico curbed its inflation from a high of 130.8% in 1987 to 6.9% in 1994
(Table 4). Chile lowered its inflation rate from 26.6% in 1990 to 12% in 1994
(Table 4), its control of hyperinflation having been achieved a decade-and-a-
half earlier.1
In term of fiscal policy, through the 1990s both Chile and Mexico have
engaged in rather conservative management of government expenditures. As
part of the stabilization process, Mexican authorities made important efforts
in order to bring the big deficit down: the overall Mexican fiscal deficit (includ-
ing the inflationary component of interest payments) accounted for 10.3% of
GDP in 1988; by 1990 and after the fiscal adjustment, the budget was showing
1 Annual averages. If we compute December to December rates, Chile's inflation also achieved
single digits in 1994.
almost balanced figures. The Chilean experience in terms of fiscal policy has
been similar. The participation of government consumption over GDP has
been stable around 10% since 1988. The Chilean government has shown a
steady surplus on its accounts, even though as a share of GDP this surplus
has decreased slightly in the last 3 years (Table 5).
Even greater differences between the two countries emerge from an analysis
of the external sector. Even though real exchange rates appreciated in the two
countries, the magnitudes of the appreciation differed. Use of the exchange rate
as a nominal anchor produced a real appreciation of 22.2% for the Mexican
peso (Table 6) from 1989 to 1994. In Chile, partially as the result of a deliberate
government policy to limit real revaluation, the Chilean peso appreciated by
only 8.8% between 1989 and 1994 (Table 6).
In terms of the balance of payments, the two countries presented quite
different results. In the 1990-94 Chilean case, current account deficits showed
a stable and decreasing trend, averaging 1.6% of GDP per year. That, coupled
with a big capital account surplus, averaging 6.8% of GDP, implied a massive
increase of international reserves held at the Central Bank: almost 8 billion
dollars in 1990-94, which amounted to 5.2% of GDP annually (Table 1). This
Table 5. Fiscal deficit* and public consumption (shares of GOP)
1988 1989 1990 1991 1992 1993 1994
Chile
Fiscal deficit -0.2 4.8 3.5 2.5 3.0 2.2 2.2
Public consumption 10.4 9.9 9.8 9.5 9.4 9.7 9.3
Mexico
Fiscal deficit -10.3 -5 -2.8 -0.2 1.5 0.4 -0.9
Public consumption 8.6 8.5 8.4 9.0 10.1 10.8 NA
Source: International Financial Statistics, IMF.

* Negative numbers reflect deficit.
Table 6. Real effective exchange rate (annual averages)
Chile Mexico
Index % Change Index % Change
1987 93.7 7.2 135.2 3.7

1988 99.8 6.5 110 -18.6
1989 97.4 -2.4 103.2 -6.2
1990 100 2.7 100 -3.1
1991 96.8 -3.2 91.1 -8.9
1992 91.4 -5.6 83.8 -8.0
1993 90.7 -0.8 78.8 -6.0
1994 88.8 -2.0 80.3 1.9
Source: IMF and author's calculations.

Table 7. Net capital inflows as a percentage of total flow
1990 1991 1992 1993 1994
Chile"
Foreign direct investment 63.5 103.3 33.3 57.1 57.5
Medium and long run credit 9.4 23.3 22.2 25.0 31.5
Portfolio investment 12.5 26.7 20.4 41.1 27.4
Short run credit 30.2 63.3 44.4 30.4 9.6
Others -16.7 -113.3 -18.5 -53.6 -26.0
Total 100.0 100.0 100.0 100.0 100.0
Mexico b
Foreign direct investment 11.5 56.7 29.6 25.0 32.9
Medium and long run credit 28.1 90.0 35.2 41.1 30.5
Portfolio investment -22.9 106.7 79.6 94.6 8.2
Short run credit 12.5 40.0 33.3 3.6 1.4
Others 7.3 -10.0 -27.8 -5.4 -2.7
Total 100.0 100.0 100.0 100.0 100.0
Source: " Banco Central de Chile; b Banco de Mexico.
increase in reserves posed a big problem for the conduct of monetary policy,
as we will see later. The Mexican experience is rather different. As a response
to the appreciated peso, and boosted by inflated expectations about future
growth fueled by entry into NAFTA, the current account began worsening in
the late 1980s, reaching an annual average of 6.1 % of GDP in 1990-94 and
peaking at 8.6% of GDP in 1994. Capital inflows therefore largely went to
finance this deficit, and the impact on international reserves was moderate:
between 1987 and the reserve peak of December 1993, reserves grew by an
annual average of 0.7% of GDP (Table 1).
In terms of the composition of net capital inflows, Chile and Mexico show
yet another important difference. For Mexico (Table 7), the principal compo-
nent of the capital in flow was short term: in the strong capital inflow period
of 1990-93 short-term flows - portfolio investment and loans under a year of
maturity - accounted for approximately 55% of the total, with the remaining
45% being long term (FDI and long-term loans). For Chile, the equivalent
breakdown is 45% short-term and 55% long-term (Table 7).
Finally, Chile also outperforms Mexico in terms of indicators of long-term
growth potential. Throughout the period 1989-1994, Chile's investment rate
surpassed Mexico's by an average of more than 3% of GDP a year. Differences
in savings were even more dramatic: Chilean savings rates were higher by an
average of 7% of GDP a year (see Table 8). Although under perfect capital
flows a temporarily low savings rate need not be a problem for economic
growth - as long as the country can finance its desired increase in the capital
stock in the international credit market - a different story arises once inter-
national capital dries out. In an environment with no external funding, high
Table 8. Shares of GDP
1989 1990 1991 1992 1993 1994
Chile
Current account -2.5 -1.8 0.3 -1.7 -4.6 0.0
Investment 25.5 26.3 24.5 26.8 28.8 26.8
Savings 23.0 24.5 24.8 25.1 24.2 26.8
Mexico
Current account -2.8 -3.0 -5.1 -7.3 -6.4 -8.6
Investment 22.2 22.8 23.4 24.4 23.2 23.5
Savings 19.4 19.8 18.3 17.1 16.8 14.9
Source: International Financial Statistics, IMF.
domestic savings rates are crucial to maintain the pace of investment, and in
that sense they represent a key requirement for a stable growth path.
EXCHANGE RATE POLICIES: FIX, FLEX OR CRAWL?2
Policy makers in Chile and in Mexico have faced some standard tradeoffs in
the design of an optimal exchange rate regime. A fixed or semi-fixed rate is
effective in bringing down inflation and (almost by definition) in minimizing
short-term nominal fluctuations; as a result, both countries relied on fixing in
the early stages of their stabilization processes. Over the longer haul, however,
greater degrees of flexibility may be desirable in dealing with capital movements
and in achieving some small degree of monetary independence. As a conse-
quence, in the late 1980s and early 1980s both moved toward mixed regimes
of crawling pegs plus bands. The similarities were sufficient to lead observers
to hail Chile and Mexico (along with Israel) as having devised a novel and
successful exchange rate regime (Helpman et al., 1994). Again, these apparent
similarities were offset by seldom stressed but nonetheless important differences.
After describing the regime policies implemented by each country, this section
speculates on how these differences may have determined macro performances
in each country.
Since 1983 Chilean exchange rate policy has explicitly attempted to target
the real exchange rate. For this purpose, the 'reference' nominal exchange rate
is adjusted periodically by the Central Bank to reflect the difference between
domestic and international inflation. In addition, in the early days the exchange
rate could float in a band of plus or minus 5% with respect to the reference
level. Such a system was adopted after an important real devaluation, and
worked well for the remainder of the 1980s: it offered the export sector a
competitive and reasonably predictable rate of exchange.
2 This section draws on Sachs et al. (1996a).

Two things changed in 1990. First, capital began flowing in as a result of

events in the USA and elsewhere in the industrialized world. Second, the newly
independent Central Bank undertook a drastic anti-inflation effort based on
tighter money. Spreads between domestic and international interest rates
increased sharply, and short-term speculative capital flew massively to Chile.
During the first half of 1990 the nominal exchange rate went from ceiling to
floor of its band, and remained there for the rest of the year. The Central Bank
had to intervene massively at the bottom of the band, accumulating US$ 2.4
billion in reserves during 1990 alone.
Such a situation posed a thorny dilemma for Chilean policy makers. High
interest rates were deemed essential to curb inflation, but the real exchange
rate appreciation that followed could potentially threaten the export perfor-
mance on which much of Chile's success was predicated. The Central Bank
could also not be sure whether the capital inflows were permanent or transitory
- if the latter were true, the case for letting the exchange rate appreciate
strengthened considerably. A fiscal contraction could have helped absorb the
capital inflow while minimizing the effect on relative prices, but there was
limited room for making fiscal policy even more austere than it already was.
Furthermore, public finance officials felt that fiscal policy should be targeted
at medium term objectives, and could not attempt to respond to every tremor
in world interest rates.
During 1991, and with the intention of discouraging short-term inflows, the
economic authorities tried to introduce some noise to the exchange rate market
by pursuing a policy of unexpected but small revaluations followed by a
compensating devaluations. Dirty floating within the band was also attempted.
Despite intervention of different sorts, pressures to revalue further mounted,
and in January 1992 the Central Bank allowed a revaluation of the peso of
5% and an increase of the width of the flotation band to plus or minus 10%.
An additional change was introduced in July of 1992, also in order to discourage
speculation by making the peso/dollar parity less predictable: the peg to the
dollar was replaced by a peg to a baskets of currencies that include the mark
and the yen as well. The weights in the basket (40% dollar, 30% yen and mark
each) reflected current trade patterns and attested to the growing diversification
of Chile's export sector. This policy had the additional advantages of preventing
a loss in competitiveness for exports sold to non-US markets whenever the
American dollar experienced an appreciation with respect to other currencies.
By late 1994 the center of the band had to be revalued again, this time by
10%, in order to ease the growing reserve pressure on the Central Bank. After
the Mexican crisis capital inflows slowed down, but markets soon noticed the
differences between Chile and Mexico, so that upward pressure on the Chilean
exchange rate has returned.
During the stabilization process and until 1988, Mexican authorities used
the nominal exchange rate as a nominal anchor: the Mexican peso/dollar parity
was fixed in an attempt to curb inflation. During January 1989, and in order
to defuse the trend toward appreciation, the system was changed to a prean-
nounced peg system: the peso/dollar rate was allowed to depreciate by 1 peso
per day in 1989, 80 cents per day in 1990 and 40 cents per day in 1991. Finally,
during November 1991 the system evolved to a crawling peg with adjustable
bands. The moving band system involved a lower bound fixed at a level of
3.05 new pesos per dollar, while the upper band was devalued at a rate of
0.0004 new pesos per day. Hence, the band was designed to widen slowly over
time: by September 1994 the band was (plus or minus) 6% wide around a
central parity of 3.2438 pesos per dollar. Much as in Chile, Mexican authorities
also intervened within the band. Unlike Chile, this was undertaken to minimize
fluctuations in the politically delicate period of NAFTA negotiation and ratifi-
cation. Dirty floating produced an increase in the level of international reserves,
from 6.5 billion in 1989 to 25.4 billion by the end of 1993.
Over time, real appreciation became an increasing worry. Between 1990 and
1993 the nominal exchange rate depreciated by 17%, but because of the big
disparity between domestic and international inflation the real exchange rate
appreciated by 25-35%, depending on the actual index used. By early 1994
Mexican inflation had declined sufficiently for the extent of overvaluation to
have stabilized. Moreover, in March 1994 the nominal exchange rate experi-
enced a depreciation of 10%, and the US dollar itself was depreciating in real
terms against the European currencies and the Japanese yen, so that Mexico's
multilateral real exchange rate was less appreciated than its bilateral real rate
vis-a-vis the US dollar. Regardless of any of this, however, concerns over the
unsustainability of the overvalued rate (and the huge external deficits that it
had helped create) were to playa major role in making investors skittish and
in prompting the December 1994 panic.
The choice of exchange rate regime is often described as a tradeoff between
flexibility and credibility. The description is particularly revealing in the case
of Mexico and Chile. Think of possible regimes as a continuum with totally
fixed rates at one end, crawling and adjustable pegs and target zones somewhere
in between, and clean floating at the other end. The more fixed the rate, the
argument goes, the greater the commitment against inflation and therefore the
greater the credibility3; the more flexible the rate, on the other hand, the greater
the ability of the government to offset shocks.
Chile's crawling peg has emphasized flexibility at the expense of credibility.
There is a degree of automatic accommodation of domestic inflation, given
that the central parity is readjusted on a daily basis to offset inflation differenti-
als. Moreover, the authorities have not been shy to move the central parity
(and thereby the edges of the band) in a surprise manner in order to accommo-
date perceived changes in market conditions. In particular, as evidence has
mounted that an important share of the capital inflow is in fact long term
(DFI and related categories), real appreciation has been allowed for. Mexico's
3 The standard caveat is that credibility could also be attached to a montary rule under flexible
exchange rates. Arguing that credibility is more easily obtained under fixing requires (a) the
assumption that there are large political costs attached to the abandonment of a fixed parity or
(b) the belief that monetary targets are too costly to observe by agents.
regime, by contrast, has put the emphasis on credibility. The edges of the band
are predetermined rather than responding endogenously to inflation differenti-
als. And when facing pressure at one of the bounds, as happened in March
1994 after the assassination of Luis Donaldo Colosio, the Banco de Mexico
has been unwilling to move the band in order to curtail reserve changes.
Mexico's stress on credibility at first seemed to payoff. Inflation rates
converged relatively quickly, edging toward dollar inflation in 1994. Chile, by
contrast, spent over a decade (from the early 1980s to the early 1990s) with
inflation in the 20-30% range, until attaining single-digit inflation for the first
time in 30 years in 1994. In addition, there were serious fears that Chile lacked
a nominal anchor (monetary policy has aimed at targeting real interest rates),
so that an exogenous shock could seriously de-stabilize the price level.
However, it was not Chile's lack of monetary and exchange rate discipline,
but Mexico's lack of exchange rate flexibility, that has proven costly over the
longer haul. The real test for Mexico came with the shocks of 1994: first the
increase in US interest rates and then the political turmoil caused by peasant
uprisings and political assassinations. In the days that followed the March
assassination the exchange rate went all the way to the top, in what constituted
a nominal devaluation of around 10%.4 The exchange rate spent the rest of
the year at or very near the ceiling. Both marginal and inframarginal interven-
tion led to large reserves losses. The upshot is that between and March and
December Mexico operated an essentially pegged exchange rate, in that only
the top of the band was relevant. 5
Having allowed the real exchange rate to become overvalued in previous
years, Mexico's unwillingness to lift the ceiling of the band in response to the
shocks in March and latter in the year was to prove costly. Opponents of
moving the band ceiling emphasized the possible credibility costs: a devaluation
might lead investors not just to doubt the commitment to low inflation, but
also to revise their assessments about the commitment to property rights of
the reformers in power. In the end the issue was moot. The combination of
loose money (in the course of 1994) and a fixed rate allowed reserves to
dwindle, making it increasingly likely that the peg could not be sustained
regardless of policy makers' wishes. When investors ran on Mexican assets at
the end of the year, there was little the government could do but let the
exchange rate float.
STERILIZATION OF CAPITAL FLOWS: HOW WISE?
At least since David Hume, economists have understood that fixed exchange
rates require that the money supply be mainly determined by the balance of
4 The fact that in the same period the Central Bank also lost around $9 billion in reserves only
attests to the magnitude of the shock.

S Of course, the ceiling itself was gradually depreciating, for a total of nearly 5% in the period.
payments. Domestic credit expansion must be limited if the pegged rate is to

remain intact. The adjustment mechanism under fixed exchange rates, as out-
lined by Hume two centuries ago, operates in practice by pushing down interest
rates when foreign lending increases, thereby increasing domestic absorption
and enlarging the external deficit (or increasing it to the level willingly financed
at the lower interest rates); the opposite occurs when capital flows out. The
Humean adjustment mechanism is seldom allowed to operate in practice,
however. Take the recent experience of Mexico as an example. In the upswing
(when the capital was flowing in), the Central Bank sterilized the monetary
effects of capital inflows, as did all other countries in the region except for
Argentina, fearing that large increases in nominal money would be inflationary.
In the downswing (when foreign lending fell sharply) the Central Bank once
again sterilized, this time to keep interest rates from going through the roof.
Thus, the automatic correction mechanism was systematically aborted.
In practice, then, under fixed exchange rates sterilization of inflows is a key
component of most policy packages, in spite of what the above theory would
advice. Indeed, Calvo et al. (1993) claim that " ... sterilized intervention has
been the most common policy response to the surge in capital inflows in both
Asia and Latin America." The mechanics of sterilization are well-known.
Sterilized intervention allows the government to control monetary aggregates
while defending the fixed exchange rate by mopping up the liquidity resulting
from foreign exchange operations. Frankel and Okongwu (1995) helpfully
distinguish between narrow sterilization, which leaves the monetary base
unchanged through the sale of domestic bonds, and broad sterilization, which
leaves the money supply constant even if the base changes, for example by
changes in reserve requirements. Both techniques have been widely used in
many countries, including Chile and Mexico.
Even though both countries received proportionally similar capital inflows
(roughly 8% of GDP since 1989), Chile had to sterilize substantially more than
Mexico did. The reason is that, given Chile's remarkable trade results and
small current account deficits, the bulk of capital inflows went to reserve
accumulation. By contrast, Mexico's large current account deficits, peaking at
almost 8% of GDP in 1994, absorbed an important portion of the capital
inflow, relieving the central bank from the need to sterilize. In Chile, inter-
national reserves held by the Central Bank increased from a level of 12.5% of
GDP in 1987 to 29.1 % of GDP in 1994, creating big pressures for sterilization.
Because of this intervention, during 1990-1994 the Central Bank's internal
debt increased by an average of almost US$ 1.9 billion a year. By 1994, total
internal debt had more than doubled relative to its 1990 level. In Mexico the
amounts to be sterilized were smaller: between 1989 and the end of 1993,
international reserves increased by US$ 6.1 billion. From 1992 to 1993, Mexican
authorities intervened in the exchange market with a monthly average of
US$ 1.3 billion in total transactions using CETES, which are mostly short-
term peso bonds. As a result, the ratio of M3 (M2 + non-bank short-term
securities) to GDP grew from 36% in 1989 to 41 % in 1993. At the end of 1993,
Cetes alone represented close to 100% of net international reserves. The impact
on overall domestic public debt, however, was different to that in Chile: because
of the fall in real interest rates in the early 1990s and the amortization of
substantial amounts (often using privatization proceeds), internal public debt
as a share of GDP decreased from almost 28% in 1988 to 12% in 1993.
What about broad sterilization? Here the policy course of both countries
also diverged. Chile, in keeping with its more activist reputation, increased
reserve requirements on foreign currency deposits held by commercial banks
by 50%, using a structure such that the required reserve decreased as the rate
as the maturity of the deposit increased. Together with this increase in reserve
requirements, the Central Bank introduced a 30% marginal reserve requirement
on interbank deposits. Mexico, by contrast, engaged in reverse broad steriliza-
tion: a zero legal reserve requirement for banks was instituted, sharply increas-
ing the money multiplier.
Sterilization is not without perils. Start with the broad kind: increases in
reserve requirements for banks can gradually cause a process of disintermedia-
tion, with the consequent loss in efficiency. Matters are more problematic in
the case of narrow sterilization, for here the list of possible ills is long:
It may increase interest rates (relative to what they would have been with a
capital inflow but without sterilization) and hence perpetuate the inflow. 6
It may deteriorate fiscal and quasi-fiscal accounts, for the domestic bonds
typically used to sterilize carry higher interest rates than is earned by reserve
holdings.
Also in the fiscal realm, it may dangerously increase the stock of domestic
debt.
Of these, the most serious problems are the fiscal ones. Calvo (1991), an
early source of concern on the issue, has even claimed that these policies, aimed
at curtailing monetization and enhancing the credibility of the anti-inflation
stance, may actually increase expected and realized inflation. This would occur
if a perverse monetarist arithmetic is at work, so that the large increase in debt
leads to expectations that it will be eventually monetized. But without going
to such an extreme, the adverse fiscal impact of sterilization was clearly felt in
Chile and Mexico. In Chile, preliminary estimations suggest that in 1990-93
the Central Bank incurred annual losses of about 0.5% of GDP because of the
interest rate differential between domestic bonds issued by the bank and interna-
tional reserves. In Mexico the same loss averaged an annual 0.25% of GDP
over the same period.
INTERNAL DEBT MANAGEMENT
The management of the internal debt created by sterilization can also be a

source of headaches. The experience of both countries is quite dissimilar in this
respect. We saw above that the amounts to be sterilized were substantially
smaller in Chile. An even greater difference lies in the types of instruments
6 Frankel (1994) has sorted out the conditions under which this is so.
chosen to carry out his sterilization, both in terms of their denomination and
maturity.
Mexico used an array of instruments, induding the peso-denominated cetes
and Bondes, the inflation-indexed ajustabonos and the dollar-indexed tesobonos.
Until 1993, however, it was the peso assets that predominated, accounting
roughly for three-quarters of domestic government interest-earning liabilities.
Chile, by contrast, relied heavily on indexed debt: all liabilities over 30 days in
maturity were (and are still) denominated in UF, an inflation-linked unit of
account. The structure of maturities was also different. Early in the decade
Mexico relied rather heavily on short-term cetes, perhaps gambling that, as the
stabilization process was consolidated rates would come down, which made it
fiscally unadvisable to borrow long. By the end of 1993, the average maturity
of Mexican internal public debt was 290 days (see Table 11), and short term
debt (of less than a year of maturity) accounted for 60% of total domestic debt
(Table 9).
The Chilean experience was quite different. When at the end of 1989 the
newly independent Central Bank launched its tight money policy, it attempted
to establish credibility as swiftly as possible. One policy chosen was to offer
10-year indexed bonds with a high real interest rate. Throughout the first year
of heavy sterilization (1990) the Central Bank kept on issuing long term debt.
The policy was abandoned at the end of the year. During 1991 short term
bonds (with maturities of less than a year) were used to sterilize, once again
reflecting expectations about the future course of interest rates. Between 1992
and 1994, the average maturity of the sterilization bonds was increased steadily,
showing an underlying preference to balance the average maturity of the central
bank's stock of debt around a target of about two years (see Table 11). As a
consequence of this maturity management, from 1990 to 1994 Chilean short
term stock of domestic debt was kept on average at 33% of total liabilities -
equivalent to 31 % of international reserves (see Tables 9 and 10).
In terms of macroeconomic performance, these differences in debt manage-
ment between the two countries were to prove important. It is likely that the
presence of a large stock of non-indexed debt kept alive in investors the fear
Table 9. Maturity of internal public debt (share of total debt)
1990 1991 1992 1993 1994
Chile"
Short -term debt b 18.0 24.0 53.0 34.0 35.0
Long-term debt 82.0 76.0 47.0 66.0 65.0
Mexico
Short -term debt" 45.3 43.0 45.2 62.6 78.4
Long-term debt 54.7 57.0 54.8 34.7 21.6
Source: Banco Central de Chile, Banco de Mexico and author's calculations.

a Debt subscribed by the Central Bank representing almost all internal public debt.
b Debt with maturities of less than a year.
"Corresponds to cetes and tesobonos.
Table 10. Short-term internal public debt, 1994 (share of total reserves)
Chile (%) Mexico (%)
January 25 104
February 22 93
March 23 106
April 22 141
May 20 157
June 21 173
July 21 182
August 22 180
September 22 183
October 24 172
November 29 280
December 29 410
Source: Banco Central de Chile, Banco de Mexico and author's calculations.
Table 11. Average maturity of new debt subscribed by the central bank (in days; 1994)
Chile Mexico
January 765 293

February 848 295
March 1378 297
April 725 306
May 1148 291
June 1170 281
July 642 278
August 974 261
September 1246 254
October 532 254
November 546 249
December 998 206
Source: Banco Central de Chile and author's calculations.
that the Mexican government would eventually return to a high-inflation policy

in order to reduce the value of outstanding liabilities. 7 As a result, ex post real
rates of interest were generally higher in Mexico than in Chile in the early
1990s. The shorter maturity of Mexican debt was also to matter. As a growing
literature suggests (Calvo and Guidotti, 1990; Alesina et aI., 1990; Cole and
Kehoe, 1996), short maturity debt can make the government particularly
vulnerable to crises of confidence and self-fulfilling runs, Differences were
obscured until 1993: that is to say, as long as both countries enjoyed an
environment of relative macroeconomic stability, falling country risk premia
and decreasing world interest rates.
7 Calvo (1988) offers a model that emphasizes this point, and which shows that non-indexed
debt may open the door to mUltiple equilibria.

During 1994, however, three things happened that were to set Mexico far
apart from Chile. First, total Mexican government short term domestic debt,
regardless of currency denomination, grew both in absolute magnitude and as
a multiple of reserves. Expressed in dollars, domestic debt amounted to 1.7
times reserves in December 1993 and 2.6 times reserves in September 1994.
Second, and more important, the average maturity of Mexican domestic debt
shrank drastically during 1994. This was the result of a deliberate policy choice.
With the increased turmoil in 1994, the yield curve turned steeper, and issuing
long-term debt became increasingly expensive. Conjecturing that the shock was
transitory, the Mexican government followed the correct policy of borrowing
short in order to get over the hump (until the end of the year, say) without
wrecking public finances. Ex post, we know that this strategy had two weak-
nesses: (a) the shock could turn out not to be transitory, in which case a real
fiscal adjustment would have been needed to compensate for the higher interest
payment burden and (b) the shorter maturities rendered the government largely
defenseless against any circumstance in which investors refused to roll over
their government bonds. Third, after the March assassination of leading presi-
dential candidate Colosio and the accompanying perceived increase in devalua-
tion risk, the Mexican government began rolling over its short-term peso-
denominated debt into short-term dollar-indexed debt. Starting at $1 billion
at the beginning of the year, by the end of September (before the last great
decline in Central Bank foreign assets), the stock of tesobonos outstanding
equaled the amount of reserves. In December the stock of tesobonos reached
$18 billion. This large stock of short-term public debt created, as Calvo (1994)
stressed, an important source of financial fragility.
Such fragility was soon to prove lethal. The December 20th devaluation of
the Mexican peso provoked an investor panic. As the tesobonos matured,
investors were unwilling to roll them over. Several bond auctions found no
takers. Mexico was on the brink of default.
CAPITAL CONTROLS: TO BE INTERVENTIONIST OR NOT TO BE?
When confronted with an inflow (and often concerned with a possible future
outflow) a number of countries have been tempted recently to resort to capital
controls. In this regard, Chile and Mexico stand as polar opposites in the range
of Latin American experiences. Chile has resorted to a battery of policies
intended to limit short-term inflows. Mexico, by contrast, has been largely
opposed to such moves, with the exception of a couple of (relatively mild)
policies intended to discourage interest arbitrage by Mexican banks.
In Chile the major policy initiative was the imposition in June 1991 of an
implicit tax on capital inflows. s The tax took the form of a non-interest-bearing
8 In addition, there was the long standing requirements that aU OFI stay in the country for at
least one year (which applies only to capital - profits can be repatriated immediately.
deposit in the central bank equivalent to 20% of total investment. This reserve
requirement was to be maintained in the central bank for a period that varied
from 90 days to one year depending on the maturity of the loan. In addition,
a stamp tax of 1.2% a year, previously applied only to domestic currency loans,
was extended to foreign currency loans in operations of up to one year. In July
1991 an alternative to the reserve requirement was created: instead of maintain-
ing a cash reserve, borrowers were permitted pay up front the equivalent of
the financial cost of the reserve requirement. In May 1992, the reserve require-
ment was extended to 30% of the foreign loan, and the period required to be
held in the central bank was fixed to one year no matter the maturity of the loan.
The combination of reserve requirement (whether paid directly or indirectly)
and stamp tax imposed no marginal cost on medium and long term lending,
but it imposed a heavy financial cost to short term loans (less than one year).
Agosin and Ffrench-Davis (1995) calculate that for a foreign loan of one-year
maturity, the value of the implicit taxes have fluctuated from an annual 2.6%
in the second semester of 1992 to a high of 3.9% in 1994. The percentages are
substantially higher for loans of shorter maturities.
In Mexico, by contrast, the monetary authorities have continued to liberalize
the capital account. Since 1990, foreign investors have been allowed to invest
in government bonds and in shares in the financial system (not voting shares).
Foreign investors can invest in basically any project developed in Mexico.
Capital mobility is, in essence, unimpeded.
The only exception to the de-regulating trend came in 1992. Concerned over
the big exposure to exchange risk that the banking system was undertaking,
Mexican authorities imposed a minimum liquidity coefficient to foreign exchange
transactions: 15% of foreign exchange borrowing must held in liquid securities
denominated in the same currency. During 1992, a regulation that limited foreign
currency liabilities of commercial banks to 10% of their total loan portfolio was
approved. Both policies limit the scope and profitability of cross-border interest
arbitrage - borrowing abroad in dollars and lending at home in pesos, earning
the differential- by banks, which had been an important source of capital inflows.
But they could also be justified on prudential grounds as ways of diminishing the
currency risk exposure of deposit-taking institutions at home.
What are controls expected to do and do they do it? International economics
commonly assert that capital controls are not very effective because they can
(relatively easily) be evaded. It is regrettably much less common to be clear
what it is that controls are ineffective at. Any evaluation of the usefulness of
controls must start by specifying what it is that they are expected to accomplish.
At a most basic level, controls of the sort we have described have as a basic
aim to discourage speCUlative capital inflows. Somewhat more subtly, however,
this can be split into three distinct tasks:
Partially to sever the link between domestic and foreign interest rates,
creating a wedge the endows domestic monetary policy with a modicum of
independence .
To reduce the total size of the inflow, presumably to reduce the extent of
real currency overvaluation.
To change the composition of the inflows (while leaving the size of the flow
pretty much unchanged), encouraging short-term (hot) flows to become
longer-term (cooler) flows.
How well have capital controls performed these three tasks? Chilean evidence
on the first point is mixed. On the one hand, Chile has been able to keep
nominal and real rates above the relevant US benchmark to a greater extent
than simple risk premia calculations would suggest. Laban and Larrain (1993)
present evidence suggesting that the 'offset coefficient' has declined since 1991
- precisely the year when capital controls were tightened - thereby endowing
the Chilean central bank with a greater degree of monetary independence. On
the other hand, the scope to exploit this degree of independence is severely
limited. There have been numerous episodes since 1990 where rates of interest
that were deemed 'excessively high' by agents brought forth a surge in inflows,
forcing as a counterpart the relaxation of the domestic monetary stance.
On the other two points (effects on the size of inflows and their composition)
the evidence is also controversial, but a consensus view increasingly holds that
controls have been quite effective at changing the composition of flows toward
longer term maturities, while relatively ineffective at reducing the overall level of
the flow. 9 Econometric evidence from Chile presented by So to (1995), for instance,
suggests that a combination of evasion and substitution toward longer maturities
has meant that, after controlling for other determinants of flows, there is little
discernible impact of the tax has left on overall volumes of funds entering the
country. The composition of the flows, however, seems sharply responsive to the
tax. Similar evidence is provided for the Colombian case by Cardenas and
Barrera (1995).
Does this mean that controls should be discarded because they are incapable
of keeping capital out? Not necessarily: affecting only the composition of flows
may be just what policy makers need. Sachs et al. (1996b), in a study of 20
emerging markets in the aftermath of the Tequila shock, find the degree of
financial and currency vulnerability is not systematically correlated with the
size of the previous capital inflow: many Asian countries, along with Chile and
Colombia, absorbed large amounts of foreign capital in 1989-94 and felt no
effects from Tequila. It is, however, correlated with the composition of such
flows: the larger the share of short-term flows in the total, other things equal,
the greater the disarray in the local financial markets in the first half of 1995.10
INTERMEDIATION OF FLOWS AND LENDING BOOMS ll
The different behavior of local banks in 1989-1994 offers the last piece of
evidence on why Mexico found itself in financial disarray in late 1994 and
9 See Ffrench Davis and Agostn (1995) and Soto (1995) for differing views on these issues.
10 Technically, that study measures financial and currency pressures by means of an index that
is a weighted average of nominal exchange rate depreciation and reserve losses. The behaviour of
local stock markets in early 1995, not reported in that paper, also fits this pattern of correlation.
11 This section dra,,:s on Sachs et al. (1996b).
early 1995, while Chile did not. Banking and currency difficulties often go hand
in hand: the link has been present in crises ranging from that of the US in the
1930s to that of Chile in the early 1980sY But the sheer magnitude of both
bank and currency crises in the recent case of Mexico, and also in Venezuela
and Argentina to cite just two additional examples, has brought back the issue
with a vengeance (see Kaminsky and Reinhart (1995) for a detailed analysis of
a number of such episodes).
Theoretically, the link between these 'twin crises' is not hard to ascertain.
Abrupt changes in the demand for money (caused, for instance, by expectations
of devaluation and an incipient speculative attack) can cause a sharp fall in
bank deposits. Under a fractional reserve system, however, banks do not have
the cash in hand; in the absence of an injection of liquidity from the outside
(typically from the Central Bank), cessation of payments and a bank panic can
readily occur. Even if banks could simply wait until loans mature in order to
satisfy depositor's demands (something that would take time, given banks'
essential role as maturity transformers), the ensuing adjustment would not be
easy or painless. The resulting credit squeeze on borrowing firms would send
interest rates sky-high. In emerging markets banks are the main sources of
corporate credit, and most firms cannot simply turn around and borrow from
the world market, no matter how de-regulated the capital account may beY
The need to avoid a wave of bankruptcies and serious economic disruption
provides yet another rationale for the authorities to step in.
One upshot is that the monetary base is not the only claim on the Central
Bank that can be called in at times of trouble. The reality is that, with bank
liabilities covered by implicit or explicit government guarantees, all M2 is
potentially a liability of the government, to be redeemed with dollars at the
time of a crunch. A second upshot is that links to the financial system make it
even more likely that self-fulfilling runs against a currency will succeed, as
Obstfeld (1994) has stressed. If fears of devaluation prompt a bank run which
in turn causes an expansion of liquidity with which Central Bank reserves can
be bought, the circle is fully closed. And, as the experience of Argentina recently
suggests, the problem is not eliminated by the adoption of a rigid peg or
currency board system, where the Central Bank is prevented from issuing
domestic credit. Sachs et al. (1996a) argue that in fact the problem may be
worsened, for the absence of a lender of last resort can magnify fears of bank
illiquidity and turn them into problems of insolvency.
The discussion so far implies that such a vicious cycle can affect all banking
systems. But banks, like Orwell's animals, are not all equal. The kind of
vulnerability that we have been describing depends crucially on two features
12 Wigmore (1987) has argued that the failure of the Fed to protect the US banking system in
the winter of 1932-33 was the result of the Fed's fears that lender of last resort credit to the banks
would undermine the link of the US dollar to gold. In Chile in 1982, high interest rates under a
fixed exchange rate helped precipitate a banking collapse; the associated expansion of domestic
credit helped precipitate the end of the exchange rate peg. See also Velasco (1991) for details.
13 Calvo (1996) stresses this point.
Table 12. Credit boom
1994 vs 1989 (%) 1994 vs average (1985-89) (%)
Argentina 23 38
Brazil 21 51
Chile 8 -12
Mexico 207 361
Source: IFS, IMF.
of a banking system. First, the size of the liquidity cushion: the greater are the
ratios of reserves and of bank capital to deposits, the larger the likelihood a
bank can withstand a shock. Second, the quality of its portfolio: weak borrowers
mean weak banks, because a small tremor in interest rates can lead to a large
share of non-performing loans. Both are of course related: a growing share of
doubtful credits eats into capital and reduces the cushion available to cover
additional shocks.
What determines bank weakness? Portfolios can be made suddenly weak
by an exogenous shock - think of oil prices and Texas banks in the mid-1980s-
but bad luck is not the only cUlprit. Portfolios are more often than not
endogenously made weak by swift expansions of credit, with boom leading to
bust. As Hausmann and Gavin (1995) persuasively argue, the empirical link
between lending booms and financial crises is very strong. Rapid growth in the
ratio of bank credit to GDP preceded financial troubles in Argentina (1981),
Chile (1981-82), Colombia (1982-83), Uruguay (1982), Norway (1987),
Finland (1991-92), Japan (1992-93), and Sweden (1991). Their data even
shows a lending boom in the US at the time of the S&L crisis. The rationale
for this link is simple. When lending expands very quickly, lenders' ability to
screen marginal projects declines, and they are more likely to end up with a
large share of weak borrowers in their portfolios. High risk areas, such as
credit cards and consumer and real estate loans, tend to grow more than
proportionately. In addition, regulators (particularly in developing countries)
soon find their limited oversight capacity overwhelmed. Thus, a bank portfolio
that is extremely vulnerable to the vagaries of the business cycle is the most
likely product of a lending boom.
Table 12 shows the evolution of the claims by the domestic financial system
on the domestic private sector (as a share of GDP) for four selected Latin
American countries. 14 If there is one single indicator that sets Chile and Mexico
14 This variable was constructed in the following way. For each year we calculated the ratio of
claims on the private sector by deposit money banks and monetary authorities (lFS line 32d) to
GDP (IFS line 99b). When inflation is high this ratio is biased upward because the available
annual figure for claims on the private sector corresponds to the figure for December, while
nominal GDP reflects the average price level for the entire year. To correct for this bias we
multiplied the biased ratio by the ratio of the average price level to December's price level. When
inflation is low this factor is basically one.
dramatically apart, this is it. Between 1989 and 1994, bank credit to the private
sector grew by 207% in Mexico, while it grew by only 8% in Chile.
Two caveats concerning lending booms are in order. A first one is that it is
extremely important to distinguish levels from rates of increase. Many successful
developing countries show very high ratios of private sector credit to output.
This is of course nothing but financial deepening, and in it of itself not
something to be concerned about. What is worrisome is the occurrence of
sharp increases in lending to the private sector within a short period of time,
which are likely to lower average loan quality. Another caveat is that lending
activity is likely to be closely related to the stabilization cycle. On the other
side of the bank balance sheet are the deposits that finance the loans. Deposits
are highly correlated with money demand, and therefore with expected inflation.
When a policy turnaround puts an end to hyperinflation, deposits swell and
so do bank loans. This effect, which is nothing but a beneficial payoff (greater
financial intermediation) from stabilization, probably explains some of the
sharp increase in lending in a country like Argentina. It does not, however,
explain an episode like Mexico's, in which stabilization occurred in 1988-89
and the increase in credit in 1991-94.
Why did a lending boom happen in Mexico (and to some extent in Argentina)
and not in Chile? A commonly cited culprit is swift liberalization of the capital
account, followed by a surge in inflows which presumably get intermediated
by the banking sector. The are two problems with this explanation. The first
one is that both countries have had reasonably open capital accounts for a
long time. The second is that there is no obvious correlation between the size
of the capital inflow and the ensuing behavior of bank credit. As we saw above,
both countries experienced similarly large capital inflows, and bank lending
grew tremendously in Mexico but not in Chile. 1s
But if capital account liberalization does not seem to have mattered, the
same is not true of domestic financial liberalization. Already in the late 1970s
and early 1980s the cycle from bank privatization and deregulation to lending
boom to eventual bust was clearly visible in a number of countries. In Latin
America, Argentina, Chile and Colombia, plus Uruguay, went through the
cycle. 16 The point, of course, is not that deregulation is bad per se, but that it
can lead to rapid credit expansion. For instance, financial liberalization in
1988-90 was followed by a lending boom in Indonesia. In Mexico, privatization
and deregulation of the banking system in the early 1990s had a similar effect.
A key difference is that in Mexico the capital inflow took place simulta-
neously with a decrease in banks' required reserve ratios, while in Chile such
ratios were increased (at least for dollar deposits). As Rodriguez (1993) has
stressed, this can set the stage for the inflow to cause a large increase in
domestic bank lending. The stance of bank supervisors probably also made a
ISSachs et al. (1996b) also find no such correlation for their sample of 20 developing countries.
16 See Baliilo and Sundarajan (1991) for studies from a set of countries, including Argentina,
Chile, Uruguay and the Philippines.
difference. Chile (and Colombia) experienced a credit boom and a financial

crisis in the early 1980s, leading to bank interventions, liquidations, and bail-
outs, all at a substantial cost to the tax payer. The lesson was deeply ingrained,
and in subsequent years both made the enhancement of bank supervision and
capitalization a priority for Chilean policy makers. By contrast, in Mexico (and
to some extent Argentina) the lending boom was allowed to continue unhin-
dered,17 even though policy makers routinely vowed to have learned the lessons
from earlier banking collapses in the region, and to prove it they implemented
Bas1e accord capital standards and other liquidity tests for suspect institutions.
The Mexican lending boom had two dire consequences. The first was a
deterioration of bank portfolios as macroeconomic conditions changed and
interest rates rose in the course of 1994. This problem was to increase exponen-
tially after the December devaluation and financial meltdown. The second
problem was that bank weakness severely curtailed the ability of policy makers
to pursue a tough monetary policy in 1994. Interest rates did go up in Mexico
in the wake of the March shock, but not enough to entice foreign lenders or
to reduce the current account deficit. That bank troubles were the reason for
this is recognized by the Banco de Mexico itself in its 1995 Monetary Program:
" ... (the fall in foreign reserves) made it necessary to carry out compensatory
operations in the money market. Had liquidity not recovered through these
operations, interest rates would have reached exorbitant levels, which would
have affected debtors, including financial intermediaries, in a highly unfavorable
way. That fact could have caused additional capital flight and could have
required an eventual expansion of primary credit." (the translation is our own).
CONCLUSIONS AND POLICY LESSONS
Exchange rate policy
While building credibility in monetary and exchange rate policy is clearly

important, unrealistic 'toughness' on the exchange rate need not increase credi-
bility. Holding on to the peso exchange rate until the bitter end did not serve
to build Mexico's long-term stature as a sound-money country. In any event,
the idea that a pegged exchange rate is the only linchpin to credibility is
misguided. Central bank independence, publicly announced inflation targets,
flexible labor markets, solid fiscal policies, are all forms of nominal anchors
that can keep inflation low even with a floating exchange rate.
Both the data in this paper and the broader sample studied in Sachs et al.
(1996b) suggest that currency overvaluation is almost always associated with
eventual turmoil in currency markets. This suggests that cautious policy makers
will want to endeavor to prevent excessive appreciation. Most economists
17 See Rojas-Suarez and Weisbrod (1995) for evidence on the recent Argentine and Mexican
banking troubles and the just-launched restructuring packages.
would agree that, ifthe capital inflow and therefore the change in the 'fundamen-
tal' real exchange rate are more or less permanent, then in the long run real
exchange rate targeting cannot succeed: repeated nominal devaluations would
simply elicit repeated increases in prices, failing to affect the real exchange rate.
As usual, definitions of what constitutes 'the long run' vary widely. If there is
enough price stickiness over plausibly short periods, and if capital inflows are
also short-lived, so that a brief period is all that is at stake, then nominal
exchange rate policy may well have some ability to prevent real appreciation.
But this policy is not costless: in the 1990s Chile and Colombia (both of which
have targeted the real rate) had higher inflation than the other Latin American
countries, in spite of virtuous fiscal policies. In short, an accommodating
nominal exchange rate policy may be able to limit real appreciation over the
short-to-medium run, though probably at some expense in terms of inflation.
Sterilization and debt management
If a country confronts highly volatile capital movements, then some degree of

sterilization if probably both inevitable and desirable. Even in Argentina's
currency board the Central Bank has manipulated bank reserve requirements
(for instance, during the capital outflow and bank run of the first quarter of
1995) in order to insulate the money supply, at least partially, from the whims
of Wall Street traders. But just as with real exchange rate targeting, this should
be a temporary measure, not a permanent one. Sterilization is fiscally costly,
and over time such costs build up. A heavy sterilization episode that goes on
for very long can cause quasi-fiscal losses that undermine the credibility of the
overall monetary stance.
Regarding domestic debt management, policy makers must recall what
corporate financial officers have always known: borrowing short can sometimes
save you on interest charges, but can also leave you hostage to the mood
changes of lenders. Moreover, the vulnerability of countries is larger than that
of companies, for the presence of exchange risk, and the absence of an intern a-
tionallender of last resort and of an international bankruptcy procedure can
easily lead to creditor panic: if one lender expects other lenders will not roll
over short-term debt, it pays to do exactly the same. A solvent country can
become a country in default overnight.
Capital controls
Most economists are understandably weary of capital controls, for the state
can easily put up an iron curtain of costly and inefficient regulations. But such
skepticism must confront the fact that several of the more successful developing
countries, such as Korea, Malaysia and Indonesia in Asia, Colombia and Chile
in Latin America, have on occasion created disincentives to short term inflows.
And, most important, it was precisely these emerging markets that passed the
Tequila shock with the smallest hangovers.
How does one ensure that such controls do more good than harm? The
experience of the Chiles and Malaysias of the world suggests two lessons. First,
get the cosmetics right: liberalize outflows as you restrict inflows, in order to
make sure that investors do not come to fear a return to the populist policies
of yesteryear. Second, do not expect controls to do more than they can: the
amount of monetary independence a Tobin tax affords is, almost by definition,
limited by the size of the tax wedge. Attempts at fixing unrealistically high
interest rates (relative to world rates) can only cause, as Chile has occasionally
found out, additional large and destabilizing inflows.
Lending booms and bank regulation
The recent experience of Mexico in this regard is unusually revealing. A lending

boom may not only lead to an eventual banking problem. The resulting bank
weakness may also severely curtail the ability of the government to carry out
a sound monetary and fiscal policy, and may therefore endanger the whole
stabilization effort. Receiving large amounts of foreign capital need not cause
a frenzy in bank lending and a growing stock of bad loans, as the experience
of countries as different as Malaysia and Chile shows. Mexican regulators
attempted to deal with the problem by stressing bank capitalization require-
ments. That they failed to contain an impending banking crisis says less about
supervisory incompetence than about the limited usefulness of that kind of
policy: at times of lending booms everyone is liquid, credit is plentiful, and
portfolios that will turn out to be weak look good on paper. In Hausmann
and Gavin's (1995) words, "It isn't that what you get is what you see; it's what
you don't see that gets you." This suggest that additional policies, both micro-
economic (loan-by-Ioan portfolio evaluation) and macroeconomic (sterilization)
may be necessary to ensure that a capital inflow does not end up in a finan-
cial crisis.
ACKNOWLEDGMENTS
Support from the c.V. Starr Center for Applied Economics at NYU is gratefully
acknowledged.
REFERENCES
Alesina, A., A. Pratti and Tabellini (1990). Public confidence and debt management: a model and a
case study of Italy. In Dornbusch and Draghi (eds.), Public Debt Management: Theory and
History.
Balino, Tomas and Sundarajan Vasudevan (1991). Banking Crises: Cases and Issues. Washington
DC: International Monetary Fund.
Calvo, G. (1988). Servicing the public debt: the role of epectations. American Economic Review.
Calvo, G. (1991). Temporary stabilization policy: the case of flexible prices and exchange rates.
Journal of Economic Dynamics and Control, IS( 1).
Calvo, G. (1996). Capital Flows and Macroeconomic Management: Tequila Lessons. Mimeo,
University of Maryland.
Calvo, G. (1994). Comment on Dornbusch and Werner. Brookings Papers on Economic Activity, 1.
Calvo, G. (1995). Varieties of Capital Market Crises. Mimeo.
Calvo, G. and Reinhart Leiderman (1993). The Capital Inflows Problem: Concepts and Issues.
Mimeo.
Calvo, G. and P. Guidotti (1990). Indexation and maturity of government bonds: an exploratory
model. In Darnbusch and Draghi (eds.), Public Debt Management Theory and History.
Cardenas, M. and F. Barrera (1995). On the Effectiveness of Capital Controls in Colombia. Mimeo,
Fedesarrollo.
Cole, H. and P. Kehoe (1996). Reputation Spillover Across Relationships: Reviving Reputation
Models of Debt. NBER Working Paper 5486.
Dornbusch, R. and A. Werner (1994). Stabilization, reform and no growth. Brookings Papers on
Economic Activity, 1.
Drazen, A. and Masson (1994). Credibility of policies and credibility of policy makers. Quarterly
Journal of Economics.
Ffrench Davis, Ricardo and Manuel Agosin (1995). Managing Capital Inflows in Latin America.
Mimeo, University of Chile.
Frankel, 1. and C. Okongwu (1995). Have Latin America and Asian countries so liberalized portfolio
capital inflows that sterilization is now impossible?
Frankel, 1. (1994). Sterilization of Capital Inflows: Hard (Calvo) or Easy (Reisen)? Mimeo.
Hausmann, Ricardo and Gavin Michael (1995). The Roots of Banking Crises: The Macroeconomic
Context. Inter-American Development Bank. Prepared for the Conference on Banking Crises in
Latin America, October 1995, Washington, DC.
Helpman, E., L. Leiderman and G. Bufman (1994). A new breed of exchange rate bands: Chile,
Israel and Mexico. Economic Policy, 19.
Kaminsky, Graciela and Carmen Reinhart (1995). The Twin Crises: The Causes of Banking and
Balance-of-Payments Problems. Working paper No. 544, International Finance Paper, Board of
Governors of the Federal Reserve System.
Laban, R. and F. Larrain (1993). The Chilean experience with capital mobility. In Bosworth,
Dornbusch, Laban (eds.), The Chilean Economy, Policy Lessons and Challenges.
Obstfeld, M. (1993). The logic of currency crises. CaMers Economiques et Monetaires, 43.
Rodriguez, C. (1993). Money and credit under currency substitution. IMF Staff Papers, 40(2).
Rojas-Suarez, Liliana and Steven R. Weisbrod (1995a). Managing Banking Crises in Latin America:
The Do's and Dont's of Successful Bank Restructuring Programs. Inter-American Development
Bank. Prepared for the Conference on Banking Crises in Latin America, October 1995,
Washington, DC.
Rojas-Suarez, Liliana and Steven R. Weisbrod (1995b). Banking Crises in Latin America: Experience
and Issues. Inter-American Development Bank. Prepared for the Conference on Banking Crises
in Latin America, October 1995, Washington, DC.
Rojas-Suarez, Liliana and Steven R. Weisbrod (1995c). Achieving Stability in Latin American
Financial Markets in the Presence of Volatile Capital Flows. Inter-American Development Bank.
Working Paper Series 304 (4).
Sachs 1., Tornell and Velasco (1996a). The collapse of the Mexican peso: what have we learned?
Economic Policy, 22.
Sachs 1., Tornell and Velasco (1996b). Financial crises in emerging markets: the lessons from 1995.
Brookings Papers on Economic Activity, 1.
Soto, M. (1995). Encaje a los Creditos Externos: La Evidencia Empl'rica. Mimeo, Catholic University
of Chile.
Velasco, A. (1987). Financial crises and balance of payments crises. Journal of Development
Economics.
Velasco, A. (1991). The Chilean financial system: liberalization, crisis, intervention. In Baliiio, T.
and Sundarajam, V. (eds.), Banking Crises: Cases and Issues. Washington, DC: International
Monetary Fund.
Wigmore, B. (1987). Was the banking holiday of 1933 a run on the dollar rather than the banks?
Journal of Economic History, 47,739-56.
BARRY EICHENGREEN
University of California at Berkeley
3. International lending in the long run:

motives and management!
INTRODUCTION
Foreign lending to sovereigns and companies has a long and colorful history.
This fact is both easy to remember and easy to forget. Each time difficulties
arise in international capital markets, observers invoke the precedent of history.
Each debt crisis occasions the publication of scholarly studies citing parallels
with debt crises past, making historical studies like this one a cottage industry.2
At the same time, the repetition of events suggests that each additional lending
burst reflects decisions by investors who, if they are not ignorant of history,
fail to use it to inform their actions. In the age of 24-hour trading, the typical
investor complains, who has time to reflect on history books? The relevance
of history is limited, moreover, by changes in the structure of international
financial intermediation, the role played by bond markets in the 1920s and
bank finance in the 1970s having given way to equity finance, fundamentally
altering the lending process.
As is predictably the case when sharp distinctions are drawn, reality lies
between the extremes. Important changes have indeed occurred over the course
of the century in the structure and organization of lending. The most prominent,
no doubt, is the evolution of intermediation: the rise and retreat of the New
York market in international bonds in the 1920s and 1930s, the triumph and
tragedy of bank lending in the 1970s and 1980s, and the growth of emerging
equity markets as a vehicle for capital transfer in the last 10 years. One might
also point to the establishment and evolution of the International Monetary
Fund and Group of Ten as mechanisms for crisis management.
These changes should not be allowed to obscure important elements of
continuity unifying the century of historical experience. Throughout the period
lending has been shaped not just by economic and political conditions in the
debtor countries but by monetary policies in the creditors' markets. Large-
J Prepared for the NYU Conference on Emerging Market Capital Flows, May 23-24, 1996.
The author is John L. Simpson Professor of Economics and Political Science at the University of
California, Berkeley, Research Associate of the National Bureau of Economic Research, and
Research Fellow of the Centre for Economic Policy Research. The present paper draws on work
with Albert Fishlow and Richard Portes (Eichengreen and Fishlow, 1995; Eichengreen and Portes,
1995), whose collaboration is acknowledged with thanks. Helpful comments were provided by
Michael Dooley and Philip Suttle.
2 The burst of lending in the 1920s and the debtservicing difficulties of the 1930s prompted the
publication of classic works by Feis (1930) and Lewis (1938). The lending boom of the 1970s and
the debt crisis of the 19805 had their counterpart in Edelstein (1981) and Fishlow (1985).
Presumably the same will be true of 1994-95 once the Mexican crisis is behind us.
49
R. Levich (ed.). Emerging Market Capital Flows. 49-74.
50 B. Eichengreen
scale lending has repeatedly posed problems of economic management for

governments on the receiving end. The countries most dependent on external
finance have also been most vulnerable to shocks to capital flows and domestic
economic stability. Once debt crises have struck, it has repeatedly proven
difficult to negotiate an orderly resolution of debt-servicing problems.
In this chapter I seek once more to distill implications for policy and practice
from this historical record. I will highlight some parallels and contrasts between
three episodes of large-scale international lending: the 1920s, the 1970s and the
1990s, and then focus on crisis management, using the history of bond finance
as a lens through which to view proposals for institutional reform to resolve
the problems created by defaulted debts.
THREE 20TH-CENTURY CRISES
Lending to emerging markets occurs in bursts; this feature of the historical

record is clear.3 The pattern is evident in the 1920s, when the market in foreign
investments boomed: US direct foreign investment, having averaged $150 mil-
lion a year in the first half of the 1920s, surged to $268 million in 1925, $350
million in 1926 and 1927, and $600 million in 1928 and 1929 (see Table 1) .
Long-term portfolio investment tripled between 1923 and 1924 and persisted
at high levels through 1928. Private short-term outflows, which averaged less
than $70 million per annum before 1927, exceeded $200 million annually for
the remainder of the decade (US Department of Commerce, 1976; Series
U19-21). Private flows to developing economies increased by roughly the same
order of magnitude between the 1960s and 1970s, although in contrast to the
1920s, when the growth of direct foreign investment was most pronounced,
this time the rise in portfolio investment was particularly dramatic (Table 2).
Starting in 1989, lending to developing countries again rose rapidly. Total
private capital flows to developing countries more than tripled between 1989
and 1992. The most dramatic increase was in portfolio equity investment, which
rose from $4 billion in 1989 to $47 billion in 1993 (Table 3) (World Bank,
1995; p. 7). Capital flows to Latin America exceeded those reached during the
peak of bank lending, rising to $24 billion in 1990, $40 billion in 1991, $64
billion in 1992 and $69 billion in 1993.
In each case, conditions in the borrowing regions helped to stimulate the
capital flow. In the 1920s, the burst of capital transfer was initiated by inflation
stabilization in Central and Eastern Europe, which rendered economic condi-
tions more secure and prospects more attractive to foreign investors. The
dismantling of wartime controls and reconstruction of the network of multilateral
trade, which stimulated the provision of trade credit and created opportunities
3 This fact was emphasized by Simon Kuznets, for whom shifts in foreign lending were a
prominent characteristic of the long swings in economic activity that subsequently came to be
known as Kuznets Cycles.
International lending in the long run 51
Table 1. Foreign dollar loans annually taken in the USA, by classes of borrowers, 1923-31 (in
millions of dollars). Aggregate loans and repayments
National and
provincial
government Municipal Corporate Total
Calendar Total Retire- Total Retire- Total Retire- Total Retire-

year face ments face ments face ments face ments
Long term
1923 231.9 54.0 16.7 5.9 80.9 12.9 329.5 72.8
1924 676.9 57.7 66.7 2.0 165.0 43.9 908.6 103.6
1925 551.6 114.2 88.3 7.7 278.5 17.1 918.4 139.0
1926 436.7 105.5 92.8 17.8 354.6 37.0 884.1 160.3
1927 584.8 63.5 198.1 18.3 456.0 76.0 1,238.9 157.8
1928 486.3 256.1 111.7 43.4 567.1 105.0 1,165.1 404.5
1929 97.4 380.6 48.0 13.8 227.4 45.7 372.8 440.1
1930 432.7 120.1 63.8 29.4 260.7 136.3 757.2 285.8
1931 75.1 217.9 22.4 33.7 101.3 93.7 198.8 345.3
Short term
1923 90.7 68.5 1.0 10.3 2.0 7.1 93.7 85.9
1924 175.5 109.0 7.5 11.3 57.1 14.1 240.1 134.4
1925 152.4 264.4 0.6 9.5 70.4 16.4 223.4 290.3
1926 98.6 156.2 7.2 2.2 41.2 26.6 147.0 185.0
1927 75.7 135.3 8.9 5.2 46.6 61.4 131.2 201.9
1928 9.2 59.2 1.8 1.0 10.0 44.5 21.0 104.7
1929 7.5 13.2 2.4 15.2 40.8 22.7 56.4
1930 162.6 99.6 25.6 14.2 17.4 26.2 205.6 140.0
1931 36.6 37.0 24.7 7.5 12.1 44.1 73.8
Source: Lewis (1938), Appendix Table 2.
Table 2. Financial flows to developing countries, 1956-80 (US$ billions)
Private
Official Direct
development private Export
Years Total assistance Total investment Portfolio credits
1956-60 21.9 13.2 8.7

1961-70 29.0 16.2 11.5 6.0 2.6 2.9
1971-80 76.6 28.1 38.1 10.7 19.9 7.4
Source: Cuddington (1989).
for direct investment, were completed only with delay. The post-war boom in
commodity prices encouraged direct investment in extractive industries and
processing capacity in Latin America and Asia and bond issues to finance
railways and port facilities linking resource-rich states and provinces to interna-
tional markets.
52 B. Eichengreen
Table 3. Aggregate net long-term resource flows to developing countries, 1989-94 (US$ billions)
Category 1989 1990 1991 1992 1993 1994*
Total private flows 41.9 45.5 62.9 102.7 159.2 172.9

Private debt flows (net) 12.7 15.0 18.5 41.4 45.7 55.5
Commercial banks 0.8 0.1 3.9 12.8 -2.2
Bonds 5.3 3.4 12.5 12.9 42.1
Suppliers 1.1 7.3 -2.2 0.0 2.0
Other 5.5 4.2 4.3 15.7 3.8
Foreign direct investment 25.7 26.7 36.8 47.1 66.6 77.9
Portfolio equity investment
(estimated) 3.5 3.8 7.6 14.2 46.9 39.5
Memo
Private grants 4.0 4.9 5.2 5.8 6.3 7.0
Net use of IMF credit -2.3 0.1 3.2 1.2 0.8 0.5
Technical cooperation grants 12.2 14.2 15.2 17.8 17.0 17.1
Real aggregate net resource
flows (long term) 91.1 105.6 127.5 154.2 222.8 227.4
Import unit value index 92.8 97.9 97.8 99.3 95.7 100.0
- Not available.
Data provided in this table cover countries included in the World Bank's Debtor Reporting System
and non-DRS developing countries. Foreign direct investment includes reinvested profits. Grants
exclude technical cooperation grants. Officially guaranteed export credits are included under
private loans, and direct export credits under bilateral loans.
Projected.
Source: World Bank (1995), p. 7.
The rise in bank finance in the 1970s responded to economic growth and
liberalization in the developing world. Growth worldwide fluctuated from 4 to
6% in the 1960s, an impressive pace by historical standards. Aspiring borrowers
in Asia and Latin America shared fully in this prosperity. Indeed, they ranked
at the upper end of the growth leagues: growth in Latin America averaged
5.7% per annum in the 1960s, while growth in East Asia was even faster. This
contrasted with the more troubled 1950s, when growth had been less uniform
and persistent. Tariffs were reduced, albeit more gradually in Latin America
than East Asia. Export promotion was embraced in both regions, albeit with
less impressive results in Latin America. This record of trade and growth served
to attract international bankers to the developing world.
From the debt crisis of the 1980s Latin America emerged with a firmer grasp
on fiscal conditions and with inflation under growing control. Consumer price
inflation in Latin America, excluding Brazil, fell to 14% in 1994, down from
1400% in 1989. The ethos of liberalization encouraged the deregulation of
domestic markets, foreign trade and capital transactions. Tariffs were reduced,
encouraging trade-related inward investment. Privatization created new oppor-
tunities for financial capital. The economies of East Asia, for their part, survived
the debt crisis largely unscathed and moved up the technological ladder toward
the production of higher value-added goods. Again, it is not surprising that

investors were attracted to opportunities in the developing world.
But economic conditions in the borrowing regions do not provide a complete
explanation for these surges of capital flows. In addition, monetary policies in
the creditor countries have been critical in stimulating the search for yield and
enhancing the credit worthiness of borrowers. This was true in the 1920s: when
the Federal Reserve Board reduced interest rates starting in 1924 to assist the
Bank of England in restoring sterling to the gold standard, the shift coincided
with the initiation of large-scale foreign lending by the United States. The yield
on domestic medium-grade bonds, the obvious substitute for Latin American
and Central European issues, peaked in 1923 and trended downward through
1928. After 1925 the yield on Lary's (1943) sample of foreign bonds consistently
exceeded that on domestic medium-grade securities. The search for yield plausi-
bly prompted the rise in US portfolio investment abroad. By early 1928 the
Fed had grown anxious about the Wall Street boom; concern that 'excessive
speCUlation' was diverting resources from productive uses led it to raise interest
rates. The rise in US discount rates increased the debt-servicing burdens of
countries with large amounts of short-term debt, of whom Germany was the
preeminent case. In response, US lending fell to virtually zero in the second
half of the year.
In the 1970s, bank lending to developing countries was encouraged by low
real interest rates in the industrial world (see Figure 1 for the USA) and by the
abundant supply of loanable funds channeled by OPEC through the money-
center banks. Most central banks of industrialized countries accommodated
the first oil shock, printing money to raise other prices along with those of
petroleum. Financial market participants, for their part, were slow to react: the
rise in nominal interest rates did not match the rise in inflation, as if many
investors continued to anticipate the maintenance of the Bretton Woods System
and the long-term monetary stability implied by its constraints. The six-month
LIBOR deposit rate fell significantly in the mid-1970s (Cuddington, 1989;
p. 30). Deflated by the change in their export price indices, the real interest
rates of developing countries became negative in 1976, where they remained
until 1981 (World Bank, 1987; p. xii). Reflecting the impact of negative real
rates on the credit worthiness and debt-servicing capacity of developing coun-
tries, spreads over LIB OR charged to developing countries fell significantly in
tItis period.
The worm turned with mounting concern over inflation in the United States
and the appointment of Paul Volcker as chairman of the Federal Reserve
Board. The Fed embarked on a strict anti-inflationary policy, and real interest
rates rose in the United States. LIBOR rose faster, reflecting the risk premium
associated with heavier debt-servicing burdens. The debt-servicing difficulties
and curtailment of lending that ensued were a logical consequence.
The role of monetary policy in the major financial centers is again evident
around the time of the 1994 Mexican crisis. Short-term US interest rates had
trended downward from their peak in 1989, coincident with the resurgence of
54 B. Eichengreen
~ ~----------------------------------------------~
(8)
10
o~~--~~==~~~~ ____ ____________

~ ~
-5
1974 1975 1976 1977 1971 1979 1910 1911 1912
12
II
10
2
1916 1987 1911 1919 1990 1991 1992 1993 1994
...-Nominal -+-Real
Figure 1. US Interest rates. (a) Prime lending rate, 1974--82; (b) prime lending rate, 1986-94.
foreign lending (Figure 1). They were reduced by an Open Market Committee
seeking to stimulate the economy's recovery from the recession of the early
1990s and concerned by the weakness of the California economy. By mid-1994
it was clear that recovery was secure, and the Fed turned its attention to
inflation. By raising interest rates, it increased the yield and attractiveness of
domestic securities and heightened the debt-servicing burdens of countries like
Mexico with large amounts of short-term debt. Monetary policy in the creditor
countries is far from a complete explanation for the most recent wave of lending
to emerging markets, but Calvo et al. (1992), Chuhan et al. (1993), Fernandez-
Arias (1994), and Dooley et al. (1996) unanimously conclude that fluctuations
in international interest rates account for a sizeable share of the variation in
capital flows.
In all three cases, capital flows had a major impact on the recipient countries.
The increased availability of liquidity and downward pressure on interest rates
stimulated domestic spending. The supply of non-traded goods being inelastic
(compared with tradeables, the supply of which is all but perfectly elastic),
inflows drove up real exchange rates. This caused resources to shift toward the
production of nontradables, widening the trade deficit. In all three episodes,
but especially in the 1920s and 1970s, the increased availability of credit
financed budget deficits which proved difficult to rein in once foreign funds
dried up. In all three instances, foreign funds were channelled through banks
which were left with a mismatch in the maturity structure and currency com-
position of their assets, rendering the banking system vulnerable to
disturbances.
One important difference between the three episodes is currency manage-
ment. In the 1920s, virtually every borrowing country was on the gold standard;
foreign investors regarded membership as a signal of financial probity and
made it a prerequisite for lending. 4 In the 1970s the transition to floating had
begun, but many developing countries, especially in Latin America, continued
to peg. By the 1990s, fully half of large developing countries had gone over to
floating, up from 27% in 1982.
In the 1920s, a capital flow automatically raised the reserves of the recipient
country. The borrower, be it a company, bank or government, converted the
foreign exchange it obtained into domestic currency, depositing the latter with
the central bank. The additional liquidity put upward pressure on prices,
worsened export competitiveness, and fueled financial activity. If the central
bank sought to mop up that liquidity by raising the discount rate, the rise in
rates relative to world levels only attracted more capital from abroad. When
the German Reichsbank kept interest rates high in the second half of the 1920s,
for example, it only stimulated a flow of foreign deposits into German banks.
4There were considerable short-term flows to countries like Germany before they returned to
gold, but these were limited to the early period during which the quick resumption of gold
convertibility was still widely anticipated. Once it became clear in 1922 that quick resumption was
not in the cards, this capital flow dried up (see Holtfrerich, 1986).
56 B. Eichengreen
In the 1970s, exchange rate policies were more diverse. Thailand, Korea,
Indonesia and Malaysia all switched from dollar to basket pegs, varying the
weights on different currencies to provide scope for exchange rate flexibility.
They followed austere fiscal policies to limit the inflow-induced appreciation
of their real exchange rates. In contrast, most Latin American countries contin-
ued to peg to the USA, causing their exchange rates to strengthen when the
dollar appreciated after 1979, and adopted accommodating fiscal policies
(Figure 2). The budget deficits of Asian countries receiving large capital inflows
averaged only 1.1 % and 3.0% of GOP in 1973-76 and 1977-82, compared
with 2.4% and 4.3% in Latin America and the Caribbean (IMF, 1994; p. 58).
Real exchange rates appreciated by 3% between 1976-78 and 1979-80 in Latin
America while depreciating by 11 % in East Asia (Sachs, 1985; Figures 3 and 4).
Latin American governments supported their overvalued rates by rationing
foreign exchange; substantial black-market premia emerged virtually every-
where but Colombia and Venezuela. 5
By the 1990s this distinction between Latin America and Asia had largely
disappeared, a growing number of Latin American countries having elected to
float. Both floaters and peggers had to cope with the tendency for capital
inflows to raise the real exchange rate, undermining the competitiveness of the
traded-goods sector. A variety of instruments were deployed to address this
problem, foremost among them fiscal policy. This time fiscal retrenchment was
more dramatic in Latin America than East Asia: while the budget deficits of
the high-inflow Asian countries fell from 3% to 2% of GOP between 1983-89
and 1990-93, those of the high-inflow countries of Latin America and the
Caribbean fell even more dramatically, from 5% to essentially zero (Figure 2).
Fiscal adjustment by itself did not suffice. A frequently cited success story
is Thailand, whose sharp fiscal correction in 1988-91 limited upward pressure
on its real exchange rate. But even that draconian adjustment did not prevent
the current account deficit from widening to 5% of GOP in 1993 or insulate
the country from the fallout from the Mexican crisis in 1994. There as elsewhere
it proved difficult to adjust fiscal policy with the speed and to the extent
required to accommodate shifting capital flows. Countries seeking to manage
their exchange rates and capital accounts resorted to other instruments, notably
sterilized and un sterilized intervention. The upward pressure that open market
sales placed on interest rates only encouraged capital inflows, as in the 1920s;
this response was evident in Brazil and Malaysia in 1991-93.6
Exchange rate flexibility mattered most when capital flows turned around.
Countries seeking to defend their pegged rates were forced to adopt drastic
measures of monetary retrenchment. Under the gold standard this implied
allowing the monetary base to decline by an amount commensurate with the
5 These are extensively analyzed by Edwards (1989).

6 In addition, sterilized intervention can have significant budgetary costs for the central bank
insofar as domestic interest rates exceed the return on foreign reserves. These costs increase with
the thinness and illiquidity of domestic markets in government securities.
(a)
1974 1975 1976 1977 1978 1979 1980 1981 1982
(b)
6
o ~--------------------------~__-,~----------~~-;
1
1986 1987 1988 1989 1990 1991 1992 1993 1994
Figure 2. Budget deficit/GDP, Latin America. (a) 1974-82; (b) 1986-94.

58 B. Eichengreen
Figure 3. Real exchange rate index: Latin America. Wholesale prices relative to US (1990 = 100).
--- unadjusted; -+- adjusted by output/worker (Summers-Heston); ---.- adjusted by
output/person (lFS).
~~-----------------------------------------------------,
ICD
150
ICD
1m 1m I_ 1"1 1m 191:1 I'" ItIS 1911 1917 1911 19It I!IIO 199\ 1992 1991
Figure 4. Real exchange rate index: Asia. Wholesale prices relative to US (1990 = 100).
___ unadjusted; -+- adjusted by output/worker (Summers-Heston); ---.- adjusted by
output/person (IFS).
loss of gold and foreign exchange reserves. The deflation that ensued could
threaten macroeconomic stability. These dynamics were evident in the late
1920s: when US interest rates rose and foreign lending declined in 1928, the
balances of payments of capital exporters like the United States strengthened,
obviating the need to increase exports. This shift had as its counterpart a
deterioration in the balance of payments accounts of capital importers in Latin
10 ~-------------------------------------------------------,
;!t 0
IS
20
~ ~------~------~------~------~------~----~------~~
1924 1925 1926 1927 1921 1929 1930 1931
Figure 5. Trade deficit/imports, 1924-31: Latin America and Central and Eastern Europe.
(Excludes Uruguay for 1926-27. Sources: International Historical Statistics: The Americas (1993)
and European HIstorical Statistics (1975) by B.R. MitchelL)
America and elsewhere, forcing such countries to boost exports and curb
imports in order to sustain their pegged currencies (Figures 5 and 6).
Stimulating exports required lowering the relative prices of the goods they sold
internationally in order to price them into world markets. In other words, for
the maintenance of external balance it was necessary for price levels to decline
more rapidly in capital-importing than in capital-exporting economies.
Eventually this adjustment was achieved, but at considerable macroeconomic
cost in countries wedded to their pegged rates. In contrast, countries which
chose to boost exports by devaluing their currencies, also halting the con-
traction of domestic credit, could slow the deflationary spiral and more quickly
restore macroeconomic stability.7
While it is still too early to assess the relative success of countries with
pegged and floating currencies in adjusting to the Mexican shock, there is some
reason to think that the policy independence conferred by exchange rate
flexibility has been beneficial. In Argentina, the archetypical example of a
country with a pegged rate, the decline in capital inflows associated with the
Mexican crisis plunged the economy into recession. Venezuela, which pegged
7 Eichengreen and Sachs (1985) and Campa (1990) make these points for Europe and Latin
America, respectively.
60 B. Eichengreen
~ r-------------------------------------------------------,
20
10
30
.~ ~------~----~----~~----~----~------~----~----~~
1929 1930 1931 1932 1933 193< 1935 1936 1937
Figure 6. Growth rate of exports, 1929-37: Latin America and Central and Eastern Europe.
(Excludes Spain for 1936-37. Sources: Exports from International Historical Statistics: The
Americas (1993) and European Historical Statistics (1975) by B. R. Mitchell. Nominal exchange
rate from BMS (1943).)
its currency before devaluing at the end of 1995 and subsequently adopted a
fluctuation band, also experienced an adjustment crisis. In contrast, floaters
like Chile and Brazil have weathered the storm relatively well. Even in Mexico,
where the policy was handled badly, currency depreciation has boosted exports.
The other place where the advantages of exchange rate flexibility are evident
is the management of financial instability. After 1928 the withdrawal of foreign
deposits and the deterioration of domestic macroeconomic conditions com-
bined to undermine the liquidity and solvency of banking systems. By the early
1930s, banking crises in debtor countries had become the norm. The most
serious crises, in the summer of 1931, originated in Austria, Hungary and
Germany, three debtor countries with fixed exchange rates. Each had suffered
serious recessions starting in 1929, reflecting the compression of demand caused
by the global economic downturn and the curtailment of capital inflows. Banks
in all these countries had loaned heavily to industry, which was battered by
the slump. And their central banks had their hands firmly tied by gold standard
statutes. Bernanke and James (1991) and Grossman (1994), analyzing samples
of developing and industrial countries, conclude that bank failures were most
prevalent in countries whose central banks were prevented by the gold standard
constraints from engaging in lender-of-last-resort intervention.
Similar contrasts are evident in the 1980s. Again the typical sequence was
a cessation of lending, a recession, and a banking crisis. The Chilean banking

crisis of 1982-3 followed the decline in capital inflows caused by Mexico's
suspension of payments and the recession associated with the country's
exchange rate-based disinflation program. Similar developments set the stage
for banking crises in Colombia and Uruguay.
In the 1990s the same patterns have been evident in Argentina, Brazil and
Mexico. At one extreme is Argentina, whose capacity to address the problems
of its banking system is limited by its fixed exchange rate. 8 The Mexican crisis,
by curtailing the inflow of funds and jacking up interest rates, undermined the
solvency of an already weak banking system and revealed that the Argentine
authorities possessed only limited capacity as lenders of last resort. Substantial
aid from the IMF, much of which has been used to clean balance sheets and
establish a deposit insurance system, was required to prevent the collapse of
the banking system. While banking problems have been far from optimally
handled in countries with more flexible exchange rates, it has at least been
possible to limit systemic instability without resorting to IMF assistance. Sachs
(1995a) and Gavin and Hausmann (1996) conclude that exchange rate flexibility
is needed to reduce the likelihood that a sudden shift in the direction of capital
flows will precipitate a banking crisis.
But even the most flexible policies and markets are sometimes incapable of
delivering adjustment to major shocks. The historical record suggests that there
are circumstances under which heavily indebted developing countries find it
impossible to maintain service on their debts and at the same time preserve
macroeconomic and financial stability. This was true of Eastern Europe, Latin
America and much of the rest of the developing world in the 1930s. It was true
of Latin America, Africa and much of Eastern Europe in the 1980s. In 1995 it
would have been true of Mexico and perhaps other developing countries in
the absence of exceptional assistance from the IMF and the USA.
Historically, problems of collective action have blocked efforts to clear away
defaulted debts and restore the borrowers' capital market access. In the 1930s,
restructuring debts required the consent of many thousands of small bondhold-
ers, something that was exceedingly difficult to obtain. In response, countries
resorted to buying back bonds at discounted market prices.9 Bondholders
organized committees to represent them in negotiations. These committees
solicited subscriptions from investors and negotiated settlement terms with
debtors. When they endorsed an offer as the best that could be obtained,
bondholders validated the agreement by registering their opinion with the
committee or cashing a coupon with the debtor. But many years could be
8 This statement should be tempered to take into account the limited capacity of the central
bank to extend credit to the financial system within the limits of the convertibility law and the
decision to permit commercial banks to utilize their own reserves by relaxing the high reserve
requirements that had been in place on the eve of the crisis. See Gavin and Hausmann (1996).
9 See Eichengreen and Portes (1989) and Klug (1993). Buybacks were also widespread in the
1980s; Peru again resorted to the practice in 1995.
62 B. Eichengreen
required to conclude negotiations; it took more than two decades to settle

some post-1930 defaults. The process was complicated by the existence of
competing committees, especially before the Foreign Bondholders Protective
Council was recognized by the US State Department in 1934, and by the efforts
of dissident bondholders to seek redress in the courts.
In the era of bank finance, the number of creditors may have been smaller,
but collective-action problems were still substantial. Hundreds of banks could
participate in a syndicated loan. Although banks formed steering committees
and attempted to act in concert in post-1982 negotiations, small banks withheld
their consent to restructuring terms in order to be bought out at favorable
terms by banks with larger stakes. No one bank had an incentive to provide
new money without an assurance that others would do likewise, and there
existed no mechanism to enforce the commitment. The Baker Plan, which
called for the banks to lend $20 billion to 15 developing countries in debt
difficulties, foundered for lack of bank support. Not until 1988, with the advent
of the Brady Plan, did the process of writing down developing-country loans
finally begin, opening the way for the resumption of lending.
The growth of portfolio capital flows since 1989 has again transformed the
problem. Equity finance obviates the need for special institutions to facilitate
restructuring; if a corporation goes bankrupt, the claims of foreign investors
can be adjudicated in domestic courts like any other. Admittedly, a stockmarket
crash can destabilize banks which hold corporate equity and which have
extended loans to companies that find themselves unable to pay. But the central
bank can head off this problem by injecting liquidity into the financial system,
as the Fed did after the 1987 Wall Street crash, without requiring the coopera-
tion of either foreign creditors or governments. 10 On the other hand, bonds
issued by the governments of developing countries may be distributed even
more widely than in the 1920s, and there no longer exist bondholders' commit-
tees to provide representation. One can only imagine how long litigation and
disruptions to international financial markets would have persisted had the
US government not stepped in and had defaults on tesobonos and cetes been
allowed to occur.
ORDERLY WORKOUTS: HISTORICAL PRECEDENTS AND POLICY PROPOSALS
Historical evidence points to the need for institutions to deal with the problems
of coordination and collective action that arise in the wake of debt-servicing
difficulties. In the 19th century and 1930s these institutions took the form of
bondholders committees; in the 1980s they took the form of the London and
Paris Clubs and bank steering committees. No analogous mechanism existed
10 Or it can do so as long as it is not committed to the maintenance of a fixed exchange rate,

which may prevent it from expanding domestic credit.
for dealing with the Mexican crisis, through which the IMF and G-7 countries
muddled, adopting an exceptional bailout package. There is every reason to
think that the response to the Mexican crisis will not be generalized. Crises
that take place further from US borders will lack the same salience in
Washington, DC. Now that the Congress has discovered the existence of the
Exchange Stabilization Fund, it will be loath to permit the President to again
use it for similar purposes. The personal connections between the US Treasury
and IMF that facilitated assembly of the Mexican package cannot be taken
for granted. Even a doubling of the General Arrangements to Borrow may not
provide the Fund with the resources needed to deal with several crises at once.
If a Mexico-style crisis again ensues, there may be no way to halt the creditors'
scramble for the exits, restructure debts in an orderly way, and inject new
money.
Elsewhere, Richard Portes and I have suggested a menu of institutional
reforms to address this problem (Eichengreen and Portes, 1995). Our first
recommendation is that the IMF more actively transmit signals about the
advisability of unilateral suspensions of debt service (temporary stays or stand-
stills). Debtor governments have the capacity to impose the equivalent of a
creditor standstill by suspending debt service payments but hesitate to do so
for fear of jeopardizing their credit market access. Encouraging the IMF to
advise the debtor and issue opinions on whether or not there is justification
for a stay of payments would allow the Fund to carry out an important
signalling function; a government which received approval for its standstill
would suffer relatively little damage to its reputation, while the possibility that
the Fund would not approve would discourage debtors from utilizing the
option strategically. Naturally, the IMF should limit its advice before the fact
to the debtor government and share its opinion with the markets only ex post
so as to avoid inciting a panic. A definitive reinterpretation of Article VIII(2)(b)
of the IMF Articles of Agreement would support the Fund in this role even if
it was not legally binding in national courts.
Creating a bondholders steering committee would eliminate uncertainty
about the locus of authority in negotiations. That committee would be responsi-
ble for restructuring bonded debts, while the London and Paris Clubs would
retain their responsibility for bank loans and official credits. Discussions
between the debtor and the Paris Club, the London Club and the bondholders
committee could rely on a specially constituted conciliation and mediation
service to prevent extended deadlocks.
Changes in bond covenants to permit a majority of creditors to alter the
terms of payment would prevent rogue investors from holding up the settlement.
To make this palatable to the lenders, dissenting creditors should have recourse
to an arbitral tribunal. To prevent a negotiated agreement or the findings of
the arbitral tribunal from being disputed in court, loan agreements would
specify that objections by minority creditors were subject to the tribunal's
arbitration.
64 B. Eichengreen
Strengthened IMF conditionality would reduce the likelihood that finan-

cial problems will recur. The knowledge that any new money injected in
conjunction with the debt restructuring, and Fund sanction for the country's
unilateral standstill, would be predicated on the government first agreeing
to fulfill stringent IMF conditions would minimize the likelihood of such
difficulties arising in the first place. Frequent monitoring by the IMF of
economic conditions in debtor countries and timely dissemination of infor-
mation by the Fund would strengthen market discipline. Increased IMF
resources would allow the Fund, where appropriate, to inject new money on
the requisite scale.
These proposals assume that the Mexican crisis was not one of a kind.
History tells us that financial crises in heavily indebted developing countries
recur, as they have in the 1830s, the 1850s, the 1870s, the 1890s, the 1930s, and
the 1980s. Moreover, periodic financial difficulties are actually a sign that
capital markets are functioning as they should. If companies never had to
declare bankruptcy, we would say that the capital market was not doing its
job. Sometimes profitable investment opportunities become unprofitable
because of unanticipated events. At that point, the company in question declares
bankruptcy, and its operations are liquidated or reorganized. This is how
efficient capital markets work. If no company ever went bankrupt, we would
infer that investors were behaving in inefficient ways. Their conservative lending
behavior would be starving firms with profitable investment opportunities
of finance.
The same point applies to countries. Governments have risky projects that
more than compensate investors for the cost of their funds, in an expected
value sense, and for bearing risk. While those investments payoff on average,
sometimes they do not, and governments find themselves in the position of
bankrupt firms. This is a normal, indeed a healthy, outcome when it occurs in
response to unanticipated events. There is no reason that it should be less true
of governments than of corporations, and no reason to think therefore that
the Mexican crisis was one of a kind. Providing more information to the
markets and making every effort to prevent foreseeable crises are desirable, but
they will not eliminate the need for procedures to pick up the pieces when
things go wrong.
The obvious objection to our proposals is moral hazard. Any procedure
that reduces the costliness of restructuring ex post will encourage borrowers
to pursue policies which increase the likelihood that debts will ultimately have
to be restructured. But while the existence of a corporate bankruptcy procedure
in the domestic setting similarly creates moral hazard for corporate borrowers,
no one argues that bankruptcy statutes should be revoked. Rather, these
statutes are constructed so as to balance the costs of moral hazard against the
inefficiencies of letting viable investment projects go unexploited as a result of
failure to restructure debts and reorganize operations. In the sovereign setting,
moral hazard risk must be balanced against meltdown risk. And the risk of a
financial meltdown should take into account the possibility that financial
instability can spread to other emerging markets.u
The alternative to a procedure for orderly workouts may not be the absence
of intervention, of course. The alternative, as in Mexico, may be a bailout. And
the prospect of a bailout creates moral hazard for lenders as well as borrowers.
Would not changes in bond covenants permitting a majority of creditors to
alter the terms of payment, like those we propose, be regarded by bondholders
as weakening their bargaining position? (In other words, might the terms at
which developing countries could borrow deteriorate if bond covenants carried
such clauses?) The same question can be asked, of course, of a corporation's
creditors in the context of a bankruptcy procedure: why do countries' statutes
permit 'cramdown' by the courts or allow two-thirds of each class of creditors
to ratify a restructuring agreement? The need for unanimous consent creates
incentives for particular creditors to behave strategically by withholding con-
sent; cramdown and majority rule can be seen as countering these incentives.
Once again the question arises of why, if such clauses have merit, they have
not already been adopted by the markets. An answer is that bargaining power
between a country's debtors and its government may be distributed more
asymmetrically than the bargaining power between a corporation and its
creditors. Courts can seize a corporation's collateral and dismiss its manage-
ment; there are no analogous mechanisms for containing moral hazard in the
context of sovereign debt. There may be a temptation for bondholders to cave
in to a government's strategic default; allowing the least compromising bond-
holders to set the terms of bargaining (or requiring them to be bought out by
the government or by other creditors) can be thought of as a counterweight.
Hence, if they are to accept majority rule, bondholders may require other
compensation. This is why we recommend that dissident creditors should have
recourse to an arbitral tribunal. To prevent a negotiated agreement or the
findings of the arbitral tribunal from being disputed in court, loan agreements
would specify that objections by minority creditors were subject to the tribunal's
arbitration.
How would the Bondholders Council be organized? History suggests that
a confusing proliferation of committees can spring up in the absence of official
accreditation. It may be desirable therefore for the governments of the creditor
11 In fact, there are reasons to worry that moral hazard is more severe in the sovereign than
the corporate setting. In the case of sovereign debts, no mediation and conciliation service or
arbitral tribunal for dissident creditors could seize collateral in the manner of a bankruptcy court.
It is not possible to 'throw out' the government of a country whose debts are restructured in the
way that bankruptcy judges in the United States can replace the management of firms in Chapter
11. (Note, however, that sovereign financial crises often lead to replacement of the finance minister,
which should have some ex ante deterrent effect on the relevant policymakers. Moreover, bank-
ruptcy procedures in other countries do not always empower the courts to replace the management
of firms undergoing reorganization.) That there can be a moral hazard problem in this context
provides the basis for arguing that IMF surveillance before the fact and conditionality afterwards
need to be strengthened.
66 B. Eichengreen
countries to recognize a particular committee (The New York Club) as the

representative of the bondholders. But a single committee could be overly
powerful and obstructive. In the 1930s, competition between the British
Corporation of Foreign Bondholders and the American Foreign Bondholders
Protective Council encouraged each to show flexibility. Hence some counterbal-
ance might be needed (e.g. one or more representatives from governments or
multilateral institutions on the steering committee of the Council). In addition,
the Council should contain a core of permanent members representing large
bondholders, mutual funds, pension funds, etc. Other members might rotate
on depending on the country or countries whose liabilities needed to be
restructured and the composition of those liabilities (foreign-currency-denomi-
nated securities, domestic-currency-denominated securities, and so forth).
If representation of the creditors by a bondholders committee is a good
idea, why haven't the markets created such an institution? After all, such entities
existed in the past and were created through private initiative. Part of the
answer is that the renewed importance of bonds as vehicles for lending to
emerging markets is a recent phenomenon. For four decades after World War II,
bond markets as a mechanism for lending to developing countries had largely
fallen into disuse. The Council of Foreign Bondholders, which relied for support
on subscriptions by bondholders, wound up its operations and closed its doors
in the 1980s. Creating such an organization entails sunk costs; there will have
to be defaults on significantly-sized bond issues before it will be in the interest
of anyone to sink them. While others (viz. Macmillan 1995) have similarly
suggested the creation of Bondholders Councils, this has yet to occur.
Historically, the effectiveness of such organizations in expediting negotiations
and securing favorable settlement terms for bondholders required avoiding a
confusing proliferation of committees. Until the Corporation of Foreign
Bondholders was created in 1868, such a proliferation of committees existed in
Great Britain. The same problem prevailed in the USA before the creation of
the Foreign Bondholders Protective Council in 1934. Multiple committees were
often dedicated to negotiating with particular governments or over particular
bond issues. Their organizers competed against one another for subscriptions
and commissions, diluting their bargaining power vis-a.-vis the debtors. Aware
that inter-committee competition reduced the likelihood of a successful conclu-
sion to negotiations, bondholders hesitated to subscribe to the services of any
committee. Their skepticism was reinforced by awareness of principal-agent
problems between the organizers and the bondholders, since the former, when
engaged in a one-shot negotiation, had an incentive to agree to settlement
terms that maximized their commission rather than the return to the bondhold-
ers. The presence on the committee of representatives of the underwriting bank
heightened the conflict of interest.
These problems were solved by the intervention of governments. In 1898
the Corporation of Foreign Bondholders was recognized by an act of
Parliament. To prevent it from being a creature of the bankers, the representa-
tives of the issue houses were removed from its Council, which was expanded
to embrace representatives of the British Bankers' Association and the London

Chamber of Commerce, along with miscellaneous members at least six of whom
were to be substantial bondholders. By the 1930s these miscellaneous members
had come to include representatives of the Association of Investment Trusts,
the British Insurance Association, the Bank of England, and the Stock Exchange
(Securities and Exchange Commission, 1937). The US State Departmeilt, in
1932-33, following the first wave of defaults on dollar-denominated bonds,
sponsored the formation of a working party to draw up plans for a permanent
organization. The Foreign Bondholders Protective Council was then founded
with finance from charitable foundations and the New York Stock Exchange.
Wouldn't such reforms entail a significant shifting of the burden toward the
creditors? Answering this requires specifying the counterfactual: how will crises
play themselves out in the absence of reform? If the alternative to orderly
workouts is a bailout, then our proposal may entail shifting some of the burden
from creditor-country taxpayers in general to the creditors themselves. This is
not obviously undesirable. Indeed, from the viewpoint of containing the moral
hazard for lenders that a bailout entails, this may have positive efficiency effects.
Debt negotiations often take on a war of attrition character, with each party
utilizing delay to elicit information about the cost-bearing capacity of the other.
Creditors hold complex and conflicting claims, and negotiations between bond-
holders and governments lack mechanisms for dealing with dissident creditors.
Insofar as our proposal for orderly workouts will expedite the conclusion of a
negotiated settlement, it could reduce the burden on all parties.
THE G-l 0 PROPOSALS FOR REFORM
The G-10 Working Group on Sovereign Liquidity Crises (the Rey Committee
after its chairman Jean-Jacques Rey) has finally come forth with its proposals
for handling financial crises in emerging marketsP To facilitate restructuring
and reorganization it proposes modifying the provisions of loan contacts. It
recommends incorporating into all loan agreements a 'collective representation
clause' clearly designating the creditors' representative and making provision
for a bondholders meeting. 13 That representative (the fiscal agent or indenture
trustee) would be empowered to deal with governments and international
llGroup of Ten (1996). At the Halifax Summit of June 15-17, 1995, the Heads of State and
Government of the G-7 countries encouraged G-lO Ministers and central bank governors to
consider new procedures for the orderly resolution of sovereign debt crises. In response, the G-I0
established a working party consisting of representatives of ministries of finance and central banks.
In a parallel initiative it has also been exploring the feasibility of expanding the General
Arrangements to Borrow in order to provide the liquidity needed to respond to financial
emergencies.
13 Currently, many sovereign bond agreements, most notably Brady Bonds, do not provide for
bondholders meetings at the initiative of the bondholders or the debtor.
68 B. Eichengreen
organizations on the investors' behalf, eliminating confusion about the locus

of authority in negotiations. 14
The Committee further recommends incorporating qualified-majority-voting
clauses into all loan agreements to allow the core terms of bond contracts to
be altered without the unanimous consent of the holders. Decisions reached
by qualified-majority vote would bind all creditors, eliminating the ability of
a small minority to block a restructuring until they were bought out by other
creditors or the debtor government.
It recommends the addition of sharing and nondiscrimination clauses like
those which have traditionally been included in bank syndicates' loan
agreements to remove the incentive for dissident creditors to litigate and
otherwise disrupt negotiations. Specifying that additional payments obtained
by any creditor would have to be shared with the entire class would diminish
the incentive to hold up a settlement. The Rey Committee recommends limiting
sharing clauses to individual bond issues rather than applying them to all of
the country's creditors as a compromise between the desire to promote creditor
cohesion on the one hand and to avoid creating cumbersome communication
problems on the other.
The Rey Report concludes that it is neither feasible nor desirable for the
IMF to protect countries from these consequences by endorsing or sanctioning
the government's decision to suspend. But it encourages the IMF to lend into
arrears, which would have much the same effect. Lending into arrears would
have two further functions: it would provide much needed catalytic finance to
jump-start the debtor's economy, since it will still be difficult to mobilize private
creditors to provide new money; and would signal the creditors that their
interests are best served by reaching an agreement with the debtor. Standard
IMF practice is to provide official finance only after negotiating a program
with a country and after the latter has cleared away its arrears. The Fund
typically waits for actual or imminent agreement with the Paris Club and the
bank steering committee, although there have been cases where it has lent
under conditions where arrears continue to accumulate. The Rey Committee
endorses this practice and suggests that the IMF extend it to debt owed to
other private creditors, including bondholders.
14 Under the United States Trust Indenture Act 1939, the indenture trustee takes responsibility
for the affairs of the bondholders in a default situation. The trustee acts as a communications
center and provides coordination services for the bondholders. He is obligated to carry out
instructions voted by the bondholders. Absent such directions, he may unilaterally accelerate the
balance due, recover a judgement against the obligor, or sue to enforce the bond covenants. See
Macmillan (1996). However, the framers of the 1939 Act exempted sovereign debt from this
provision, instead giving more limited responsibilities to the fiscal agent (who, for example, has no
fiduciary responsibility to the bondholders). The implication of the Rey Committee's recommenda-
tion is that the Trust Indenture Act should be amended to allow for indenture trusteeship in the
case of sovereign debt. Similar legislation would also have to be adopted in the other principal
creditor countries, like the UK, where the fiscal agent is also used.
But the Committee recommends against providing large-scale emergency

financing like the $50 billion Mexican package as a general rule. It notes that
using loans from the US or the IMF to service debts to private creditors
constitutes a covert transfer from taxpayers in the creditor countries to their
fellow citizens who hold bonds. Large-scale emergency financing would create
moral hazard for the creditors, who would have an incentive to lend regardless
of the risks because they could anticipate a bailout; indeed, they would have
no incentive to even gauge the risks. The report emphasizes that new official
financing, including lending into arrears, should be conditioned on the immi-
nent implementation of an adjustment package.
The Rey Committee portrays its proposals as complementing efforts to
enhance crisis prevention. It recommends strengthening IMF surveillance,
improving the quality and timeliness of external debt data, and fortifying
financial systems in developing countries in an effort to head off crises before
they occur.
In advocating model clauses providing for bondholder representation, quali-
fied majority voting, and sharing, the G-IO working party recommends a
'market-driven' process. The role for governments is to trumpet the virtues of
such clauses but to otherwise take no action; officials are simply to hope that
the markets will see the light. But because of different national traditions, there
are special obstacles to agreeing on a single set of contractual provisions.
Different countries provide for the organization and representation of bond-
holders in different ways. Because national practices differ so radically,
underwriters of international bond issues have been unable to agree on an
arrangement that is not off-putting to a particular set of national clients, and
an institutional lacuna has developed.
Then there is the 'pre-nuptial agreement' problem. If only some sovereign
borrowers include qualified majority voting clauses in their loan agreements,
creditors may suspect that the debtors in question anticipate having to restruc-
ture sometime in the not too distant future. The qualified majority voting
clause will be taken as a negative signal and render investors reluctant to lend.
If such clauses are to become widespread, it may therefore be necessary for
countries whose credit-worthiness is well established, notably the advanced
industrial nations, to adopt them first. Similarly, the governments of the leading
creditor countries may have to guide underwriters to a particular set of model
clauses to solve the coordination problem that would otherwise result from
the existence of different national traditions. It is naive to think that the markets
will immediately recognize the merits of model clauses simply because officials
have acknowledged their desirability.
The changes in contractual provisions recommended by the Rey Committee
could be promoted by enabling legislation. The US Trust Indenture Act of
1939 could be modified to allow the trustee to take a more active role in
representing the bondholders in restructurings. Sharing clauses could be added
to all sovereign bonds through an act of simple legislation. But the report,
perhaps in a desire to look market friendly, is silent on the need for legislation.
70 B. Eichengreen
In its absence, new clauses will work their way into the markets only
gradually, as old loans are retired and new ones are issued. Since bond issues
run 10, 20 or 30 years to maturity, it will be well into the next century before
much of an effect is felt. Another approach would have been for the Rey
Committee to encourage governments to convert old issues into new ones prior
to maturity and even to recommend that G-10 governments and the IMF
provide some finance for the purpose.
While noting that bondholders often organize representative committees
and suggesting that this is an adequate way of solving the representation
problem if and when the markets find it congenial, the report does not recom-
mend that governments themselves promote the establishment of standing
committees for this purpose. The Rey Committee may have been impressed
that the Costa Rican, Guatemalan and Panamanian restructurings of the 1980s
and 1990s were accomplished without the intervention of a bondholders com-
mittee; rather, negotiations proceeded through direct contacts between the
government and members of the main groups holding the securities. Is But it
is not clear that this mechanism will work so smoothly for larger countries
with more numerous creditors. The G-10 Committee may have anticipated
that defaulted debts will be bought up by 'vultures' whose small number will
allow governments to negotiate with them relatively easily.I6 While this is not
unrealistic given sufficient time, the process of consolidating bond holdings in
the hands of a small number of investment professionals will not be completed
in a matter of days or months. In the absence of a representative committee
authorized to speak for the bondholders, negotiations will remain messy for
some time. Again, the Rey Committee may have erred on the side of inaction
in order to appear as uninterventionist as possible.
The Rey Report discusses the idea of an independent entity to act as
coordinator, conciliator and arbitrator in negotiations interchangeably with
proposals for an international bankruptcy court, apparently on the grounds
that both would involve the creation of a new international agency. But the
idea of an agency for voluntary mediation and conciliation is more limited. Its
involvement could be subject to the express approval of both debtors and
creditors; provision for this might be made in the bond contract itselfY It
would be a low-cost way of giving official agencies like the IMF a way of
recognizing and supporting the authority of particular representatives of the
bondholders. The Rey Committee objects that existing arbitration procedures
For details, see Fernandez-Ansola et al. (1995) and Pinon-Farah (1996).

IS
The Committee may have had in mind the Dart Family, for example, which bought up more
16
than $1.38 billion of Brazilian debt and engaged in extensive negotiations with, and litigation
against, the Brazilian Government in 1994-96.
17 In fact, in Eichengreen and Portes (1995) we proposed mediation and conciliation only in
cases where its use was expressly agreed to by both the debtor and the creditors (and presumably
provided for in the bond contract). The Rey Report's rejection of the possibility of creating an
agency for voluntary mediation and conciliation thus appears to rest on a rather restrictive
interpretation of that proposal.
are essentially designed to adjudicate cases of contract performance and'''could

not be easily adapted" to cases of contract renegotiation. We would say instead
that they should be adapted in that direction. Similarly, the committee observes
that the ICSID is designed to resolve disputes over contract enforcement and
interpretation and "could not be easily applied" to bond restructurings. Again,
we would argue that ICSID-like procedures should be adapted so that they
could be more easily applied to bonds. Once again, the Committee may have
erred on the side of inaction in order to minimize the appearance of meddling
with the market.
Even these modest reforms may not be adopted without the strong support
of G-10 governments. A change in IMF policy to allow lending into arrears
would require the assent of the Fund's principal shareholders. There are good
reasons to think that the model clauses in bond contracts recommended by
the Rey Committee will be adopted only slowly if at all without action by the
governments of the advanced industrial countries. Unbeknownst to the Rey
Committee, a League of Nations committee established in the aftermath of the
sovereign debt defaults of the 1930s also recommended changes in the provis-
ions of bond covenants designed to enhance bondholder organization and
representation and to provide for the equivalent of qualified majority voting
and sharing clauses in the event of litigation. But in the absence of anything
beyond a statement of desirability by the League, there was no response by
the markets.
Will the advanced industrial countries, the developing countries in the
strongest financial position, and international institutions like the IMF push
for these proposals with the force required for their implementation? The
Clinton Administration appears to be on board, not surprisingly given that
the USA is the leading source of portfolio capital to emerging markets and the
country which underwrote the largest share of the Mexican bail-out. It has
kindred spirits in the front office of the IMF, an institution which sees the Rey
Committee's proposals as a way of expanding its influence and raising its
profile. The Europeans and Japanese are more skeptical. The German
Government is preoccupied by moral hazard and worries that all reforms, no
matter how modest, will encourage reckless lending and over borrowing. The
Japanese, their experience with bank insolvencies firmly in mind, feel much the
same way. The French and Italian Governments worry that agreement to
rewrite international debt contracts will force them to do the same for their
parastatals. The most prosperous and financially secure developing countries,
while not consulted by the G-lO, are unlikely to embrace innovations which
acknowledge the possibility, however slight, that their debts might one day
have to be restructured.
Thus, as with the Mexican meltdown in 1995, the debate will array the USA
and the International Monetary Fund against their reluctant partners.
Institutional reform to better cope with future crises in emerging markets will
therefore require strong leadership from the USA and a clever campaign to
win over the financial community.
72 B. Eichengreen
CONCLUSION
Surges of lending to emerging markets do not occur at random. Typically, a

conjuncture of events initiates the flow of capital to developing countries:
prerequisites include brightening growth and investment prospects in the recipi-
ent regions and low interest rates in the financial centers. A corollary is that a
rise in world interest rates, by heightening debt-servicing burdens, can interrupt
the flow of funds even in the absence of policy problems in the borrowing
countries. Developing countries which are small relative to global capital
markets have found it hard to manage capital inflows and adjust to their
withdrawal. Large inflows have been associated with real appreciation, current
account deficits, and worsening competitiveness. Countries that have appropri-
ately adjusted their exchange rates and fiscal policies in the period of significant
inflows and its aftermath have tended to cope best. Nonetheless, the painful
adjustments required have repeatedly proven to be beyond their capacity. Default
or its equivalent has ensued, disrupting the operation of international capital
markets.
Circumstances have changed with the shift from bond to bank to equity and
bond finance. The creation of the London and Paris Clubs has provided new
institutional vehicles for restructuring bank and intergovernmental debts. The
IMF's involvement in the debt crisis of the 1980s created a mechanism for signal-
ling credit worthiness and injecting new money. But these institutions and their
functions, however desirable, appear increasingly impotent and under-funded in
the face of enormous, highly liquid markets. Crises which required weeks to leap
national borders in 1931 took only days to do so in 1982 and hours in 1995. With
securitization, a debt crisis no longer threatens the solvency of major money-
center banks but rather that of banks in the borrowing country which serve as
conduits for foreign funds. A consequence, to quote Ted Truman, is that the days
are gone 'when the G-lO central banks could assemble a bridge loan in a few days
that would serve to stabilize expectations about a major borrowing country's
situation. Also gone are the days when the Managing Director of the IMF and
the Chairman of the Board of Governors of the Federal Reserve System could
get representatives of 15 major private international financial institutions in a
room and easily convince them that a systemic crisis is, first and foremost, a crisis
for their own institutions' (Truman, 1996; pp. 24-25).
Some observers have argued that the markets should be left to deal with
the consequences. IS This would be inefficient, however. Investors facing a
problem of collective action have an incentive to 'rush for the exits', aggravating
any liquidity crisis. Asymmetric information and negotiating costs render volun-
18 Thus, Allan Meltzer has argued that the market solution would have been better for Mexico.
"Default and renegotiation was the lower cost solution. Mexico would not have been the first
country to default, and the default would not have been the first for Mexico. The record of recent
defaults shows that, once there is an agreement on the terms of the renegotiation, capital flows to
the country soon resume" (Meltzer, 1995; p. 11).
tary restructurings exceedingly difficult. Coordinating the provision of new

money is impossible.
Under these circumstances, the 'market solution' is suboptimal. Nor is it
likely that more Mexico-style bail-outs will be forthcoming. 19 Institutional
reform is the only game in town.
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Bernanke, Ben and Harold James (1991), The gold standard, deflation and financial crisis in the
great depression: an international comparison. In R. Glenn Hubbard (ed.), Financial Markets and
Financial Crises. Chicago: University of Chicago Press, pp.33-68.
Chuhan, Punam, Stijn Claessens and Nlandu Mamigni (1993). Equity and Bond Flows to Latin
America and Asia: The Role of External and Domestic Factors. Policy Research Working Paper
no. 1150. Washington, DC: The World Bank.
Calvo, Guillermo A., Leonardo Leiberman and Carmen M. Reinhart (1992) Capital Inflows to Latin
America: The 1970s and 1990s. Unpublished paper, International Monetary Fund.
Campa, J.M. (1990). Exchange rates and economic recovery in the 1930s: an extension to Latin
America. Journal of Economic History, 50, 677-682.
Cuddington, John T. (1989). The extent and causes of the debt crisis of the 1980s. In Ishrat Husain
and Ishac Diwan (eds), Dealing with the Debt Crisis. Washington, DC: The World Bank, pp.l5-42.
Dooley, Michael, Eduardo Fernandez-Arias and Kenneth Kletzer (1996). Recent private capital
inflows to developing countries. World Bank Economic Review, 10,27-50.
Edelstein, Michael (1981). Overseas Investment in the Age of High Imperialism, New York: Columbia
University Press.
Edwards, Sebastian (1989). Real Exchange Rates, Devaluation and Adjustment. Cambridge: MIT
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Eichengreen, Barry and Albert Fishlow (1995). Contending with capital flows: what is different
about the 1990s? Council on Foreign Relations Occasional Paper, New York: Council on Foreign
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Eichengreen, Barry and Richard Portes (1989). After the deluge: default, negotiation, and readjust-
ment during the interwar years. In Barry Eichengreen and Peter Lindert (eds), The International
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Feis, Herbert (1930). Europe, The World's Banker, 1870-1914. New Haven: Yale University Press.
Fernandez-Ansola, Juan Jose and Thomas Laursen (1995). Historical Experience with Bond
Financing to Developing Countries. Unpublished manuscript, IMF.
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Research Working Paper no. 1312. Washington, DC: The World Bank.
Fishlow, Albert (1985). Lessons from the past: capital markets during the 19th century and the
interwar period. In Miles Kahler (ed.), The Politics of International Debt. Ithaca, New York:
Cornell University Press, pp. 37-94.
Gavin, Michael and Ricardo Hausmann (1996). The Roots of Banking Crises: The Macroeconomic
Context. Working Paper Series 318, Office of the Chief Economist, Inter-American
Development Bank.
19 The enormous cost of support packages, plus doubts on the part of creditor-country politicians
and financial institutions that they have much at stake, make it unlikely that 'bridge loans' (read
'bail-outs' or 'emergency assistance') on the same scale will be offered to the next Mexico.
74 B. Eichengreen
Grossman, Richard (1994). The shoe that didn't drop: explaining banking stability during the great
depression. Journal of Economic History, 54, 654-682.
Group of Ten, Working Party on the Resolution of Sovereign Liquidity Crises, The Resolution of
Sovereign Liquidity Crises.
Holtfrerich, Carl-Ludwig (1986). US capital exports to Germany: 1919-1923 compared to
1924--1929. Explorations in Economic History, 23,1-32.
International Monetary Fund (1994). World Economic Outlook. Washington, DC: IMF, October.
Klug, Adam (1993). The German buybacks, 1932-1939: a cure for overhang? Princeton Studies in
International Finance, no. 75. International Finance Section, Department of Economics,
Princeton University.
Lary, Hal B. (1943). The United States in the World Economy. Washington, DC: GPO.
Lewis, Cleona (1938). America's Stake in International Investments. Washington, DC: The Brookings
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Macmillan, Rory (1995). The next sovereign debt crisis. Stanford Journal of International Law,
31, 305-358.
Meltzer, Allan H. (1995). A Mexican Tragedy. Unpublished manuscript, Carnegie Mellon
University.
Pinon-Farah (1996). Private bond restructurings: lessons for the case of sovereign debtors. IMF
Working Paper no. 96/00 (February).
Sachs, Jeffrey D. (1985). External debt and macroeconomic performance in Latin America and East
Asia. Brookings Papers on Economic Activity, 2, 523-564.
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script, Harvard University.
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and Agenciesfor Holders of Defaulted Foreign Bonds. Washington, DC: GPO.
Truman, Edwin M. (1996). The risks and implications of external financial shocks: lessons from
Mexico. International Finance Discussion Paper no. 535, Board of Governors, Federal Reserve
System (January).
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Washington, DC: GPO.
World Bank (various years). World Debt Tables. Washington, DC: The World Bank.
PHILIP SUTTLE
J.P. Morgan
Comments on 'International lending in the long-run:

motives and management' by Barry Eichengreen
Professor Eichengreen's paper covers two sets of issues, with his usual degree
of straightforwardness and clarity. The first is that of the similar patterns
evident in cycles in lending to developing countries, emerging markets, or 'high-
risk far-off places' (call them what you will). He compares the 1920s, the 1970s
and 1990s and emphasizes that the period of surging lending shared three
common characteristics:
Apparent improvements in the long-run economic prospects of borrowing
countries;
Easy monetary conditions in the lending economies;
Ensuing problems of macro-management in borrowing countries in both
boom and, especially, bust periods. Particularly difficult throughout is the
choice of an appropriate exchange rate regimen.
I agree that this is the right way to think about the swings in capital flows to
emerging economies, and I do not have a great deal to add to what Barry has
written. I would like to make a couple of points, however, from the perspective
of the markets today. First, since February, we have had (in market terms) a
significant shift in thinking on U.S. interest rates; 2-year note yields have risen
by over 100 basis points. The last two times this happened were February 1994
and OctoberjNovember 1994. And we all know what happened in emerging
markets - specifically Mexico - on both occasions. This time, however, the
peso has actually appreciated against the dollar, Mexican foreign exchange
reserves have edged up, and short-term interest rates have fallen from 50% to
25%. These moves have a lot of market participants talking about emerging
markets decoupling from U.S. rates. I noted, for example, an article on that
very theme in the Wall Street Journal yesterday.
What should we make of this? One point to make is that it illustrates the
short time horizon of market thinking. Let us wait and see how well emerging
markets do in the late summer when the Fed is likely to tighten policy. Another
point, which is being a bit more generous to the markets, is that the rate link
is particularly important when the maturity of the lending is short term. This
was certainly the case in 1994-95 (not just in Mexico), and was also true of
These comments reflect the personal opinions of the author and do not necessarily reflect the
views of J.P. Morgan.
75
CI 1998 Kluwer Academic Publishers.
76 P. Suttle
the late 1970s and early 1980s. The bottom line is that the countries that get
into trouble when rates shoot up are those with a lot of short-term debt.
Second, concerning this point, we need to think globally and not just about
U.S. interest rates. U.S. short-term interest rates are almost double their lows
of 1993, but German and, especially, Japanese interest rates remain very low.
This helps to explain, I think, why capital flows into Emerging Europe and
Emerging Asia have been so strong recently (in some cases too strong, illustrat-
ing a point that Barry makes about policy problems in dealing with capital
inflows). To take one illustration: The liabilities of Thailand to BIS-area banks
(mainly G-10 banks) rose by $28 billion in the first 9 months of 1995. Much
of this was short term and much came from Japan, looking to take advantage
of the short-term spread between Japanese short-term rates of 0.5% and Thai
short-term rates of 10%. Indeed, you could even go as far as to say that the
next 'bubble' being created by the Bank of Japan's current excessively easy
monetary policy is not to be seen in Japan, but in the extended boom that is
going on in its smaller neighbors to the southwest.
One lesson to bear in mind looking ahead is thus: Beware rising Japanese
and German interest rates. I am not saying they would have the same devasta-
ting effect on Emerging Asia and Emerging Europe, respectively, that rising
U.S. rates in 1994-95 had on Latin America, but my view is that markets
currently underweight this risk.
The second set of issues that the paper then goes on to consider is that of
how to handle crises, on the assumption that they periodically occur in the
area of sovereign lending. The Mexican crisis was the latest in the long line of
such accidents, and it would be foolish to think that it will be the last of this
round. The key proposition of the paper is that we have a classic case of market
failure where what is good for efficiency in the vast majority of cases (i.e. a
capital market that takes risk) is a poor outcome for all when the bad event
occurs. Barry thus suggests that the world would be a better place if two key
institutional reforms were adopted:
The IMF were put in the position of being able to declare that a moratorium
of payments by a country is justified;
New bond contracts were written (and, if possible, old ones rewritten) in a
way that would allow a bondholder committee to be formed quickly with
the power to restructure bonded debt.
I am skeptical that such proposals would do much good. I would not wish the
role of default arbiter on my worst enemy, let alone on the IMF. As we all
know, default is as much about willingness to pay as ability to pay, and I am
not sure how to judge when it was objectively fair for a country to cease
making payments. Moreover, rewriting bond contracts may not do much good.
Bonds are already flexible enough: They go down in price to reflect the fact
that I am not being paid, or may not be paid. Moreover, most emerging market
bonds start off being non-investment grade - that is subject, in the eyes of the
rating agencies, to considerable default risk. If these price mechanisms fail to
work - as in the case of Mexico - then there arises a public policy choice of
Comment 77
either doing something ad hoc, surprising and innovative, as was the case in
Mexico, or relying on the creation of some form of bondholders committee
which, whether constituted ex ante or ex post, would hold its first meeting
soon after any formal default (and probably sit for many years after).
In fact, almost 18 months on from the onset of the Mexican crisis, I think
distortion arises in an attempt to compare the Mexican crisis with the debt
crisis of the early 1980s. Then, Mexico was a domino (not even the first) in a
process that did bring down a whole set of countries. Rescheduling became an
industry, and institutions - steering committees, Paris Clubs, London Clubs,
the IIF - were created left, right and center. Last year, Mexico suffered a
sudden loss in market access, which certainly spread to Argentina but not
much further. Mexico and Argentina were forced into very painful, deep adjust-
ments, as small open economies occasionally are when they overextend
themselves.
Of course, support packages were put together for both countries, and may
well have helped (I think probably did) the spread of contagion effects to other
countries and regions. But growth in many Latin American countries remained
strong in 1995, and growth in all other parts of the emerging world actually
picked up in 1995. This was fueled by stronger, not weaker, capital flows. At
the start of the year, it looks as if the Mexican crisis would make the overall
emerging world's growth much weaker in 1995; in fact, the growth surprises
were generally on the weak side in the OECD, not in the emerging markets in
1995. We did not have another generalized debt crisis and I do not think we
are on the edge of one today.
I also think that it is wrong to call the support that Mexico enjoyed last
year a 'bail-out.' For the U.S. Treasury, the assistance extended has turned out
so far to yield a significant financial return (although not as good as if they
had bought Brady's), and clearly helped stabilize the Mexican economy, which
is now nicely moving into a phase of recovery. Those creditors who were bailed
out in the early months of 1995 were classic sellers at the lows. Of course, they
got more back than they might have done, but the point is that the package
(from today's vantage point at least) seems to have been a pareto improvement:
I can see plenty of winners, but I have a hard time spotting losers.
Remember that Mexico returned to the markets this time within 7 months,
rather than the 7 years that it took last time. To me, this suggests that a flexible
approach that involved as little market disruption as possible worked wonders
compared to the institutional "getting everyone together in a smoke-filled
room" approach that Barry quotes Ted Truman as looking back at wistfully
in his paper.
In conclusion, I do not want to give the impression either that a bottomless
pit of cash from the public sector is the right approach to every problem, or
that the market works perfectly. There are cases of market failure which make
it highly appropriate for public sector institutions to play a role in dealing
with incipient crisis as decisively as possible. In some cases large packages may
be important; in others, a different approach may be warranted. Last year, for
78 P. Suttle
example, the support enjoyed by Argentina and Mexico from the IMF was
radically different, even though their quotas as the Fund, which should govern
access, are very similar. I would say that famous 'case-by-case' approach that
guided the early response to the debt crisis of the early 1980s is probably the
most adept way to deal with international financial market difficulties that
inevitably lie ahead. Remember, that for all the regularities in international
finance there seem to be, we are often hit by the next crisis because we are
trying too hard to look backwards to solve the last one.
MICHAEL P. DOOLEY
University of California at Santa Cruz
Comments on 'International lending in the long run:

motives and management' by Barry Eichengreen
This is a challenging paper. It puts forth a clear and forceful argument for
systematic government intervention in international capital markets. First let
me layout the bare bones of the argument.
Financial contracts do not, in practice, eliminate the risk that debtors will
be unwilling to meet their obligations under some circumstances. Contracts
that set out all the contingencies under which both debtors and creditors might
be willing ex ante to adjust repayment terms would involve enormous transac-
tions costs and would reduce, but not eliminate, moral hazard and the tempta-
tion for ex post self-interested bargaining. For these reasons real world contracts
are quite simple. Contingent conditions are strictly limited to easily verified
factors such as international interest rates that are beyond the control of
the debtor.
It follows that a proportion of countries will default on their obligations. If
international interest rates rise, then this proportion increases. The point made
in the paper that I think is the most useful is that an efficient private debt
market will, nevertheless, make such loans with positive default probability
and charge an appropriate default premium. Financial crises are a feature of
an efficient system. I agree with the author that we must learn to live with this
feature of financial markets.
A good system would be one in which the parties agree costlessly to enter
into a new agreement that reflects conditions realized after the contract was
entered into. In the best case the new contract is the same as would have been
agreed upon if the original contract had been contingent on the state of the
world that in fact occurred.
A domestic bankruptcy court can be thought of as a place where all the
contingent contracts are recorded and an impartial judge decides which con-
tract to enforce. When the actual contract generates insolvency the judge
impartially applies well known criteria to rewrite the contract and compels all
creditors and the debtor to comply with its interpretation of the facts. Thus, a
bankruptcy court mimics a complete menu of contingent contracts.
For international contracts there is no court to enforce a judgment. This
leads to strategic behavior by debtors and creditors to protect their interests.
Eichengreen focuses on self-interested bargaining among private creditors as
an important factor in generating costly settlements. In the background is the
79
C> 1998 Kluwer Academic Publishers.
80 M.P. Dooley
sensible fear that this leads to prolonged wars of attrition among private
creditors that are very damaging to debtor countries.
The solution therefore has two building blocks. The first requirement is that
a settlement mechanism must have some power to enforce a settlement. Since
coercion is not possible for private creditors from different legal systems, an
alternative is a cash side payment from an international organization or its
equivalent. In practice this might take the form of new multilateral loans that
are junior to the existing private debt. As Eichengreen points out, the terms
on which new loans are made can be a powerful source of incentives for both
debtors and creditors to agree to a settlement. Moreover, he argues that because
the cost of failure to attain a settlement is so high that creditor governments
cannot credibly commit to not providing side payments.
The obvious problem with side payments are that they will feed back to the
first part of the game. An important feature of the domestic bankruptcy court
is that it does not offer cash to buy creditor agreement. To the contrary lawyer
fees are recognized as an important dead weight loss that must be shared
among the debtor and its creditors. (I might add that in this light lawyers are
actually useful since they provide a commitment mechanism.) This is equivalent
to the IMF appropriating some of Mexico's reserves for the service of enforcing
an agreement among private creditors rather than making new loans on gener-
ous terms. The original contracts are obviously distorted by the expected value
of the costs or payment. The domestic distortion is usually too little debt; the
international distortion is too much debt.
There is a domestic counterpart for a mechanism that involves positive side
payments, the lender of last resort (LOLR) to the banking system. Since the
LOLR is also a creditor the game with investors inevitably involves the expecta-
tion that risky investments involve private benefits and public costs. The well
known solution to the distortion associated with lenders of last resort, or more
generally side payments to buy agreement, is supervision and regulation. For
this reason Eichengreen proposes an expanded role for the IMF to provide
just such a supervision and regulation for governments. He points out, I think
correctly, that the Fund would be happy to expand into this very labor intensive
role in the system. But I have serious doubts about the Fund's ability to play
such a role.
Part of the problem is identified by Eichengreen. Solvency crises need not
reflect bad economic management, at least not bad management that can be
identified ex ante. Simple, noncontingent debt contracts mean that a certain
number of 'no fault' insolvencies are a feature of an efficient system. The Fund
cannot see these coming any better than creditors. The Fund as an institution
did not see Mexico coming even though some staff members provided very
clear warnings about the likely impact of rising international interest rates.
Why not? We may know that certain shocks to the system will expose weak
creditors. A rise in international interest rates is the dominant example. But
there is no evidence that we can guess which debtor will attract speculative
interest and which will be unable or unwilling to fight off an attack.
Comment 81
We do know that the initial capital inflow will go to countries most likely
to use up their own resources and borrow from the Fund or friendly govern-
ments in order to defend the regime. I would argue that this is likely to be
countries with fixed exchange rates, weak banking systems and access to
political good will. The lesson I draw from history is that solvent governments
that offer an exchange rate guarantee and a banking system guarantee suffer
from private inflows just large enough to exhaust the governments' net worth.
Increasing the access of such governments to an international lender of last
resort will increase the scale of private capital flows necessary to exploit the
expected insurance.
My conclusion is that extension of even greater incentives for another round
of insurance seeking capital inflows is not as Eichengreen argues "the only
game in town".
The debtor countries themselves are the players in the game that have the
most to lose from such 'solutions'. Their alternative is to break the circle of
insurance. First, fixed exchange rates must be replaced by more flexible forms
of exchange rate management. Second, domestic banking systems must be
effectively regulated. Third, private investors must be given no hope for a side
payment in the event of a crisis. It may be that creditor governments cannot
resist the temptation to save the world. After all, they are correct in arguing
that the bailout process does not cost them much, if anything. But debtor
countries are the big losers in this game and this means that they can and
should refuse to participate in the bailout of international investors.
PART TWO
Returns on emerging market equities

ROY C. SMITH and INGO WALTER!
New York University
4. Rethinking emerging market equities
The Mexican financial crisis of late 1994 and early 1995 resulted in a linked
collapse of stock market values in almost all developing countries, regardless
of economic policies or performance. The contagion effect was clear, and much
commented on, if not fully explainable by either theory or past experience.
Other Latin American equity markets, being close to ground zero, universally
declined by 15-30% in less than a month, as did markets in Asia, where equity
indexes in Hong Kong, Singapore, Taipei, Seoul and Bangkok dropped 10-15%
in a matter of days. Markets in Poland, Hungary and the Czech Republic
fell by similar amounts see (Figure 1). Overall, the International Finance
Corporation's IFCI Latin America Index lost 19% during the calendar year
1995; IFCI Asia index lost 7% while the IFCI EMEA Index (Eastern Europe,
Middle East and Africa) gained 20%, but this was due almost entirely to gains
by the heavily-weighted South African equity index (Littler and Malouf, 1996).
Meantime, the U.S. S&P 500 index had risen over 30%.
These dramatic price movements occurred against the backdrop of an ongo-
ing decline in emerging market share prices. 2 Together with sizeable losses in
emerging market bonds, the investment performance of sophisticated hedge
funds, country funds and regional funds that had made major commitments to
emerging equity markets was savaged. These developments, in turn, triggered
sharp portfolio adjustments and mutual fund redemptions and caused a general
loss of confidence in developing-country stock markets as serious investment
vehicles. Apparently portfolio managers all rushed for the exits, whether or not
the local markets were directly related to Mexico, to avoid performance punish-
ment and to anticipate fund redemptions, as well as to maintain their port-
folio weights.
1 This paper is based in part on an earlier paper by the authors (Smith and Walter, 1996).
2 The Morgan Stanley Group Emerging Market Index dropped nearly 20% in the calendar
year 1994, having risen by 20% in 1993, and 48% in 1992. Stock prices in individual countries
that had attracted particularly large portfolio equity inflows were hit much harder than the index
as a whole. As measured in dollar terms at the end of January 1995, as compared with January 1,
1994, the stock market in Turkey was down 57%, Mexico 56%, China 54%, Poland 50%, Hong
Kong 41 %, Israel 40%, and 10% or more in just about all the rest of the emerging market
countries. The principal exceptions were Chile where the market was up 42%, Brazil 39%, South
Africa 10% and South Korea 9% over the same period.
85
R. Levich (ed.), Emerging Market Capital Flows, 85-105,
86 R. C. Smith and I. Walter
LATIN AMERICA
Mexico -22.2
Peru -19.2
Brazil -10.2
Chile -e.g
Argentina .Q.8
Venezuela 4 .8
EUROPE
Hungary -21 .1
Poland 13
Turkey -12.9
Czech Repub lic 7
ASIA
Pakistan -13.4
Philippines -13.2
China -12.5
India -12.2
South Korea -11 .4
Taiwan -11 .3
Hong Kong -10.3
Thailand -10.3
Malaysia oQ.2
Indonesia -8.3
Singapore -6.5
Sri Lanka -2.3=
-25 -20 -15 - \0 ..s 0
Figure 1. Equities: the Mexico effect, January 1995.

Source: Bloomberg Financial Services.
Observers with long memories and students of economic history saw in

these events clear echoes of the past. Developing country bond market collapses,
mainly sovereign debt defaults by government issuers, occurred repeatedly
in the 1820s, the 1870s, and the 1930s (Figure 2), visiting repeated and often
massive losses on foreign investors but spaced widely enough apart to convince
investors that past performance was not a good guide to current conditions. 3
Still, international bond markets remained decidedly on the sidelines when the
great developing country borrowing boom built momentum in the 1970s, which
consequently involved almost exclusive reliance on the market for syndicated
bank loans and eventually visited large losses on the lending banks after the
Mexican crisis of 1982_ The 1980s saw dreary cycles of massive loan reschedul
ings, new-money packages, maturity stretch-outs and forced lending, with the
end of the crisis heralded by Brady bonds-for-Ioans conversions - in tum
setting the stage for the emerging markets securities boom of the early 1990s.
Indeed, the emerging market investment phenomenon of the early 1990s was
partly a bubble - the result of a global investment stampede in which aggressive
institutions and mutual funds competed to buy up a relatively small supply of
securities. The strong demand induced an increase in that supply, as new
3 For an excellent review of the history of developing country debt defaults and reschedulings,
see Salomon Brothers, 1993.
Rethinking emerging market equities 87
50
40
30
c:CD ,'"
rf 20
0
10
Figure 2. History of Sovereign debt defaults, expropriation of investment, and bank debt reschedul-
ings, 1823-1989.
Nation-states in default on foreign bonds
- ---- Nation-states involved in reschedulings
- - -- Major country foreign investment in default
Note: Major countries refer to Great Britain (1823-1939), France (1833-1939), Germany
(1880-1939) and the United States (1914-1939).
Source: Salomon Brothers, Inc.
securities were issued through secondary offerings by public companies and

initial public offerings, privatizations of state-owned enterprises, and financings
of new projects. According to the IFC, during the 4-year period to the end of
1994, approximately $500 billion of new foreign money poured into fewer than
30 developing countries. Of this total, approximately 20% was in the form of
portfolio investments in stocks, which at that point had a combined market
value of about $200 billion, despite the discouraging market results during
1994 due to substantial profit-taking and a sharp curtailment of new investment
inflows. In 1985, global stock market capitalization stood at about $4.7 trillion,
with the share of emerging markets about 4%. By the end of 1995 that had
risen to about $15.2 trillion, with the emerging market share having risen to
almost 13%. Emerging market equity trading volume rose from under 3% in
1985 to roughly 17% of the global total during the same period. 4
These developments raise three important questions of interest to interna-
tional investors and governments of emerging market countries alike, which
we address in this paper: (i) What caused the investment surge to begin, and
4 World Bank data, as cited in The Economist, January 28,1995, and Financial Times, February
20, 1995.
to end? (ii) Does this mean a longer-term erosion of investor interest in

emerging markets? (iii) If so, what are the implications for the widely-heralded
thinking about economic development being the just reward for drastic policy
changes toward free markets and sound money, thinking that today is referred
to as the 'Washington Consensus'?5 The answers are offundamental importance
to the economic development process, and to global capital allocation more
generally.
In this chapter, we take the view that the emerging market equity boom in
the early 1990s was not so much ill founded as it was excessive. As Krugman
(1995) has pointed out, the surge of investments into these markets had many
characteristics of a tulip bulb mania. That is, prices got out of line with reality.
The market has presumably had its reality-check. Equity flows to specific
emerging market countries will continue, but these will have to be 'earned', not
only by the continuation of determined policies intended to expedite the sound
evolution of market economies, but also in competition with other countries
seeking to do the same. This is a process of succeeding in a competitive
environment, something that many developing countries have not been overly
concerned about in the past. The dramatic surge of equity flows into these
countries, and out again, has left behind some lessons which countries intent
on real economic progress in the future will have to master.
BEHIND THE SURGE
The end of the 1980s saw a collapse in the market for high-performance
investment vehicles such as leveraged buyouts, takeovers financed with junk
bonds, speculative real estate development in North America, Japan and
Europe, as well as Japanese stocks, a market which had enjoyed nearly 20 years
of continuously rising prices. Institutions had been the principal investors in
these instruments which, having served their time, needed to be replaced.
Despite the difficulties of the late 1980s, financial markets looked ahead
optimistically to a continued expansion of global investment activities as a
result of the considerable deregulation in Western Europe following efforts to
implement the EU's single market initiative, the rebirth of Eastern Europe as
a collection of nascent market-driven economies, and the recognition that
liberalizing reforms in countries like Chile and Mexico could bring to Latin
America much of the potential realized in the market-oriented economies of
Asia. Indeed, in the gloomy recession-bound environment of the early 1990s
in New York, London and Tokyo, the lure of the emerging markets of Latin
5 A term coined by John Williamson of the Institute for International Economics as the
conventional wisdom among opinion-leaders that free markets and price stability are preconditions
for viable economic development, comprising such elements as removal of internal and external
market distortions, balanced budgets, pegged exchange rates and privatization of state-owned
enterprises.
America and Asia became self-evident. Attention was attracted away from the
conventional international investments of the past to zero-in on the promise
of undervalued, high-growth and diversification opportunities in parts of the
world that had not materially participated in international portfolio invest-
ment before.
Emerging markets emerge
The first equity markets to 'emerge' during the 1980s were actually France,
Germany, Spain and Italy - all countries in which capital market instruments
appeared in some quantity for the first time following deregulation efforts and
market reforms. After the fall of the Berlin Wall in 1989, the excitement shifted
to Eastern Europe, where investment opportunities were pursued aggressively,
especially in Poland, the Czech Republic and Hungary, although such invest-
ments were severely constrained by a shortage of securities. Country-specific
investment funds such as the Morgan Stanley Germany Fund, which was
intended to identify choice investments in the newly reunified nation, quickly
rose in the market to trade at substantial premiums above their net asset values.
Also during this time, the major international banks were unwinding the
last of their Latin American loans (and some in other parts of the world) which
had been in arrears for many years. Some were able to sell their loans at deep
discounts in the secondary market to market-makers who would resell them
to others. The Brady debt restructurings beginning in 1989 created a new
supply of debt instruments for loan conversion (about $250 billion at par value)
which were collateralized as to principal by US government securities and
offered partial interest payment guarantees. These soon became actively traded
as a new form of low grade, high-yield bond, offering equity-like returns to
investors. Bond yields of 25-40% were available on many Latin American
issues, yields which continued to reflect bank loan losses that many investors
felt were not likely to apply to the post-Brady situation. The Brady restructur-
ings were coupled to government promises of immediate and significant regula-
tory reforms and improved economic management. The first country subject
to Brady debt restructuring was Mexico under President Carlos Salinas de
Gortari, soon followed by Argentina, where the new government of Carlos
Menem, a former radical Peronista, had aggressively pursued market economics
and privatization.
Early success with Brady bonds, recognition of beneficial effects of serious
economic policy reforms, evidence of substantial foreign direct investment by
multinational corporations, and the return of massive amounts of flight capital
by residents of several Latin American countries began to be reflected in the
stock markets of those countries. Private capital flows to major Latin American
countries exceeded $72 billion in 1993, a substantial turnaround from the late
1980s when capital flows were significantly negative. This activity attracted
American, British and other fund managers, who began to invest aggressively,
and the sudden flow of funds into comparatively illiquid markets began to
demonstrate the expected effects. Stock prices rose rapidly, encouraging invest-
ment bankers and money managers to augment their offerings of emerging
market funds to smaller institutions and to the general public. On June 30,
1993 the 100 largest among such funds had an aggregate net asset value of
$26.3 billion. By the end of that year, the combined net asset value of these
funds had more than doubled to $54.1 billion as a result of both market
appreciation and new money raised (Micropal, 1994).
It was not so much the availability of attractive investment returns that
caused the capital stampede: these had been available before. Rather, it was
the changed perception of these countries from backward, hopeless places in
which money could only be made by those on the inside, to bright beacons of
hope for revival based on the long delayed discovery of economic truth. This
was not just a reading of the situation in terms of the Washington Consensus;
it was a view shared by those with serious money in New York, London,
Zurich and Tokyo.
The buoyant demand for emerging market securities encouraged countries
that were undecided about the free market policies to join the bandwagon. The
obviously positive market-effects of the new policies were a testimony, many
felt, to their wisdom. Rising equity prices made possible many important
privatization issues. New issues by emerging market countries, principally
privatizations, reached $17.5 billion in 1994, about $2 billion more than the
year before. These included nearly $3 billion in Peruvian, $2 billion in Chinese,
and over $1 billion each in Pakistani and Indonesian privatization issues.
Argentina issued $900 million of privatization equities in 1994, bringing total
proceeds since 1992 to more than $11 billion. Such activity was vastly in excess
of any prior usage level of capital markets on the part of these countries.
Indeed, by historical standards these amounts were astonishing.
A popular explanation offered by investors to explain their aggressive
involvement in emerging markets was the idea that corporate assets were
available very cheaply in some countries relative to the value of comparable
assets in the USA or other developed country markets, because expected values
were attractive and/or the political and economic risks were so high. But what
if the expected returns were boosted and/or the risks dropped dramatically
because of sensible economic practices along the lines of the Washington
Consensus? Argentina was often used as an example: once the government's
new economic policies were known and appeared to be both credible and
durable, the Buenos Aires stock market shot up to correct the undervaluation
6
of the corporate assets for the new environment embodying dramatically lower
perceived risk. Thus, equity investors' search should not only be for potentially
attractive companies, but also for countries whose economic policies were
about to change. Early investments in Peru, Turkey, Poland and China were
made on this basis. An associate of George Soros noted that they liked to
invest when things have gone from "utterly hopeless" to "just plain desperate."
"Peru has come back to the world," he said. It had dug itself out of "an
economic mess second to none," and was now a suitable place to invest
(Powers, 1993).
The apparent wisdom of putting eggs in different baskets
Modern investment concepts also contributed to the surge of capital allocation

to emerging market equities. Everyone knows that prudent investors don't put
all their eggs in one basket. Here was a whole new set of baskets that promised
not only high returns but also great potential for investment diversification.
Within a modern portfolio optimization framework the attractiveness of adding
any individual asset or group of assets (cash, gold, stocks, bonds, real estate,
etc.) to a portfolio depends on the expected total returns on that asset and
what impact it has on the risk of the overall portfolio. The less correlated the
returns of a given asset are with the other assets already in the portfolio, the
greater the benefits from diversification and therefore the less risky is the overall
portfolio. For investors large and small in the early 1990s, emerging markets
appeared to offer extraordinary benefits in this regard. Not only did they expect
their overall returns to be very high - fundamentally a product of extraordinar-
ily high expected real growth rates associated with new, internationally
acclaimed economic policies in many emerging market countries - but the
international portfolio diversification (IPD) benefits were seen to be extraordi-
narily high as well, due to evidence of relatively low correlations between
emerging market stock returns and the major market indexes such as the
Standard & Poors 500 index, the French CAC-40 or the German DAX equity
averages.
Figure 3 shows this pattern using a so-called 'efficient frontier' mapping
risks and returns for different equity portfolio allocations between 100% major-
market and 100% emerging market asset allocations. 6 During the 1987-94
period, for example, US dollar-based investors could achieve both lower risk
and higher returns (a financial 'free lunch') by deploying a significant portion
of their stock investments in emerging markets. According to Figure 3, for the
same level of investment risk as in a portfolio without emerging market securi-
ties (i.e. invested 100% in major markets, which returned about 9%) a higher
return of about 13% was possible with an allocation of 44% of the portfolio
into emerging market stocks. Similarly, if the object was to minimize risk, a
portfolio consisting of 22% emerging market securities produced a return of
about 11%, far higher than the 8.5% return on the 100% major-market
portfolio, and at substantially lower risk. The IPD gains are attributable both
to less than perfectly correlated movements in stock market indexes between
6'Major market" in this case is defined as the US dollar-based Morgan Stanley Capital
International World Index, while 'emerging market" is defined as the US dollar-based International
Finance Corporation Emerging Markets Composite Index, each weighted by the capitalizations
of the various markets.
Risk Minimizalion: 22" Emerging. 7811; Major

100
Rlsk(%)
.. ..
Figure 3. Investor gains from emerging market equity portfolio allocation, 1987-1994 (year-end).
Our proxy for the major global equity markets is the US dollar-based MSCI World Index which
is composed of securities in the major markets worldwide, including the US. For emerging markets,
we use the US dollar-based IFC Emerging Markets Composite Index, an aggregate of activity in
emerging markets globally. Risk is defined as absolute volatility using the standard deviation of
month-to-month total returns. Average return is the annualized total return performance over the
designated period. We assume no adjustment for withholding taxes.
Source: Merrill Lynch Global Investment Strategy.
major and emerging markets, as well as less than perfectly correlated exchange
rate movements against the dollar, ensuring 'different baskets' for the invest-
or's eggs. 7
The data certainly looked good, but how reliable were they? Many of the
more popular emerging markets had only a few years of history, most of which
covered a time of global speculative boom. In such markets, statistical informa-
tion provided by governments and by corporations is often late or unreliable,
or both. Net returns require subtracting from gross equity returns transaction
costs (bid-offer spreads, fees, commissions, custody charges, clearance and
settlement costs and delays, etc.), which in emerging market countries are often
enormous in comparison to the more developed markets. And large risk adjust-
ments are required for market illiquidity, where even moderate buying or selling
pressure often leads to massive price changes. Such conditions were certainly
far removed from what many investors were used to - adequate and timely
information disclosure and dissemination, low transactions costs and liquid
7IPD gains tend to be greater across global equity markets than across global bond markets,
where they derive solely from less than perfectly correlated interest rate and exchange rate
movements. Moreover, unlike the global bond markets, stocks are highly differentiated and subject
to local trading conditions, although listings on foreign stock exchanges through depository receipts
have made some emerging market equities considerably more accessible to foreign investors.
markets - 'details' often overlooked by investors anxious to establish positions

before prices ran away from them, and not exactly emphasized by salesmen
anxious to earn fees and commissions. 8
THE END OF EMERGING MARKET EQUITIES?
The period 1990-1994 could therefore be characterized as one in which global

investors, commanding enormous resources, discovered a limited supply of
securities in risky countries that, because of expected economic reforms,
appeared to offer exceptional opportunities for price appreciation in the short
run, and for growth and further development over the long run, together with
extraordinary IPD benefits. The rush to buy pushed emerging market share
prices higher, attracting even more investors. Share prices in many markets
were bid to levels that considerably exceeded reasonable estimates of risk-
adjusted returns. The story ended for some in 1995, for others in 1997.
Speculative excesses
As expected, salesmen of emerging market mutual funds aggressively promoted

these investments to individuals and institutions in the United States and other
developed countries, touting their performance and IPD virtues. Successful
sales efforts rapidly expanded investable assets of these funds, which then had
to be deployed according to the portfolio weights indicated in the sales materi-
als. As new funds poured in, the underlying equities had to be purchased,
further increasing demand for them. Market valuation levels surged further.
Such periods of speculative excess usually do not last more than a few years
before something happens that causes investors to rush for the exits. LBOs,
junk bond-financed takeovers, biotech stocks, Japanese equity warrants and
US mortgage-backed securities, to mention a few examples, all had several
years of intense investor interest, abnormal returns, and portfolio appeal before
reverting to more normal (mean) price levels. Once this occurs, however, there
is very little evidence in history that the speculative frenzy that characterizes
these particular assets re-emerged soon; they usually revert to being traded at
8 Nor was it much easier to assess investment parameters in emerging debt markets, comprising
bond issues by sovereign governments and corporations and sold to international investors. These
securities, being rated below investment grade by the principal rating agencies, were looked upon
as 'junk bonds'. International investors usually evaluate junk bond opportunities by comparing
the price of the bonds to the risk-free rate of interest for the credit involved. This means adding
the default loss rate (i.e., default rate adjusted for recoveries) for foreign bonds to the risk-free rate
(e.g. US Treasuries of comparable maturities), so that a dollar bond issued by the government of
the Philippines, for example, might be priced at 2)1.% over comparable US Treasuries to compensate
the investor for the higher default risk - commonly called a 'haircut'. In the case of emerging
market corporate bonds, very little default rate data existed. Instead, investors would look at the
country's prevailing sovereign bond yields and would add to it a default rate expectation based
on the corporate credit risk involved, a sort of 'crew cut' against the risk-free rate.
normal, risk-adjusted returns. Indeed, as all investors in emerging market

equities now know, the bubble burst in the months just before the Mexican
crisis, and the value of emerging market shares fell throughout 1995. By the
beginning of February 1996, all of the gains achieved in an emerging market
composite index, compared with the MSCI major-market index, over the
5 years beginning in 1991 had been extinguished (Figure 4). In 1997 it was
Southeast Asia's turn. A reasonable expectation, therefore, is that the period
of easy money in emerging market stocks is over and, by adding the first
quarter of 1995 to the efficient frontier depicted in Figure 3, is displaced
downward and to the right (lower return, higher risk; Figure 5).
AFTER THE BUBBLE
In following emerging market trends, a great many sophisticated fund managers

were led to violate the strictest of their own investment rules, something they
do with almost predictable regularity. Fund managers have a great deal of
money to invest for others, and must meet competitive performance standards
to keep it. If they are not invested in this year's fashionable vehicles, their
performance may lag during the early phases of an investment cycle. For
example, throughout the 1980s US institutional investors were thought to be
responsible for driving high-risk stock and bond prices above reasonable risk-
adjusted levels, only to finally secure their positions in time for the market
to decline.
'~, --j
0-1'0 ~-- . _1
I
i).l~ ~ ....... _............."._. . !
I b:merging Market Composite Index
I
'" I
Relativr to Major M.rket Composite Index
.......................................................j
I
i
.. I
...._.... .. .......................1
." i"i ................... ..

I
0.50 .
~I~--~--~----+----+----~--~---+----~--~---+--~--~
.1..,.81 Jun-81 000411 Mar-41Z Kov-8Z Apru Oct93 M..... Sop-Q4 F.WS A"lI.Q5 ".,96
Figure 4. Comparative emerging market equity performance, January 1991-February 1996.

Source: Merrill Lynch.
RI.k('lfo)
..
Figure 5. Investor gains from emerging market equity portfolio allocation, 1987 (year-end) to 1995
(first quarter).
Our proxy for the major global equity markets is the US dollar-based MSCI World Index which
Professional fund managers have become somewhat used to this, and take
their punishment quietly when it comes, because the punishment tends to affect
many if not most of their rivals in the same way. After major price changes,
most fund managers will announce that they are looking for opportunities.
This occurred in the case of US junk bonds, mortgage-backed securities, REITs,
venture capital and other forms of relatively liquid high risk investments, but
it has not occurred in the case of large American LBOs or Japanese leveraged
investments. With the exception of bottom-fishing in specific 'oversold' issues,
this has not occurred in emerging market equities either, where the period of
abnormal risk-adjusted returns is unlikely to reappear within the next several
years.9 There are a number of reasons for this:
9 For example, the Mexican stock market reached a low of 1447.52 on the Bolsa index on
February 27, 1995 and had by mid-July recovered to about the same level (2231.11) it held on
December 20, 1994, the day before the initial peso devaluation that set off the crisis. The recovery
was mainly due to buying of undervalued shares by local investors, in addition to international
funds selectively rebuilding their Mexican portfolio weights and hedge funds trying to take advan-
tage of low share values. Lower US interest rates, lower Mexican inflation rates, and a new
Mexican sovereign debt issue may have contributed to market confidence as well. In dollar terms,
however, the converted Bolsa index at that point had only recovered from 2231.11 to about 1400,
due to the weakness of the peso.
96 R. C. Smith and 1. Walter
Investors who took large hits and lost considerable confidence in many
emerging equity markets are not likely to plunge back in again soon. They
will certainly be cautious about investing new money in such markets, and
will endeavor to get some of it out. They may exploit special 'buying
opportunities', but not in large volume. This has shown-up in a reduced
level of transactions in country funds and in emerging market manager
selections by pension funds and other institutional investors. Indeed, it was
already appearing in the US during the first three quarters of 1994 when,
according to the Securities Industry Association, combined purchases of
foreign securities had dropped nearly 90% from a year earlier, to the lowest
level in 4 years. The decline had been progressive, with the third quarter
down 69% from the second quarter, which in turn was down 43% from the
first quarter of 1994. For the full year 1994, combined US purchases of
foreign securities, net of sales, declined by more than 60% from the record
levels achieved in 1993.
Investors will be careful not to assume low correlations with the major markets.
As an investment class, emerging markets demonstrated a much higher correla-
tion with each other during the early part of 1995 than had been previously
experienced. The Mexican crisis clearly spilled-over onto many other emerging
equity markets, adversely affecting their performance as well. This demon-
strates a substantial erosion of the IPD gains associated with emerging market
investments, at least in the short-term. As inter-market correlations shot up,
it was revealed that the eggs being placed in different baskets that were in
fact all tied together. The risk-return characteristics thus appeared to be
substantially altered over a period of just 3 months and triggered by events
in only one emerging market country, albeit an important one. This may
have done lasting damage to the confidence of investors and fund managers in
the underlying value of emerging market equities in international portfolio
diversification, and was repeated in 1997 in Asia.
Investors now appear to realize that there are more risks in securities traded
in inefficient emerging markets than were originally considered. These
include vulnerability to shock-effects from sudden political or economic
developments, lack of hedging vehicles to manage risk, and the effect of low-
quality information disclosure by companies and governments upon which
to base investment decisions. Indeed, disclosed information in many emerg-
ing markets is often nearly useless, being late or highly misleading. Auditing
and accounting standards are often well below OECD standards, and in
many cases few regulations protecting investors' rights exist or are enforced.
Accordingly, the best investment information comes from insiders or specula-
tors or those 'in the know', which makes these markets much more suscepti-
ble to market rigging, fraud and corruption - as one Hong Kong investor
was quoted as saying: "Invest in anything where I don't have some kind of
inside information? Don't be silly!" (Smith and Walter, 1997).
Liquidity in many emerging markets is also well below the minimum stan-
dards prevailing in developed countries. Often there are virtually no investing
institutions, and most shares are owned by individuals or by foreigners. A

shortage of supply pushes prices upwards when foreigners are buying, and
makes it almost impossible to sell when foreigners are trying to get out. In
some countries such as Malaysia, for example, foreigners in 1993 owned more
than 50% of all stocks, and their buying by the end of the year had pushed
the value of the stock market capitalization to nearly twice the value of the
country's GNP. They then helped the market collapse in 1997.
Finally, the degree of volatility that investors must tolerate in many emerging
markets has been several times greater than in US and other developed coun-
tries' markets. For a 60-month period ending in March 1994, for example, the
annualized percentage standard deviation of returns in a selection of Latin
American countries was 27.99%, and an Asian group 24.18%, compared with
12.51 % for the US and 19.92% for the combined European and Japanese
markets. Polish returns experienced an average standard deviation of 104.23%,
Brazilian 83.21 %, Argentine 68.00%, Turkish 67.62% and China, Colombia,
Peru, Philippines, Taiwan, Pakistan, Hungary, and Greece had standard devia-
tions greater than 40% during the same period. 10
Such high volatilities require the commitment of substantial equity capital
by investors - to avoid being wiped out during market declines - substantial
patience to wait out the worst of adverse market conditions to finally realize
long term gains, and indeed require an expected risk-adjusted total investment
return substantially greater than OECD averages just to break even. Although
such returns might have been possible for the earliest wave of emerging market
investors, they soon evaporated after prices had begun their rapid upward
adjustment. However, the earlier one invests in such markets the less one has
on which to base decisions, and so investing under these circumstances can
indeed be compared to a 'casino' experience.
LESSONS FOR INVESTORS
The simple lesson for investors in emerging equity markets appears to be that
asset allocation to these markets can be justified only when the acquisition
price is low enough to provide a margin to cover the true incremental risks,
and only when the investor has the ability, the confidence and the patience to
ride out the market panics or periods of great illiquidity that occur from time
to time. Surely there will be many investors who will continue to participate
actively in these markets, but they will tend to be specialists who are realistic
about the prices they are willing to pay. Those who are not specialists are most
likely to stay away or reduce their commitments.
We thus expect that global investors will be much more tough-minded about
emerging equity markets in the future. High-performance fund managers will
look elsewhere for assets, and emerging market country funds will continue
10 Data: Bloomberg Financial Services.

trading at substantial discounts from their net asset values, to which they
reverted in 1994-95.11 Foreign portfolio equity capital will revert to being a
scarce commodity in many developing economies, and the term 'emerging
markets' itself may fade away, its particular time in the colorful lexicon of
finance having passed. Countries too, therefore, will have to adjust to new
circumstances. What should equity investors look for in the next phase of
the process?
Sound economic policies. The easy-money conditions of the early nineties
are over, so foreign capital must be must be competed-for by countries on
the basis of good, long-term, risk adjusted investment returns. Providing an
economic environment that holds out adequate prospects of such returns is
a big job that includes many changes and reforms, and one that by no
means should be shrugged off with the notion that legislation is planned to
take care of this or that. Investors care about what actually happens, not
whether legislative bills are passed or not. Nor is there much use complaining
about foreign investors serving as self-appointed 'judge and jury' of the
efficacy of national economic policies. These are real people with hard-
earned money invested in assets they hope make sense for them, or entrusting
others to do so on their behalf relying on real political and economic analysis
by people whose careers are on the line.
Building financial infrastructure. Governments that want to attract interna-
tional portfolio investment must be clear about the priority need to create
some basic preconditions for viable capital markets - an obvious point
honored as much in the breach than in practice (Walter, 1993b).
Fundamental is a functional financial system that embraces a viable banking
industry,12 insurance and securities industries,13 pension and mutual funds. 14
11 On July 4, 1994 the average premium over net asset value of 32 emerging market mutual
funds was 28.4%. A year later, the same funds traded at an average discount of 6.9% to net asset
value. Barron's, price quotations for closed-end funds, July 4, 1994 and June 20, 1995.
12 Banks in many emerging market countries are all too often large, subsidized bureaucratic
institutions that possess few skills in finance and drive customers to transact in parallel (unofficial)
markets. Many are loaded-down with nonperforming loans from state-owned enterprises or large
domestic corporate combines deemed 'too big to fail'. The worst of this debt ultimately will have
to be separated from the banking system and put into 'bad banks', from which future recoveries
might someday be paid. The bad bank in such a country, possibly a subsidiary of the central bank,
can 'purchase' impaired loans from commercial banks using government bonds. Thus recapitalized
and solvent, banks can begin again to develop a viable lending business.
13 This involves providing a central market place, a trading system that includes rules for price
disclosure and settlements, and rules providing for the fitness and capitalization of securities firms
dealing with the public. The role of banks in the securities industry must also be determined, as
well as the extent to which the participation of qualified foreign firms is to be permitted. Foreign
firms (often through joint ventures) can contribute considerably to the training of employees and
management of local firms, and to the general professionalism and efficiency of national financial
systems.
14 Some developing countries have also created short-term markets in government securities
and commercial paper, in tandem with banking activities, as a competitive alternative borrowers
and depositors. Countries like Korea, the Philippines and Colombia have had domestic commercial
paper markets in operation for twenty years or more, while Poland has recently created one.
They need to enact a sensible securities law in order to provide regulatory

and enforcement authority against market fraud and other abuses: many
countries have done this in recent years and that ample precedents are
available. Such rules should address the principles of fiduciary responsibility,
full disclosure, fair markets, surveillance and enforcement, and require that
minimum standards for training and certification of fiduciaries and interme-
diaries be met. 1S Arguably, banks in some developing countries should be
encouraged to develop close relationships with particular companies to
improve information flows and monitoring their progress (Smith and Walter,
1993; Walter, 1993a)
Overhauling corporations. Governments must attach priority to making
corporations fit for public ownership, which requires common financial
accounting and auditing standards, a company law, and protection against
exploitive concentrations of voting power by insiders. The largest source of
shares in many countries will come from the privatization of state-owned
enterprises intended to end such firms' operating inefficiencies, raise capital
for the government, develop a public shareholder base, and establish a
growing, profitable, market-oriented private sector. Some, especially in Latin
America and Asia, have enjoyed great success with privatization programs
and have used the strong markets of the early 1990s to float as many issues
as possible. 16 Absent basic conditions for viable public ownership, govern-
ments should consider privatization through the sale of assets to corporate
buyers, perhaps mostly foreign, who can inject capital, knowhow and man-
agement, and contribute to the process of rebuilding the companies.
Although there may be some political reasons to restrict foreign direct
investment in developing economies, there are no good economic ones. Few
sources of economic growth are more assured and quick-acting than direct
investment by knowledgeable foreign corporations seeking long-term market
opportunities.
The role of capital controls. Governments might consider certain techniques
of limiting the form of portfolio investment inflows - a recommendation
that goes against the grain of the Washington Consensus. Although at the
end of 1996 all emerging equity markets combined represented only about
13% of global stock market capitalization, the effect of portfolio equity
1~ For example, much of the recent distress in the Chinese securities market, particularly that
involving the Shanghai bond futures market, have been associated with insufficient regularity and
enforcement powers.
16 Others, such as Russia and the former Czechoslovakia, rushed-through privatization programs
in the interest of quick reform, but on a basis that may ultimately prove to be self-defeating. None
of the foregoing conditions for public ownership were in place, few of the enterprises were
economically viable in their own right - or depended on continued government subsidies or public
procurement to continue in business - management was not substantially improved, and the
process of ownership-distribution through vouchers was rife with fraud, corruption and racketeer-
ing. It is difficult to see how ordinary citizens will benefit from such privatization efforts if left with
worthless shares while the valuable ones fall into the hands of the well-connected or corrupt.
100 R. C. Smith and 1. Walter
inflows on many countries has often been a glut of foreign exchange and
liquidity, which can have severely adverse effects. Principal among these is
inflationary pressure, caused by a sudden, substantial increase in the money
supply, and appreciation of real exchange rates. Imports in some countries
subjected to such inflows consequently increased, exports declined, and trade
balances deteriorated. Some governments, such as Chile, South Africa and
several Asian countries, have limited portfolio capital inflows in various
ways to avoid the problem of excess liquidity and to maintain a competitive
exchange rate. Without such controls, the impact of massive portfolio flows
is hard to counteract. I7 It may also be worth considering whether foreign
portfolio equity investments via mutual funds should be tapped using closed-
end rather than open-end funds. In closed-end funds, the shock of investor-
demand shifts is taken by secondary-market prices of the funds in the
developed-country stock markets rather than by massive, destabilizing,
cross-border financial flows.
What about the IPD benefits of emerging market equity investments?
Despite the dramatic spike in inter-market correlations in the period immedi-
ately before and after the Mexican crisis, long-term correlations with major
markets remain extremely low. Table 1 shows the weekly total return correla-
tions in dollar terms between the Standard & Poors 500 index and various
emerging market indexes during the 3-year period February 1993 to January
1996 period. The efficient frontier mapping risks and returns between the
Morgan Stanley major market index and the IFC emerging index snapped-
back to the same contour it had before the 1994-95 Mexican crisis, as shown
in Figure 6.
IMPLICATIONS FOR THE FUTURE
In Paul Krugman's provocative essay on the end of emerging markets

(Krugman, 1995), he maintains that the views of the Washington Consensus
induced a bubble-like market effect, which ultimately burst as all bubbles do,
leaving developing countries with little to show for it and much confusion as
to what policies to pursue in the future. The painful adoption of the virtues of
free markets and sound money may now be in doubt by those not finding the
expected rewards. Burst by the bubble, the new theory of economic development
through self-help and reform may itself now be discredited. Something new
will have to emerge. Krugman does not say what.
Observers of previous financial bubbles know that markets over-react from
time to time, especially when new conditions that are not fully understand
17 In Chile, such controls in effect seek to increase the cost of investment by imposing reserve
requirements on loans, stamp taxes on securities transactions, and widening the bands within
which the currency can fluctuate .. Of the countries which experienced increased equity market
prices in 1994, as against emerging market trends at the time, most maintained restrictions on
capital inflows.
Table 1. US-emerging market correlations, February 1993-January 1996 (weekly price returns in
dollar terms)
Asia
China -0.06
Hong Kong 0.23
India 0.03
Indonesia 0.05
Korea -0.01
Malaysia 0.08
Pakistan -0.01
Philippines 0.01
Singapore 0.14
Sri Lanka -0.09
Taiwan 0.08
Thailand 0.20
Latin America
Argentina 0.36
Brazil 0.25
Chile 0.18
Colombia -0.04
Mexico 0.26
Peru 0.22
Venezuela 0.18
Africa
Nigeria 0.06
South Africa 0.07
Zimbabwe -0.04
Emerging Europe and Middle East

Czech Rep -0.14
Greece -0.11
Hungary 0.01
Isreal 0.15
Jordan 0.07
Poland -0.01
Portugal -0.18
Russia -0.10
Turkey -0.11
come into play, and investors respond to revised expectations against current
asset prices. These observers know that those who get in early are the ones
who make money, but for them the risks were substantial at the time because
no respectable consensus had yet been formed in Washington, New York or
anywhere else to make everyone feel comfortable and, indeed to pave the way
for many new investors. They also knew that the formation of broad-gauge
agreement about such complex and elusive subjects as economic growth
15.0 ..----....------.-----.-----.-I-----r------clr----"I
No Change In Major
~::~~~;gkln~";!~ Major

I !
.j
~ _ .I!! LLll
_~.j... ~l~:w_w____ 100% In Emerging ___ _
-EFJc"" . . .~
13.0
,0 i
, !
I! Equity Markets
;;
:r
.2'
;;
~
~

11.0 'K"",' i ____-'-
+-- 1100% in Major Global Equity Markets 1
9.0~---~---~---~---~---_4---~---~
3.6 4.0 4.4 '.8 5.2 5.6 6.0 6.4
Risk (%)
Figure 6. Investor gains from emerging market equity portfolio allocation, 1987-1995 (year-end).
The proxy for the major global equity markets is the US dollar-based MSCI World Index which
in developing countries should be taken with more than a grain of salt.

Washington opinion leaders were responding to the investment numbers: the
money was flowing, so there must be a reason, probably, they thought, because
the new policies were working at a time when there was no capital flow into
those developing countries still sticking to the old, statist policies. The numbers
also were responding to the Washington Consensus. The new policies would
change the values of securities much more quickly than they would change
observed GDP, but what that meant was the likelihood of a large one-time
adjustment in values, and one had to get in early to get the benefit of it. As
Krugman points out, one did not want to stand out as a disbeliever in the
new, demonstrated results. Now, after the bubble has burst, we are beginning
to hear the revisionists tell us how the basic ideas imbedded in the Consensus
were not altogether right.
We do not agree, although it does appear that the basic ideas have occasion-
ally been misunderstood as a panacea for most developing-country problems
and a form of alchemy for investors. In the long run, the policy changes
prescribed by the Washington Consensus are the right ones, but they are
difficult to implement and as a result it takes a long time to get real and lasting
results. Markets will anticipate these results to some extent: they work by
discounting future expectations, not remembering the past, but only to some
extent. The hard work is in sticking with the free-market policies until they
produce some of the expected results. Its a long term process, usually accompa-
nied by some policy backsliding and victimization by world economic events
outside the control of individual countries. The new paradigm, if there is one,
is to adopt the policies and simultaneously to build the infrastructure necessary
for them to provide the greatest value, i.e., to attract foreign capital from a
competitive marketplace and to retain it.
Recent World Bank evidence (Levine, 1996) suggests that the development
of local equity markets plays a critical role in the economic growth process:
Countries that had more-liquid stock markets in 1976 tended to grow much
faster over the next 18 years than those which did not.
High levels of stock market liquidity, measured by the turnover ratio (trading
volume divided by market capitalization) tends to be associated with more
rapid growth over the same period.
Countries with high trading-to-volatility ratios likewise tended to grow
faster, after controlling for conventional economic, political and policy vari-
ables associated with growth differentials for various periods and country
samples. Volatility per se does not seem to be related to growth, but rather
the ease with which stocks can be traded.
Stock market development seems to complement (rather than substitute for)
bank finance, both of which seem to promote growth independent of each
other. Higher levels of development of the banking system are associated
with faster growth no matter what the state of development of the stock
market, and vice-versa, for reasons that are not yet well understood.
Although most corporate investment in developing countries is finance
through bank loans and retained earnings, both (along with the debt-equity
ratio) are positively associated with stock market liquidity.
Such findings suggest that international portfolio capital flows may playa
substantially more important role in the emerging market growth process than
previously thOUght. They can contribute disproportionately to market liquidity,
especially in the presence of 'noise traders' such as open-end mutual funds
which must sell in response to new client investments and redemptions and
maintenance of portfolio weights. They can force securities prices into line with
those prevailing on global markets. They can encourage upgrading of the legal
infrastructure, trading systems, clearance and settlement utilities, information
disclosure and accounting standards, and custody services. They can improve
the process of corporate governance, perhaps in association with significant
shareholdings by banks. They can also serve as a bellwether for local portfolio
investors, who may find encouragement from a significant foreign presence in
the marketplace.
Very few emerging market countries have the economic capacity or the
political will to adopt far-reaching free-market policies all at once. Who does?
Gradual approaches work, however, perhaps best of all. Successfully rebuilt,
former developing countries like Japan, Germany, South Korea, Taiwan,
Singapore, Spain, Chile at no point adopted a totally free-market approach.
They moved purposefully in that direction, but only at a pace that could be
accommodated by the accompanying political thinking and infrastructure-
building. Other countries that have tried hard to accept the new policies
(Mexico, Argentina, Brazil, perhaps India) have had considerable success
despite some recent disappointments. They need more time for their efforts to
bear the fruit that their more successful peers have enjoyed, but so far it appears
there is little likelihood of a reversion to the pre-Washington Consensus era in
any of these countries. The most powerful part of the new paradigm, however,
is that countries must know that it all depends on them. A consistent barometer
of their efforts, flawed as it may be from time to time, is in the capital they are
able to attract. IS
While it may be true that foreign capital can be attracted by offering assets
for investment at extremely low valuations, that is not the way most countries
are going to want to do it. Earning higher valuations will depend on being
able to create a credible environment for open market-driven institutions and
practices to develop. Some may instead attract investment simply by encourag-
ing GNP growth so that the funds will flow in despite other factors. This
appears to be the current Chinese approach. But it will certainly be a fragile
one, and regardless of the economy's impressive growth investors are not going
to take the country seriously until China changes its basic investment climate.
Investors have other places they can go instead. India today may well be one
of these. In the end, China may need foreign capital so badly that it will adjust
its approach.
For now, global equity investors have retreated from emerging markets after
price collapses shattered what may have been excessive confidence in their near
term future. From now on, money may be harder to come by, but it will still
be available to those developing countries which follow basic economic strate-
gies consistent with long-term growth and build sound and durable domestic
financial infrastructures. Countries want to attract long-term, patient investors
who are interested in harvesting suitable risk-adjusted returns as a reward for
careful selection of countries, industries and companies, and bearing the risks
over substantial periods of time.
Governments of emerging market countries have to face reality. To attract
capital one has to compete for it in a world market that offers many opportuni-
ties to those with funds to invest. To compete successfully, countries have to
do what is good for themselves in the long run, yet often difficult and politically
controversial in the short term. They have to fully adopt market economics,
satisfy a number of preconditions and then rebuild or build de novo the
banking and non banking financial institutions that are the core of a workable
18 It also depends on where a country is starting from - how much market infrastructure already
exists. In Eastern Europe, very little existed and without it large institutional change has been
almost impossible to undertake despite some promising signs of entrepreneurial development. Even
so, major differences exist between the available infrastructure in the Czech Republic and Russia,
between Poland and East Germany, and between countries within this region and China
financial marketplace. Governments must also resolve important issues related

to the public ownership of private sector companies and make a credible and
sustained commitment to privatization. There are precedents in developing
countries that make these steps easier to take, and many sources of aid and
technical assistance for those seeking to move in these directions. It usually
takes years for these measures to be accomplished in full, but as progress
becomes visible and selected gains appear in the interim, so will rekindled
interest by global equity investors.
The Washington Consensus, properly adapted, is hardly dead as a set of
guideposts for policy from the perspective of the international investor, who
see economic stability as a precondition for making asset selections at prices
that actually mean something based on economic fundamentals and underlying
investment values. This hardly means that punters and bottom-fishers can't
make plenty of money in chaotic markets shocked by irresponsible public
policies. They have in the past and they will again. Nor does it mean that there
is a foolproof association between the Washington Consensus criteria and
actual economic performance. But the big international money in the end wants
to avoid casinos, and governments should understand that the investors' inter-
ests in allocating capital on the basis of long-term economic performance of
countries, industries and companies should not be too different from their own.
REFERENCES
Corbo, Vittorio and Leonardo Hernandez (1994). Macroeconomic adjustment to capital inflows.
World Bank Policy Research Working Paper No. 1377.
Krugman, Paul (1995). Dutch tulips and emerging markets. Foreign Affairs, July/August.
Levine, Ross (1996). Stock markets: a spur to economic growth. Finance and Development. A
summary of twelve papers presented at a World Bank conference on Stock Markets, Corporate
Finance and Economic Growth.
Littler, Graeme and Ziad Malouf (1996). Emerging stock markets in 1995. Finance & Development,
March.
Micropal (1994). World's 100 largest emerging market equity funds. Micropal, April 1994.
Powers, Mary (1993). Soros fund manager says Peru has turned around. Reuters Asia-Pacific
Report, July 23.
Salomon Brothers (1993). Emerging Market Borrowing: Lessonsfrom History. New York: Salomon
Brothers Inc.
Smith, Roy C. and Ingo Walter (1993). Bank-industry linkages: models for Eastern European
economic restructuring. In Christian de Boissieu (ed.) The New Europe: Evolving Economic and
Financial Systems in East and West. Amsterdam: Kluwer.
Smith, Roy C. and Ingo Walter (1996). Rethinking emerging markets. Washington Quarterly.
January 1996.
Smith, Roy C. and Ingo Walter (1997) Street Smarts. Boston, Harvard Business School Press.
Walter, Ingo (1993a). The Battle of the Systems: Control of Enterprises in the Global Economy. Kiel:
Institut fUr Weltwirtschaft.
Walter, Ingo (1993b). Cross-border equity flows: tapping into global markets. ASEAN Economic
Journal, October.
GEERT BEKAERTl, CLAUDE B. ERB2, CAMPBELL R. HARVEy3
and TADAS E. VISKANTA 4
1 Stanford University, 2.4 First Chicago Investment Management Co., 3 Duke University
5. The behavior of emerging market returns
ABSTRACT
The behavior of emerging market returns differs substantially from the behavior of developed
equity market returns. We show that these differences have persisted in the period ending
March 1996 but, at the same time, document how some salient characteristics of emerging
markets vary through time. Finally, we offer some ideas on the forces that drive the cross-
section of returns, volatility, skewness, kurtosis and correlation in emerging milrkets and
detail the implications for asset allocation.
INTRODUCTION
Currency devaluations, failed economic plans, regulatory changes, coups and

other national financial shocks are notoriously difficult to predict and may
have disastrous consequences for global portfolios. Indeed, these characteristics
often define the difference between investment in the capital markets of devel-
oped and emerging economies. Research on emerging markets has suggested
three market features: high average returns, high volatility and low correlations
both across the emerging markets and with developed markets. Indeed, the
lesson of volatility was learned the hard way by many investors in December
1994 when the Mexican stock market began a fall that reduced equity value
in US dollars by 80% over the next 3 months.
We have learned far more about these fledgling markets. First, we need to
be careful in interpreting the average performance of these markets. Errunza
and Losq (1985) and Harvey (1995) point out that the International Finance
Corporation (IFC) backfilled some of the index data, resulting in a survivorship
bias in the average returns. In addition, the countries that are currently chosen
by the IFC are those that have a proven track record. This selection of winners
induces another type of selection bias. Finally, Goetzmann and Jorion (1996)
detail a re-emerging market bias. Some markets, like Argentina, have a long
history beginning in the last half of the 19th century. At one point in the 1920s
Argentina's market capitalization exceeded that of the UK. However, this
market submerged. To sample returns from 1976 (as the IFC does) only
measures the ore-emergence' period. A longer horizon mean, in this case, would
be lower than that calculated from 1976. This insight is consistent with the
out-of-sample portfolio simulations carried out by Harvey (1993) indicating
that the performance of the dynamic strategy was affected by the initial 5 years.
It must also be realized that exposure as measured by the IFC is not necessarily
attainable for world investor's (see Bekaert and Urias, 1996).
107
R. Levich (ed.), Emerging Market Capital Flows. 107-173.
o 1998 Kluwer Academic Publishers.
108 G. Bekaert et al.
Second, we have learned that the emerging market returns are more predict-
ble than developed market returns. Harvey (1995) details much higher explana-
tory power for emerging equity markets than developed market returns. The
sources of this predictability could be time-varying risk exposures and/or time-
varying risk premiums, such as in Ferson and Harvey's (1991, 1993) study of
US and international markets. The predictability could also be induced by
fundamental inefficiencies. In many countries, the predictability is of a remark-
ably ~imple form: autocorrelation. For example, Harvey (1995) found a 0.25
autocorrelation coefficient for Mexico in a sample ending in June 1992. An
investor who followed a strategy based on autocorrelation in this country
would have lost 35% like everyone else in December 1994. However, the
investor would have been completely out of the market in the next 3 months
(or shorter if possible). Momentum appears to be important for many of these
markets.
Third, we have learned that the structure of the returns distribution is
potentially unstable. Garcia and Ghysels (1994) reject the structural stability
of the prediction regressions presented in Harvey (1995). These regressions
allow for the influence of both local and world information. Bekaert and
Harvey (1995, 1996a) present a model which explains the results of Ghysels
and Garcia. The Bekaert and Harvey model allows for the relative influence
of local and world information to change through time. They hypothesize
that as a market becomes more 'integrated' into world capital markets, the
world information becomes relatively more important. Bekaert and Harvey
(1996a) found that the changing relative importance of world information also
influences volatility.
Fourth, the Bekaert and Harvey (1996a) framework suggests that the increas-
ing influence of world factors on emerging expected returns may manifest itself
in increased correlation with developed market benchmarks.
The goal of this paper is to explore three aspects of the emerging markets
data. First, we examine the behavioral characteristics beyond the volatility, the
skewness and kurtosis. Second, the paper explores the relation between risk
variables and expected returns. Harvey (1995) and Bekaert (1995) find that
higher values of beta (from a capital asset pricing framework) are associated
with lower expected returns. This is the opposite from what we would expect
from theory, however, it is consistent with these markets being segmented. That
is, the countries with the higher beta values are more likely to be integrated,
and hence have lower expected returns relative to the segmented countries.
Third, we examine the time-varying correlation of these markets with developed
markets. Longin and Solnik (1995) and Erb et al. (1994) describe how correla-
tions change through time in developed markets. Harvey (1993,1995), Errunza
(1994) and Bekaert and Harvey (1996a) show some evidence that correlations
are changing in emerging markets. Finally, we examine what is important for
explaining both the cross-section of expected returns and volatility in emerging
markets. Following Erb et al. (1996b), we try to link political, economic, and
The behavior of emerging market returns 109
financial risk, as well as a number of fundamental attributes to explain the

cross-sectional behavior of emerging market returns.
DISTRIBUTION OF EMERGING MARKET RETURNS
Which emerging market benchmarks should be used?
The two main sources of emerging market benchmarks are the International
Finance Corporation (IFC) and Morgan Stanley Capital International
(MSCI).5 Both provide country benchmark indices which are based on a value
weighted portfolio of a subset of stocks which account for a substantial amount
of the market capitalization within each emerging market.
The IFC produces two types of indices: Global (IFCG) and Investable
(IFCI). For nine countries, data exists back to 1976. Currently, the IFC provides
data on 27 countries. 6 MSCI also produces both Emerging Markets Global
(EMG) and Emerging Markets Free indices (EMF) which resembles the IFCI.
Our paper focuses on the global indices. Part of the interest in studying
emerging markets is the impact capital market liberalizations have on the
returns. Hence, we study markets before and after they are accessible by
international investors. 7
IFC and MSCI use a different hierarchical process in the company selection
for the country indices. MSCI follows the same technique that it uses in its
popular developed country indices. First, the market is analyzed from the
perspective of capitalization and industry categories. Next, a target of 60%
coverage of the total capitalization of each market, with industry weightings
approximating the total market's weightings is established. Finally, companies
are selected based on liquidity, float, and cross-ownership to fulfill these goals.
In contrast, the IFC's order of preference is size, liquidity and industry. The
IFC primarily targets the largest and most actively traded stocks in each
market, with a goal of 60% of total market capitalization at the end of each
year. As a second objective, the index targets 60% of the trading volume during
the year. Industry is of tertiary priority. Although there is some hierarchical
differences in the structure of construction, there is little difference in the
behavior of the IFCG and the EMG. Table 1 details the difference between the
IFCG and the EMG returns over identical samples for each index. Of the 22
countries where there is MSCI and IFC data, the returns indices have greater
5 Barings also provides the Barings Emerging Market Indices (BEMI). However, we choose to
focus on the IFC and MSCI indices.

6The IFC announced June 20, 1996 that 17 new emerging markets will be added from
September 30, 1996.
7 For the period January 1989-March 1996, the correlation between the IFCI and the MSCI
EMF indices is 91.8%. For the period April 1991-March 1996, the correlation between the IFCI
and the MSCI EMF is 97.2% The correlation between ENG (EMF) and the MSCI World-All
Countries is 41% (49%).
.....
.....
Table 1. Comparison of IFC and MSCI emerging market global indices. 0
Mean Volatility Tracking

0
difference difference error Correlation Correlation Correlation Correlation Correlation
tx:J
(1:0
Start IFC-MSCI IFC-MSCI IFC-MSCI IFC vs. IFC v.~. MSCI vs. IFC vs. MSCI vs. ~
Country date (%) (%) (%) MSCI AC world AC world composite composite tl
(1:0
"'i
(1:0
Argentina Jan. 88 -10.6 -2/.1 61.9 0.76 0.01 -0.06 0.19 0.04
Brazil Jan. 88 1.4 2.3 19.4 0.96 0.22 0.23 0.28 0.34 tl
--
:-
Chile Jan. 88 1.7 -0.8 7.6 0.96 0.08 0.05 0.32 0.36
Colombia Jan. 93 -4.5 -2.0 7.8 0.96 -0.04 0.04 0.16 0.05
Greece Jan. 88 7.0 0.8 11.9 0.96 0.18 0.13 0.05 -0.01
India Jan. 93 5.0 -1.5 6.6 0.98 0.02 -0.13 0.38 0.16
Indonesia Jan. 90 -1.4 2.2 9.1 0.96 0.11 0.15 0.37 0.45
Jordan Jan. 88 -4.2 -0.1 11.9 0.75 0.09 0.22 0.16 0.14
Malaysia Jan. 88 0.6 0.1 4.8 0.98 0.49 0.46 0.48 0.48
Mexico Jan. 88 1.4 -1.3 10.9 0.96 0.28 0.26 0.45 0.48
Pakistan Jan. 93 0.1 2.5 4.5 0.99 0.01 0.02 0.51 0.15
Peru Jan. 93 -0.1 2.6 7.0 0.99 0.45 0.44 0.46 0.46
Phillippines Jan. 88 2.3 0.0 9.7 0.95 0.37 0.36 0.50 0.47
Poland Jan. 93 -7.3 3.3 15.1 0.99 0.38 0.46 0.35 0.41
Portugal Jan. 88 -0.5 0.4 6.4 0.96 0.48 0.49 0.12 0.14
South Africa Jan. 93 -1.4 -0.2 3.2 0.99 0.35 0.35 0.48 0.53
South Korea Jan. 88 -0.2 0.3 6.7 0.97 0.37 0.35 0.38 0.38
Sri Lanka Jan. 93 2.5 -0.8 5.1 0.99 0.00 0.00 0.36 0.35
Taiwan Jan. 88 1.0 -1.1 7.2 0.99 0.21 0.22 0.82 0.81
Thailand Jan. 88 0.4 0.6 5.3 0.99 0.36 0.33 0.48 0.47
Turkey Jan. 88 2.8 -2.5 22.1 0.94 0.02 0.01 0.20 0.24
Venezuela Jan. 93 -4.0 -2.0 9.1 0.98 -0.03 -0.12 0.19 -0.15
Average -0.4 -0.8 11.5 0.95 0.20 0.19 0.35 0.31
Composite: (FC global composite; AC world: MSC( all country world index.
Source: (FC global indices, MSCI EM indices. Monthly returns in US dollars.
Table 2. Market weights in the IFC indices, March 1996
[Fe global indices [Fe investable indices
Market Weight Market Weight

No. of capitalization in [Fe No. of capitalization in [Fe
Market stocks (USS million) composite stocks (USS million) composite
Latin America
Argentina 35 22307.8 2.0 31 22161.1 3.5
Brazil 86 93939.6 8.5 68 63813.7 10.2
Chile 47 39421.3 3.5 43 39019.3 6.2
Colombia 28 6658.9 0.6 15 5334.2 0.9
Mexico 81 65162.4 5.9 65 58686.5 9.3
Peru 36 7421.7 0.7 20 6910.0 1.1
Venezuela 16 2652.3 0.2 5 1930.8 0.3
East Asia
China 171 29494.8 2.7 23 3005.5 0.5
Korea 151 125037.1 11.2 145 17314.7 2.8
Philippines 46 39729.2 3.6 35 19314.9 3.1
Taiwan, China 83 114474.5 10.3 83 17504.9 2.8
South Asia
India 131 71141.3 6.4 76 14792.2 2.4
Indonesia 45 54570.7 4.9 44 27724.6 4.4
Malaysia 123 162134.5 14.6 123 135326.0 21.5
Pakistan 68 6646.6 0.6 25 4951.0 0.8
Sri Lanka 44 1314.9 0.1 5 456.5 0.1
Thailand 73 95035.9 8.5 72 30821.1 4.9
EMEA
Czech Republic 69 12346.3 1.1 5 5206.7 0.8
Greece 53 11199.7 1.0 47 10623.8 1.7
Hungary 16 2957.4 0.3 8 2544.8 0.4
Jordan 51 3276.3 0.3 8 1107.4 0.2
Nigeria 35 1712.4 0.2 0 0.0 0.0
Poland 23 3892.8 0.4 22 3874.5 0.6
Portugal 30 11404.5 1.0 26 9012.0 1.4
South Africa 63 105981.4 9.5 63 105981.4 16.9
Turkey 54 20641.3 1.9 54 20641.3 3.3
Zimbabwe 24 1677.0 0.2 5 370.4 0.1
Regions
Composite 1682 1112232.6 100.0 1116 628429.1 100.0
Latin America 329 237564.0 21.4 247 197855.5 31.5
Asia 935 699579.5 62.9 631 271211.4 43.2
EMEA 394 175089.1 15.7 238 159362.2 25.4
is sharply lower than the average returns detailed in Harvey (1995) reflecting
the 80% drop in the Mexican market over the period December 1994-February
1995. Over the past 5 years, the average return in Venezuela was negative.
Over this period, the average return of the IFC Composite was similar to the
MSCI World and the MSCI World-All Countries. The difference between the
emerging markets is in the volatility. The IFC Composite had a volatility of
Table 3. Summary statistics, April 1991-March 1996.
GMM Bera-
Arithmetic Geometric Standard normality Jarque Kolomorogov- First Beta Beta Beta
Start return return deviation test test Smirnov order MSCI MSCI lFCG
Country date (%) (%) (%) Skewness Kurtosis p-value p-value .<ttatistic autocorrel world AC world compo8ite
Argentina Apr. 91 35.5 25.6 56.7 3.09 16.92 <0.01* <0.01* 1.17* 0.06 1.53 1.69 0.91
Brazil Apr. 91 44.3 37.1 52.2 0.89 1.51 <0.01 <0.01* 1.06* 0.09 1.19 1.43 1.38
Chile Apr. 91 24.7 23.6 26.6 0.35 -0.43 0.Q2 0.41 0.73 0.23 0.09 0.20 0.64
China Jan. 93
Colombia Apr. 91 40.5 39.0 40.1 1.33 2.02 <0.01* <0.01* 0.95* 0.54 -0.05 -0.01 0.25
Czech Republic Jan. 95
Greece Apr. 91 -2.7 -5.5 24.1 -0.34 0.06 0.41 0.57 0.64 0.16 0.52 0.54 0.28
Hungary Jan. 93
India Apr. 91 12.6 6.3 36.8 0.67 1.47 0.07 0.02* 0.91* 0.25 -0.60 -0.49 0.69
Indonesia Apr. 91 9.5 5.5 29.2 0.15 0.09 0.84 0.89 0.49 0.18 0.58 0.72 1.04
Jordan Apr. 91 10.0 9.4 14.3 0.34 -0.80 <0.01* 0.24 0.95* 0.07 0.1I 0.13 0.11 ;;!
Malaysia Apr. 91 20.4 19.1 23.9 -0.06 1.03 0.31 0.40 0.48 -0.16 0.57 0.67 0.87 <:)-
""
Mexico Apr. 91 \5.7 8.5 37.5 -1.01 2.04 <0.01 <0.01* 0.54 0.33 0.83 1.08 1.40
Nigeria Apr. 91 37.5 12.7 69.5 U9 11.92 0.07 <0.01* 2.02* -0.04 U5 U4 -0.05 ""::s-
~
Pakistan Apr. 91 22.4 18.1 35.3 1.03 1.92 <0.01 <0.01* 0.88* 0.30 0.06 0.15 0.57 '"c
Peru Jan. 93 .....
Philippines Apr. 91 24.1 22.4 28.7 1.37 4.47 0.08 <0.01* 0.94* 0.Q2 0.54 0.69 1.l0 <Q.,
Poland Jan. 93
Portugal Apr. 91 8.3 6.6 19.6 0.41 1.55 0.25 0.05* 0.51 om 0.98 Lot 0.25 ""~
South Africa Jan. 93 ""
~
South Korea Apr. 91 7.8 4.7 26.0 1.07 1.75 <0.01 <0.01* 0.95* 0.04 0.41 0.51 0.68 S
~
Sri Lanka Jan. 93
Taiwan Apr. 91 7.3 1.4 37.1 2.24 7.65 <0.01* <0.01* 1.12* 0.08 0.69 0.88 1.42 ~
~
Thailand Apr. 91 20.1 17.2 30.0 1.08 1.85 <0.01 <0.01* 0.87* 0.03 0.20 0.35 1.14 .....
;>;-
Turkey Apr. 91 13.6 -3.9 61.2 0.64 0.42 <0.01 0.13 0.68 0.08 -0.12 -0.01 0.87 ....
Venezuela Apr. 91 -7.0 -16.8 45.8 -0.45 1.91 0.15 0.01* 0.65 -0.25 0.45 0.54 0.57 "".....
Zimbabwe Apr. 91 4.8 -l.l 34.9 0.38 0.87 0.39 0.27 0.65 0.32 0.84 0.90 0.55 ....
""
:::
.....
MSCI world Apr. 91 11.2 lU 10.7 -0.32 -0.34 0.01 0.50 0.48 -0.25 1.00 1.01 0.20 ;::!
MSCI AC world Apr. 91 11.0 11.0 10.5 -0.23 -0.39 0.03 0.59 0.44 -0.22 0.98 1.00 0.25 '"
IFCG composite Apr. 91 11.4 10.6 16.4 0.93 3.47 0.03 <0.01* 0.71 0.40 0.47 0.62 1.00 ......
......
w
Composite: IFC global composite; AC world: all country world index.
Source: IFC global indices, MSCI EM indices. Monthly returns in US dollars.
* Significant at 0.05 level based on empirical distributions. Kolomorogov-Smirnov empirical critical value: 0.835.
16.4% compared to the MSCI World-AC volatility of 10.5%. Hence, over the
past 5 years, the contribution of a diversified emerging markets investment to
a diversified global portfolio must have come from the correlation properties.
Figure 1 presents rolling 5-year average returns for the 20 emerging markets
and the three benchmark indices. The 're-emergence' effect of Goetzmann and
Jorion (1996) appears evident for six countries in particular: Argentina, Chile,
the Philippines, Portugal, Taiwan and Turkey. For these countries, the average
returns in the 5 years after emergence in the IFC database are much higher
than the subsequent 5 years. However, there are a number of exceptions, with
no such pattern in Brazil, Greece, Colombia, Mexico, Nigeria, Pakistan, South
Korea, Thailand, Venezuela, and Zimbabwe. Overall, the evidence for the
re-emergence effect is mixed. These figures suggest that the mean returns are
time-varying. The evidence presented in Harvey (1993, 1995), Bekaert (1995)
and Bekaert and Harvey (1995) suggest that emerging market returns are more
predictable than developed market returns. While rolling 5-year mean returns
are useful descriptors of the data, the evidence on predictability suggests that
time-varying means are best captured by regression models.
Bekaert and Harvey (1995, 1996a) suggest that care must be taken in
specifying the prediction model. In particular, if a market experiences increased
(or decreased) integration into world capital markets, it is likely that the
parameters of the prediction model change through time. Bekaert and Harvey
propose models where the influence of world versus local information changes
with the degree of integration. That is, as a market become more integrated
into world capital markets, it is more likely that world information will have
a greater impact on the time-varying mean returns.
The final panel of Figure 1 shows mean returns in the 1980s and 1990s.
Most of'the capital market liberalizations took place before 1992. The graph
shows that the mean returns in many countries are much lower in the 1990s
compared to the 1980s. For example, the four countries who had greater than
65% returns in the 1980s all had less than 25% returns in the 1990s.
Changing volatility
Figure 2 presents 5-year unconditional volatilities for the 20 emerging markets

and the three benchmark indices. We will focus on the patterns in the last
5 years. For many countries, there has been a sharp decrease in volatility: most
notably, the volatility levels in Argentina and Brazil have been halved over
this period. Other countries which have experienced large decreases in volatility
are Greece, Jordan, Portugal, Taiwan, and Turkey. While a number of countries
have seen increased volatility, the overall pattern in emerging market volatility
is downward. This is especially evident in the final panel of Figure 2. The IFC
composite volatility was 28% in 1991 and only 16% in the five years ending
March 1996. This decreased volatility mirrors the decreased volatility in the
MSCI World index, which dropped from 18% in 1991 to 10.7% in the 5 years
ending March 1996.
Argentina
Total Return
2' 140%
~ 120%
J100%
.I...

80%
j 60%
40%
f 20%
~
f
C 0%
-20%
-40% ,...
CXl CXl ;b CXl CXl CXl CXl
N
i <Xl 0> N
C') It) 0 C') It)
0> Cii 0> 0> ~
<C <C
CXl 0> 0>
0> 0> 0> 0> 0> 0> 0> 0> 0> 0> 0> 0> 0> 0> 0> 0>
..- ..- ..- ..- ..- ..- ..- ..- ..- ..- ..- ..-
Brazil
Total Return
r 80%
~
Iii 60%
f.
....~
j
40%
:8 20%
E
~ 0%

~
l-20%
i N C') -.:t It) ,...
<Xl 0> 0 N -.:t C') It) <C
<Xl <Xl <Xl <Xl en Cii en en en en en
<C
<Xl <Xl CXl CXl
'"
..- '" '" '"
..- .- '" en
.- '"en
..- .- .- .- '" '"
en .- .- en
en .- .- '" '" '"
Chile
Total Return
2' 100%
~ 80%
!
....I 60%

j 40%
20%
i
f
-20% -
0%
1&
~ -40%
.- N C')
;b It) <C ,... <Xl en 0 ... N C') -.:t It) <C
<Xl
en .-
.- en
<Xl CXl
~.~
CXl
~ .- .-
CXl
'"
en .-
<Xl
'" ...'" '"'"..- .-'"'"

<Xl CXl en en en
en
..- ~ ...'" '" '"
en
~ .-
Figure 1. Five-year rolJing average returns in U.S. dollars.

.."
~.
0"1
;;:
.....
-
o
~ ~
5' Average Arithmetic Return - Five Year Rolling ;0::-
Average Arithmetic Return - FI"" Veer Roiling Average Arithmetic Return - Five Year Roiling I:l
~ ...a. f\) I\l W W
~ ~ ~ ~ m ~ N W W .,JIo. .,.. c.n en 0) !':>
m 0 ~ 0 mom o 0 000 0 0 c.n 0 c.n 0 c.n 0 c.n 0 .......
! ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ '#. ';/e *' ?I! tf!. ';/! '#. ~ !':>
1981 1981 1981 ....
I:l
1982 1982 1982 :-
1983 1983 1983
1984 1984 1984
1985 1985 1985
c} 1986 c} 1986 c}
til _ _0
-::I
- 1987 ..,
-iiG> 1987 til 0
1988 ;o~ 1988 ;0 CD 1988
CD CD CD
io3
1989 til c_C"
_.
..,~ 1989 ..,i:~ 1989
.., til
1990 ::I ::I ::I
1990 1990
1991 1991 1991
1992 1992 1992
1993 ! 1993 1993
1994 1994 1994
1995 1995 1995
1
~ ~
1996 1996 L -_ _ _ _ __________ 1996rL____________________~
Indonesia
Total Return
:i'"
15%
~
Iii 10%
~
~,
5%
J
~
~
u 0% I
II
E
~
II
-5%
'"
-
J: -10%
co co '"
~ Nv
co co co '"
r-- co
co co co '"
L()
c;; '" v
0 N to
'" '" '" '" '" '" '" '" '" '"'" '" '"'" '"'" '"'" '"'" '"'"
co
~
L()
Jordan
Total Return
.~20%
&
~ 15%
~
.;, 10%
Iu 5%
1l
E
:5
.,
~ 0%
~
J: -5%
a; '" co co '"co cor-- coco '"co 0'" c;; '" '"'" '" '" '"'"
N
co co
V L() N V L()
'" '" '" '" '" '" '" '" '" '" '" '" '" '" '"
~
'" ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~
Malaysia
Total Return
~35%
~
Iii 30%
~
~ 25%
E
~ 20%
u
""~ 15%
lf 10%
Iii
J: 5%
v
co co '"
to r-- co
'" v
'" '" '" '" '" '" '" '" '"'" '"'" '" '"~ '"'" '"'" '"'" '"'"
~ N L()
co co co co co co co
0
c;; N to L()
~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~
Figure 1. (Continued.)
.."
~.
00
--
....~
o
~g.
Average Arithmetic Return - Five Yeer RaUlng A_age Arithmetic Return - Five Ye.. Railing
~
;>;-
Average Arithmetic Return - Five Ye. RoIling , I:)
! c.n 0 tn ~ ~ ~ ~ ~ o 0 0 ~ ~ B ~ o B ~
"#. "#. "#. "#. "#. "#. "#. "#. "#. "#. "#. "#. "#. "#. "#. "#.
'" ~ ~ "#. ~ "#. ""......
~ll:I" ~I 1981 ...""
1981rr- I:)
1982 1982 1982 :-
1983 1983 . 1983
1984 1984
1985 1985
1986 1986 ~ ~
~
1987 Iit"tl 1987 litz 1987 lit 3:
1~1 -CD
1988 i~ 1988 C' 1988 ~ ~.
CD
!. CD ~ CD n
1989 -AI 1989 c:
-i _. AI 1989. i:o
5; ::s ~
...,
1990 ::s 1990 - ::s 1990 . ::s
1991 1991 . 1991
1992 1992 1992
1993 1993 1993
1994 1994 1994
1995 1995 1995
1996 1996 1996
..,
~.
;;1
~
~.
I:
Average Arithmetic Return - Five Vear Roiling Average ArithmeUc Return - FlveVe.. Roiling
, Average Arithmetic Return - Five Vear Roiling
I\.) to.> ..,. U1 1\.)..,. '"
~ ~ I\J U) ::.. 01 en ...... Q)
~ 0 0 0 0 0 0 0 0
'" o~ 0 0 000 0000000 0
*- *- *- *- *- *- *- *- *- *- *- *- *- *- *- *- *- *- *- *- *- *-
1981 1981 1981
1982 1982 1982 i_
1983 1983 1983
1984 1984 1984
1985 1985 1985
1986 o'g' 1986 0' 1986 ~ ~
1987 -I: 1987 --u
III 0
o'-u '='"
e!.g: -.., 1987 [E;
1988 1988 ~
:::U" :::ue- 1988 R :::u is" s:::.
CD CO <:::
1989 Soo 1989 I:
- I l_l ~ ~"
~ CiJ .., 1989 .,o
:::::I III :::::I ... CD
1990 1990 1990 :::::I rn .sa.,
1991 1991 1991 ~
~
1992 1992 1992 ~
1993 1993 ( 1993 ~ ~.
1994 1994 t 1994 ::!
1995 1995 s:::.
1995
~
1996 1996 L I_ _ _- - ' ' - -_ _ _ _ _ ~
1996 L-'_ _ _ _ _ _ _ ~--..-J
....,~
~
...
;:
~
'"
.....
.....
\C
..., .....
~. tv
~
o
.....
~
~ b::J
'" ~
Average Arithmetic Return - Five Vear Roiling ;0:;-
, Average Arithmetic Return - Five Vear Roiling Average Arithmetic Return - Five Vear Rolling $:)
~ ~ N W .::. c.n C') ...... ~
, ~
~
N .j>. C1I
0 0 0 000 0 0 0 0 0 0 0 0 0 0 '" N.J:!o. m [X)
....
0
'" a 0 0 00 0 ....
I ?ft- ::.e ?ft- '* '#. t/!. *' t/!. '#. ?ft- ?ft- ?ft- ~ ~ ?ft- ?ft- ?fl. "if!. '#. ;Ie '#. ?f!. ~
....
1981 1981 1981 $:)
1982 " :-
1982 1982
1983 " 1983 1983
1984 1984 1984
1985 1985 1985
1986 [ ~ 1986 ~ 1986
1987 ; ~
~i? 1987 iii;!
-Ill
1987 ~~
1988 ' :;0;- 1988 :;0= :;0 ~.
CD CD CD III 1988
1989 CD III
C'<
... 1989 -~
c: Q, 1989 C~
1990 ~
... ..,
1990 ~ 1990 ~
1991 1991 1991

1992. 1992 ~. 1992
1993 1993 1993
1994 ,. 1994 1994
1995 1995 "
1996 ,L--L_ _ _ _ _ _ _ _ _- - ' 1996 1996
Venezuela
Total Return
I 80%
,.
~
;;;
60%
f
ii:
r:: 40%
.a
~
u 20%
i
fII
0%
f
-20% ,...
~
ex>
N
ex> '"ex> ~
ex>
II)
ex>
<C
ex> ex>
ex> en 0
ex> ex> en
N
c;;
en en '" it II)
en
<C
en
en en en en en en en en en en en en en en en
~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~
Zimbabwe
Total Return
... 60%
~;;;
,. 40%
~,
c: 20%
.a
~
u 0%
i
E
E
<-20%
II
-
'"
j -40% ;;; Nex> ex> ;1i II) <C ,... ex> en 0
'" ex> ex> ex> ex> ex> en en en en it en en
N <C
'"
II) ~
en en ~ en en ~ en en en
~ ~ ~ ~
en en en en en en en
~ ~ ~ ~ ~ ~ ~ ~
MSCI World
Total Return
r 35 %
,.~ 30%
II
.~ 25%
II.
E20%
.a
~ 15%
1
,ho%
~
.
II
OJ
iii
5%
~ 0% ,...
ex> ex> ex> ex> ex> ex> ex> ex> ex> en c;; en CI) CI) en en
N
'" <C ex> 0 N
'" <C
~ ~ II) CI) ~ II)
en en en en en en en en en en en en
~ ~ ..- ~ ~ ~ en en
~ ~ ~ ~
MSCI All Country World

Total Return
~14%
i
S12%
~
, 10%
j
i 8%
If 6%
! 4%
N <"l It) co .... co (I) 0 a; N <"l ~ It) co
~ co co co co (I)
~
co
(I)
co co co (I) (I) (I) (I) (I) (I)
(I) (I)
~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~
IFC Global Composite

Total Return
~40%
~
II
35%
,! 30%
!
'725%
E
1 20 %
1 15%
! 10%
& 5%
II
~ 0%
a; N <"l It) co ....
co 0 a; N <"l It) co
...
~ (I)
~
co co co co co co co co
...'"
(I) (I) (I) (I) (I)
~
(I)
~
'"
~ ~ ~
(I)(I)
~
'"
~
(I)
~
'"
~
(I)
~ ~
(I)
~
(I)
~ ~
Emerging Market Returns

19808 vs. 19908
IFC Global Indicell - lbIal ReIurna USS
~100%
~
1i
80%
60%
40%
II: 20%
&
j O%rr~~~----------~
0% 20% 40% 60% 80% 100%
Average Raturn (1990:01-1996:03)
~~
!""
~
Amuallzed Volatility - Five Year RoIling Annualized Volatility - Five Yea, Roiling Annualized Volatility - Five Yaa, Roiling
l ~ m m ~ ~ ~
~ 1:7: ~ !l: ~ ~ g: 8l o~ 0 0 0 0 0 0 .j>. en 00
[ '#. '#. '#. '#. '#. '#. '#. '#. '#. '#. '#. '#. '#. '#. '#. 0 0 0 ~
;- '#. '#. '#. '#.
OQ
1981 1981
1981
s 1982 1982
1982
1983 1983 ~'
fr 1983
a 1984 1984
1984 c
~
1985 c 1985
~, 1985
1986 1986
1986
;;1
(\)
g" c::::
sa, 1987 2,(") 1987 ~llJ 1987 ~~
_cc <::r
-~ ~
1988 I:Il =r 1988 I:Il I:Il I:Il CD
~ _. =N 1988 s::.
~ ~
Q.
1989
-
=Ci'
~ 1989 r ~= 1989
a~
~~ ...0'
1990 1990 1990
~ <Q.,
1991 1991 (\)
!! 1991 ;:I
1992 . (\)
1992 1992
~ ~
1993 1993 1993 ~'
1994 1994 1994 ;:I
1995 1995 1995 ...s::.
1996 fL'_ _ _ _ _ _ _ _ _--1 1996tL _ _ _ _ _ _ _ _~ 1996 ~
~
-
E'
~
'"
.-.
N
W
.." ..-
00' tv
... .j:>.
'"'"
!'>
~ 0
c
'"
5" Annualized Volatility - Five Yea, RoIling
~
;>:-
Annualized Volatility - Five Yea, RoIling Annualized Volatility - Five Yea, Roiling I:>
... NNW W ~
~ I\J W ".. 01
a 0'1 0 r.n 00'10 J\..) I\.) W W ~ ~
''""
.t: af!. -;;. fI!. tf!. if!. tf!. oe. a a a a a '"a o c.n 0 0'1 0 ::l
'"af!."'" af!. af!. af!. af!. af!. af!. af!.
'" af!. af!. af!. af!. af!. '"af!."'" ~
1981 1981 ....
1981
I:>
1982 1982 1982 .~
:-
1983 1983 1983
1984 1984 1984
1985 1985 1985
1986 1986 1986
1987 1987
~-
-:::I ~G> 1987 ~g>
1988 !!l.a. - ..,
I CD iii 0
1988 r~ 1988
== iii =CD ~3
1989 =0 _. C"
~ 1989 ~CD 1989
1990
~iii
1990 1990
1991 1991 1991
1992 1992 1992 .
1993 1993
1994 1994 Co
1995 1995
~::!
1995
1996 1996 1996
~~
~
~
'"g. Annualized Volatility - Five Year Rolling Annualized Volatilily - Five Year ROiling Annualized Volatilily - Five Year Rolling
N ~ ~ NNW W ~ ~ ~ ~ ~ ~ ~ hl N NNW W W W W
o ~ ~ m ~ 0 N W ~ rn m ~ ~ ~ 0 ~ W woo ~ ~ N
~ ~ ~ ~ * ~ ~ ~ * ~ # ~ ~ ~ ~ ~ ~ ~ *' ~ 'cf!. #. ?J? rf!.
1981 1981 1981
1982 " 1982 1982
1983 1983 1983
1984 1984 1984
1985 1985 1985
1986 1986 1986 ~ ~
tI>
1987 <s: 1987 1987 <5" <:r-
Q.e!..
a.c..
-0
o c.
-0
tI>
til .., ~
1988 til til 1988 t 1988 . ~::::l :::.
ct. s:g. =(\) <;
=(/1
1989 ~iii' 1989 ~::::l 1989 ~ ~. ...o
1990 1990 1990 <Q.,
tI>
1991 1991 1991 ~
tI>
1992 1992 1992
~
1993 1993 1993 ~.
1994 .~ 1994 Co
1994 ~
1995 ~ 1995 1995 ...:::.;.;-
1996 1996,~____________________~ 1996 ~ ......:::::; ~
....
tI>
....
;:
...
;::
'"
N
VI
-
..., ......
~.
N
s: 0\
~
~
r:; ~
c
:: ~
g. Annualized Volatility - Five Va"r RoIling
;>;-
0: Annualized Volatility - Five Year Rolling Annualized Volatility - Five Year RoIling l:)
~ ....a. l\) f\.) W w .J::!r. '" W ".. c:n Q) .....,
'"
.!:: 01 o 01 0 01 0010 ~ ~ ~ ~ ~ ~ ~ o 0 000 0 ......."'
0~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~
1981 1981 1981 ...."'
1982 1982 1982 !?--
1983 " 1983 1983
1984 1984 1984
1985 1985 1985
1986 1986 1986
1987 ~"tI
-I
1987 ~z 1987 ~3:
I 25: iii cC' -CD
1988 cr.1/I 1988 cr.CD 1988 !!.><
=. C::;"
1989 ~~ 1989 ~ ~. 1989 ~O
1990 ~ 1990 1990 "
1991 1991 1991
1992 1992 1992
1993 1993 1993
1994 1994 1994
1995 1995 1995
1996 " 1996 fL...-_ _ _ _ _ _ _ _ _- - - ' 1996 "
Philippines
Volatility
45%
'"
.5
~
: 40%
)'
~
~35%
.
;;;
~
~ 30%
11
:>
~
25%
a; co '"
N
co """
It') I'- co 0>
'"
co co co co co co
0
0> c;; N
0> '"0>0> """0>0> It')
0>
'"
0>
0> 0> 0> 0> 0> 0> 0> 0> 0> 0> 0> 0> 0>
~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~
Portugal
Volatility
60%
,
~ 50%
~
.
~40%
~
ii 30%
~
i
!.1:1 20% -
~
10%
a; '"
co co ~ co co I'-
N It') co 0>
'"
co co co
0
0> c;; N
0> '"en'" """'"
It')
0> '"en
0>
0>
~
0>
'" '" '"
~ ~ ~
0>
'" '"
~ ~
0>
~
0> 0>
~
0>
'" '"
~ ~ ~
South Korea
Volatility
45%
.~
~40%
~
~ 35%
.
~
;;;
~ 30%
::>
~25%
!!I
c
.l
20% ,... co 0> 0 c;; N
a; N
'"
co co """
It')
'"
co co co co co co '" c; It')
'"enen
0>
~
'"
~ ~ 0> ~ 0> 0> ~ 0> en ~ en en
~ ~ ~
0> 0>
~ '" ~ ~
'" ~
0>
0>
~
...,
~. IV
00
~
!'-'
-
() 0
t:J:j
;:::
'"
:;. ~
Annualized Volatility - Five Year Roiling Annualized Volatility - Five Year Roiling ~
Annualized Volatility - Five Year Rolling !:l
~ --. J\J f\) W W
rn m m ~ ~ 00 ~ w ~ ~ (.h tn en m ..... ~
rn 0 ~ 0 ~ a 0 c.n 0010 01 0 CJ1 o en 0 U't 0 c.n 0 ....
! fF. 'of!. (/!. ~ 'if!. ?fe. :.e
0 ~ ~ ~
...
"#. *' *' ?/!.. *' *' ;f!. *' cf.. cI! '#. ~
1981 1981 1981 ...
!:l
1982 ' 1982 1982 c. :-
1983 1983 1983
1984 1984 1984
1985 1985 1985
1986 1986 1986
1987 ~~ 1987 <-I
o :r 1987 ~~
_t: -
II)I I__
)
II) ..,
1988 ,. =:~ 1988 r 1988 21:i-
=11) =11)
-- :::I
1989 ~~ 1989
--
~Q. 1989 ~:::1
1990 1990 1990
1991 1991 1991
1992 1992 1992"
1993 1993 1993
1994 i 1994 l
1994 1-
1995 . 1995 1995-
1996L[____________________~ 1996 1996
.."
""....'"
'"
!"
~
Annualized Volatility - Ave Yaar Rolling Annualized Volatility - Five Year Rolling
"5" Annualized Volatility - Five Year Rolling
~ ~
t\,) I'\) W W ~ .J::to. CJ'1
'"'" 0 ~ 0> 0> o
'" ( 11 o en 0 c.n 0 c.n 0 ~ ~ ~ t ~ &; g; ~ ~
~ 'iJ!. 'iJ!. 'iJ!. 'iJ!. 'iJ!. :.!!
o
-
'" 'iJ!. ~ ';Je '#. ?f!. ';Je '#. ?fi 'iJ!. ';Ii!. ';/t! ~ '* ';j!. '*' ?J!. '*
1981 1981 1981
1982 1982 1982
1983 1983 1983
Hl84 1984 1984
1985 1985 ~
1985
1986 " s:: 1986 1;c 1986 ~
t\)
1987 c:::::cn 1987 C <~ 1987 ! <~ <::l"
2.0 2.3 2.~
Q) - I C" Q) CD ~
1988 1988 =::r.1 1988 =::r. N \:>
_. 0
5!::e =:C" =:c <;
1989 1989 1989 (3
.:<" ... .:<"~ .:<"~ ...
CD I
1990 c:: 1990 1990
~
1991 1991 1991
~
1992" 1992 ,~ 1992 E
1993 1993 t
~
1993 ~.
1994 1994 1994
~
~
1995 1995 1995
;':.
1996 1996 1996L[__________~________~ ~
...
t\)
....
;:
~
'"
N
\0
-

Volatility
16%
I!'
~ 15%
j!! 14%
Ii:
i-13%
;a

;e 12%
J!! 11%
i
10% ....
co
N <') II) ..,
<D .... co ."
co co co co co co co co
0
." ;;; ."
N <')
."
..,
."
II)
."
<D
."
....
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.... ....
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....
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." ." ."
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....

Volatility
30%
~28%
~
~ 26%
~
....! 24%
~22%
,20%
)18%
~
~ 16%
14%
a; ..,
co co co co co ....
....
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~
Emerging Market Volatility

19808 VB. 19908
IFe GIObeI Indlc8ll - Total Raiurllll USS
::!
~100%
I.. 80%
:::::. 80%
. .. .
J
~
I
40%
20%
.:
I 0,% 20% 40% 60% 80% 100%
Annualized VoIaIIllty (1990:01-1996:03)
There are a number of hurdles to be faced when trying to understand

volatility in emerging equity markets. First, given the evidence of nonnormali-
ties in the market returns (see Harvey, 1995; Bekaert and Harvey, 1996a), it is
unlikely that the standard implementation of autoregressive conditional hetero-
skedasticity (ARCH) models is fruitful. As a result, only models which explicitly
account for leptokurtosis and skewness are likely to be useful. Second, given
the existing evidence on return predictablity (see Bekaert and Harvey, 1995),
variance specifications allow for time-varying conditional means.
Importantly, the volatility process should allow the relative importance of
local and world information shift through time as emerging equity markets
become more or less integrated into world capital markets. As with the mean
process, the increasing impact of world factors on volatility may be consistent
with increased market integration.
Changing skewness and kurtosis
It is well known that emerging market returns depart from the normality. Tests
presented in Harvey (1995) and Bekaert and Harvey (1996a) show substantial
deviations from normality. Part of the goal of this paper is to examine which
countries show large deviations from normality and how those deviations
change through time.
There are a number of reasons why we observe non-normality in the equity
market returns. First, the presence of limited liability in all equity investments
may induce option-like asymmetries in returns (Black, 1976; Christie, 1982;
Nelson, 1991). Second, the agency problem may induce asymmetries in index
returns (Brennan, 1993). That is, a manager has a call option with respect to
the outcome of the firm's investment decisions. Managers may prefer high
positive skewness. Third, conditional heteroskedasticity may induce fat tails.
Fourth, regimen shifts, such as those detailed in Bekaert and Harvey (1995)
may induce both skewness and kurtosis. Finally, thinly traded securities' returns
may appear non-normal. The behavior of conditional skewness is studied in
Harvey and Siddique (1997) for a sample of developed countries.
Emerging market returns have more positive skewness than developed
market returns, with a coefficient of skewness greater than zero in 16 of 20
emerging equity markets. The highest skewness is found in Argentina and
Taiwan's equity returns. Emerging markets also present more excess kurtosis
than the world benchmark: Chile and Jordan are the only two countries where
the excess kurtosis is lower than the world benchmark.
We present three tests of normality: one based on Hansen's (1982) general-
ized method of moments (GMM), Bera-Jarque (1982) test and Kolomogorov-
Smirnov. Normality is generally rejected. Based on the empirical distribution,
the GMM test rejects normality in 4 countries, the Bera-Jarque in 13 countries
and the Kolomogorov-Smirnov in 11 of the 20 countries. All tests are based
on the last 5 years of data. These results are consistent with those in Harvey
(1995) and Bekaert and Harvey (1996a). Bekaert and Harvey (1996a) calculate
empirical distributions based on larger samples that reject the hypothesis of

normality.
Figures 3 and 4 present the rolling 5-year skewness and excess kurtosis
measures for the 20 emerging markets and the benchmark returns. If the data
are normally distributed, then both of these measures should be zero. Over the
past 5 years, skewness has shown large increases (become more positive) in
Argentina, Brazil, Colombia, Nigeria, Philippines, South Korea and Taiwan.
In Mexico, skewness sharply increased in 1992 and 1993. However, much of
that increase was reversed with the returns in December 1994-February 1995.
In the IFC composite index, 5-year trailing skewness increased from 1991
through mid-1995. Since then, the skewness has dropped back close to zero.
Two countries show huge excess kurtosis: Argentina and Taiwan, both of
which have a progressive increase in kurtosis in the last 5 years. Eight other
countries also experienced increases in excess kurtosis while seven countries
experienced decreased kurtosis. In the remaining three countries there was little
change in kurtosis. Overall, the IFC composite showed a sharp increase in the
excess kurtosis from 0.8 in 1991 to 3.5 in March 1996. In the MSCI World-AC
index the excess kurtosis was only 0.4 in March 1996.
The departures from normality are important to portfolio managers in a
number of respects. First, the usual mean-variance framework is no longer
adequate to characterize investment decisions. It is reasonable to assume that
investors have a preference for skewness (prefer more positive skewness). It is
also reasonable to expect that there are preferences for kurtosis. The second
implication is that these higher moments are evolving through time. Consistent
with the evidence on the means and volatilities, dynamic models of these higher
moments are necessary.
Conditional correlations
Figure 5 presents rolling 5-year correlations with the MSCI World-AC for the
20 emerging markets and the IFC Composite index return. As detailed by
Harvey (1995), these correlations are generally small. By March of 1996, the
5-year trailing correlation with the world is less than 40% in all countries
except Portugal. Interestingly, there has been no clear trend in the correlations
across the emerging markets over the past 5 years.
Bekaert and Harvey (1996a) present a model of conditional correlation
where the means, volatilities and co variances are influenced by both local and
world information. Their model predicts that as a market becomes more
integrated with world capital markets, the relative influence of world and local
information changes. This change will affect the conditional correlation between
the emerging market and the world benchmark. Bekaert and Harvey offer
evidence that conditional correlations increase after capital market lib-
eralizations.
Many of the major liberalizations occurred before 1992 (Bekaert, 1995). It
is also clear in the data that correlations generally have increased over the
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Venezuela
Skewness
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Skewness
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Emerging Market Skewness
19808 V8. 1990s
IFe Global IndIces - ToIIIl Relwns USS
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1990 ,. ..' l7i ~ 1990 -'0:." Q 1990 ~;'" It- l7i
Q
o~ ...0'
...c: ~ Q
~ ~ ::. <Q.,
1991 , 1991 :'" ~ 1991 ~
~. ~ .~
..... '\ ( ~
;. 1992 1992 1992 ~
\ ~ ~ ~
:E .......,.. 5: ~.. c. 5: ~
0 1993 1993 1993 L--
::!.
/ ~'
0- 1994 ~~ 1994 1994
r'{'o
<T 3
...
::l
..,
::r
1995
'.'\" 1995 r 1995 r
fa, ~
...
~ 1996 '.
1996 rc ..... 1996 c
E!
~
I~ ......~
~
...i'I"
l" ...;::...
::!
'"
. j::.
\0
-
...,
~' v.
0
i;l
-
~
nc 0
:: t;x:,
~
5' Five Ye. RoIling Comoletlan Five Y. . RoIling Correlellon ;>;-
s:: Five Yeat RoIling ComoIetian I:l
0 0 0 0 0 0 ~
~ 0 0
'" 6 6 0 0 0 0 0 6 6 p b b
~ :,... ;., b ;., :,... a. Co b :,... ;., b :,... a. a. b :,... ;., b ;., :,... a. a.0 b ::l.
, 1981
'" ~
1981 " 1981 t ...
.~i" I:l
1982 "..... 1982 1982 :-
1983 ..",' 1983 1983
"
1984
!
,i' 1984
/:
}
;;
1984
;;
1985 .] 0 1985 .:' 0 1985 0
.,..
'" II: G1 G1
~, .. 1986 '
1986 r("" 1986
0 I,. 0 00
1987 0 1987 r: .. .. .l o (j) 1987 ~ 0
3
1988
/! ~ CD -
=I :::I
1988
-.~~.
"
II 1988
I!
'8 Cil 0'
III
- Q_..
~
i-CDi iii 3
III (')
if , J ..if
1989 cr. 1II 1989 gCD 1989 o=:C"_.
0 .~. :::I III
~ :::I ~ :::I 1990 ~
1990 0 1990 ..' ,Q ,Q
1991 ~~ 1991 1991

:j 1~ 1~
1992 ' 1992 ~ 1992, ~
::I. ::I.
a. a. a.
1993 1993 c 1993
1994
,;.... 1994 1994,
1995
"! 1995 1995
" .
1996 :':::r 1996 '-: 1996
Indonesia
Correlation
1.0
0.8
I IFC Glo~omPOSite MSCI~~~.~.World
IS0.6
I!' 0.4
r
".',
~ 0.2 / ".
~ 0.0
1II.
-0.2
-0.4 .....
N <') v It) CD ,... co 0> 0 ..... N <')
;;r; It) CD
...
co co co co co co co co co
..... ..... ..... ..... ..... ..... .....
0> 0> 0> 0> 0> 0>
..... ..... .....
0> 0> 0> 0>
0> 0>
0>
0>
~ ~
0>
.....
0> 0> '"..... .....0>
0>
Jordan
Correlation
1.0
IFC Global Composite MSCI (AC) World
0.8
c:
l
a
11
0.6
I!' 0.4
~ 0.2 ........
II ~......!"\
~ 0.0
1II.
-0.2
-0.4
;;; N <') V It) CD ,... CO 0> 0
C;; N <') V It) CD
0>
..... ...
CO
0>
CO
~ ...
CO
0>
CO
0>
.....
CO
0>
co co
..... ..... .....
0> 0>
CO
0>
... ...
0>
0> 0>
0> 0>
0> 0> 0> 0>
.....
0>
..... ..... ..... '" ... 0>
0>
Malaysia
Correlation
1.0
c:
0.8
i!
~
0.6 ..f :........
8r 0.4 .
:' !..........
.
~'\
~ 0.2
II
~ 0.0
1II.
-0.2 I IFC GIO~mposlte MSCI.. ~~~.WOrJdl
-0.4 ...co N <') It) CD ,... co 0>
~ co co co co co
0
C;; N <')
;;r; It) CD
'".....
co
'" '"
co
..... '"
..... '" ..... 0>
'"..... '"... 0> 0>
..... '"'" '"...
'"..... 0>..... ..... 0>
~ '"..... ...'"
0> 0>
.." .....
~' Ul
...s:: IV
..
!J'
(:j ~
~ b:l
E' Five Year Roiling Correlation Five Year Roiling Correlation ~
'"
s:: Five Ye.r RoIling CorrelaDon , , s::.
6 6 0 0 0 0 0 6 6000 0 0 !=>?PPPPP.
......
~ ~ N 0 N ~ in 00 0 ~ NON ~ in 00 0
'".......
.,. '" 0 '" "'" '" ex> 0
1981 1981 1981 \ ~
1982 1982 1982 ~:~;: l2-
1983 1983 1983 1 ..
t
1984 1984 1984 ,I"
"i
.--
"i .~" "i
1985 0 o 1985 o
1985 ::~ ..
!il ~
1986 1986 ~ 1986 ....
0-0 ~ o ~ 0
1987 o I 1987 "
"If
I~ 3 ~ ~
1987 ~ g z li3 g s::
.., CD
CD _, 3
t'...............:~
1988 I
- I I_I 1988 a; cO'
-CD 1988 ~ /l ~ ><
I .., ~ !!t 0'
1989 i =1 i 1989 ~. .. -, 0
~ 0 ::I 1989 g: iii' .:-. ~ 0
In ::I In ::I
1990 0 1990 ~ ::I 1990 Q
Q
1991 ~): 1991
~~ 1991 ,9 L~
1992 ':IE '~ 1992 Co
1992 ~
1993 '
~ i'i: 5:
1993 L- 1993
1994 1994 1994
1995 - 1995 ..... 1995
1996 '."
1996 1996
.."
~ .
...
'"
~
:s
.,g. Five Year Roiling Correlation Five Year Rolling Correlation Five Year Roiling Correlation
6 6 o 0 0 a 0 6 6 0 0 p p p . 6 6 0 p 0 o 0
'"
.!::: ~ ;., o ;., ~ en ix> 0 :,. ;., 0 ;., ~ 0'> 00 0 ~ ;., 0 ~ CD ex, 0
1981 1981 1981
'"
'
.......
1982 1982 1982
,i
,
1983 ~: 1983 1983
1984 f 1984 1984
.....i 'ii
()
'ii 'ii
1985 ,_.r 1985 () 1985 ()
Gl
1986 ........... ~ 1986 1986 ~ ~
.... :.~. [ ()CIJ I[
" ()lJ ~
1987 o., 0c: 1987 b'lJ 19871,
-g
() o :7 0-
.;;' ., 0 0
, ::::: ~
: ; :f ~ 3 ::r-
1988 1988 1988 CD -C'
~.
;-c:::. 15 -"0 :::.
!!!.CC <:::
1989 \ I ~6 1989 ar o_. I
_ 1989 ~ ~ :i" O
'~'t ;:: CD ....
1990 ~ gm ~ :I en
o:I UI
"" Q 1990 Q 1990 :Q .sa,
1991 1991 :> ~
~ ~ 1991 ~.9 ~
1992 ~
~ 1992 ~ 1992 ~
5: 5: a: ~
1993 1993 1993 ~.
1994 1994 1994 ~
1995 :::.
1995 1995 ....
;>;-
~
1996 1996 1996 .......
~
l::
.......
::!
'"
......
Vl
W
.." .-
~. VI
., ~
'"~
?i
<:>
o
::s
g. Five Veer RoIling Correlation Five v.. RoIling Correlation ~
Five V RoIling CorreleOon tl
''"" b !=' !=' !=' !=' !=' ,.. 6 boo 0 0 0 .... 6 0 0 0 0 0
~ :... P :... NON :... ;" Co 0 P ~
.....
'" 0 '" .co. Ol CD 0 .co. N (:) N :,. 0, CD 0
1981 1981 - ~
.....
1981
.\ tl
1982 1982 1982 :-
"'1
1983 1983 '. 1983 "
~.,
1984 ,--- 1984 1984
;; ;;
1985 o 1985 \',..,. ~ 1985 o
1986 (")
1986 ....... 1986
I.. (")
1987 1987 bl-l 1987 g iii'
~
CD
ct
... i. ...... i. I! 3 ; ~
1988 ~ 1988 '" 1988 !. i'
I\)
- CD i'i'
cr.:::J
I I
III
1989 1989 I
~'
III
:,.
1989
gcr.,< g Co ocr.:::J
1990 1990 ".-';" ~ :::J
.~ ~ 4'1 990 " .0 .'.:'......\
1991 ~~ 1991 ~~ 1991 ~~
1992 'j 1992 'j 1992 'j .i
a. is: -::.~~
1993 L..- 1993 1993
1994
"
'i.T':=~ 1994
:... ""
1994 '0,:
1995 .'} 1995 1995 ....
......
...: ......
1996 i' 1996 1996 ,"
Venezuela
Correlation
Zimbabwe
Correlation
1 --;:::::::=========;--,
lIFe GIo~ompoaIte MSCI..I:~~.WorId I
1.0

Correlation
1.0 1 --r==========;---i
IMS~ ~v.brld I MSCIAlI..
<.~
fLY' ---
Emerging Market Cot1'8IatiomI

19801 ... 1980a
lFe Gaot.I iridic. - Tot.I R.lurne USS
i*
~ 0.8
O.
ii 0.2 .:
t
j 00
S'O~~.2--;;0.-;;-0--;;0-;;-.2--;;.':;-.--;;0.';" ...J
CCIn'.won ..... World (1.0:01-1_:03)
Arithmetic Return
50%
R Sq: 6.6%
T-Stat: 1.13
40%

30%
20%
10%

0%

-10%

-1.0 -0.5 0.0 0.5 1.0 1.5 2.0
Beta vs. MSCI AC World
Figure 6. Risk and return - IFCG indices. Sample: April 1991-March 1996.
longer horizon (see final panel of Figure 5). For example, the correlation of
Argentina and Brazil with the world was zero or slightly negative in the 5 years
ending in 1981. By March 1996 the correlations were above 30%. Long horizon
increases are also evident in South Korea and Thailand. However, in the last
5 years there has been little overall change. In the 5 years ending in 1991 the
correlation of the IFC Composite and the MSCI World was 30%. In March
1996, the correlation was 35%. Slightly higher correlations are found comparing
the IFC Composite to the MSCI World-AC, which has a higher emerging
market composition.9
MEASURING RISK IN EMERGING MARKET RETURNS
Asset pricing theory and emerging market returns
Risk is notoriously difficult to measure in emerging market returns. A simple

implementation of the capital asset pricing model (CAPM) of Sharpe (1964)
and Lintner (1965) is problematic. In these markets, there is no relation between
the risk measured by the CAPM and expected returns. Consider Figure 6,
which plots the average returns over the past 5 years and the p-value against
the World-AC index. These p-values are also presented in Table 3. While there
9The MSCI World-AC begins in 1988. Before 1988, we splice the MSCI World index to the
AC index.
Arithmetic Return
50% r---------------------------------------------------i
R Sq: 21.4%
T-Stat: 2.21
40% -
30%
20%
10%
0% r---------------------------------------------------~

-10% L-~ __ ~ __ ~ ___ L_ _ ~

_ _~_ _~_ _L __ _~~_ _~_ _~_ _~_ _~
10% 20% 30% 40% 50% 60% 70% 80%

Volatility
Figure 7. Risk and return - IFCG indices. Sample: April 1991-March 1996.
is a positive relationship between f3 and average returns, the t-statistic on the

f3 coefficient is 1.1 which is not significant at conventional levels.
The failure of the CAPM to explain emerging market returns could be
interpreted in a number of ways. First, following Roll and Ross (1994) and
Kandel and Stambaugh (1995), the benchmark world portfolio may not be
mean-variance efficient. Second, perhaps a multifactor representation, following
Merton (1973), Ross (1976) and Chen et al. (1986) is more appropriate for
emerging markets. Third, following Ferson and Harvey (1991), an examination
of average returns and average risk could be misleading if the risk and expected
returns change through time. Finally, the CAPM is not the appropriate frame-
work if these markets are not integrated into world capital markets. In integ-
rated capital markets, the projects of identical risk command identical expected
returns, irrespective of domicile (Stulz, 1981a,b; Solnik, 1983; Campbell and
Hamao, 1992; Chan et al., 1992; Heston et al. 1995; Bekaert, 1995; Harvey,
1991, 1995; Bekaert and Harvey, 1995).
It is likely that many of these markets are not fully integrated into world
capital markets. As a result, the f3 value suggested by the CAPM may not be
that useful in explaining the cross-section of average returns. Indeed, in com-
pletely segmented capital markets, the volatility is the correct measure of risk.
The relationship between average returns and volatility is shown in Figure 7.
Similar to the f3 graph, there is a positive relationship which is now significant
at conventional levels of confidence (R2 = 21 %). However, even among the
segmented markets, there might only be a weak relation between volatility and
expected returns because the premium accorded to volatility could vary across
countries (Bekaert and Harvey, 1995).
Alternative risk attributes
Following Ferson and Harvey (1994), Erb et al. (1995a, 1996b) and others, we
examine the relationship between some country-specific risk attributes and the
distribution of returns.
Survey-based measures
The first of the measures used to group these attributes is Institutional Investor s
Country Credit Rating (IICCR). Institutional Investor country credit ratings
are based on a survey of leading international banks who are asked to rate
each country on a scale from zero to 100 (where 100 represents the maximum
creditworthiness). Institutional Investor averages these ratings, providing greater
weights to respondents with higher worldwide exposure and more sophisticated
country analysis systems. These ratings have appeared in the March and
September issues of Institutional Investor since 1979 and now cover over 135
countries (for additional details see Erb et al., 1996a).
Whenever a surveyor expert panel is used to subjectively rate credit-
worthiness, it is hard to define exactly the parameters taken into account.
At any given point in time an expert's recommendation will be based upon
those factors the expert feels are relevant. In a recent survey of participants,
the most important factors for assessing emerging markets' credit rating were
(i) debt service, (ii) political outlook, (iii) economic outlook, (iv) financial
reserves/current account and (v) trade balance/foreign direct investment.
The next four measures are from Political Risk Services' International
Country Risk Guide. They include the political risk index (ICRGP), economic
risk index (ICRGE), financial risk index (ICRGF) and the composite risk index
(ICRGC). The political index is studied in Harlow (1993) and Diamonte et al.
(1996). Erb et al. (1996b) examine the information in all four of the ICRG risk
indices. On a monthly basis, ICRG uses a blend of quantitative and qualitative
measures to calculate risk indices for political, financial and economic risk, as
well as a composite index. Five financial factors, 13 political factors and six
economic factors are used. Each factor is assigned a numerical rating within a
specified range. A higher score represents lower risk (for additional details see
Erb et al., 1996b). The composite index is simply a linear combination of the
three subindices. The political risk is weighted twice that of either financial or
economic risk. ICRG, as well as many of the other providers, think of country
risk as being composed of two primary components: ability to pay and willing-
ness to pay. Political risk is associated with a willingness to pay, while financial
and economic risk are associated with an ability to pay.
We also include Euromoney's country credit risk (EMCCR). Euromoney's
rating system is based on both qualitative and quantitative methods. The
political component is a qualitative survey of experts. The economic component
is quantitative and based on Euromoney's global economic projections. The
financial component is also quantitative and based on (i) debt indicators,
(ii) debt in default or rescheduled, (iii) credit rating (Moody's or Standard and
Poors), (iv) access to bank finance, (v) access to short-term financing and
(vi) access to international bond and syndicated loan markets.
Macroeconomy
The survey-based measures gauge indirectly the future macroeconomic condi-
tions in each country. One of the primary economic measures that influences
these ratings is the inflationary environment. Ferson and Harvey (1993, 1994)
argue that asset exposure versus world inflation helps explain both the cross-
section and time-series of expected returns in 18 developed markets. Erb et al.
(1995b) examine the interaction of inflation and asset returns in emerging
markets. We use a trailing 6-month measure of inflation represented by the
consumer price index reported in the International Financial Statistics database
of the International Monetary Fund. In the case of Taiwan, which is not a
member of the IMF, we use inflation reported in their national accounts.
Demographics
Bakshi and Chen (1994) propose a life-cycle investment hypothesis. Younger
investors have a higher demand for housing than for equities. As age increases,
more investment is allocated to the stock market. As a result, a rise in average
age should be accompanied by a rise in the stock market. Bakshi and Chen
(1994) found support for this hypothesis using data from the USA. Erb et al.
(1997) found that average age growth explains the risk premiums in a number
of developed countries. We examine three variables: population growth, average
age and average age growth. All of these data are based on annual statistics
compiled by the United Nations.
Market integration
Bekaert and Harvey (1997a) argue that the size of the trade sector relative to
the total economy is a reasonable proxy for the openness of both the economy
and the investment sector. They use exports plus imports divided by GDP as
an instrument for market integration. This variable, along with other proxies
for market integration, is used in a function which assigns time-varying weights
to world versus local information. Bekaert and Harvey found that increases in
this ratio are associated with the increased importance of world relative to
local information for both the mean and the volatility of the country's stock
returns.
Persistence
A number of researchers have pointed to momentum as an important firm-
specific attribute (Jegadeesh and Titman, 1993; Asness et aI., 1996; Ferson and
Harvey, 1997). We examine two measures of momentum: the lagged monthly
return and the lagged quarterly return from 4 months ago to one month ago,
i.e. the quarterly return lagged by an extra month.
Size
We follow a number of studies, beginning with Banz (1981) that document a
relationship between firm size and expected returns. Recently, Berk (1996a,b)
has argued that size measured by market capitalization should be a proxy for
risk. This attribute has recently been studied on a country-level basis by
Keppler and Traub (1993) and Asness et al. (1996) who found that size helps
explain the cross-section of expected returns in a sample of developed markets.
Fundamental valuation measures

Following a number of papers that link 'fundamental attributes' to asset valu-
ation (for example, Chan et al., 1991; Keppler, 1991; Fama and French, 1992;
Ferson and Harvey, 1994), we use three valuation ratios: price to book value,
price to earnings and price to dividend. Value-weighted indices of company
level data are produced by the IFC. Ferson and Harvey (1997) show that some
of these ratios, most notably price to book, appear to capture information
regarding changing risk in a sample of 21 developed countries. In addition,
sudden changes in these ratios may also reflect changes in the degree of market
integration (Bekaert and Harvey, 1996b). A change in the marginal investor
from domestic to international could lead to a change in the fundamental
valuation ratios and a change in the riskiness.
Summary statistics
Some summary measures for many of these attributes are included in Table 4.
The March 1996 value of the attribute is reported. In the lower panel, the
rank-order correlation of all of the attributes is reported. Most of the correla-
tions follow from intuition. Consider the ICRG indices. These indices are highly
correlated with the Euromoney and Institutional Investor country credit risk
measures. All of the survey measure are negatively correlated with inflation
(high inflation means low rating). The most negative correlation with inflation
is found for the ICRG economic risk index. Average age is positively correlated
with the survey risk indices, indicating that low average age is associated with
a low rating. Size is positively related to the ICRG ratings (smaller markets
appear more risky). There is also a positive relation between the size of the
trade sector and the ICRG ratings. The lowest correlations are found for the
ICRG indices and the fundamental attributes.
WHAT MATTERS IN CHOOSING AN EMERGING MARKET FOR

PORTFOLIO INVESTMENT?
Portfolio approach
A commonly used technique in examining the cross-sectional importance of a

fundamental variable is to form unique portfolios based on their ranking. We
will examine the country risk variables by forming portfolios based on the risk
Table 4. Country attributes, March 1996.
Country ICRGC ICRGP ICRGF ICRGE ICCR EMCRR INFLATE TRDGPD POPGR AAGEGR AVEAGE MKTCAP PIE PIB PID
(%) (%) (%) (%)
Argentina 72.5 76.0 35.0 34.0 38.4 57.2 0.7 12.8 1.2 0.3 30.9 22308 16.7 1.4 29.2
Brazil 65.5 64.0 34.0 33.0 35.8 55.4 29.2 13.6 1.7 0.8 27.1 93940 40.3 0.5 28.9
Chile 80.5 76.0 43.0 41.5 59.2 79.8 7.6 42.1 1.6 0.6 29.0 39421 15.9 1.9 26.1
China 72.0 68.0 38.0 38.0 56.4 70.8 1.0 0.9 29.6 29495 31.8 2.0 37.6
Colombia 66.0 58.0 39.0 35.0 46.7 62.6 19.1 61.4 1.6 0.9 26.2 6659 12.0 1.0 36.8
Czech Republic 82.5 82.0 42.0 40.5 60.1 74.6 8.5 12346 13.4 1.0 87.7
Greece 75.0 76.0 38.0 36.0 49.8 73.3 8.5 60.2 0.3 0.6 38.9 11200 10.8 2.1 24.6
Hungary 76.0 79.0 40.0 32.5 43.6 67.7 29.6 49.7 -0.5 0.2 37.7 2957 21.4 1.1 125.0
India 67.0 62.0 36.0 36.0 45.8 66.7 9.7 17.2 1.9 0.5 26.0 71141 14.3 2.3 65.8
Indonesia 70.5 65.0 39.0 37.0 51.8 73.2 10.5 43.9 1.5 0.8 26.2 54571 26.6 3.5 1124 ~
(I:>
Jordan 74.5 73.0 38.0 38.0 30.5 54.3 7.0 130.1 4.6 0.3 21.4 3276 15.6 1.7 50.0 <:::r'
(I:>
Malaysia 79.5 75.0 43.0 41.0 68.4 84.5 3.3 166.4 2.3 0.6 24.8 162134 28.4 3.7 83.3 ;:-
!::>
Mexico 69.5 66.0 40.0 33.0 41.2 58.8 43.8 37.2 2.0 0.9 24.8 65162 18.6 1.7 117.6 ~
21.5 1712 12.2 3.3 23.3

C
Nigeria 50.5 54.0 23.0 24.0 14.8 32.3 69.9 40.7 3.0 0.0 ....
Pakistan 60.0 54.0 34.0 31.5 29.5 50.7 9.8 35.4 2.8 0.3 21.9 6647 16.4 2.1 45.7 ~
2.7 90.1 (I:>
Peru 64.0 59.0 34.0 34.5 27.2 47.5 11.6 20.2 7422 13.8
~
Philippines 68.5 63.0 37.0 36.5 38.1 63.5 12.3 54.3 2.1 0.6 24.0 39729 21.2 3.8 153.8
Poland 77.5 77.0 41.0 37.0 40.2 56.5 20.4 38.3 0.1 0.6 34.3 3893 8.5 1.8 84.7 ~
Portugal 83.5 83.0 43.0 41.0 68.8 81.9 2.5 56.1 -0.1 0.6 36.6 11405 14.8 1.5 35.1 ~.
South Africa 76.0 75.0 41.0 35.5 46.3 64.9 6.8 38.5 2.2 0.2 25.0 105981 19.2 2.7 49.0 ~
South Korea 82.0 77.0 46.0 41.0 72.0 85.0 4.5 53.7 1.0 1.0 30.5 125037 21.0 1.3 54.3 !::>
....
Sri Lanka 66.5 61.0 36.0 35.5 32.5 50.6 11.8 80.7 1.3 0.9 28.2 1315 8.9 1.5 39.8 ~
.....
Taiwan 83.0 75.0 48.0 43.0 78.9 91.5 3.0 86.7 114475 21.6 2.8 85.5 ....
(I:>
Thailand 76.5 69.0 43.0 41.0 63.4 82.1 5.4 64.9 1.0 1.2 27.9 95036 20.5 3.1 55.9 .....
:::
Turkey 60.5 55.0 36.0 30.0 40.4 58.4 78.9 31.6 1.9 0.6 26.5 20641 12.2 3.7 40.2 ~
Venezuela 64.5 65.0 33.0 31.0 30.1 44.7 78.1 40.1 2.2 0.8 25.1 2652 16.3 2.6 63.3 '"
Zimbabwe 63.5 66.0 28.0 32.5 32.2 50.5 25.8 74.8 2.4 0.2 21.4 1677 8.2 1.4 21.1
....
0\
....
Table 4. (Continued.) 0'1
N
-
Country ICRGC ICRGP ICRGF ICRGE ICCR EMCRR INFLATE TRDGPD POPGR AAGEGR AVEAGE MKTCAP PIE P/B P/D
~
(%) (%) (%) (%)
a,
~
;>0;-
Rank correJalions I:>
~
ICRGC 1.00 0.89 0.90 0.84 0.82 0.82 -0.70 0.40 -0.59 0.25 0.57 0.47 0.28 -0.17 0.23 .......
ICRGP 1.00 0.68 0.59 0.61 0.61 -0.55 0.24 -0.59 0.04 0.61 0.23 0.15 -0.36 0.09 ~
ICRGF 1.00 0.83 0.88 0.88 -0.59 0.43 -0.50 0.42 0.44 0.58 0.31 -0.03 0.30
...
~
ICRGE 1.00. 0.79 0.81 -0.76 0.52 -0.39 0.43 0.33 0.54 0.29 0.03 0.17
nCCR 1.00 0.97 -0.61 0.39 -0.58 0.54 0.53 0.66 0.36 -0.02 0.13
EMCRR 1.00 -0.65 0.38 -0.54 0.44 0.48 0.71 0.45 0.06 0.21
INFLATE 1.00 -0.31 0.24 -0.10 -0.27 -0.50 -0.28 0.02 0.06
TRDGDP 1.00 0.02 0.18 -0.11 0.06 -0.02 0.06 -0.01
POPGR 1.00 -0.47 0.95 -0.09 -0.05 0.35 -0.07
AAGEGR 1.00 0.39 0.36 0.26 -0.12 0.11
AVEAGE 1.00 0.07 0.02 -0.36 -0.09
MKTCAP 1.00 0.68 0.26 0.27
PIE 1.00 0.16 0.37
P/B 1.00 0.27
P/D 1.00
ICRGC, political risk services: international country risk guide - composite. ICRGP, political risk services: international country risk guide - political. ICRGF, political risk services:
international country risk guide - financial. ICRGE, political risk services: international country risk guide - economic. nCCR, institutional investor country credit ratings. EMCRR.
Euromoney country risk ratings. INFLATE, annual consumer inftation: IFS database. TRDGDP, trade openness (exports + imports)/GDP. POPGR, annual growth in total
population - UN data. AAGEGR, annual growth in average age or population - UN data. AVEAGE, average age or population - UN data. MKTCAP, IFC global market
capitalization (US$ millions). PIE, IFC global price/earnings ratio. P/B, IFC global price/book ratio. P/D. IFC global price/divident ratio.
level itself. These portfolios are investible with respect to the attribute: that is,
lagged attribute information is used to determine which countries are in the
portfolios and the analysis is conducted out of sample. Given the small number
of emerging markets, we examine only two portfolios: high attribute and low
attribute. In each case, we track the returns to portfolios that are equally
weighted by country, and those that are weighted by each country's equity
market capitalization. To reduce potential transactions costs, we only consider
quarterly rebalancing.
Table 5 presents the results of the portfolio strategies. Of the ICRG indices,
the composite index (ICRGC) produces the greatest separation of expected
returns. With the equally weighted investment scheme, the high attribute port-
folio (low risk) presents 29.7% average return with a 25.7% volatility. The
low attribute portfolio (high risk) delivers a 36.6% average annual return
with a slightly lower volatility, 23.5%. Interestingly, the fl-value against the
World-AC is much lower for the low attribute portfolio. Hence, the alpha of
this strategy is quite large.
Of the family of ICRG indices, the financial and economic risk appear to
be the most important and in the equally weighted portfolio strategies. The
political risk measure is only important in the capitalization weighted invest-
ment strategies. These results are consistent with those presented in Erb et al.
(1996b). This implies that pure political risk is diversifiable and not priced.
Both the Institutional Investor and the Euromoney credit ratings also are able
to discriminate significantly between high and low expected return securities.
As with the ICRG Composite, the low attribute portfolios have higher means
and lower volatilities than the high attribute portfolios. Inflation also appears
to be an important instrument in portfolio selection. In this case, the high
attribute portfolio has much higher expected returns than the low attribute
portfolio. However, in contrast to the ICRG, EMCCR and nCCR, the high
attribute portfolio has much higher volatility than the low attribute portfolio.
Trade to GDP has only marginal ability to distinguish between high and
low expected returns. The low attribute portfolio has higher expected returns
than the high attribute portfolio. However, the volatility of the low attribute
portfolio is greater. Nevertheless, the fl-value of the low attribute portfolio is
close to zero leading to a very high ex-value. Caution needs to .be exercised
here: the fl-value of the low attribute portfolio may be low because the market
is not intregrated. The idea of Bekaert and Harvey (1997a) is that trade to
GDP is a proxy for integration. Indeed, the low fl-value of the low trade to
GDP portfolio is consistent with their results.
The three demographic variables - population growth, average age growth
and average age - offer no ability to discriminate between high and low
expected return countries. The demographic asset pricing theory presented in
Chen and Bakshi (1994) is most appropriate for time-series analysis of devel-
oped countries. That is, holding other factors constant, an increasing average
age will be associated with higher demand for equities. It is difficult, if not
Table 5. Country risk level portfolio strategy, January 1985-March 1996.
~
-
Risk attribute High attribute Low attribute Low-high attribute
{FC MSC{ Average {FC MSC{ Average {FC MSCI

o
Portfolio Standard compo AC world annual Portfolio Standard compo AC world annual Portfolio Standard compo AC world ~
;0:-
return deviation beta beta turnover return deviation beta beta turnover return deviation beta beta s:::.
(%) (%) (%) (%) (%) (%) (%) (%) (%) (%) ~
....
""
Equal weighted
ICRGC 29.7
f2..
25.7 0.65 0.69 50 36.6 23.5 0.32 0.24 57 5.3 26.6 14.5" 17.3 b
ICRGP 35.3 27.4 0.67 0.76 55 30.4 21.4 0.29 0.16 53 -3.6 23.9 5.6 8.8
ICRGF 31.8 27.4 0.65 0.69 58 35.9 25.2 0.29 0.19 68 3.1 29.7 13.4 16.5"
ICRGE 27.8 21.7 0.51 0.45 59 40.4 27.3 0.50 0.52 72 9.9- 23.4 11.8 10.9
ICCR 26.5 26.1 0.60 0.69 41 39.9 24.2 0.39 0.25 46 10.5- 25.0 16.lb 19.9b
EMCRR 27.1 24.8 0.59 0.70 40 39.8 23.5 0.41 0.26 46 IO.OS 21.5 14.9b 19.00
INFLATE 41.9 25.7 0.46 0.44 62 26.2 20.9 0.50 0.52 54 _11.1- 18.0 _ 11.2b -liS
TRADEGDP 32.6 23.7 0.55 0.76 35 35.0 24.3 0.43 0.17 46 1.8 21.9 5.7 13.9b
POPGR 30.2 19.9 0.26 0.26 30 36.1 25.8 0.58 0.63 38 4.5 19.9 0.7 0.7
AAGEGR 33.3 26.1 0.53 0.74 37 31.7 22.9 0.31 0.14 36 -1.2 24.3 5.0 11.3
AVEAGE 37.2 29.0 0.64 0.62 39 28.5 19.2 0.19 0.25 26 -6.3 24.4 3.8 2.8
MKTCAP 24.8 26.9 0.81 0.66 49 41.0 25.9 0.16 0.28 55 13.OS 32.5 29.8 26.3 b
MOM-I 38.9 26.8 0.52 0.66 203 26.8 21.8 0.46 0.30 220 -8.8 23.1 -4.7 -0.7
MOM-2-4 37.0 28.3 0.57 0.68 205 28.8 21.5 0.40 0.28 215 -6.0 25.2 -0.3 3.6
PIE" 22.8 27.7 0.65 0.79 77 39.6 21.8 0.31 0.30 88 13.7- 26.8 22.6 24.7
P/B" 20.8 27.2 0.66 0.82 72 42.3 20.7 0.30 0.26 80 17.7b 24.3 25.9 27.6
P/D 29.4 29.2 0.70 0.51 88 39.6 22.2 0.25 0.43 86 7.9 25.2 18.7 12.4
Capitalization weighted
ICRGC 12.0 33.0 1.06 0.61 30 29.8 28.6 0.47 0.38 58 15.~ 40.1 35.4 30.9b
ICRGP 13.7 34.3 1.12 0.72 22 20.3 23.4 0.39 -0.04 38 5.7 35.9 26.6 27.3 b
ICRGF 15.7 33.6 1.05 0.74 23 22.2 31.5 0.49 0.03 49 5.6 44.0 27.1 b 29.6b
ICRGE 16.8 31.8 0.96 0.60 25 18.0 38.5 0.91 0.73 45 1.0 42.0 10.2 5.9
IICCR 16.4 32.0 0.99 0.64 22 24.7 35.9 0.82 0.60 34 7.2 37.0 16.5 13.3
EMCRR 17.1 31.9 0.99 0.64 23 19.4 36.9 0.84 0.59 46 2.0 37.2 11.2 8.8
Table 5. (Continued.)
Risk attribute High attribute Low attribute Low-high attribute
[FC MSC[ Average [FC MSC[ Average [FC MSC[

Portfolio Standard compo AC world annual Portfolio Standard camp. AC world annual Portfolio Standard compo AC world
return deviation beta beta turnover return deviation beta beta turnover return deviation beta beta
(%) (%) (%) (%) (%) (%) (%) (%) (%) (%)
INFLATE 19.6 34.0 0.82 0.67 43 17.0 31.8 0.98 0.61 23 -2.2 34.2 1.7 4.2
TRADEGDP 20.1 35.0 1.06 0.72 19 15.3 31.1 0.71 0.44 30 -4.0 38.8 9.1 7.8
POPGR 16.7 27.1 0.60 0.50 21 14.3 27.1 0.63 0.65 20 -2.1 30.3 3.1 0.6
AAGEGR 15.8 31.8 0.82 0.91 17 15.7 20.9 0.37 0.07 17 -0.1 29.0 12.6 18.0b
AVEAGE 16.2 27.7 0.63 0.57 20 18.5 26.6 0.62 0.59 15 2.0 30.7 5.8 3.8
~
~
MKTCAP 15.1 32.5 1.07 0.63 22 27.7 26.3 0.14 0.43 50 11.0 44.7 38.3 c 25.6"
<:J-
MOM-1 23.8 29.7 0.72 0.67 237 19.3 34.3 0.99 0.58 232 -3.6 38.0 1.9 7.3 ~
~
MOM-2-4 15.2 36.7 1.01 0.72 130 19.4 30.7 0.73 0.41 139 3.7 39.7 17.4 17.1 :::.
PlEa 14.5 35.5 1.09 0.98 33 21.9 32.4 0.59 0.29 69 6.4 43.0 25.1" 26.2" '"c
p/Ba 10.5 38.1 1.18 0.92 40 24.6 26.1 0.48 0.57 64 12.7 42.3 33.9c 25.7"
....
P/D 17.8 36.4 1.12 0.68 42 32.9 26.3 0.41 0.39 85 12.8 41.0 34.6c 25.0' .sa.,
~
IFC composite 15.7 22.5 1.00

;s
0.58 ~
MSCI AC world 16.1 14.5 0.24 1.00 ~

~.
Significance level: a 10%. b 5%. c 1%. IFC global and MSCI world indices in US dollars: unhedged. Countries enter portfolios when they emerge in IFC indices. From ;s
January 1985-December 1987 the MSCI world index was substituted for the MSCI all country (AC) world index. Price/earnings and price/book ratios are unavailable :::.
....
until January 1986. Portfolios were formed by sorting the countries into two halves based on the level of the attribute. Portfolios were reformed quarterly. ~
ICRGC. political risk services: international country risk guide - composite. ICRGP. political risk services: international country risk guide - political. ICRGF. political
....
....
~
risk services: international country risk guide - financial. ICRGE. political risk services: international country risk guide - economic. nCCR. institutional investor
country credit ratings. EMCRR. Euromoney country risk ratings. INFLATE. annual consumer inHation: IFS database (six month lag). TRADEGDP. trade openness ....
=-
:::
(exports + imports)/GDP (six month lag). POPGR. annual growth in total population - UN data. AAGEGR. annual growth in average age of population - UN data. '"
AVEAGE. average age of popUlation - UN data. MKTCAP. IFC global market capitalization. MOM-I. trailing US$ total return - last month. MOM-2-4. trailing .....
US$ total return - months -4 to -2. PlEa. IFC global price/earnings ratio. P/B'. IFC global price/book ratio. P/D. IFC global price/divident ratio. 0\
VI
impossible, to hold other factors constant in emerging markets. For example,

a changing degree of market integration could confound the relation between
demographics and returns. In addition, given that the age dynamics are predict-
able, the demographic analysis is best directed at explaining long-horizon
expected returns (Erb et ai., 1997).
Size appears to be an important instrument in discriminating between high
and low expected returns. This is consistent with the analysis of developed
markets presented by Asness et al. (1996). For example, the low market capital-
ization portfolio produces an average annual return of 41.0% with a volatility
of 25.9%. The high capitalization portfolio delivers 24.8% average annual
return with a 26.9% volatility. The p-value of the low capitalization portfolio
is much lower than the high capitalization portfolio. As with the trade to GDP
measure, the p-value is to be interpreted with caution. Bekaert and Harvey
(1996a) consider market capitalization to GDP to be another proxy for market
integration. It is likely that low market capitalization is indicative of market
segmentation.
The evidence for the momentum variables is mixed. The high momentum
portfolio (high lagged returns) has a 38.9% average annual return whereas the
low momentum (low lagged return) has a 26.8% average annual return. While
this appears impressive, there is also a large difference in volatility. The high
momentum portfolio has 26.8% volatility compared to 21.8% volatility for the
low momentum portfolio. Interestingly, there is little difference between the
momentum specifications. In addition, the p-value of the low momentum
portfolio is 50% smaller than the high attribute portfolio, effectively eliminating
the ct..
The final set of attributes involves the traditional accounting ratios. While
dividend yields (DP) are available on all the indices one year after the market
enters the IFC data, the price to book (PB) and price to earnings (PE) ratios
are only available from January 1986. Hence, the evaluation of the PB and PE
ratios is over a different sample than all of the other portfolio simulations.
There are sharp differences between the high and low attribute portfolios for
these attributes. For example, the high PB portfolio earns 20.8% average return
with a 27.7% annual volatility. The low PB portfolio delivers 42.3% average
return and a 20.7% volatility. The p-value of the high PB portfolio is 0.82
compared to 0.26 for the low PB portfolio. Similar, but less dramatic results,
are found for the PE ratio. The dividend yield also discriminates between high
and low expected returns over a longer sample than PB and PE. The high DP
portfolio has 29.4% average annual return with 29.2% volatility compared to
the low DP portfolio which has 39.6% average return and 22.2% volatility.
These results suggest that a number of attributes are useful in discriminating
between those countries which will experience high and low expected returns.
It is likely, as argued in Ferson and Harvey (1994, 1997), that these attributes
are related to risk. Unfortunately, determining the appropriate measure of risk
is difficult in emerging markets.
Trading emerging market portfolios
The cost of trading is high in emerging markets. Table 6 presents estimates of

transactions costs from Barings Securities. The percent spread calculation is
the difference between the offer and bid price divided by the average of the
Table 6. Estimated transaction costs in the emerging markets - Baring Securities emerging market
index spread analysis
Weight BEMI
+ standalones
Spread in Weight BEMI (%)
Country basis points (%)
Argentina 155 5.94 5.46

Brazil 85 15.69 14.42
Chile 393 6.46 5.94
China 134 0.00 1.66
Colombia* 100 0.00 1.13
Greece 48 1.80 1.65
India* 150 0.00 4.39
Indonesia 112 3.11 2.86
Jordan 58 0.00 0.25
Malaysia 69 14.25 13.09
Mexico 93 11.68 10.74
Pakistan 38 0.56 0.52
Peru 111 2.31 2.12
Philippines 94 4.47 4.11
Poland* 150 0.00 0.69
Portugal 93 1.91 1.75
South Africa 112 12.23 11.23
South Korea 41 4.56 4.19
Taiwan 47 5.23 4.81
Thailand 70 8.19 7.52
Turkey 160 1.61 1.48
* Spread numbers are approximate.
Global spread (basis points)
Cap weight Equal weight

Index Cap weight + standalones Equal weight + standalones
Global 108 110 108 110
Asia 69 80 67 84
Europe + Africa 108 109 103 104
Latin America 146 145 167 156
Source: Baring Securities (July 1995).

Please note that these figures represent spreads only, and do not include either commissions or
various taxes.
Countries and weights differ from both IFC and MSCI.
offer and bid price. Barings uses the midpoint in the divisor in order to avoid
the problems caused by large fluctuations in the current price. The percent
spreads in Table 6 are based on snapshots of individual stocks during the weeks
of July 17 and July 24, 1995. The country spreads are calculated by capitaliza-
tion weighting the percentage spreads of the individual firms within each
country. The percentage spreads are, in many countries, much larger than one
would expect in developed markets. The spread in Chile is close to 400 bp. In
both Argentina and Turkey, the percentage spread is more than 150 bp. These
high transactions costs reinforce the need to minimize trading. Indeed, many
investment managers do not practice active stock selection strategies in emerg-
ing markets because of the massive transactions costs. 'Active' management in
emerging markets is often interpreted in the context of country selection rather
than stock selection.
While the portfolio analysis shown in Table 4 does not explicitly account
for transactions costs, we do include a measure of average turnover. The highest
turnover is found with the momentum strategies. The turnover is so high that
it is unlikely that these strategies could be successfully implemented in the form
specified here. The lowest turnover is found with the demographic variables.
This is not unexpected given that the data is only available annually and there
is little variation over the years.
The most impressive ratios of low-high portfolio returns to turnover are
found for the survey risk attributes, in particular the ICRGC, EMCCR and
IICCR. For example, in the low attribute of EMCCR portfolio, the turnover
is 46%. With 10 countries in that portfolio, four or five would change over the
entire year (four rebalancing opportunities).
Another important constraint is investibility. The portfolio analysis is init-
iated in 1985 and includes all the countries in the IFC-Global database.
However, for much of this period many of the returns were not attainable due
to investment restrictions (Bekaert and Urias, 1996).
Risk attributes and the behavior of emerging market returns
The portfolio exercise suggests that many of these risk attributes can discrimi-
nate between high an low expected returns environments. What about the
other moments? Erb et al. (1996a), and Bekaert and Harvey (1997a) argue that
attributes like trade to GDP and credit rating affect conditional volatility.
Ferson and Harvey (1994, 1997) establish a link between country attributes
and time-varying risk exposures. It makes sense to examine the relation between
these some of these attributes and the other moments of returns.
Figure 8 focuses on three attributes: ICRGC, trade to GDP, and PB. The
average values of these attributes over the past five years is plotted against the
moments of the country returns: mean, standard deviation, skewness, excess
kurtosis and correlation with the World-AC. For each of the attributes, there
is a negative relation between the value of the attribute and the average returns
which is consistent with the portfolio exercise. For the ICRGC and the
AnnualtedVolatillty
80%
''''
""
50%
.,%
,,% "
~~------------------ 20"
'O%50~----eo::::-----=-o':'O""----~80----"" ,~
Average ICRG Compoelta Rdnga " 50

" "
Average leRG CompaeIte Ratings 80
I
...... ...--
::f
4.0
3.0
,~
20 r 10.0 ~
'.0 l----~~--!-----------__j
5.0 ~
0.0 f----------'----~-----
" " '

"
.1.0 00 f
-2.050~----:eo:-----:70~----BO=------: -5.0
AV8f1I98 ICRG Composite RIlInp " "
60 70
Average leRG CompDllita Ratings
so
"
MSCt AC Wot1d
Bela - Correlation - MSCI A.C World
2.0,------------------
06[
'.5
0.4 L
'.0
o.,L--~--..;---~:-...c-- 02
0.0 ~--------=------------
0.0 ~--=----------------_!
.(l.'
-1.050'----~BO-----,LO- - - -..
-----" .().250L--~--60=-----:":-----;80~---~"
-...
AVaragII leRG CompoeIte Rdnp Averaga leRG Compoeita Rdngs
-.. AnnllllllzedVoAatllIty
,,%
-I
-' ,,%
60%
"" ,,%
20%
40%
,~
,-
3D"
.,:~
-
20"
, .,,, ,,,,, ,.". ,""
.........-
""0%
--
~ 20% 40% 60%
""
_TnodeIGNP
'20% 140% ,eo%
"", 20% 60%
Average l'nIdeIGNP
'20% '40"
4.0 20.0
3.0 15.0
~O
10.0
'.0 "
5.0
0.0
,
0.0
-1.0
-2'00%
20" 40" 60" ,,% ,,,% '20"
Average TradelGNP
'40" '60" '60%
-5.0
'" 20% .", "" 80% 100%
Average TradafGNP
'20% 140% 160" 180%
Figure8. Explaining returns: IFCG indices, sample: April 1991-March 1996.

a... - USCI Ae WDftd CoIre/IIIkIn-MSC!ACWorId

2.0 0.6
I..
0.'
1.0
0 -
o ,
0.2
r-
o.of---~-----
o.ol---~--------------j
.(l.'
--- --
"'0ow. 20% 40'4 .,.., 80% 1~ 12m' 1~ 16O'Mo 1110% ~.2,", 20% 4(fIJI, 6()% 80% 1(1()% 120% 140% 160')1, 180%
~~ AwnIgeTnIdIIIGNP
'''' "'"
""
_r----_--;-___,
10"
-
--- ---
~r------~-------~
--
.10%0';;-.0---;1.';;"0---::2.::-0---;;',.o;:----:':,.o:-----},.o '~0~.0---;'.':-O---::2.':-0----::'.O;:---~'.::-0--~'.'0
--
'.0
3.0 -
20.0
15.0
10.0
10
f-~-------- ..-~-~
0.0t---------''----~-----1
---
00
---
-1.0
.0 ---:27.0 ---:,':".0---,':".0--..J,.o
-2.0';;-.0- - - : ,7 -s.OOL.
O- - - :'-=-.O---::2'::-0---::,-=-o- - - :.'::-0---!,.o
a... - MSCI AC World Can.r.Ian _ Macl AC World

2.0 0.6
1.'
OA
0.2
0.0
---
0.01--------------=-..,
---
.(l.5
.1.00.';;-0---;,.70 ---:;2.';;"0---:;,.7
0 ---;,.':-0---:~o .(l~.LO---:,~.0---::2':".0---::3'::-.0---:,7.0---:~0
Trade/GDP, there is a sharp negative relation between the rating and volatility.
There is no significant association between PB and volatility. None of these
three measure does well in explaining the cross-section of skewness. There is a
negative relationship between the Trade/GDP variable and skewness, but this
is not significant at conventional levels. All three measures show a negative
association with kurtosis. Low composite rating, low Trade/GDP and low PB
are associated with higher kurtosis. PB has considerable success in explaining
the cross-section of fJ-values which is consistent with Ferson and Harvey's
(1997) evidence that PB is an instrument for time-varying risk exposure. Low
PB is associated with higher risk. Finally, there is a positive relationship
between the ICRG composite risk and correlation with the world market.
Consistent with Bekaert and Harvey (1997a), there is a positive relationship
between Trade/GDP and correlation with the world.
CONCLUSIONS
This chapter has further explored the behavior of emerging market returns.
The first goal of the paper was to go beyond the mean and variance and
investigate skewness and kurtosis. Indeed, there is considerable research interest
in asymmetric variances, semi-moment analysis and down-side optimization.
These advances make a lot of sense in emerging markets where the returns
distributions depart from the usual normal assumption. We showed that the
deviations from normality are persistent in the emerging market returns, show
no evidence of disappearing in the near future, and are time-varying in nature.
We then explored what matters for emerging market investment. The tradi-
tional fJ-risk paradigm is problematic in emerging markets because a number
of the markets are unlikely fully integrated into world capital markets. Indeed,
in a completely segmented market, country variance (which is usually consid-
ered idiosyncratic) is the appropriate measure of risk. We explored a group of
risk attributes that have been successfully applied in developed markets. We
found that a number of these attributes such as the International Country Risk
Guide's composite risk, trade to GDP and price to book value are useful in
identifying high and low expected return environments.
Finally, we tried to link our attribute analysis to the behavior of the emerging
market returns. The risk attributes, not only discriminate among the mean
returns, they also offer information about other moments. For example, we
found that low ICRG composite ratings are strongly associated with high
volatility, high excess kurtosis and low correlations with the world benchmark.
This analysis suggests that models of formal asset allocation in emerging
markets need to go beyond both the attribute sorting portfolio approach and
the simple mean-variance analysis. In these markets, the attributes contain
information about volatility, correlation, skewness and kurtosis as well as
expected returns.
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IAN DOMOWITZl, JACK GLEN2 and ANANTH MADHAVAN 3
I Northwestern University, 2 International Finance Corporation, 3 University of Southern California
6. Cross-listing, segmentation and

foreign ownership restrictions
ABSTRACT
We examine empirically the impact of international cross-listing on stocks traded on the Mexican
Stock Exchange. We focus on the Mexican market because equity issues in Mexico differentiate
between foreign and domestic investors, permitting tests of hypotheses about the effects of cross-
listing on different shareholder classes. For shares open to foreign ownership, ADR introduction is
associated with higher volatility unrelated to volume and lower liquidity, consistent with the
hypothesis that cross-listing induces market fragmentation. However, the implicit bid-ask spreads
for shares open to foreign ownership decrease although there are no such changes for shares
restricted to domestic ownership. This finding is consistent with the hypothesis that cross-listing
also creates in greater competition for order flow in some segments of the market. These effects
vary with firm characteristics such as market capitalization. Internal capital market segmentation,
induced by foreign ownership restrictions is an important factor in these results. Cross-listing is
thus more complex than previously believed, with differential impacts on foreign and domestic
investors.
INTRODUCTION
Trading offoreign stocks in the Untied States has grown exponentially as investors
recognize the need for international diversification while seeking higher expected
returns. Accompanying this growth is an increase in the number of American
Depository Receipt (ADR) listings on US exchanges. 1 While foreign corporations
presumably view ADR listing as value enhancing, it is not clear that all classes of
domestic investors are better off as a result. Indeed, relatively little is known about
the effect of foreign listings on the domestic market. 2 Changes in liquidity, volatility,
I Foreign companies wishing to trade equities (and debt) in the US market often achieve this
goal by issuing American Depository Receipts (ADRs). The ADR represents shares held by a
trustee in the local market. The receipts, issued by a US depository (usually a large bank), are
then treated as US securities for clearance, settlement, transfer, and ownership purposes. The
depository is responsible for the payment of dividends (in dollars) to investors, for the distribution
of information about the issuer, and for conversion between shares and ADRs. Foreign stocks may
also be traded exclusively in the 'pink sheet' or over-the-counter market.
2 Chan et al. (1994) analyze the intraday price behavior of dually listed stocks; Forster and
George (1993, 1994) study the pattern of return variances for international cross-listing; Alexander
et al. (1987, 1988), and Howe et al. (19.93) discuss the impact of international listing on US stocks;
Kleidon and Werner (1993) examine the effect of cross-listing on UK stocks; Jorion and Schwartz
(1986) and Foerster and Karolyi (1993, 1994) analyze cross-listed Canadian stocks; Jayaraman
et al. (1993) examine the effect of US ADR listing on domestic stock prices; and Freedman (1990)
provides a theoretical model of international lisitng.
175
R. Levich (ed.). Emerging Market Capital Flows, 175-192.
CI 1998 Kluwer Academic Publishers.
176 I. Domowitz et al.
and the cost of trading associated with order flow migration following cross-listing
may adversely affect the domestic market. In a segmented market, the benefits and
costs of cross-listing may not be shared equally by all investor classes, even if cross-
listing is value enhancing. These issues are especially important for smaller
European capital markets facing new competition resulting from economic integ-
ration and for emerging markets that are less liquid than their foreign competitors.
Debates over consolidation and fragmentation also make the potential
impacts of international cross-listing controversial in academic settings. Models
of multi-market trading (e.g., Pagano, 1989) suggest that trading gravitates to
the most liquid market centers. In an international context, these theories
suggest that cross-listing, by providing another venue for trading, may induce
order flow migration to overseas markets that offer lower transactions costs.
Faced with a loss of order flow, liquidity in the domestic market may decrease,
thereby increasing bid-ask spreads and price volatility. The presence of traders
with private information could exacerbate such migration (Chowdhry and
Nanda, 1991) since traders would prefer to trade in markets that offered the
most transparency, i.e., information on prices, quotes, and trades. Alternatively,
if markets are transparent and the total number of investors in both markets
increases after cross-listing, liquidity and price efficiency can increase. In
addition, competition for order flow may also lead to the dissipation of dealer
rents in the local market arising from new foreign competition, as in Madhavan
(1995), thereby lowering spreads.
Recent evidence provided by Foerster and Karolyi (1994) for Canadian
securities listed on US exchanges, however, suggests that a strict dichotomy
between market consolidation through enhanced competition and fragmen-
tation through order flow migration is inappropriate. Rather, cross-listing may
result in fragmentation as well as greater inter-market competition in those
segments of the equity market facing order flow migration. This is likely to be
especially important in emerging markets where investment barriers as restric-
tions on foreign equity ownership are relatively common. 3 We refer to this
occurrence as market segmentation.
We address these issues using new data on daily prices and volumes from
1989-1993 obtained from the Mexican Stock Exchange, the Bolsa Mexicana
de Valores (BMV). The Mexican market is of particular interest for this study.
Previous studies of international listing have focused almost exclusively on
developed economies, especially Britain, Canada, and Japan, for which data
are readily available. However, little is known about the impact of cross-listing
on an emerging market such as Mexico. International listing may have a
significant impact on an emerging market because these markets are generally
much smaller and less liquid than the foreign markets where cross-listing
occurs. Foreign listing is also likely to have a significant impact on the domestic
3 Examples include China, Thailand, and Mexico. See Eun and lanakiramanan (1986) for a
more detailed description of these investment barriers.
Cross-listing, segmentation and foreign ownership restrictions 177
Mexican !Darket, since foreigners (mostly US nationals) account for over 27%
of holdings and up to 75% of trading. Further, the BMV is open for trading
during much of the time that the United States' equity markets are open.
Consequently, an analysis of trading in Mexico provides a way to better
understand the effects of inter-market competition. Finally, the Mexican data
include information on multiple series of stock for some individual companies,
with alternative forms of foreign ownership rights. As noted above, the effects
of market segmentation are most likely to be observed in markets with such
distinctions.
We find strong evidence for the market segmentation hypothesis. In particu-
lar, for those series open to foreign ownership, cross-listing is associated with
an increase in volatility unrelated to volume, as well as a reduction in liquidity.
These findings are consistent with a fragmentation hypothesis emphasizing the
diversion of order flow. However, such shares also experience a decline in
implicit bid-ask spreads following ADR introduction. The decline in spreads
may be explained by increased competition among domestic liquidity providers
as they attempt to retain order flow in these issues following cross-listing. No
such effects are present in a control group of matched stocks, indicating that
our results are not driven by market-wide phenomena or macroeconomic
factors.
Interestingly, there is no discernible pattern to the changes in liquidity
and the implied bid-ask spread for shares whose ownership is restricted to
domestic nationals, although there is an increase in the price volatility
unrelated to volume for such shares. This suggests that the changes in
liquidity observed in other series were the result of a migration of foreign
investors to US markets. Finally, although ADR listing is associated with
positive excess returns, these benefits accrue largely to those series open to
foreign investors prior to cross-listing. Our results thus provide strong
support for the market segmentation hypothesis, which acknowledges both
the costs of order flow fragmentation following the cross-listing as well as
the benefits of increased inter-market competition. This implies in turn that
the benefits of cross-listing are not evenly spread among all classes of
investors. In addition, we find some evidence that the effects of order flow
migration are concentrated in larger stocks, possibly because these stocks
are favored by foreign investors prior to cross-listing.
INSTITUTIONS AND DATA
The Bolsa Mexicana de Valores
The BMV, Mexico's only stock exchange, is a private institution owned by 26

Mexican-owned brokerage houses. These brokerage houses were the only enti-
ties allowed to trade on the floor of the BMV; during the sample period, no
foreign brokers or traders are allowed in Mexico. In 1993, there ,were 884
equity instruments traded on the BMV. The market, however, is highly concen-
trated in a few issues, with Telefonos de Mexico stock alone accounting for
18% of trading volume. In 1993, 26 equity instruments were also traded as
ADRs in the United States. This set of 26 series, issued by 16 of the largest
firms on the BMV, is the focus of our study.
Mexican equity instruments are of particular interest for our study in that
each company may issue several different series of shares, each with different
rights or shareholder bases. All series have full participation in the earnings of
the firm.4 The major divisions are into series A, B, and C (or L). Series A
shares may legally be held only by Mexican nationals and account for at least
51 % of company voting rights. s Series B shares are open to foreigners and
institutional investors and are limited to 49% of the ownership.6 Both A and
B shares can be further divided into fixed (lor F) and variable (2 or V)
components, all of which carry equal rights. Under a company's statutes, it
must carry a minimum level of capital, the fixed part, which can only be
changed by vote of shareholders at an extraordinary meeting. The variable
part changes whenever rights are issued or the company decides to buy back
shares. Series C shares are open to all investors, but are limited to 30% of
total capital. Series Land 0 are also available to all investors, but carry limited
or no voting rights. These arrangements ensure that Mexican nationals control
the voting of listed companies. Similar divisions are found in other countries
where public policy seeks to restrict or control the foreign ownership of capital.
Alternatively, foreign ownership restrictions may arise endogenously, as shown
by Stulz and Wasserfallen (1995) in the case of Switzerland. A variety of other
series designations exist, but are not relevant to the sample considered here.
The exchange operates from 8:30 a.m. to 4:00 p.m. local time from Monday
to Friday, so that the market first opens at the same time as the New York
Stock Exchange, where most Mexican ADRs are traded, but closes an hour
earlier. Orders are either sent to the BMV computer systems or worked by
floor brokers through open outcry.7 Preopening orders can be entered by
computer and crossed automatically subject to certain price limits. Block trades,
like all transactions, must occur on the trading floor and are subject to the
rules governing the auction process. In summary, the trading mechanism on
the BMV closely resembles a standard continuous auction market.
4 The exception is a new class of 'D' shares issued by very few companies. Such series are not
represented in our data.
5 Foreigners may participate only through the Mexican national development bank (NAFIN)
trust, if at all. In this case, the series designation changes from A to N or CPO. Voting rights then
are held by NAFIN.
6 If the B shares are for a financial group, they can be owned only by Mexican institutional
investors. Financial groups are not among the companies in the subset of shares experiencing an
ADR introduction.
7 The computer systems handled little volume and small orders over the time period of this study.
The data
The data used in this study were obtained from the BMV, and until now have
not been publicly available. The sample used here consists of daily observations
on prices, returns, and share volumes of 26 equity series. These series represent
16 firms over the period September 1989 to July 1993, all of which experienced
an ADR listing over the sample period. In addition, we gathered data on 10
non-ADR companies with similar trading frequencies and characteristics to
form a control sample to check the validity of our results. On average, there
were 828 trading days per series, with some variation due to the introduction
of new series types over the full period.
The data were screened and cross-checked in a number of ways to detect
potential errors. The major problem encountered was the fact that companies
routinely change series designations after corporate actions, although the under-
lying changes often have no effect on ownership or voting rights. For example,
the A series of company CIFRA underwent seven changes in series designation
between January 1988 and July 1993. Companies typically took at least one
action per year that had some effect on series designation, few of which were
meaningful. Each such change was investigated using information from the
Anuario Bursatil (the BMV's year book) and data supplied from Mexican
brokerage houses.
Returns were adjusted based on information from the BMV and from the
Anuario Bursatil, as were volumes. This process is more complicated than the
usual simple adjustments for dividends and stock splits. For example, the BMV
would occasionally announce the simple cancellation of outstanding tradeable
shares in the A series. This happened to CMA (which was used as a control in
some of our analyses but is not in the ADR sample), for example, on 9/11/90,
when 3.6% of the shares traded disappeared. Share holdings were also adjusted
based on reciprocal buy/sell offers between companies under what seemed to
be the same parent umbrella. Again for CMA, this happened on 8/13/94, when
such an agreement between Compania Mexicana de Aviacion and Corporacion
Mexicana de Aviacion increased the CMA holdings by 2.6%. Corrections for
these types of problems were made manually. Screening of the data indicated
a few outliers for most series. Except for a formulaic error that affected all
series for a few months early in the sample, the outliers did not seem to be a
result of keypunch error. This error was rectified, but we did not alter the data
otherwise.
Company names, acronyms, and series identifiers for the 26 stocks our
sample are provided in Table 1. Of the 26 series, 11 are A class (including fixed
and variable) shares, 9 are B class shares, and the remaining 6 are C, L, or 0
(non-voting) shares. The majority of the ADRs in our sample are traded over-
the-counter or in the 144A market. Of the stocks in our sample, only three are
listed on an exchange and for these stocks we have data on trading in the USA
as well as in the domestic market.
180 1. Domowitz et al.
Table 1. Stock series abbreviations, names of companies, stock exchange keys (board keys), and
series by company in our sample for stocks traded on the Bolsa Mexicana de Valores for which
an ADR was introduced
Abbreviation Company name Board key Series
CEM Cemex CEMEX A,B

ClF Cifra ClFRA A,B,C
COM Controladora Comercial Mexicana COMERCl B
SAN Corporacion Industrial Sanluis SANLUlS A,AV
EPN Epn EPN AF
LIV El Puerto de Liverpool LIVEPOL O,C
FEM Fomento Economico Mexicano FEMSA BV
GCA Grupo Carso GCARSO AF
MAS Grupo Industrial Maseca MASECA AV,BV
SYN Grupo Synkro SYNKRO A,B
CER lntemacional de Ceramica CERAMIC B
PON Ponderosa Industrial PONDER A,B
TEL Telefono de Mexico TELMEX A,L
ITO Tolmex ITOLMEX BV
TMM Transportacion Maritima Mexicana TMM A,L
VIT Vitro VITRO 0
Table 2 shows the data of ADR listing, the average daily trading volume (in
shares), return volatility (in percentage), and the number of trading days before
and after ADR listing available for analysis for each stock. Note that stocks
are listed by their abbreviation followed by series identifier and type. Thus,
TTOBV denotes the B (Variable) series for company Tolmex (TTO). The dates
of ADR listing vary widely across the sample, with the earliest being company
EPN (AF series), listed in December 1989 and the most recent being
Transportacion Maritima Mexicana, listed in June 1992. It is clear that there
is a wide range in trading activity and volatility across stocks. Similarly, it is
difficult to discern a pattern to the changes in volume and volatility following
ADR listing. We turn now to a more detailed examination of this issue.
ESTIMATION ISSUES
Empirical hypotheses
Consider first the case where a security is domestically traded. Market partici-
pants, both domestic and foreign nationals, buy and sell the stock according
to auction principles. In this market, it is intuitively clear that the greater the
number of participants, the deeper the market, where market depth is measured
in terms of the ability to accommodate order flow shocks without substantial
price movements.
Suppose now that the risky asset is internationally cross-listed, providing
an alternative venue for trading. Cross-listing may result in a net increase in
Table 2. Volume and volatility by stock series
ADR Volatility Volatility Volume Volume Days Days

Series listing prior after prior after prior after
CEMA 5/91 2.40 2.38 444 343 409 551

CEMB 5/91 2.59 2.27 175 374 166 551
CIFA 1/91 2.86 1.99 893 847 336 624
CIFB 1/91 2.75 2.06 699 2228 336 624
CIFC 1/91 2.38 2.04 2618 3979 61 624
COMBV 2/92 2.75 2.06 1199 774 203 353
SANA 7/90 2.12 3.00 289 82 219 741
SANAV 7/90 2.12 3.33 462 269 219 741
EPNAF 12/89 2.73 1.98 349 955 70 760
LIVO 6/92 1.51 1.91 47 220 685 275
LEVC 6/92 1.50 1.96 103 480 685 275
FEMBV 4/91 2.32 2.62 396 1186 387 573
GCAAF 10/91 2.18 2.01 16.3 720 312 444
MASAV 4/92 2.35 2.89 291 513 431 311
MASBV 4/92 2.24 2.80 301 664 431 311
SYNA 6/90 1.42 1.16 137 54 192 768
SYNB 6/90 1.39 1.52 22.8 25.8 192 768
CERB 4/91 1.07 1.36 8 36 387 573
PONA 5/91 1.00 2.35 2 417 543
PONB 5/91 2.41 3.26 357 177 417 543
TELA 5/91 2.23 1.75 6797 1539 415 545
TELL 5/92 1.73 1.71 8318 11438 247 297
TTOBV 9/91 2.67 2.27 615 466 388 455
TMMA 6/92 2.40 2.37 45.6 88.2 73 270
TMML 6/92 2.56 2.29 90.5 60.0 73 270
VITO 11/91 1.91 2.14 150 457 547 413
Summary statistics for all stock series in our sample of stocks traded on the Bolsa Mexicana de
Valores for which an ADR was introduced. The month and year of the ADR introduction are
given under 'ADR listing'. Volume prior and Volume after are average daily shares traded, in
thousands, before and after the listing, respectively. Volatility prior and Volatility after denote the
average standard deviation of daily percentage returns, before and after the listing. Days prior and
Days after are the number of trading days in the sample before and after the listing.
the number of investors participating in trading if the costs of trading in the

newly created foreign market are lower than those of the domestic markets for
some investors. However, the existence of a significant cost differential between
the two markets may also result in order flow migration from the domestic
market. These two factors, together with different views about the availability
of trade information, give rise to some natural conjectures about the impact of
cross-listing.
The first hypothesis, which we term the competitive hypothesis, maintains
that foreign listing provides another form of competition for domestic markets,
enhancing efficiency and liquidity. Formally, suppose that market information
is costless, so that prices are equal in both markets. If the foreign market
provides lower costs of trading for some new investors, cross-listing results in
an increase in the total number of traders in both markets. It follows that there
is more liquidity and greater depth. Participation by new investors should
result in more efficient aggregation of investor beliefs, increasing signal precision
and lowering the subjective variance of the price forecast. Although these effects
arise because of increased participation in the foreign market, price competition
among market centers may further reduce the costs of trading in the domestic
market (Madhavan, 1995) as domestic liquidity providers seek to retain
order flow.
An alternative hypothesis, which we term the fragmentation hypothesis,
maintains that international listing results in a migration of investors away
from the domestic market and that this results in less efficient pricing and
lower market quality. Formally, suppose intermarket price competition is
imperfect or there is a delay in disclosing transactions resulting in reduced
transparency. If the costs of trading abroad are lower in the foreign market
than in the domestic market for some current investors, then the number of
domestic investors decreases (as these investors migrate abroad), leading to a
decrease in liquidity following cross-listing. In this scenario, the foreign market
(with lower transaction costs) receives not only a portion of the pre-listing
order flow but also the order flow arising from new participants. Fragmentation
may also lead to higher variance in public beliefs because information aggrega-
tion is less efficient with fewer market participants. As a result, the subjective
variance of investors' beliefs regarding the asset's fundamental value may
increase following international listing. Factors ignored in our simple analysis
are likely to exacerbate these effects. In particular, the analysis of Chowdhry
and Nanda (1991) suggests that order flow migration may be more likely to
occur under asymmetric information. In turn, this implies that trading costs
(e.g., the bid-ask spread) are likely to increase with market fragmentation.
An intermediate view, which we term the segmentation hypothesis, combines
aspects of the two extreme theories, recognizing that the effects they seek to
highlight are not necessarily mutually exclusive.s In this view, the local market
may experience differential effects to international listing ifthere is segmentation
between the assets held by foreign and domestic customers. If foreign investors
currently trading in the domestic market obtain the greatest reduction in
trading costs by moving abroad (as seems likely), the loss of order flow is most
likely in securities where foreign ownership is significant. As with the fragmenta-
tion hypothesis, the loss of order flow is associated with a decrease in market
liquidity and an increase in volatility if intermarket arbitrage is not perfect.9
However, even in the absence of current price information, imperfect intermar-
ket competition may still benefit the domestic markets in the form of lower
transactions costs for those securities facing the greatest order flow loss.
8 In the international asset pricing literature segmented markets are markets in which either the
price of risk differs or prices are determined by different risk factors (Jorion and Schwartz, 1986).
9 However, as in Madhavan (1995), this phenomenon may be associated with a narrowing of
bid-ask spreads as domestic liquidity providers respond to the loss of order flow.
Estimating the changes in liquidity and volatility
Empirical tests of the hypotheses described above is difficult given the available
data. Our approach to testing for changes in liquidity and volatility is based
on the idea that price volatility has two components: the first component
represents the volatility arising from changes in fundamentals and imperfect
information signals, while the second component represents the volatility
related to the changes in investor holdings, i.e., to trading volume. As discussed
above, any effects of international listing on liquidity and volatility should be
associated with changes in base-level volatility and market liquidity, and can
thus be estimated. To see this, consider a simple microstructure model (motivated
by Kyle, 1985) the 'daily' price change on day t is given by
APr = pX r + Gr
In this representation, Ap is the price change, x is the net (signed) order
imbalance, G is the innovation in public beliefs due to public news announce-
ments, and p captures the sensitivity of prices to order flow. The coefficient p
reflects the effects of asymmetric information as well as, perhaps, inventory
control costs, and is hypothesized to be an inverse function of the number of
market participants. Taking the variance on both sides, we obtain
(J2(Ap,) = W, + p2(J2(X,)
where Wr is the variance of, G" the random innovation in fundamental values.
Assume further (omitting time subscripts for notational ease) that the order
imbalance, x, is the sum of N normally distributed order shocks, q, where N
represents the number of traders and q represents each trader's (signed) order
size. Then, the standard deviation of x is proportional to E [I x I] = N E [I q I] =
V, where V represents the expected volume for the day. Intuitively, higher
volumes are associated with larger expected absolute order imbalances, and
hence greater price volatility.
It follows that the price change from period to period can be represented
as
(1)
where A. (proportional to p2) is a parameter that is inversely related to the
number of market participants, and V, is the expected volume period t. We can
interpret Wr as an inverse measure of the precision of public information, which
in turn is likely to be positively related to the number of traders who choose
to gather information about the stock. More precise public information implies
that conditional expectations are more accurately centered on fundamentals
so that the changes in expected beliefs have smaller variance. Hence, WI is
smaller the greater the precision of public information. Similarly, the parameter
A. is an inverse measure of market liquidity. More active trading implies lower
values of ),.
184 I. Domowitz et at.
To estimate equation (1), we need some additional structure. First, we

replace the unobservable price variance term on day t with the absolute price
change on that day, which is proportional to the standard deviation of price
changes under normality. Second, we model the base-level volatility as W t =
CLo + CL11L\pt-ll, which is economically plausible since it allows for possible
dependence on past return shocks.
The preceding discussion suggests that the parameters of the model may
shift following international cross-listing. Accordingly, we estimate:
lL\ptl = CLOt + CL1tlL\pt-d + i't V~, (2)

with time-varying parameters given by
i't = Po + PI ADRt
CLOt = Yo + Yl ADR t (3)
CL lt = 150 + 15 1 ADR"
where ADRt is a dummy variable taking the value 0 if date t is before ADR
listing and 1 otherwise. Under the competitive hypothesis ADR listing increases
liquidity and price volatility so that PI and Yl are negative. Under the fragmen-
tation hypothesis, ADR listing decreases liquidity and price volatility so that
PI and Yl are positive. Segmentation allows for mixed effects depending on the
asset involved.
Computation and testing of implicit spreads
Our model assumes that transactions occur at a single market clearing price,
but in reality, transactions occur at bid or ask prices. The results of Foerster
and Karolyi (1994) suggest that cross-listing is associated with changes in the
cost of trading, as measured by the bid-ask spread. Unfortunately, even though
it is straightforward to incorporate a spread into our model, we cannot directly
make inferences about the bid-ask spread without quotation data. In this
section, we discuss an alternative approach to making indirect inferences about
changes in the cost of trading accompanying ADR listing.
Models of dealer trading imply that any change in transaction costs
(measured by the implicit spread) following ADR listing should be in the
opposite direction to the change in liquidity and is likely to be in the same
direction as the change in volatility. If foreign listing increases market fragmen-
tation (competition, market quality should decrease (increase) and transaction
costs (and hence implicit spreads) should increase (decrease) as well. Under the
segmentation hypothesis, both liquidity and spreads may decrease as the result
of cross-listing.
To see this, suppose that ADR listing results in a reduction in the number
of investors participating in trading, so that A. rises and liquidity falls. In a
segmented market, this loss is most likely to occur in stocks with significant
foreign ownership, since foreign investors are more likely than domestic inves-
tors to obtain a reduction in their trading costs by trading in the US ADR
market. However, since dealers in these issues also face more price competition
for smaller orders from the foreign market, spreads may narrow after cross-
listing.
Roll (1984) provides a technique using the covariance in successive price
changes to make inferences about the size of the bid-ask spread when bid-ask
quotations are unavailable. The idea is simple: bid-ask bounce causes the serial
covariance to be negative, and this can be computed using transaction prices
alone. Roll's model has been extended by George et al. (1991; hereafter referred
to as GKN) among others.
The GKN procedure builds on the intuition of the Roll (1984) model but
offers several extensions including adjustments for potential autocorrelation.
Our approach to estimation differs slightly from GKN in the way we adjust
for autocorrelation and by our use of generalized method of moments (GMM)
to jointly estimate the underlying parameters of the implicit spread. The GMM
technique is attractive for several reasons, but most importantly because we
can construct a new statistic to test the change in implicit spreads following
ADR listing. Domowitz, Glen and Madhavan (1996) provide a formal treat-
ment of this test statistic.
EMPIRICAL RESULTS
Price volatility and market depth
We estimate the time-varying parameter model in equations (4) and (5) using
Hansen's generalized method of moments. The GMM procedure produces
consistent parameter estimates under very general distributions for the stochas-
tic processes generating the data, and the standard errors correct for hetero-
skedasticity and autocorrelation. Further, with GMM the parameters for
individual series within a company can be estimated jointly. This is particularly
important because the cross-correlation in errors across different series for the
same company are likely to contain valuable information.
Table 3 presents the GMM estimates, with corresponding autocorrelation
and heteroskedasticity consistent standard errors in parentheses, for all 26
series in the sample. The estimates confirm the general findings in the literature
with respect to the positive price variability-volume relationship. The coefficient
Yo is positive in all cases and A.t is positive in 22 of 26 cases, with any negative
values being very close to zero.
Overall, volatility increases following the ADR listing. Averaging across all
series, the volatility coefficient OCot rises from 0.105 prior to listing to 0.226
afterwards. This increase is observed in 21 of the 26 series. The result is
consistent with empirical evidence (e.g. Jayaraman et at., 1993), which suggests
that the return variance increases following international listing. The sensitivity
Table 3. Volatility and liquidity model estimates
Series Yo YI Do DI Po PI
CEMA 0.122 0.463 0.270 -0.110 1.998 6.868 0.233
(0.012) (0.043) (0.060) (0.076) (0.393 ) (3.228)
CEMB 0.161 0.355 0.033 0.189 0.013 0.611 0.167
(0.026) (0.047) (0.063) (0.078) (0.288) (0.294)
CIFA 0.034 0.097 0.200 -0.093 -0.002 0.000 0.096
(0.005) (0.011) (0.079) (0.090) (0.001) (0.001)
CIFB 0.030 0.121 0.311 -0.049 0.047 -0.038 0.212
(0.005) (0.013) (0.109) (0.123) (0.056) (0.064)
CIFC 0.022 0.028 0.085 0.119 0.002 -0.003 0.073
(0.005) (0.006) (0.144 ) (0.149) (0.001 ) (0.001)
COMBV 0.032 0.175 0.190 -0.024 0.130 0.017 0.084
(0.004) (0.006) (0.078) (0.093) (0.038) (0.094)
SANA 0.043 -0.021 0.032 0.068 0.004 0.450 0.044
(0.006) (0.006) (0.061 ) (0.075) (0.001 ) (0.078)
SANAV 0.040 -0.011 0.183 -0.021 0.002 0.055 0.047
(0.005) (0.006) (0.068) (0.082) (0.001 ) (0.023)
EPNAF 0.002 -0.002 0.026 -0.029 0.016 0.900 0.240
(0.001) (0.001) (0.095) (0.094) (0.023) (0.430)
LIVO 0.Q78 0.104 0.170 0.034 1.157 1.892 0.144
(0.008) (0.023) (0.053) (0.094) (0.085) (1.341)
LIVC 0.072 0.218 0.283 -0.214 0.987 0.222 0.192
(0.008) (0.029) (0.065) (0.087) (0.042) (0.175)
FEMBV 0.082 0.128 0.158 0.066 -0.065 0.056 0.184
(0.007) (0.017) (0.054) (0.077) (0.066) (0.067)
GCAAF 0.094 0.371 0.067 0.252 144.7 -144.6 0.248
(0.023) (0.054) (0.066) (0.097) (74.89) (74.89)
MASAV 0.131 0.077 0.281 -0.167 1.103 3.783 0.094
(0.013) (0.024) (0.066) (0.091 ) ( 1.307) (2.447)
MASBV 0.106 0.113 0.322 -0.263 2.176 0.413 0.129
(0.012) (0.021 ) (0.060) (0.090) ( 1.260) (1.566)
SYNA 0.013 0.001 0.168 0.128 -0.Q15 0.302 0.088
(0.003) (0.004) (0.099) (0.149) (0.024) (0.043)
SYNB 0.113 0.007 0.145 0.063 -0.945 15.91 0.084
(0.003) (0.004) (0.093) (0.114) (0.435) (7.196)
CERB 0.006 0.044 0.104 0.042 24.97 -16.21 0.085
(0.002) (0.006) (0.089) (0.107) (5.833) (6.491 )
PONA 0.001 0.0008 0.067 -0.018 635.1 -583.2 0.152
(0.001 ) (0.0002) (0.061) (0.089) (296.5) (295.8)
PONB 0.006 -0.001 0.270 -0.031 -0.001 0.082 0.085
(0.001) (0.001) (0.051) (0.081 ) (0.004) (0.032)
TELA 0.043 0.174 0.389 -0.324 0.000 -0.048 0.195
(0.005) (0.014) (0.085) (0.095) (0.000) (0.012)
TELL 0.068 0.008 0.122 -0.083 0.004 0.003 0.105
(0.007) (0.011) (0.071) (0.096) (0.002) (0.003)
TTOBV 0.114 0.201 0.312 -0.187 0.011 7.063 0.185
(0.012) (0.027) (0.074) (0.092) (0.037) (3.125)
TMMA 0.327 0.007 0.029 0.207 86.17 -74.67 0.064
(0.065) (0.074) (0.109) (0.122) (7.459) (16.73)
TMML 0.409 -0.060 -0.048 0.253 383.3 -139.9 0.077
(0.067) (0.078) (0.079) (0.100) (295.5) (309.5)
VITO 0.658 0.743 0.217 -0.084 82.09 -82.29 0.090
(0.054) (0.130) (0.052) (0.076) (51.22) (52.23)
Coefficient estimates and heteroskedasticity-consistent standard errors (in parentheses) for the
liquidity model given by equations (4) and (5). The model is estimated by generalized method-of-
moments, with equations for multiple stock series within a single company estimated jointly.
Volume is measured in tens of millions of shares. The series represent all stocks traded on the
Bolsa Mexicana de Valores for which an ADR was introduced.
of current volatility to past volatility shocks does not appear to change in any
systematic fashion. The base coefficients imply that ;, is higher, therefore liquid-
ity is lower, following ADR listing in a majority of the 26 series. On average,
liquidity as measured by;, is lower by 26% after the listing. These findings
combined with those pertaining to volatility support the fragmentation
hypothesis.
This summary of results obscures an important feature of the problem. The
nature of the individual series determines the degree of foreign ownership in
the Mexican market, and A series cannot be owned by foreigners. Foreign
cross-listing cannot therefore result in a migration of foreign investors to the
ADR markets for these shares. Unless cross-listing is associated with substantial
migration of domestic investors, it is unlikely that domestic market liquidity
will suffer in the A series shares. On the other hand, series B, C, L, and 0
shares are traded by foreigners in the home market. Consequently, if foreign
investors migrate to US markets (as appears likely since most foreign investors
in Mexico are US nationals), then liquidity may decrease in these shares.
Indeed, in the B shares, liquidity tends to fall (i.e., /31 rises in seven cases
and falls in two cases) while volatility rises in all but one case. Series 0 shares
uniformly show an increase in volatility, and the single estimated increase in
liquidity is estimated with a large standard error. C shares also exhibit higher
volatility, while the L shares experience no significant change in volatility or
liquidity. The L shares are similar to C, but carry limited voting rights, and
the effect of cross-listing appears to have no effect on the home market trading
of such instruments. On the other hand, series A shares show very mixed
results, as measured by changes in ;,. Volatility rises significantly in six cases,
but falls for three series, with the remaining results being statistically
insignifican t.
We also note that simple increases in trading volume after ADR introduction
are distributed rather randomly, regardless offoreign ownership rights. Overall,
62% of the series experienced some increase in volume, but this figure is not
statistically significantly different from 50%. The figure is slightly higher for
the A shares, at 67%. Higher volume is observed for 63% of the B shares, and
for about 60% of all shares with foreign ownership rights prior to interna-
tionallisting.
In summary, our results thus far suggest that ADR listing is associated with
an increase in base-level volatility unrelated to volume, as well as an increased
sensitivity of price variability to volume. The latter finding is indicative of less
liquidity following ADR listing. These findings are consistent with the fragmen-
tation and segmentation hypotheses.
Changes in implicit spreads
We also computed formal tests of changes in implicit spreads after ADR listing.
At first glance, the change in the spread is largely negative. The estimated spread
decreases in 17 of 23 series that experienced some change. The impression
that spreads declined overall must be tempered by the statistical significance

of the test results and an examination of the foreign ownership rights of the
different series. In fact, of the 10 A series in the sample, only two exhibit a
statistically significant drop at the 10% level of significance, with one significant
increase in the spread. The remainder of the changes are statistically negligible.
On the other hand, seven of 13 series that allowed foreign ownership prior to
the ADR introduction exhibit a statistically significant decline, with only a
single significant increase.
The conclusion that emerges is that shares that cannot be traded by foreign-
ers in the home market show essentially no change in the spread following the
ADR listing. Rather, the differences in spreads for A shares are basically
random, a finding that may be explained by changes in the incentives to acquire
private information. By contrast, shares permitting foreign ownership in the
domestic market largely exhibit a decline in the spread post-ADR, with 10 of
13 cases being negative, seven of these statistically significant at the 10% level.
The decline in spreads for share issues open to foreign ownership, associated
with a decrease in liquidity and an increase in return volatility unrelated to
volume, is not consistent with the fragmentation hypothesis, but fits the segmen-
tation hypothesis. Specifically, faced with foreign competition, providers of
liquidity in the domestic market are likely to reduce spreads to retain order
flow. Indeed, Foerster and Karolyi (1994), in their study of cross-listed
Canadian stocks, find that changes in trading costs are related to both domestic
and foreign volume. Such effects are most likely to be observed in issues open
to foreign investors, because these investors are probably the most likely to
obtain lower transaction costs in US ADR markets.
There is additional support of the segmentation hypothesis. Domowitz et al.
(1997) examined the prices of a different sample consisting of purely domesti-
cally traded Mexican stocks subject to ownership restrictions that distinguish
between individual and institutional investors and between foreign and dom-
estic investors. They found price differentials between restricted and unrestricted
stock (in a manner predicted by Stulz and Wasserfallen, 1995), which suggests
that these investment restrictions can result in segmentation. If this were not
the case, the segmentation hypothesis clearly could not explain our findings.
Cross-sectional evidence
In addition to the tests described above, we performed several other tests to

verify our results. In particular, we are interested in the cross-sectional determi-
nants of the impacts of cross-listing on liquidity and spreads. Table 4 contains
maximum likelihood estimates for logit models of the form
eZ
PrEy = 1] = F(X{3); F(z)=--
1 + eZ
where X is a vector of independent firm-specific variables. The dependent
variable, y, takes on the value of 1 if ). (a liquidity parameter, higher values of
Table 4. Logit models
Percentage
y=1 CONS P P/BV MCAP LR predicted
i. increase -11.36 0.155 2.629 0.179 0.048 70.6

(10.31) (0.154 ) (2.534) (0.137)
s decrease -9.213 0.133 1.770 0.190 0.073 88.2
(8.802) (0.133 ) (2.200) (0.134)
i. increase -4.481 0.040 1.205 0.086 0.087 78.5
and s decrease (2.433) (0.053) (0.711) (0.086)
This table contains maximum likelihood estimates for logit models of the form PrE y = 1] = F(XfJ);
F(z) = eZ /1 + eZ The dependent variable, y, takes on the value of 1 if i. (a liquidity parameter,
higher values of which indicate lower liquidity) increases; if s (the bid-ask spread) decreases; and
if i. increases and s decreases for the same stock series. All changes are measured relative to the
introduction of the ADR for any given series. The explanatory variables are: a constant term
(CONS), price relative to book value (P/BV), share price (P), and market capitalization (MCAP),
all measured as of the date of ADR introduction. LR is the significance level of a test of the joint
significance of p, P/BV, and MCAP Percentage predicted is the percentage of cases correctly
predicted by the model. The sample consists of 17 series for which corporate data were available.
which indicate lower liquidity) increases; if s (the bid-ask spread) decreases;

and if ). increases and s decreases for the same stock series. All changes are
measured relative to the introduction of the ADR for any given series.
The explanatory variables in the logistic regressions are: a constant term
(CONS), price relative to book value (PIBV), share price (P), and market
capitalization (MCAP), all measured as of the date of ADR introduction. LR
is the significance level of a test of the joint significance of P, PIBV, and MCAP.
Percentage predicted is the percentage of cases correctly predicted by the model.
The sample consists of 17 series for which corporate data were available from
the IFC.
While the individual coefficients are estimated with a high degree of error
because of the small sample size, a likelihood ratio test rejects the hypothesis
that the corporate variables do not explain the post-ADR results. The percen-
tage of cases correctly classified is high, indicating the model has explanatory
power. In particular, it appears that adverse liquidity effects are manifested in
the higher capitilization stocks. One explanation for this is that foreign investors
prefer larger stocks, and hence fragmentation is more likely to occur in these
stocks following cross-listing. Unfortunately, without additional data, it is
difficult to make more conclusive statements.
It is possible that the effects we attribute to international cross-listing are
in fact the result of economy-wide changes. Indeed, Bailey and Chung (1994)
chronicle several significant political and economic events in Mexico over our
sample period. A related issue is that of market externalities. In particular, the
effects on volatility and liquidity in the most active internationally cross-listed
stocks may affect other shares traded in the domestic market that are not
cross-listed via ADRs. Domowitz et al. (1996) tested for similar shifts in
volatility and liquidity in a control sample of 10 matched stocks that did not
have ADRs. They found no changes in base-level volatility and liquidity in the
control group over the period during which ADRs were introduced in other
comparable securities. Similarly, the control group exhibited no significant
price effects around any of the ADR listing dates relative to the behavior of
the series for which ADRs were listed. This leads to the conclusion that
economy-wide changes over the period are not responsible for the changes we
observe in the market for securities that experience cross-listing. The effects of
ADRs did not spread to the remainder of the market, ruling out negative
externalities along the dimensions examined here.
CONCLUSION
Despite the rapid increase in the number of internationally cross-listed securi-

ties, relatively little is known about the impact of such actions on the domestic
market. This topic is especially important for smaller European capital markets
facing new competition resulting from economic integration and for emerging
markets that are typically much smaller and less liquid than the foreign market
where cross-listing occurs.
The Mexican market offers a unique opportunity to analyze questions
relating to intermarket competition because the US ADR markets provide
direct competition during exchange hours. Further, because Mexican stocks
are typically differentiated by ownership and voting characteristics, we can
examine the role of investment barriers in determining the effect of cross-listing.
Our study is the first of an emerging market, and the results suggest several
new directions for future research. We demonstrate that the traditional dichot-
omy between models of consolidation and fragmentation may be inappropriate
in considering the effects offoreign listing. Rather, international listing embodies
aspects of both increased competition and the possibility of order flow diversion.
For shares open to foreign ownership prior to international cross-listing,
ADR introduction is associated with an increase in volatility unrelated to
volume, as well as a reduction in liquidity manifested by a heightened sensitivity
of price variability to volume. These findings are consistent with a fragmentation
hypothesis emphasizing diversion of order flow. However, such shares also
experience a decline in the implicit bid-ask spread following ADR introduction.
The decline in spreads may be explained by increased competition among
domestic liquidity providers in their efforts to retain order flow in these issues
following cross-listing. Our results are consistent with this hypothesis; for issues
where ownership was restricted to domestic residents prior to the ADR listing
and for issues without voting rights, changes in domestic market liquidity and
spreads are generally small and unsystematic. Thus, a strict dichotomy between
hypotheses emphasizing the benefits of increased market competition or the
costs of order flow fragmentation following ADR introduction may be inappro-
priate. Rather, higher volatility and less depth in the domestic market coexist
with increased, but imperfect, competition to domestic liquidity providers.

Further, the benefits of cross-listing are not evenly spread among all owner-
ship classes.
As emerging economies continue to expand, it is increasingly likely that
corporations in these nations will turn to more developed securities markets
to provide the liquidity necessary to sustain their tremendous growth. As a
result, the impact of such actions on volatility, spreads, and liquidity in the
domestic market is of major concern for policy makers as well as market
participants.
ACKNOWLEDGMENTS
This paper was prepared for the New York University Salomon Center
Conference on Emerging Markets. We thank Rene Garcia and other seminar
participants for their helpful comments. Financial support from the World
Bank is gratefully acknowledged. Expert research assistance and several helpful
suggestions were provided by Mark Coppejans. The comments and opinions
contained in this paper are those of the authors and do not necessarily reflect
those of the International Finance Corporation, or the World Bank.
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WILLIAM N. GOETZMANW and PHILIPPE JORION 2
I Yale School of Management. 2 University of California at Irvine
Risk in emerging markets revisited
INTRODUCTION
Recent research shows that emerging markets (EMs) are distinguished by high
returns and low covariances with global market factors. These are striking
results, because of their immediate implications for international investors.
Such findings have been reported in a stream of papers, including those of
Errunza and Losq (1985) and Harvey (1995). In parallel, practitioners have
generally advocated EMs on the basis of their performance. For instance,
Divecha et al. (1992) report that, over the 5-year period ending in March 1991,
an EM Index returned 7.1 % more than the World Index. With a correlation
of 0.35 between the two indices, a mean-variance analysis reveals that investing
40% in EMs apparently would have increased returns by 4% annually relative
to the World Index, with no greater risk. This apparent 'free lunch' may help
explain the stampede into the stock markets of developing countries, where
net portfolio inflows reached $22 billion in 1995, up from only $138 million
in 1985. 1
Such results can be given differing interpretations. One view is that the
mispricing is due to market segmentations. Segmentations can occur because
of legal barriers, due to restrictions on capital movements or on the ownership
offoreign assets, or information effects, possibly due to differences in accounting
rules, language barriers and so on. Whatever the reason, segmentations imply
that assets in different countries do not display the same risk-adjusted expected
returns. In other words, foreign assets appear mispriced from the viewpoint of
domestic investors.
This first interpretation formalizes the 'free lunch' story. In practice, the
story must rely on a pricing model to adjust for risk - not an easy matter
given all the controversy surrounding the appropriate pricing model for US
equities. Further, as Bekaert and Harvey (1995) have shown, relationships may
evolve over time, as the flow of foreign investment into EMs coincides with a
financial restructuring of the market that eventually leads to close integration
with developed markets.
I Source: World Bank Debt Reporting System.
193
I 1998 Kluwer Academic Publishers.
194 w.N. Goetzmann and P. Jorion
Another interpretation is that econometric analysis of emerging market data

is strongly conditioned on availability. Typically, emerging markets become
included in standard databases when a market has become large enough.
Markets are only continuously tracked when there is no interruption in trading.
Some markets are even backfilled. In 1980, for instance, the International
Finance Corporation started a database with a group of nine markets, which
were backfilled to 1975. 1 This induces two kinds of biases. First, markets are
only considered when they are viable in 1980; other candidate markets in 1975
that did not prosper were not considered. Second, the companies included in
the sample in 1980 must have been in continuous operation for the last 5 years.
As a result, we would expect the performance of these 5 years to be subject to
survivorship bias.
More generally, all studies of long-term returns on asset classes come from
either the USA or from the UK. These two markets, arguably the most
successful capitalist countries in the world, have continuous price histories
going back for at least a century. Yet 40 markets existed in the 19OOs. For
example, little data are available for the Japanese and German markets before
suspension of trading in the 1940s, or for the Russian market, before the major
hiatus in capitalism.
Table 1 provides a partial list of the founding dates of the world's stock
exchanges. The table tells us that most of today's stock exchanges have long
histories. In fact, many so-called 'emerging' markets are really 're-emerging'.
Stock markets existed during the colonial rule, and in South and Central
America. The reasons for market interruption were numerous, including: wars,
in most of Europe; expropriation, in Eastern Europe; hyperinflation, in
Denmark and Germany; political changes, in Egypt, Lebanon, Portugal. Some
of these were related to global events, but a great many were idiosyncratic to
each country. Yet the recent performance of EMs systematically eliminates all
market interruptions. The key issue is whether this process fundamentally flaws
performance numbers.
DIRECT EVIDENCE ON SURVIVORSHIP
Survival has been examined in a number of papers. Brown et al. (1995), for
instance, provided analytical solutions for a process where all firms start at the
same time, but disappear as soon as they hit a lower threshold. They found
that average returns are biased upward, but that the volatility is not affected.
Volatility does affect the magnitude of the bias, however. The greater the total
risk of the series, the higher the ex post conditional mean. This is especially
important for emerging markets due to their high volatility. In addition, survival
induces all kinds of spurious relationships; Goetzmann and Jorion (1995), for
instance, examined the predictability of stock returns based on dividend yields
1 See the description of indices in International Finance Corporation (1995).

Risk in emerging markets revisited 195
Table 1. Time line stock market founding dates. This table compiles the founding dates of exchanges
in cities currently within the borders of the identified countries, in chronological order up to 1975,
when standard databases started.
Netherlands 1611 Brazil 1877 Philippines 1927

Germany 1685 India 1877 Colombia 1929
UK 1698 Norway 1881 Luxembourg 1929
Austria 1771 South Africa 1887 Malaysia 1929
USA 1792 Egypt 1890 Rumania 1929
Ireland 1799 Hong Kong 1890 Israel 1934
Belgium 1801 Chile 1892 Pakistan 1947
Denmark 1808 Greece 1892 Venezuela 1947
Italy 1808 Venezuela 1893 Lebanon 1948
France 1826 Mexico 1894 Taiwan 1953
Switzerland 1850 Yugoslavia 1894 Kenya 1954
Spain 1860 Sri Lanka 1900 Nigeria 1960
Hungary 1864 Portugal 1901 Kuwait 1962
Turkey 1866 Sweden 1901 Thailand 1975
Australia 1871 Singapore 1911
Czechoslovakia 1871 Finland 1912
Poland 1871 Indonesia 1912
Argentina 1872 Korea 1921
New Zealand 1872 Slovenia 1924
Canada 1874 Uruguay 1926
and found that survivorship biases the results toward finding spurious evidence
of predictability.
This particular survival process, however, may not adequately represent the
actual selection of emerging markets. Typically, emerging markets become
included in standard databases when a market has become large enough. So,
instead of the 'down-and-out' process analyzed in previous work, the actual
selection resembles an 'up-and-in' process.
Goetzmann and Jorion (1996) analyzed patterns in equity markets that
follow the latter rule for emergence. They provide simulations of a simple
model where all markets are priced fairly (according to their global p-values),
but are only retained in the sample when their capitalization exceeds a size
threshold. This allows them to compare the apparent performance of emerged
markets with their true expected returns and to develop estimates for the extent
of survivorship biases, which are found to be surprisingly high; the bias in
average return can be 5-10% for recently emerged markets. Furthermore, the
return bias increases with residual variance, as if local factors were 'priced'.
Apparently, markets that have 'emerged' appear to be mispriced solely due to
the selection process.
These simulation results are complemented by an examination of the histori-
cal performance of emerging markets. The simulations reveal empirical regulari-
ties which should be present in recent data if survivorship is an issue. In
particular, they demonstrate that returns immediately after emergence are
196 w.N. Goetzmann and P. Jorion
greater than later on, which is consistent with the simulations. They also show
that the performance of not-yet-emerged markets is typically inferior to that
of emerged markets.
INDIRECT EVIDENCE
Another fruitful line of research would be to examine the predictive power of

measures for the probability of market upheaval, such as credit risk ratings or
default spreads. For instance, Erb et al. (1995) examined a sample of 40 markets
over 1975-1993 using credit rating information. They found that, cross-
sectionally, low credit ratings are associated with high average returns and
low fJ-values. In a global market with well-diversified investors, however, we
should expect to find that high returns are associated with high fJ-values. Thus
one interpretation the 'free lunch' story (for investors who indeed have the
ability to invest in these markets).
These results are reinforced by the analysis of Bekaert et al. (1996). They
attempted to discriminate among markets using a number of different variables:
credit rating, inflation, trade-to-GDP ratio, demographic variables, size,
momentum variables, and accounting ratios. Remarkably, they found that the
best performance is attained using the credit rating information. Along similar
lines, Bailey and Chung (1995) showed that the credit spread on Mexican
sovereign bonds has predictive power for expected returns on the local stock
market.
Another interpretation of these results is that we have omitted those markets
with high credit risk that disappeared or were interrupted over the sample
period. One notable example is that of Kuwait, one of the largest Middle
Eastern markets with $10 billion in market capitalization; its credit rating
plummeted during the 1990 Gulf War, and the market never appeared in EM
databases. Thus high returns are conditional on survival.
As the survivorship story suggests, credit rating may proxy for the prob-
ability of market failure. The issue then is whether mixing the high returns of
successful market with those of failed market results in unconditional perfor-
mance that is substantially lower than before.
CONCLUSIONS
Survivorship effects are akin to the 'peso problem' in the foreign exchange
market. The term was first used in the early 1980s, when forward rates on the
Mexican peso appeared to be systematically biased forecasts of future spot
rates. This was because forward rates rationally anticipated the probability of
devaluation that was not observed in the test sample period.
More generally, peso problems can be interpreted as a failure of the paradigm
of rational expectations econometrics, which requires that the ex post
Risk in emerging markets revisited 197
distribution of endogenous variables be a good approximation to the ex ante

distribution that agents think may happen. The failure may not be that of the
economic agent, but that of the econometrician, who only analyzes series with
continuous histories. Unusual events with a low probability of occurrence but
severe effects on prices, such as wars or nationalizations, are not likely to be
well represented in samples, and may be totally omitted from survived series.
The implication is that the recent performance of emerging markets may be
misleading since it is strongly conditioned on survival.
Thus, the concept of risk, as measured by traditional measure such as
standard deviation, is not quite appropriate. This is why further analysis of
risk, such as those provided by Bekaert et al. (1996) is so useful.
By now, we hope to have created some doubt in the mind of the reader
about the 'free lunch' in emerging markets. Another interpretation for the large
returns and low correlations of EMs is that these patterns result from the
sample selection process. If this is the case, the recent history of emerged
markets provides an overly optimistic picture of future investment performance.
REFERENCES
Bailey, Warren and Peter Chung (1995). Exchange rate fluctuations, political risk and stock returns:
some evidence from an emerging market. Journal of Financial and Quantitative Analysis, 30,
541-561.
Bekaert, Geert and Campbell Harvey (1995). Time-varying world market integration. Journal of
Finance, 50, 403-444.
Bekaert, Geert, Claude Erb, Campbell Harvey and Tadas Viakanta (1996). The Behavior of
Emerging Market Returns. Working Paper, Stanford University.
Brown, Stephen J., William N. Goetzmann and Stephen A. Ross (1995). Survival. Journal of Finance,
50, 853-873.
Divecha, A., J. Drach and D. Stefek (1992). Emerging markets: a quantitative perspective. Journal
of Portfolio Management, Fall, 41-50.
Erb, Claude, Campbell Harvey and Tadas Viskanta (1995). Country risk and global equity selection.
Journal of Portfolio Management, Winter, 74-83.
Errunza, V. and E. Losq (1985). The behavior of stock price on LDC markets. Journal of Banking
and Finance, 9, 561-575.
Goetzmann, William and Philippe Jorion (1995). A longer look at dividend yields. Journal of
Business, 68, 483-508.
Goetzmann, William and Philippe Jorion (1996). Re-emerging Markets. Mimeo.
Harvey, Campbell (1995). Predictable risk and returns in emerging markets. Review of Financial
Studies, 8, 773-816.
International Finance Corporation (1995). The IFC Indexes: Methodology, Definitions, Practices.
Washington, DC: IFC.
STIJN CLAESSENS
World Bank!
Comments on the paper

'Rethinking emerging market equities'
by Roy C. Smith and Ingo Walter
This is a very nice and interesting paper which reviews and sets out the
rationales for investing in emerging markets, the experiences with investing in
emerging market equities over the last few years, and draws some lessons from
the experience in December 1994 in Mexico. The issues raised by the authors
are indeed the important ones, for investors as weIl as policy makers in emerging
markets. At the same time, this is a difficult paper to comment on: one is more
likely to disagree with the tone of its conclusions than with any of the issues
raised or the analysis done.
In general I have no problems with most of the paper, particularly since
much of it is more of a descriptive nature. I do not share the authors' somewhat
pessimistic views, however, on emerging markets. One way to sum up the
paper's and my view of emerging markets is that the authors see the glass as
half-empty, while I see it as half-full. I may be more optimistic, and, we all
have to wait and see what is the right tone for investing in the emerging
markets. But, in my opinion there is some support in the facts for a more
optimistic view. Four facts have influenced my 'half-fuIl' vision.
The tequila effect was limited and did not last long, except in Mexico. The paper
rightly points out that the Mexico crisis resulted in a overhang, the tequila
effect, in Mexico and many other emerging markets in the first quarter of
1995. But there has been a substantial correction since then (Figure 1, data
from the IFC's Emerging Markets Data Base). Stock markets in Argentina,
Indonesia, Malaysia, and Thailand, for example, soon recovered and were
at the same level or higher at the end of 1995 compared with January 1994.
Since then, equity markets have further recovered in many emerging markets.
Yes, portfolio equity flows declined in 1995, but they had already been declining
in 1994 from their record level in 1993. On the other hand, total private flows
are very resilient. There was indeed a further decline in portfolio flows in
1995 and equity flows were half of those in 1993 (Table 1, data from World
Debt Tables, 1996b, World Bank). Overall, however, private flows (portfolio
(debt, equity, FDI, commercial bank lending and other private flows) to
all developing countries actually increased between 1994 and 1995, from
$159 billion to $167 biIlion, up slightly from $154 billion in 1993 (Table 2,
data from World Debt Tables, 1996b, World Bank). FDI to developing
! These views do not necessarily represent those of the World Bank.
199
~ 1998 Kluwer Academic Publishers.
200 S. Claessens
1,000 1,200~-----------~
Chile Argentina
~~--------------------~ 4OOL---------------------~
JM Mar May Jul Sep New Jan Mar May JiJ Sep New JM Mar May Jul Sep New Jan Mar May Jul Sep Nov
1994 1995 1994 1995
1~r---------------------~ 5OOr-------------------------~
Indonesia Brazil
60~------------------------~ 200L-------------------------~
Jan Mar May Jul Sep New JM Ma May Jul Sep New Jan Mar May Jul Sep Nov Jan Mal May Jul Sep Nov
1994 1995 1994 1995
~Or------------~ 1.200 ~------------~
Malaysia Mexico
200 ' - - -_ _ _ _ _ _ _ _ _ _--.J 200 L-_ _ _ _ _ _ _ _ _ _ _----1

Jan Mar May Jul Sep New Jan Ma May Jul Sep Nov Jan Mal May Jul Sep Nov Jan Mal May Jul Sep Nov
1994 1995 1994 1995
500r-------------------------~ ~O~------------------------~
Thailarld Philippines
~L---------------------~ 200L---------------------~
Jan Mar May Jul Sep New Jan Ma May Jul Sep Nov Jan Mal May Jul Sep New Jan Mar May Jul Sep Nov
1994 1995 1994 1995
Figure 1. Stock market price trends, January 1994-December 1995, indices.

Comment 201
Table 1. Aggregate net private capital flows to developing countries, 1990--95 (US$ billions)
Category 1990 1991 1992 1993 1994 1995*
Total private 44.0 61.6 100.3 154.2 158.8 167.1

Portfolio investment 6.7 20.4 27.3 83.9 67.1 55.7
Debt flows 3.0 12.8 13.2 38.3 32.2 33.7
Equity flows 3.7 7.6 14.1 45.6 34.9 22.0
Foreign direct investment 25.0 35.0 46.6 68.3 80.1 90.3
Commercial banks 1.7 2.5 13.8 -4.9 9.2 17.1
Other private 10.6 3.7 12.6 6.9 2.4 4.0
Aggregate net long-term
resource flows 101.9 127.1 155.3 207.2 207.4 231.3
Private capital flows as a
percentage of aggregate
net long-term flows 43.2 48.5 64.6 74.4 76.6 72.2
* Preliminary.
Source: World Bank, Debcor Reporting System.
countries has especially continued to grow very fast, at 13%, leading to a

record inflow of $90 billion in 1995. Most Asian countries actually saw an
increase in private flows as did Argentina. In 1995 Brazil and Mexico saw
a large decline, however, by about half, in private flows.
GDP growth rates have not declined in most countries and reform efforts in
some countries have intensified. Yes, again Mexico is still only recovering -
but faster than many observers expected, but most other countries have seen
little negative effects on their growth rates. The aggregate data reflects this:
by region, only Latin America has seen growth rates which are substantially
lower compared to previous years (Table 3, data from Global Economic
Prospects, 1996a, World Bank). In many countries, both affected and not
affected by any aftermath of the crisis, have reform efforts actually increased.
Sometimes a crisis is necessary to tackle long-festering problems, such as
those in the banking systems of many developing (and developed) countries.
Private flows had little to do with causing the Mexico crisis. Poor macro-
management in Mexico, when mixed with adverse domestic and external
shocks, led to a situation which ex-post turned out to be unsustainable.
Foreign investors financed the large current account deficits, but in part
they reacted to the large structural improvements in the economy and the
(implicit) official pronouncements from Mexico and Washington that the
macro-economic situation was stable and the reform program was on track.
As such, foreign investors did not 'cause' the crisis and may actually have
been withdrawing from Mexico later than domestic investors did. In general,
there is evidence that foreign investors are not usually the one to contribute
to price or capital flow volatility (see, among others, the papers in this
volume by Wolf and Cumby and Khanthavit). If anything, foreign investors
tend to have a stabilizing influence as they are more geared to market
202 S. Claessens
Table 2. Net private capital flows to developing countries, 1990-95 (US$ billions)
Country group or country 1990 1991 1992 1993 1994 1995"
All developing countries 44.0 61.6 100.3 154.2 158.8 167.1

Sub-Saharan Africa 0.2 1.0 0.3 -0.8 4.7 5.0
East Asia and the Pacific 20.4 26.2 44.7 62.9 77.3 98.1
South Asia 2.4 2.1 2.8 4.6 7.4 6.0
Europe and Central Asia 8.2 7.1 21.6 25.0 15.6 17.3
Latin America and
the Caribbean 12.2 22.7 30.4 58.8 49.7 33.9
Middle East and North Africa 0.5 2.4 0.4 3.8 4.1 6.8
By income group
Low-income countries 12.3 11.8 24.6 45.9 58.1 52.4
Middle-income countries 31.7 49.8 75.7 108.4 100.7 114.7
By country of destination b
China 8.1 7.5 21.3 38.0 46.6 44.7
Mexico 8.2 11.9 9.2 21.9 17.4 10.9
Brazil 0.5 3.2 9.7 16.1 11.9 6.9
Korea, Rep. of 1.1 5.5 7.5 8.7 8.1 16.5
Malaysia 1.6 3.8 6.4 8.7 6.7 12.1
Argentina -0.2 2.9 5.8 13.7 8.2 8.8
Indonesia 3.3 3.5 4.7 0.5 7.4 11.4
Thailand 4.7 5.0 4.0 4.4 4.1 8.2
Russia 4.3 0.2 10.5 3.1 0.7 3.6
India 2.1 1.9 2.0 3.5 5.5 4.4
Turkey 1.7 1.1 4.5 7.2 1.5 2.3
Hungary -0.3 1.0 1.2 4.7 2.7 5.0
Other 8.9 14.0 13.4 23.8 38.0 32.3
Percentage share of top
twelve countries 79.8 77.2 86.6 84.6 76.1 76.0
" Preliminary.
b Country rankings are based on cumulative 1990--95 private capital flows received.
Source: World Bank, Debcor Reporting System and staff estimates.
fundamentals and less likely to pull out when faced with short-term uncer-
tainty or volatility.
These four factors lead me to the following explanation of what we observed
over the last few years. There was an initial portfolio adjustment in the early
1990s as emerging markets suddenly became credit unconstrained due to the
Brady debt reductions and, very importantly, due to their better macro policies
and structural reforms. Combined with low international interest rates and
initial euphoria, both in New York and Washington, private capital flows
expanded rapidly and expectations of continued high returns on emerging
stock markets became the accepted wisdom.
The Mexico crises in December 1994 has led to a sense of realism in the
market. Investors now evaluate countries and companies better, and they look
closer at the fundamentals and risks involved. The initial euphoria, and, impor-
tantly, the effects of the initial portfolio adjustment of investors in developed
Table 3. World growth summary, 1966-2005 (annual percentage change in real GDP)
Forecasts
Region 1966-73 1974-80 1981-90 1991-94 1995" 1996-97 /996-2005
World total 5.1 3.4 3.1 1.5 2.8 3.1 3.5

High-income countries 4.8 3.0 3.2 1.7 2.5 2.6 2.9
QECD countries 4.7 2.9 3.1 1.6 2.4 2.6 2.8
Non-OECD countries 8.8 7.0 5.2 6.2 5.5 5.6 5.5
Developing countries 6.9 5.3 3.0 1.0 3.9 4.8 5.3
East Asia 7.9 7.1 7.9 9.4 9.2 8.2 7.9
South Asia 3.7 4.0 5.7 3.9 5.5 5.5 5.4
Sub-Saharan Africa 4.7 3.5 1.7 0.7 3.8 3.7 3.8
Latin America and the Caribbean 6.4 4.8 1.7 3.6 0.9 2.6 3.8
Europe and Central Asia 6.9 6.1 2.1 9.0 -0.7 3.0 4.3
Middle East and North Africa 8.6 4.9 0.8 2.4 2.5 3.2 2.9
Memorandum items
Eastern Europe and
the former Soviet Union 7.0 5.1 1.8 -9.4 -2.5 2.9 4.4
Developing countries
excluding Eastern Europe
and the former Soviet Union 6.2 5.0 3.4 5.0 4.9 5.1 5.4
Note: GDP measured at market prices and expressed in 1987 prices and exchange rates. Growth rates over historical intervals are computed using least g
squares regression. ;:!
a. Estimated. ;:!
~
Source: OECD national accounts statistics; World Bank data, staff estimates, and projections. ~
tv
o\;.)
204 S. Claessens
countries are now over. In addition, a different class of investors, more sophisti-
cated and with a much longer time horizons, have now started to invest (or
are looking at investing) in emerging (equity) markets.
This is overall good news, both for investors and emerging markets. The
Mexico crisis and the involvement of more sophisticated and more demanding
investors has led to increased reform efforts in emerging markets which will
make these markets more attractive, transparent, reliable and less volatile. At
the same time, the diversification benefits for investors 2 and the growth opportu-
nities in emerging markets remain. Neither do I sense that there is a great lack
of interest in emerging markets among institutional investors. If anything, these
investors are only now getting ready to commit serious long-term money.
There is just more realism on both sides. The countries now understand better
that they need to earn these flows. And the investors realize that there are no
20% or more returns at low risks forever.
What does my analysis imply for the lessons and recommendations of this
paper? The paper has four main messages, mainly for emerging markets: pursue
sound macroeconomic policies; build the institutional infrastructure for securi-
ties markets; overhaul the management of corporations; and use, selectively,
capital controls.
On sound macro: As (almost) all economists, I fully agree and, as I have argued,
this has been reinforced by the Mexico crisis.
Building financial infrastructure: Here I also agree that emerging markets need
to speed up their efforts at building better environments for investing and
trading in securities. I would actually like to reinforce one of the messages
of the paper. As the paper points out, building financial infrastructure is
partly demand-driven, so foreign influence and inflows may be very useful
to stimulate this. We have seen this in particular in transition economies,
for example in Russia, but also in other emerging markets. Opening up to
foreign capital may thus be a way of improving the infrastructure, even
though at the same time the infrastructure can be a bottleneck when attract-
ing foreign capital.
Overhauling corporations: I agree that no sustainable capital market will emerge
unless a country has well-managed and solid firms. Additionally, I agree
with the way the paper proposes this should be done: corporatize state
enterprises, and then privatize in a sensible, careful manner, preferably to a
strategic investors. I do not share the views on transition economies, how-
ever, because many, such as the Czech and Slovak Republics and Russia,
did not have a choice but to privatize quickly. These countries' political
economy would have made the alternative - poor management under state
ownership combined with massive asset stripping and profit transfers - even
worse than the admittedly imperfect privatization which they pursued.
2 The mean-variance efficient frontier of the authors is not the way to do it; the paper by Harvey
provides a much better methodology for looking at risk and return in emerging markets.
Comment 205
Capital controls: I would disagree. Yes, for some countries which have had
capital controls on in- and outflows for a long time and where these controls
have been reasonable effective (some East Asian countries fall in this cate-
gory), capital controls may continue to benefit them in terms of guarding
against some aspects of international capital flows. But, capital controls on
inflows will come at a price. We know, for example, that capital controls
are more often motivated by desires to protect domestic financial markets
than by good macro or micro-economic arguments (see, for example, Alesina
et al., 1993; Dooley, 1996 for a review). Capital controls can thus stifle
competition and innovation in the financial sector. For these countries, there
will thus be a tradeoff between better macro control and a more efficient
financial sector. This tradeoff will mainly exist for capital inflows (and then
only for some countries); controls on outflows have in the past not prevented
a massive capital flight from many developing countries. For many develop-
ing countries, capital controls have also not limited overall capital inflows.
Particularly in Latin America and Africa, capital controls on in- and outflows
have not been very effective. At most, capital controls on inflows have
changed the composition of inflows (there is some evidence on Chile which
shows that they are inefficient; see Valdes-Prieto and Soto, 1996; see also
Cardenas and Barrera, 1995 for Colombia). For these countries, capital
controls could be just distortionary, with limited net gains.
REFERENCES
AJesina, Alberto, Vittorio Grilli and Gian Maria Milesi-Ferretti (1993). The Political Economy of
Capital Controls. Working paper 4353, National Bureau of Economic Research, Cambridge, MA.
Cardenas, Mauricio and Felipe Barrera ( 1995). On the Effectiveness of Capital Controls for Colombia.
Mimeo, FEDESARROLLO and University of Chicago. Paper presented at the 8th
InterAmerican Seminar on Economics organized by the NBER and FE DESARROLLO
(Bogota, November 16-18, 1995).
Dooley, Michael P. (1996). A Survey of Academic Literature on Controls Over International Capital
Transactions. Working paper 5352, National Bureau of Economic Research, Cambridge, MA.
Valdes-Prieto, Salvador and Marcelo Soto (1996). New Selective Capital Controls in Chile: Are they
Effective? Mimeo, Universidad Cat6lica de Chile, Santiago, Chile.
World Bank (1996a). Global Economic Prospects, 1996. Washington, DC.
World Bank (1996b). World Debt Tables, 1996. Washington, DC.
RENE GARCIA
University of Montreal
Comment on 'Cross-listing, segmentation and foreign

ownership restrictions' by Ian Domowitz, Jack Glen
and Ananth Madhavan
This paper is important since it sheds some light on an unexplored issue: the
impact of cross-listing on an emerging market, which is potentially smaller and
less liquid than a market in a developed economy. Previous studies of interna-
tional listing had focused on countries such as Britain, Canada, and Japan.
The emerging market studied by the authors is Mexico, during the period from
the end of 1989 to the middle of 1993. This period is chosen as to avoid two
main turmoils that have rocked the Mexican economy. It starts just after an
hyperinflation period and ends just before the monetary crisis of 1994-1995.
However, 1989-1993 was a period of restructuring of the economy and bank
privatization. The rate of inflation fell from 20% per annum in 1989 to a yearly
rate of 10% in 1993, but the exchange rate remains relatively stable during
the period.
The data set used by the authors is new and made up of daily observations
on prices, returns and share volumes of 26 equity series, issued by 16 large
firms having experienced an ADR (American Deposit Receipts) listing. One
interesting feature is that we can observe the returns and volumes of various
classes of shares having different restrictions regarding foreign ownership. The
main difference is between securities from the A series, which can be held
legally only by Mexicans, and securities from the B series, which can be owned
by foreigners and institutional investors.
Methodologically, the paper differs from previous studies attempting to
discriminate between segmentation and integration of capital markets. For
example, in Jorion and Schwartz (1986) markets are segmented if the price of
risk differs between markets or if prices are determined by different risk factors.
Hence, the authors focus on restrictions imposed by a certain asset pricing
model on the pricing of assets. They carry therefore joint tests of the integration
hypothesis and of the chosen asset pricing model. Instead, the authors of this
paper examine the impact of Mexican ADRs on volatility, liquidity and bid-
ask spreads of domestic shares. In this context, they analyze three hypotheses:
the competitive hypothesis, in which the foreign listing provides for more
liquidity and greater depth (less volatility) in the domestic market; the fragmen-
tation hypothesis, in which the migration of investors away from the domestic
market provides less liquidity and more volatility and the bid-ask spread is
likely to increase; finally, the segmentation hypothesis where the effects are
mixed, e.g. the bid-ask spread might decrease. This concept of segmentation is
207
R. Levich (ed.). Emerging Market Capital Flows, 207-210.
ro 1998 Kluwer Academic Publishers.
208 R. Garcia
therefore different from the previous definition found in the international asset
pricing literature and appears more as a way to qualify mixed empirical results.
To test the aforementioned hypotheses, the authors rely on two models, one
estimating and testing changes in volatility and liquidity, the other computing
and testing changes in spreads. In the first model given by equations (2) and
(3), support will be found for the competitive hypothesis if PI < 0 and YI < 0,
while fragmentation will be consistent with PI > 0 and YI > O. If mixed effects
are obtained, the authors conclude that markets are segmented. For the second
model on changes in the bid-ask spread, the authors rely on a technique
developed by Roll (1984) to infer the size of the bid-ask spread based on the
covariance of successive price changes.
In analyzing the results, the authors compare the parameter estimates of the
A and B series for the two models taken separately. From one model to the
other, the criteria for assessing the effects seem to differ. For the first model,
the authors argue that liquidity falls (PI> 0) in seven of nine cases, but the
coefficient is significantly different from zero in only three cases at the 5%
level, while five coefficients are positive and significant for the A series. For the
change in spread model, the sign is negative for most of the securities of the A
series, but the authors argue that only two have a p-value of less than 10%.
Two additional comparisons involving the two models taken together appear
useful. Using the first, one can compare the results in terms of sign and
significance for companies that issue both A and B series (Table 1).
It is hard to conclude from Table 1 that the results are very different for the
A and B series. Another useful comparison consists in looking jointly at results
from models 1 and 2 for securities of the B series (Table 2).
Table 1. Comparison of the A and B series for the same securities
A series B series
y, p, llS i', p, llS
CEM +* +* * +* + *
CIF +* + +* +* *
MAS +* + - (12%) +* + *
PON +* + +* +
SYN + +* + +* *
* Significance of 5% for the coefficients and a p-value of 10% for llS as selected by the authors.
Table 2. Analysis of results for B series securities
CEM CER CIF COM FEM MAS PON SYN TTO
i', +* +* +* +* +* +* + +*
p, + + + + +* +* +*
llS -* +* + * + * *
Comment 209
It is only for TTO that one finds statistically significant evidence for the
fragmentation hypothesis based on YI and PI, and for segmentation when
adding the change in spread result.
Two individual cases for the A series are also worth mentioning. For both
GCA and TEL, which had respectively the highest increase and the highest
decrease in volume before and after the ADR introduction, the results show
that YI > 0, PI < O. For GCA, Po and PI are of opposite sign and of the same
magnitude and have equal standard errors. For both GCA and TEL, the
coefficient C>l is very significant and of the same sign as the change in volume.
These results suggest some identification problems caused by the correlation
between the absolute value of the price change and volume.
Regarding estimation issues, the authors never mention the instruments used
in the estimation nor the p-value of the overidentification l-statistic, making
it hard to evaluate the overall adequacy of the model. By using the absolute
value of price changes to measure the standard deviation of price changes, the
authors rely implicitly on a normality assumption and therefore lose one of
the advantages of using the distribution free GMM method. Therefore, the
authors could gain some efficiency by using maximum likelihood techniques
to estimate a model of the ARCH-type family. This could have the added
advantage of modeling the mean return with an asset pricing model, and make
the link with the previous literature on segmentation versus integration.
Within the GMM framework, the authors could add some useful tests to
their results. Since different series for the same company are estimated jointly,
the LR test of Eichembaum et al. (1988) could be used to test whether the
orthogonality conditions for the B series hold with possibly different parameters
than the A series. The authors could also use predictive tests of structural
stability proposed by Ghysels and Hall (1990) to test whether the orthogonality
conditions hold after the ADR introduction given the estimates of the parame-
ters obtained before the ADR listing. This test is potentially more powerful,
since it does not involve the estimation of the coefficients after the ADR listing.
On the more general issue of controlling for macroeconomic factors, since
non-ADR firms tend to be smaller firms, cross-sectional evidence showing that
fragmentation is more likely to occur in larger firms might be worrisome if one
considers that inflation might affect smaller and larger firms differently and
that the inflation rate changed during the period.
In conclusion, this seminal paper on the issue of cross-listing in the context
of an emerging market shows that ADR introduction tends to be associated
with higher volatility, lower liquidity and a reduction in the bid-ask spread.
What is less clear than suggested by the authors is the fact that these effects
are limited to the shares open to foreign ownership prior to the international
cross-listing.
REFERENCES
Eichenbaum, M.S., L.P. Hansen and K.J. Singleton (1988). A time series analysis of representative
agent models of consumption and leisure choice under uncertainty. Quarterly Journal of
Economics, 103, 51-78.
210 R. Garcia
Ghysels, E. and A.R. Hall (1990). A test for structural stability of Euler conditions parameters
estimated via the generalized method of moments. International Economic Review, 31,355-364.
lorion, P. and E. Schwartz (1986). Integration vs. segmentation in the Canadian stock market. The
Roll, R. (1984). A simple implicit measure of the effective bid-ask spread. Journal of Finance, 39,
1127-1139.
VI HANG R. ERRUNZA
McGill University, Montreal, Canada
Comments on 'Rethinking emerging market equities'

by Roy C. Smith and Ingo Walter
I tend to agree with a number of issues and ideas put forward by Smith and
Walter. Given their emphasis on the current state of the markets, it would be
useful to restate the two fundamental principles of emerging market (EM)
investing in an effort to put their arguments in a richer perspective. First, EM
investors must have a long-term perspective. The focus on the short term on
the part of media and some fund managers is not only inconsistent but has
damaged the whole concept of EM investing. The emphasis on long term is
and should be the basis of all investments, domestic or international, and is
critical for the mutual benefits to investors and recipients. Second, the primary
motivation for investment in EMs is risk reduction through diversification. In
the long run, investors may expect higher returns assuming that the EMs will
continue to grow at a higher rate and that the economic growth will be reflected
in equity returns. Thus, correlations with developed markets (DMs) and return
volatility playa critical role. We review each in turn.
It is often stated that EM correlations with DMs will increase due to
increasing economic integration. This is a myth. Despite economic integration
and internationalization of stock trading, diversification benefits have persisted
among DMs. In addition, by and large, the EM correlations have remained
low in the long run. This result has withstood the test of time regardless of
data sets, sample countries, test periods and methodology used to measure
benefits to international portfolio diversification (see Errunza, 1994, and refer-
ences therein). Over time, some markets have become more correlated, many
have remained stable and some have shown a decrease in correlations. Figure 1
plots Thai correlations with the US, which show an uptrend, Figure 2 plots
Argentinean correlations with the US, which suggests no clear trend and
Figure 3 plots Indian correlations with the US which show a downtrend.
Indeed, EMs have provided valuable hedging services during major global
declines. Figure 4 plots returns for a group of EMs and DMs during the
October 1987 market crash. Economic and industrial structures along with
other nation specific attributes guarantee this. In summary, the case for risk
211
212 v.R. Errunza
-0.4
-0.6
-0.8L-~~-----~~~~----------~-----~--------------------~----------~
78 80 82 84 86 88 90 92 93
IFC TOTAL RETURNS INDICES
Figure 1. Correlations with US - Thailand.
-0.2
-0.4L-----------~-----~~=-~-------~~--~~~--------~
78 80 82 84 86 88 90 92 93
Figure 2. Correlations with US - Argentina.
diversification from inclusion of EMs in global portfolio has remained intact

since the late 1950s, and can be reasonably expected to remain so in the
foreseeable future. Of course, the global developments (European community,
Eastern Europe, trade/production rationalization etc.) and the reforms that
impact competition and industrial organization will affect composition, correla-
tions and the performance of EM portfolios in the long run. An assessment of
Comment 213
0.4
0.2
-0.2
-0.4 ~ ..........
,"",""",",,'---'--_~--'--:~_---L _ _ _ _ _.!'----_ _ _ _.....J
78 80 82 84 86 88 90 92 93
Figure 3. Correlations with US - India.
US$ RETURNS: During the October 1987 Market Crash
20
10
o
-10
-20 :
-30
-40
-50~~~~~~~~~~~~~~~~~~~=-~~
~ a:l ~
IFC TOTAL RETURNS FOR EMs
MSCIP GD RETURNS FOR DMs
NOle: Returns are for Mexico, Malaysia, Brazil Philippines, Korea, Pakistan, India, Venezuela,
Zimbabwe, Japan, United States, United Kingdom, Australia, and the World market.
Figure 4. Percentage returns - October 1987.
214 v.R. Errunza
the impact of such developments will necessarily remain judgmental until we

develop a clearer understanding of the complex interrelationships at work.
It is a widely held view that EM returns are very volatile and hence
investment in EMs is very risky. It is true that the standard deviations of
individual EMs are high in comparison to major DMs. However, the evidence
is mixed vis-a-vis smaller developed markets considered investable by institu-
tional investors. With respect to risk, if we view riskiness as the contribution
of EMs to the risk of the global portfolio, the evidence suggests EMs to be
very low risk assets. This is because a large part of the domestic systematic
risk is diversifiable in the global context i.e. inclusion of EMs lowers overall
portfolio risk. The reason is the low correlations discussed above.
The paper The Behavior of Emerging Market Returns by Bekaert et al. is
interesting and suggests fruitful avenues for future research. The paper essen-
tially consists of three parts. The first part extends and confirms existing
literature on EM return distributions (see for example Errunza and Losq, 1985,
and references therein). It is based on a longer and a larger data set and deals
with the higher return moments in more depth. Although some of their initial
comments regarding interpretation of IFC data are well taken, we should be
careful and not overreact. For example, the survival and the selection bias at
the firm level were addressed by Errunza and Losq (1985). The sample selection
on the basis of 1980 trading volume data rather than at the beginning of the
sample period (i.e. 1976) did not affect their conclusions regarding the behavior
of security prices. Similarly, the incidence of bankruptcy was too small not to
allow generalizations for the heavily traded segments of EMs. The reemerging
bias related to the start date of 1976 even though the markets had existed prior
to this date is not unique to the IFC database or EM investing. Indeed, none
of the widely used DM data sets go back to the beginning of its constituent
markets nor have researchers used the entire data set (from the date of the
market beginning) even when available. The 1976 start date was a result of the
desire to have at least a 5-year historical data within the constraints imposed
by budget and availability of quality data. Nonetheless, the arguments put
forward by Goetzmann and Jorion (1996) regarding reemerging bias are impor-
tant and apply to many developed markets as well.
The second part of the paper deals with measurement of risk. This is most
interesting and promising. I wish that the authors had motivated the discussion
using literature on asset pricing theory under capital flow controls (see refer-
ences in their paper) that is widely accepted as relevant to EMs rather than
the CAPM under complete integration. The alternative risk attributes could
then be fully exploited within the context of the asset pricing models under
mild segmentation. The third part of the paper makes useful suggestions on
portfolio choice.
The paper International Cross-Listing, Ownership Rights and Order Flow
Migration: Evidence from Mexico by Domowitz et al. deals with a topic of
current interest to the policy makers in emerging economies. Specifically, they
Comment 215
examine the impact of ADRs on bid-ask spreads, volatility and liquidity of

domestic shares.
The concept of segmentation hypothesis is rather confusing. First, segmenta-
tion has a clear definition in the asset pricing literature (see footnote 8 in their
paper). Second, the presence of barriers need not imply segmentation. The
barriers have to be binding and non-circumventable. Finally, for issues open
to foreign ownership, a decrease in bid-ask spread, higher volatility and lower
liquidity associated with ADR introduction is plausible as found by the authors.
However, it seems that it is the ownership restriction and not segmentation
per se that matters. In summary, to label this as segmentation hypothesis
detracts from the main result and is unnecessary.
I wish the authors had formally developed a theoretical framework. As it
stands, the intermediate (segmentation) hypothesis appears to be motivated by
the results. In the absence of a theoretical model development, it would be
fruitful to link the paper with existing ADR pricing models, for example, the
Eun et al. (1993) dealing with impact of ADRs on domestic pricing and the
Errunza et al. (1993) model that relates bid-ask spreads, volume and pricing
under different world market structures.
REFERENCES
Errunza, Vihang (1994). Emerging-markets: some new concepts. Journal of Portfolio Management,
20,82-87.
Errunza, Vihang and Etienne Losq (1985). The behavior of stock prices on LDC markets. Journal
of Banking and Finance, 9, 561-575.
Errunza, Vihang, Arthur Moreau and Jin-Chuan Duan (1993). The Pricing of American Depository
Receipts: Theory and Evidence. Working Paper #93-05-06, McGill University.
Eun, Cheol, Stijn Claessens and K wang Jun (1993). International trade of assets, pricing externali-
ties and the cost of capital. In Claessens, Stijn and Sudarshan Gooptu (eds), Portfolio Investment
in Developing Countries. Washington, DC: World bank Discussion Papers.
Goetzmann, William and Philippe Jorion (1996). Re-emerging Markets. Working Paper, University
of California, Irvine.
PART THREE
Integration of emerging markets and international equity

markets
HOLGER C. WOLF
Stern Business School and NBER
7. Determinants of emerging market correlations
INTRODUCTION
The confluence of several trends has radically altered the nature of capital
flows to developing countries over the last decade. Securitization, privatization
and capital account liberalization have boosted the supply of assets available
to foreign investors. Substantial improvement in market institutions, ranging
from insider trading regulations to efficient settlement and registration mecha-
nisms, have reduced micro-risk, while more stable macroeconomic policies have
lowered country risk. On the external side, eased restrictions on emerging
market investment for institutional investors from developed markets! and the
attractive perceived risk/return tradeoff led to substantial investor interest in
emerging markets. In combination, these trends caused a significant shift in
the composition of capital flows from public to private and from FDI and
bank loans to portfolio, in particular equity, investment. 2
Despite these developments, investment advice for emerging markets contin-
ues to be frequently prefaced with the warning 'caution, high risk'. Part of this
perceived risk is homemade, reflecting the vagaries of the economic, and at
times political development processes unfolding in many of the recipient coun-
tries, and is compensated by the higher average expected returns yielded by as
yet unexploited profit opportunities in the newly open markets. However, any
reader of the recent business press might be tempted to conclude that a
significant part of the risk reflects not so much changing fundamentals in the
recipient countries but rather the fickleness of foreign investors. Judging from
the tone of the press, investment in emerging markets is largely undertaken by
novice investors and mutual fund managers with little understanding of funda-
mentals, 3 ready to rush 'lemming like'4 into and out of markets at the slightest
1 Notably the introduction of rule 144A in the United States on the equity side and the revised
guidelines for the Samurai bond market in Japan on the bond side.
2 While official flows increased slightly from US$ 41 bn in 1988 to US$ 54 bn in 1993, private
flows dramatically accelerated from 33 to $159 bn over the same period.
3 "Yet one can still find mutual-fund managers investing in the region whose knowledge of Latin
America scarcely goes beyond steaks and sombreros." Economist, Survey on Latin American
Finance, December 9th, 1995, page 3.
4 Economist, May 13th, 1995: 71-73.
219
220 H.C. Wolf
provocation, thereby aggravating volatility far beyond the levels justified by a

'detached' view of fundamentals.
Investors, in this view, fail to adequately discriminate between emerging
markets, lumping countries with stellar credentials together with newly opening
countries with as yet fragile records into the single asset class 'emerging markets'
(Buckberg, 1996). Strong contagion effects between markets are the result:
"(T)he governments of Argentina and Brazil, among others, have strenuously
tried to show 'we are not like Mexico', but turbulence has hit markets across
the board as the herd instinct continues to take flows away from emerging
countries."s Whether such contagion effects are indeed present is of some
concern, both from the investor's and from the policy-maker's perspective.
From the investor's point of view, the benefits of international diversification
shrink if returns to emerging stock markets are predominantly driven by
common factors external to these markets themselves (Levy and Sarnat,
1970; Ripley, 1973; Solnick, 1974; Lessard, 1974, 1976; Grauer and Hakansson,
1987; Black and Litterman, 1991). From the policy-maker's perspective,
contagion effects imply sudden costly 'irrational' capital flow reversals caused
by factors outside their control, reducing the benefits of financial opening
(Calvo, 1995a,b).
In contrast to the business press, the academic profession has, by and large,
not accorded 'contagion' - defined as a co-movement of asset markets not
traceable to a common co-movement of fundamentals - a major role in explain-
ing return correlations across emerging markets, at least over the longer term.
Nonetheless, the question whether shorter term spikes in the correlation of
returns could be traceable to factors other than fundamentals has recently
begun to attract renewed interest. Two broad strands of literature have emerged
in this field, loosely concerned with informational and institutional factors,
respectively.
On the information side,6 Keynes' familiar depiction of the stock market as
a contest decided by the ability to pick other investors' favorites provides the
simplest generic example for a self-justifying sell off in emerging markets securi-
ties: if a sufficient number of investors believes other investors to have become
disenchanted (or enchanted) with the asset class 'emerging markets', a conta-
gious decline (or upswing) will be observed, which mayor may not be linked
to a change in the actual of perceived fundamentals. The multiple equilibrium
property implies that the decline might be avoided by co-ordination. With few
actors, each with significant exposure, a co-operative solution to the capital
flow reversal might be found - to some extent the resolution of the 1982 debt
crisis falls into this category. The increase in the number of investors, the
decrease in their average exposure and the enhanced liquidity of their claims
in the recent, equity dominated inflow period however renders such co-operative
S The Banker, February 1995, page 23.

6Devenow and Welch (1995) provide a survey. The topic of course has a long history, see
MacKay (1841).
Determinants of emerging market correlations 221
resolutions all but impossible, thus enhancing the scope for contagious
volatility.
While this simple model of an expectations driven market provides an
example of 'spurious volatility', it skirts the deeper issues, notably, why all
emerging markets should be viewed as a single entity, why investors should
think in terms of 'the market' rather than individual securities and, most
importantly, the cause for the change in expectations without an accompanying
change in fundamentals. Brennan (1990) provides a partial answer to the first
question: with costly learning, information gathering and processing will only
be undertaken if the expected benefits exceed the costs. As these benefits depend
upon other investors also acquiring, processing and, crucially, acting upon this
information to remove the pricing inefficiency, a mispricing may exist both
across and within markets.
Principal-agent problems in asset management (Scharfstein and Stein, 1990;
see also Grinblatt et al., 1995), roughly built around another observation
attributed to Keynes, that it is better for reputation to fail conventionally than
to succeed unconventionally, provide a second potential explanation for herding
behavior. If managers are evaluated not with respect to the efficient frontier,
but either relative to a market average or to an index of other managers in the
same asset class, low returns shared with most other managers carry little
penalty relative to an ex-post unsuccessful pursuit of an unorthodox strategy.
Given the reward structure, even above-average quality managers may opt to
hide in the herd rather than follow strategies which (ex-ante) may dominate
on risk-return basis. Applied to emerging markets, the principal-agent problem
might thus lead to correlated withdrawals even if (a subset of) mangers is
(ex-post correctly) confident about fundamentals.
Aside from these 'rational contagion effects' reflecting information issues,
contagion has also been attributed to institutional features, notably forced
redemption and two stage investment strategies. A significant fraction of the
inflows into emerging equity markets has been through open ended mutual
funds. 7 Large scale withdrawals from these funds in excess of cash reserves,
coupled with reductions in inflows and limits on permissible borrowing, may
force partial liquidation to honor redemptions. Table 1 provides an illustration
for a sudden end to capital inflows in the aftermath of the Mexican crisis. In
the case of multi-country funds, these liquidations are likely to be concentrated
in the most liquid markets. If these markets were not initially adversely affected,
the redemption pressures may thus generate a contagion effect. In this case, the
contagion reflects not so much a reduction of confidence in these markets, but
rather, perversely, their quality, reducing the costs of forced liquidations.8
7 As of mid 1995, some 519 open-ended mutual funds managed some US$ 39.7 bn, compared
with 237 closed end funds with US$ 37.4 bn under management.
8 The same outcome would of course be observed if global mutual aim to exploit perceived
mispricing via purchases in the most downtrodden markets financed through sales of equities in
less affected markets.
222 H.C. Wolf
Table 1. International equity issues (US$ million)
Net equity
Emerging Share in purchase by
markets global mutual funds
1994.1 3.826 31.1 19625

1994.II 3.677 21.3 2390
1994.111 4.703 57.9 6016
1994.1V 5.930 51.7 5349
1995.1 622 14.8 347
1995.II 2.804 22.3 4734
1995.III 3.361 45.3
Source: Andrews and Ishii (1995).
Contagion through forced redemptions explains why even money-managers

quite confident about prospects of particular markets may be forced to sell,
and suggests how the effect may spread across markets. Since the original
redemption decision by individual investors is taken as given, redemptions
however do not provide an independent explanation for contagion effects.
Two stage investment strategies, in which some fraction of the overall
portfolio is allocated to the 'emerging market' category and is then sub-
allocated according to some index weighting (Buckberg, 1996; Chuhan, 1994;
Howell, 1993) provide the second of the institutional explanations for contagion
to the extent that first stage decisions, even if motivated by internal ('pull') or
external ('push') factors relevant to some emerging markets, may also affect
markets for which these factors are of little importance. Again, however, the
relevant institutional constraint - the decision to lump the entire set of emerging
markets into a single asset category - is taken as exogenous, both institutional
explanations of contagion are thus conditional on some underlying unexplained
investor behavior. 9
Given the important implications of contagion for both investors and for
policy makers, and their widespread discussion in the aftermath of the Mexican
crisis, one might have expected to find a rather sizable empirical literature
devoted to measuring contagion, yet while a number of literatures in empirical
finance carry important implications for contagion, fairly little direct work has
been undertaken. The lack of attention presumably partly reflects the conflict
between important medium-term contagion effects and the strongly held belief
in the benefits of international portfolio diversification, based on the 'stylized
fact' of low correlations among emerging markets and between emerging and
mature markets. A second reason might be the slippery nature of contagion:
defined as a co-movement of returns not attributable to a co-movement of
fundamentals, it is by definition a residual effect and, as any residual, may also
9 Again, a self-enforcing dual equilibrium lurks in the background: to the degree that decisions
based on viewing emerging markets as a single asset class generate contagion across these markets
on a significant scale, emerging markets do, in fact, resemble a single asset class.
reflect the presence of yet another excluded fundamental. Put differently, the
presence of contagion can only be established conditional on a given set of
explanatory variables and a given postulated relationship between these vari-
ables. Finally, while little direct work on emerging market contagion has been
done, the very substantial literature on establishing factors driving emerging
market returns is of course directly linked with the topic: the residual variance
left unexplained by this literature poses an upper bound on contagion effects.
Is contagion in fact as prevalent as the recent business press suggests? A
first stab at the data suggests otherwise. During the three most recent 3-year
periods, returns in the top twenty emerging markets differed dramatically, with
a total range between the highest and lowest return of above 300 % in every
period, and a range of 100 % even if the five top and the five bottom performers
are excluded. Nor were monthly returns particularly highly correlated. Table 2
reports, for individual emerging markets, statistics on the correlations of
monthly returns over the period 1988 to 1993 vis-a-vis a set of some twenty
other emerging markets. The results are in line with the general tone of the
literature (see Claessens et al., 1993, 1995a,b; Claessens, 1995; Errunza and
Losq, 1985): the average correlation equals 0.13, for nine markets the correla-
tion does not significantly differ from zero, and the maximum average correla-
tion of one equity market with all other equity markets amounts to just 0.25
Table 2. Correlations
Mean Minimum Maximum
Argentina 0.06 -0.26 0.79

Brazil 0.04 -0.34 0.31
Chile 0.06 -0.32 0.46
China 0.21* -0.43 0.70
Colombia 0.26* -0.23 0.58
Hungary 0.07 -0.57 0.50
India 0.14* -0.26 0.58
Indonesia 0.23* -0.26 0.53
Jordan -0.00 -0.43 0.41
Korea 0.05 -0.57 0.28
Malaysia 0.25 -0.22 0.64
Mexico 0.15 -0.21 0.51
Pakistan 0.15* -0.18 0.55
Peru 0.21* -0.26 0.79
Philippines 0.23* -0.18 0.70
Poland 0.05 -0.27 0.50
Sri Lanka 0.14* -0.45 0.55
Taiwan 0.20* -0.15 0.65
Thailand 0.22* -0.24 0.62
Turkey 0.02 -0.45 0.36
Venezuela -0.03 -0.45 0.46
Mean 0.13 -0.32 0.55
* Differs significantly from 0 at 5%.

224 H.C. Wolf
for Malaysia. On first sight, evidence for contagion, at least over extended
periods, is thus slim, judging from the unconditional correlation of stock market
indices, the preferred (if implicit) measure of much of the recent writing on
contagion.
The motivation of this paper is to argue that these unconditional correlations
of market indices however provide quite poor measures of contagion, for two
reasons. First, index returns are partly determined by sectoral composition and
partly obscured by idiosyncratic noise. For example, consider two emerging
markets dominated by equities in a single sector, say petroleum. An increase
in the world demand for oil may lead to a substantial increase in the equity
prices of oil companies in both economies. Given the market weight of the
sector, a high correlation of the two overall indices results, yet this correlation
has little to do with "contagion" as the term is used. To the degree that returns
differ across sectors and sectoral composition differs across markets, it thus
becomes necessary to correct market indices for composition effects to obtain
meaningful measures of co-movements (Roll, 1992). Table 3 throws some light
on these two issues. The first column reports, for each market, a similarity
index defined as the sum of the absolute differences between the fraction of
total market capitalization in that market accounted for by each of 25 sectors
and the percentage of the market capitalization in all emerging markets
accounted for by the same sectors. A value of zero implies an equal distribution
Table 3. Sectoral composition
Weight Weight
Overall Least equal in in Sectoral
similarity weighted country world stock returns Cumulative
index sector market market 1984-93 percent
Malaysia 0.73 Diverse holding 15.8 5.6 Communications 6183

Brazil 0.80 Electricity/gas 23.0 9.3 Cement/glass 1457
Korea 0.87 Communications 2.0 13.8 Electricity/gas 1028
Thailand 0.92 Banking 36.1 14.6 Rubber prod. 793
Taiwan 0.94 Communications 0.0 13.8 Food 780
Indonesia 0.98 Communications 0.0 13.8 Transp. equip. 709
Philippines 1.01 Food 25.5 4.2 Electric equip. 695
Turkey 1.06 Petroleum 18.4 2.8 Construction 655
Mexico 1.09 Communications 33.3 13.8 Paper 616
Zimbabwe 1.11 Services 15.8 1.9
Chile 1.11 Electricity/gas 37.0 9.3 Prim. metals 292
Venezuela 1.12 Electricity/gas 30.6 9.3 Agriculture 265
Pakistan 1.13 Chemicals 24.9 2.5 Banking 250
Argentina 1.17 Communications 47.4 13.8 Textile mi11s 236
Jordan 1.21 Banking 57.1 14.6 Fabric. metals 224
India 1.23 Chemicals 18.1 2.5 Insurance 143
Colombia 1.31 Food 26.0 4.2 Petroleum 122
Nigeria 1.60 Food 38.6 4.2 Brokers 96
Source: Author's calculations based on IFC.

of sectors in the country as in the universe of emerging stock markets, higher

index numbers imply greater dissimilarity. Malaysia is revealed to be the market
most similar, Columbia and Nigeria the markets least similar to the average
of all markets. Columns 3-5 list, for each market, the sector with the largest
weight deviation from the average, along with the market and the average
weight, illustrating the numerical significance of differences in market struc-
ture. 1O The last two columns report the cumulative returns on sectors over the
period 1984-1993, illustrating the wide range between annual returns ranging
from 6.9 and 8.3% for firms in the brokerage and petroleum industries to 51 %
for the telecom industry. Over the same period, the annual range of sectoral
returns was above 100 % and the coefficient of variation > 1 in all but 3 years.
There is thus ample reason to expect, ex ante, that composition effects matter
significantly for index returns.
The potential bias introduced through composition effects thus suggests
caution in using the correlation of market returns as measures of contagion,
certainly for short periods and between small groups of markets. However,
even if composition effects were controlled for, the use of unconditional correla-
tions would remain problematic. Contagion, in the sense typically used, refers
to co-movements that cannot be attributed to changes in perceived fundamen-
tals. In the aftermath of the Mexican crisis, both the Hungarian and the
Taiwanese market declined, eliciting commentaries of the type quoted above.
Yet the two countries differ significantly: Hungary shares most of the problems
leading to the crisis in Mexico (low savings, large current account deficits, low
reserves) while Taiwan does not. Arguing informally, the decline in the Taiwan
market might thus on first sight be viewed as a contagion effect, but a decline
in the Hungarian market, in the wake of re-evaluations of the risk-return
tradeoff based on the new information revealed by the Mexican debacle,
cannot. l l To be convincing, any claim for contagion based on correlations will
thus have to argue that the observed co-movement cannot be attributed to
shared changes in fundamentals.
In summary, large positive correlations of aggregate stock market indices
are neither necessary nor sufficient for establishing contagion. The correlation
is unsatisfactory for two reasons. First, correlations may be spuriously high or
low due to composition mismatch between emerging markets. Second, a high
correlation between two markets is only indicative of contagion to the extent
that it cannot be attributed to an equally high correlation between fundamen-
tals. In this paper we address the first issue. To evaluate the importance of
10 Table 3 reports results at a particular moment. New issues and price changes can change the
relative ratings significantly. However, as long as these changes do not equalize the weighting
structure across markets, and there is no a priori reason to expect that they will, composition
effects will remain important.
11 See e.g. Cline (1995): "Rationally, spillover to the other big emerging markets from the
Mexican crisis should be limited, because few have the explosive combination of low reserves,
sizable short-term government debt held by foreigners, a large current-account deficit and a fixed
exchange rate:
226 H.C. Wolf
composition effects, we construct a measure of co-movement purging the effects

of different sectoral makeup as well as idiosyncratic noise. The correlation
pattern between these market returns provides an upper bound on contagion
effects, and could be matched to co-movements between fundamentals to assess
the importance of the second qualification.
To avoid any confusion, it might be useful to also set out what we do not
attempt to do. We do not aim to explain the average level of correlations
across emerging markets, we do not examine issues of pricing efficiencies in
these markets (Bakaert and Harvey, 1995a,b; Cashin and McDermott, 1995;
Cashin et al., 1995), nor do we link the results formally to a particular model
of asset pricing. Rather, the paper attempts to answer a simple question: what
is the co-movement between emerging markets that can be attributed to market
factors rather than composition effects or idiosyncratic noise?
In the next section, we present some stylized facts regarding the equity
returns used in the paper. We then review the methodology used in this paper,
and familiar from other studies, to decompose individual stock returns into
market, sector and idiosyncratic return components and conclude by character-
izing the properties of the market components.
"The inhabitant of London could order by telephone, sipping his morning
tea in bed, the various products of the whole earth ... He could at the
same moment and by the same means adventure his wealth in the natural
resources and new enterprises of any quarter of the world, ... he regarded
this state of affairs as normal, certain and permanent."
Keynes, Economic Consequences of the Peace, Macmillan, London, 1919.
DATA AND STYLIZED FACTS
The contagion measures derived below are based on the US $ denominated

total return series on individual stocks contained in the Emerging Markets
Data Base (EMDB) published by the IFC. The database covers 24 countries
and 21 sectors, listed in Table 4. The longest sample span ranges from January
1976 to April of 1995. The first full year for which returns are available for
each country is listed in column two. The full dataset is used to estimate
country effects.
Conceptionally, the stock return to an equity at time t, r;i, can be decomposed
into a country component common to all stocks in country i, ~;, into a sector
component common to all stocks (globally) in sector j, f3{ and into an idiosyn-
cratic component v;i:
(1)
We use a fixed effect regression, estimated separately for each month, to
extract the country effect. The number of observations changes over time
around a positive trend, for the period 1985-1995 which will be used in most
Table 4. Dataset: countries and sectors
Country First year Sectors
Argentina 1984 Agriculture, forestry, fishing

Brazil 1988 Mining
Chile 1976 Construction
China 1993 Food and tobacco
Colombia 1985 Textile products
Hungary 1993 Paper
Indonesia 1990 Chemical
India 1990 Petroleum refining
Jordan 1979 Rubber and plastics
Korea 1976 Stone, clay, glass, concrete
Malaysia 1985 Metals
Mexico 1976 Industrial, commercial computer equipment
Nigeria 1985 Transportation equipment
Pakistan 1985 Misc. manufacturing
Peru 1993 Transport
Philippines 1985 Communications
Poland 1993 Utilities
South Africa 1994 Depository Institutions
Sri Lanka 1993 Other finance, insurance, real estate
Taiwan 1985 Services
Thailand 1976 Miscellaneous, wholesale and retail trade
Turkey 1987
Venezuela 1985
Zimbabwe 1976
India and Food and tobacco are reference points.
of the analysis, it varies between 400 and 1300 stocks. Since every observation
belongs to both one country and to one sector, it is not possible to uniquely
identify the country effect. The identification problem can be addressed in a
number of ways, we use benchmarking against a reference country (India) and
a reference sector (Food). The reference points were chosen since at least one
observation was available for both in every time period. The alternatives are
use of a generalized inverse (Zervos, 1994) and referencing relative to the
sample mean (Heston and Rouwenhorst, 1994). The appropriateness of the
identification method used depends upon the issue examined. Since our focus
is solely on the correlations, rather than the magnitudes, of the identified
country effects, the precise reference point chosen is of secondary importance
as long as it is common for all observations.
Country and, to a lesser extent, sector effects together explain between one-
third and one-half of the variance of returns on individual stocks, as graph 1,
plotting the 12-month rolling average of the R2 of the fixed effects regression
throughout the sample period time illustrates. The result is in line with earlier
studies (Divecha et al., 1992; Zervos, 1995) finding country effects to dominate
sector effects, with total explanatory power in the 33-50% range. Comparing
results for emerging and developed markets reveals the primacy of c~untry
228 H.e. Wolf
over sectoral effects to be a common feature of both, though the dominance is

more pronounced for the emerging markets. 12
Table 5 compares the correlations of the estimated country effects (above
the diagonal) and the total returns (below the diagonal). The exclusion of
sector and idiosyncratic effects is seen to alter the correlation structure quite
significantly. The average correlation is enhanced from 0.06 for total returns
to 0.22 for the country effects, for 88 out of the 105 country pairs, the correlation
of the country effect exceeds the correlation of total returns. The revisions are
quite substantial, for twenty-five country pairs, the difference in correlations
exceeds 0.3, for 47 pairs it exceeds 0.2 and for 71 it exceeds 0.1.
While the different reference points prevent an exact comparison, the results
suggest that a significant portion of the risk-reduction gains commonly attrib-
uted to international diversification may in fact reflect benefits from sectoral
and idiosyncratic diversification. Correlations decrease somewhat over longer
horizons, the average correlation of country effects in the ten non-overlapping
twelve month periods between 1985 and 1995 amounts to 0.16, with three
countries (Jordan, Philippines, Thailand) exhibiting average correlations with
all other markets between 0.3 and 0.35, while four markets (Argentina, Nigeria,
Venezuela and Zimbabwe) exhibit small negative average correlations.
Since all returns are denominated in US dollar, the relevant standard for
US-based investors, the high explanatory power of country effects may reflect
either a common element in local returns or the common element introduced
through the exchange rate movement in the period. 13 By extension, correlations
of estimated country effects may also to some extent capture co-movements in
the exchange rate vis-a.-vis the dollar.
To assess the empirical significance of the exchange rate factor, the estimated
country effects were regressed on the change in the exchange rate vis-a.-vis the
rupee. In the hypothetical case of zero local currency returns, the country effect
would be entirely accounted for by the exchange rate movement. The first two
columns of Table 6 report the R2 of the regression along with the coefficient,
strongly rejecting the notion that the estimated country effects are significantly
influenced by exchange rate movements. The exchange rate explains at most
5% of the variance of the country effect. Nine of the 13 estimated coefficients
are negative, though only the coefficients for Chile and Korea are not signifi-
cantly different from -1. The last three columns report, respectively, the
average correlation of country effects, the corresponding average correlation
of depreciation rates and the average absolute difference between the two
matrices. With the exception of Nigeria and Venezuela, depreciation rates are
12See Beckers et al. (1992), Lessard (1974, 1976), Adler and Dumas (1983), Solnik and de
Freitas (1988), Grinold et al. (1989), Drummen and Zimmermann (1992), Roll (1992) and Heston
and Rouwenhorst (1994) for a small sample of work on developed markets. Heston and
Rouwenhorst (1994) is closest in approach to this paper.
13 See Adler and Simon (1986), Eun and Resnick (1988), Jorion (1991), Levy and Lim (1994),
Stockman and Dellas (1987) inter alia for discussions of the exchange rate in portfolio
diversification.
Table 5. Correlation matrix: total return and country effect
Arg Bra Chi Col Jor Kor Mal Mex Nig Pak Tai Tha Tur Yen Zim
Arg -0.22 -0.11 0.02 0.10 -0.08 -0.13 0.27 0.11 0.07 -0.05 0.08 0.15 -0.03 -0.06
Bra -0.19 0.14 0.08 -0.10 -0.06 0.00 -0.02 -0.11 -0.11 0.11 -0.10 0.16 -0.23 0.02
Chi -0.02 0.21 0.09 0.28 0.29 0.22 0.27 -0.03 0.21 0.31 0.22 0.01 -0.08 0.13 ...""t:l
Col -0.08 0.14 -0.10 0.33 0.20 0.24 0.21 0.38 0.63 0.23 0.25 0.27 0.25 0.17 "OJ
Jor -0.14 -0.08 om 0.07 0.53 0.52 0.50 0.32 0.52 0.41 0.49 0.03 0.23 0.40 3""
;;.
Kor -0.\3 -0.\3 -0.03 -0.06 0.04 0.55 0.49 0.38 0.45 0.45 0.37 0.07 0.27 0.50 ~
~
,~
Mal -0.11 0.12 0.11 0.19 0.19 0.30 0.54 0.37 0.42 0.52 0.60 0.33 0.08 0.54
Mex 0.35 0.08 0.07 -0.02 -0.05 0.27 0.42 0.28 0.42 0.51 0.41 0.08 0.16 0.46 '"
.Q.,
Nig 0.07 -0.11 -0.21 0.09 0.05 0.\3 0.06 -0.02 0.33 0.10 0.21 0.28 0.30 0.29
Pak 0.04 -0.03 0.04 0.43 0.10 0.09 0.11 0.04 -0.03 0.31 0.36 0.14 0.20 0.38 ""3
Tai -0.07 0.14 0.22 0.11 0.22 0.24 0.44 0.30 -0.15 0.11 0.38 0.20 0.07 0.36 ""
~
Tha 0.06 0.02 0.20 0.16 0.19 0.16 0.65 0.28 -0.02 0.22 0.28 0.23 0.03 0.36 ~.
Tur 0.16 0.15 -0.13 0.10 -0.07 -0.03 0.17 -0.13 0.20 0.04 0.18 0.18 -0.08 0.09
3
Yen 0.06 -0.19 -0.19 0.17 -0.12 -0.05 -0.18 -0.11 0.19 0.04 -0.20 -0.16 -0.09 0.38 ~
"OJ
Zim -0.12 0.04 -0.14 -0.05 -0.15 -0.05 0.27 0.08 0.06 -0.02 0.07 0.06 0.03 0.17 ;>;-
~
Above diagonal: country effects. Below diagonal: total returns. ~
"OJ
'"
"OJ
""~
g.
~
'"
tv
tv
\0
230 H.C. Wolf
Table 6. Exchange rate effects
Mean Mean
correlation correlation Mean
equity depression absolute
Country R2 Coeficient returns rates difference
Argentina 0.000 -0.036 0.093 0.001 0.112

Chile 0.051 -0.648** 0.550 0.195 0.327
Columbia 0.000 0.080 0.571 0.237 0.338
Jordan 0.009 -0.260 0.490 0.316 0.182
Korea 0.048 -0.848** 0.608 0.264 0.321
Malaysia 0.005 -0.277 0.604 0.242 0.348
Mexico 0.007 0.210 0.347 0.213 0.150
Nigeria 0.039 -0.289** 0.079 0.109 0.085
Pakistan 0.007 -0.277 0.605 0.308 0.306
Philippines 0.002 -0.182 0.551 0.248 0.279
Thailand 0.009 0.370 0.627 0.281 0.319
Venezuela 0.002 0.069 0.124 0.169 0.Q78
Zimbabwe 0.013 -0.314 0.346 0.186 0.199
All 0.430 0.213 0.234
more correlated across markets than are country effects, implying the presence
of significant idiosyncratic factors. Overall, exchange rate movements thus
account for at most a small portion of the country effects and their correlations,
a finding consistent with other work in this area.
Tables 7 and 8 examine the presence of causality effects between markets.
Table 7 applies Granger causality tests for the 1985-1995 period to examine
temporal linkages between the estimated country effects. The Philippines,
Pakistan and Malaysia are found to be temporally prior to three and two
Table 7. Causality patterns
Market Causes Is caused by
Argentina (ARG) TUR BRA

Brazil (BRA) ARG IND, JOR, MAL, MEX, PHI, THA
Columbia (COL) ZIM THA
Indonesia (lND) BRA PHI
Jordan (JOR) BRA
Korea (KOR) TUR
Malaysia (MAL) BRA, MEX
Mexico (MEX) BRA MAL, PHI
Pakistan (PAK) THA, ZIM
Philippines (PHI) BRA, IND, MEX
Thailand (THA) BRA, COL, ZIM PAK, VEN
Turkey (TUR) KOR,ZIM ARG
Venezuela (VEN) THA
Zimbabwe (ZIM) COL, PAK, THA, TUR
Table 8. VAR decomposition: own effect
Lag
2 4 6 12
Thailand 59.8 39.5 33.2 26.5

Malaysia 65.9 47.0 39.3 26.9
Venezuela 71.8 60.0 42.2 28.8
Colombia 81.6 59.3 46.6 31.4
Argentina 64.9 51.1 39.5 32.9
Korea 68.2 43.8 40.1 33.0
Zimbabwe 78.2 68.1 46.1 34.5
Pakistan 76.1 58.4 51.4 34.7
Mexico 78.5 55.7 50.4 34.9
Chile 87.3 62.3 52.6 35.7
Nigeria 66.8 53.5 41.2 36.5
Jordan 70.9 55.9 49.5 37.3
Taiwan 85.6 60.7 54.9 40.7
Philippines 84.9 76.9 60.3 42.9
other markets, out of 14 markets in the sample. 14 Brazil and Zimbabwe, being
Granger-caused respectively by six and four other markets, seem most sensitive
to developments elsewhere. Overall, there is little evidence for global leaders,
nor for the type of regional spillover effects from larger to smaller markets
found for capital flows (Calvo and Reinhart, 1994). Table 8 reports the contribu-
tion of own shocks to the variance of the estimated country effects at lags
between two months and one year, estimated by a VAR including the
13 markets for which complete data from 1985 to 1995 were available. A lower
contribution signals a greater dependence on other markets. Thailand, Malaysia
and Venezuela are seen to be least independent of shocks to other markets,
Jordan, Taiwan and the Philippines most independent. Again, however, no
clear outliers emerge, the proportion of the variance explained by own shocks
varies in the fairly narrow range from 26 to 42. Neither table thus suggests the
presence of dominant 'leading markets'.
"For those that think of Latin America in terms of generals, jungles and
sackfuls of worthless currency, it may be time to overhaul some myths.
Things have changed. (S)oldiers have long since goose-stepped back to
the barracks, their power usurped by squadrons of technocrats and battal-
ions of economic miracle makers."
FT August 27-28, 1994.
"Mexico's currency crisis has dimmed expectations for economies
throughout Latin America. The crisis and the border war .. , between
Peru and Ecuador have raised some fundamental questions in the minds
14The sample was restricted to countries with data beginning in 1990 or before.
232 H.C. Wolf
of investors about the wisdom of investment in Latin America. (S)ome

may well retire from the region for good."
FT, February 20, 1995
'The history of investment in South America throughout the last century
has been one of confidence followed by disillusionment, of borrowing
cycles followed by widespread defaults."
Royal Institute of International Affairs (1937)
CONCLUSION
A century ago, Bagehot noted that "the same instruments which diffused capital
through a nation are gradually diffusing it among nations" and warned that
while "the effect of this will be in the end much to simplify the problems of
international trade ... for the present, as is commonly the case with incipient
causes whose effect is incomplete, it complicates all it touches.,,15 The assess-
ment remains valid today. Over the last decade, capital flows to emerging
markets have dramatically risen and, for the first time since the late 19th
century, been dominated by private-to-private flows. The inflows have generally
been cautiously greeted by governments aiming to enhance integration with
international financial markets. Yet the transition from closed to integrated
financial systems has not been without cost. In particular, policy-makers have
been concerned with the potentially disruptive consequences of capital flow
reversals. To the degree that such reversals reflect internal decisions, adoption
of stringent fiscal and monetary policies, possibly augmented with restrictions
on some types of capital flows, could be used to mitigate the likelihood and
extent of reversals. More recently, in particular in the wake of the Mexican
crisis, the possibility of reversals largely unrelated to any domestic fundamentals
under the influence of policy makers has attracted increased attention. To the
degree that such 'contagion effects' - capital flow reversals unrelated to funda-
mentals - are indeed present, financial integration, even though desirable long
term, may impose significant costs (Williamson, 1993; Gooptu, 1993).
The presence of contagion has been widely inferred from high correlations
of aggregate indices, mostly over very short durations. We argued above that
such unconditional correlations do not, in fact, provide good indicators of
contagion effects, for two reasons. First, aggregate returns were shown to be
subject to very significant composition effects potentially leading to spurious
correlations. Second, contagion, at least in the sense used here, requires
co-movements not attributable to changes in joint movements in fundamentals.
We asked whether the scope for contagion effects remains sizable once these
two problems have been corrected. Using a regression of individual equity
returns on country and sector dummies, we isolated a market effect purged of
15 Bagehot Economic Studies, London 1880.

sectoral composition effects and idiosyncratic noise. The market effects exhibit
higher correlations across emerging markets compared to the correlation of
market indices, a correlation which can not be attributed to exchange rate
movements. However, there do not appear to be strong causality patterns
among emerging markets, little evidence emerges in favor of either local or
global 'leading markets'. In sum, the potential scope for contagion effects is
enhanced by removing composition effects. However, as argued above, a con-
vincing argument that the observed correlation in fact reflects contagion must
also establish the absence of a matching correlation between fundamentals, a
task left for future.
ACKNOWLEDGMENT
I thank Maha Ibrahim for excellent research assistance and the IFC for kindly
making the Emerging Market Data Base available.
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ROBERT E. CUMByl and ANYA KHANTHAVIT2
1 Georgetown University: 2 Thammasat University
8. A Markov switching model of market integration
ABSTRACT
In this paper we estimate a bivariate two-state Markov switching model of excess returns
on both domestic equities and a world index of equities for Thailand, Taiwan, and Korea.
Our reason for doing so is to determine if changes in the behavior of equity returns can be
linked to changes in policies governing the integration of these economies and their capital
markets with world markets. We find clear evidence of two regimes: one characterized by
a low variance of domestic equity returns and a low {3 of domestic equities relative to the
world index, the other by a high variance of equity return and a high {3, in all three countries.
The differences across states in the covariance of the local market returns with the world
index is consistent with greater integration of goods and capital markets in the high-
covariance, high-{3 state. We find, however that the even in the 'integrated' state, equity
returns are not consistent with a simple, single-{3 model of an integrated world capital
market. For all three countries our estimates suggest that stock returns are higher than
would be predicted by a simple CAPM. Only for Thailand is the temporal behavior of the
probability that the high-covariance state is generating the data consistent with a change
in government policies leading to greater goods and capital market integration. The esti-
mated probabilities indicate quite clearly that a regime change occurred in the mid-1980s.
The early 1980s are characterized by the low covariance state, 'segmented' state and
thereafter, the data are generated by the high covariance, 'integrated' state.
INTRODUCTION
During the 1980s a number of Asian countries undertook a series of steps

toward economic liberalization. The liberalization programs often involved
export-orientated economic policies along with steps aimed at greater openness
of domestic capital markets to foreign investors. These liberalization measures
were followed by periods of rising, export-led economic growth and stock
market booms. In this chapter we will model the behavior of stock returns in
three countries, Thailand, Taiwan, and Korea, which followed somewhat
different liberalizing policies. We then attempt to link the behavior of these
returns to the opening of both goods and financial markets.
Figure 1 shows the value of a portfolio of equities in the three countries. We
normalize the value of the portfolio as $100 in December 1984 and assume all
dividends are reinvested. In all three countries, period of relatively low average
returns is followed in the second half of the 1980s by a period of rapidly rising
equity values. In Taiwan that dramatic rise was followed in 1990 by an even
more dramatic crash. After the crash, Taiwanese and Korean equity values
237
238 R.E. Cumby and A. Khanthavit
Thai Stock Market

Cumulative Returns, 1977 - 1994
2000 , - - - - - - - - - - - - - - - - - - - - ,
1500 -------------------------------------- -
8
,...;
~ 1000
~
,...;
500 - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - --
o~~==~~====~--------~
1977 1979 1981 1983 1985 1987 1989 1991 1993
Korean Stock Market

800,-------------------------------~
600
~~~~.~: ::::::::~~~::
200 - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - --
O~------------------------------~
1977 1979 1981 1983 1985 1987 1989 1991 1993
Figure 1. Stock returns in Thailand, Korea, and Taiwan.

A Markov switching model of market integration 239
Taiwanese Stock Market

1400-----------------------------------
1200 - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - -
1000-- -----------------
800 - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - -
II
~
~ 600---------------- --------- ---------- ----
400 -- - - - - - - - - - - - - - - - - - - --
200 -- - - - - - --
o1985
--------------------------------------
1986 1987 1988 1989 1990 1991 1992 1993 1994
moved in tandem. The early 1990s slump was both shorter lived and milder in
Thailand, where it has been followed by another dramatic rise in equity values.
Figure 1 suggests that equity returns might be characterized by more than
one regime. We therefore model the distribution of equity returns as subject to
(stochastic) changes in regime. We then ask whether the differences in the
distribution of returns across regimes is consistent with the effects of greater
integration of both financial and goods markets with those abroad. Because
investors can sometimes circumvent legal or regulatory restrictions, effective
capital market integration need not coincide with legal changes. Our approach
is therefore to let the data determine when regime changes occur rather than
using legislative or regulatory changes to impose a particular date (or set of
dates) for the regime changes.
The plan of the paper is as follows. In section I, we describe a two-state
Markov switching representation of equity returns and present estimates for
equity returns in the three markets. In section II, we expand the univariate
models of section I and examine bivariate models of equity returns in each
market and the return on a world index of equities. We present estimates of
constrained and unconstrained versions of the bivariate models that allow us
to examine the effects of goods market and capital market integration and to
test the restrictions of a simple version of a capital asset pricing model. In
section III, we compare the results described in section II with estimates of the
same bivariate Markov switching representation applied to countries with long-
standing links with world goods and equity markets. Section V offers some
concluding remarks.
I. A TWO-STATE MARKOV REPRESENTATION OF EQUITY RETURNS
Consider an economy in which the stochastic process governing equity returns

is influenced by policies regarding the integration of domestic markets with
the rest of the world. We will represent these policies as consisting of two states,
state 0 is one in which domestic markets are segmented and state 1 is one in
which domestic markets are integrated. The distribution of equity returns is
assumed to depend on the state variable St, which takes on the values of zero
and one, as follows,
't = J1(St} + Zt,

where 't is the excess rate of return on equities, J1(St = O} = J1(0}, J1(St = I} =
J1(1}, (12(St = O) = (12(0), and a2(St = 1) = (12(1}.1
The state variable, St, is assumed to be the realization of a first-order Markov
process with transition probabilities,
P(St = 11 St-1 = I) = 7t11

P(St=0ISt-1 = 1)= 1-7t 11
P(St = 0 ISt-1 = O} = 7t00

P(St = IISt-1 = O} = 1-7t00.
This representation, which decomposes the time series of equity returns into a
sequence of random walks with drift, is more general than assuming that equity
values follow a random walk. Within a regime, equity values are assumed to
be a random walk with drift, but the regime can change stochastically. If stock
returns in one period are independent of the state that prevailed in the previous
period (7too = 1 - 7t11), this representation reduces to a random walk. On the
other hand, different values of the transition probabilities of the Markov chain
can yield a wide variety of stochastic behavior of stock returns. For example,
if the probability of remaining within a state is high, equity returns can display
the sort of 'long swings' that Engel and Hamilton (1990) use to describe
exchange rates. Finding long swings in the data would be consistent with
changes in the states resulting from infrequent changes in policies governing
the integration of markets (although other plausible explanations are
abundant).
Because we do not observe the realization of the state variable, St, we cannot
directly estimate the parameters of the model. Instead, we use the filtering
1 The random variable z, can follow an autoregressive process but the return data we analyze
do not appear to have an autoregressive component.
Table 1. Summary statistics for excess rates of return
Thailand Korea Taiwan

Mean 0.0101 0.0048 0.0121
Standard Deviation 0.0820 0.0849 0.1434
Autocorrelation at lag
1 0.0849 -0.0318 0.0545

2 0.0996 0.0775 0.0134
3 0.0227 -0.0196 -0.0838
4 -0.0836 -0.0062 0.0280
5 -0.0591 0.1006 0.0273
6 -0.0999 -0.0745 -0.0978
7 0.0647 0.0065 -0.0104
8 0.0585 0.0418 -0.1578
9 0.0804 0.0609 0.0736
10 0.0951 0.0074 0.1097
11 0.0123 -0.0785 0.0728
12 -0.0269 0.0816 0.1022
Q(l2) 13.9050 9.3520 10.4013
[0.3068] [0.6726] [0.4178]
Monthly data from January 1977 to December 1994 (216 observations) are used for Thailand and
Korea and January 1985 to December 1994 (120 observations) for Taiwan. The Q(12) statistic is
the Ljung-Box test for autocorrelation and is distributed as X2 ( 12). Under the null hypothesis that
returns are independently and identically distributed, the autocorrelations have an asymptotic
standard error of T-I/2, which is 0.068 for Thailand and Korea and 0.091 for Taiwan.
algorithm described by Hamilton (1988, 1990) to determine the probabilities,

P(St Ir" rt - 1 , rt -2, . ). These filter probabilities can then be used for maximum
likelihood estimation of the parameters describing the stochastic process gov-
erning returns.
The equity returns we use are the continuously compounded local currency
rate of return on each country's World Bank/IFC Emerging Markets index in
excess of a local short-term interest rate. 2 These indexes are market capitaliza-
tion-weighted averages of stocks selected to include actively traded issues with
broad sectoral diversity and are computed in a consistent way for a large
number of countries. The equity returns series include cash dividends and the
dividend implicit in rights issues with SUbscription prices below market price
as well as price changes. Estimation begins in January 1977 for Thailand and
Korea and January 1985 for Taiwan and ends in December 1994.
We provide some summary statistics in Table 1. Both the means and the
volatilities are high in all three markets. In Thailand and Taiwan, the average
excess rate of return on equities over the full sample exceeds 1% per month.
In Korea, the average excess return is about 0.5% per month. As Figure 1
suggests, Taiwanese equities are the most volatile of the three. The standard
deviation of excess rates of return is over 14% per month. The other two
2 The data are described more fully in the data appendix

Table 2. Univariate Markov switching models of excess equity returns
1/(0) -0.0083 0.0097 -0.0015

(0.0041) (0.0079) (0.0091)
1/(1) 0.0230 -0.0004 0.0304
(0.0092) (0.0121) (0.0290)
!r u 0.9712 0.9544 0.8972
(0.0260) (0.0304) (0.0506)
!roo 0.9529 0.9609 0.9307
(0.0272) (0.0279) (0.0372)
00 2 (0) 0.0013 0.0036 0.0044
(0.0002) (0.0009) (0.0009)
0-2(1) 0.0101 0.0109 0.0413
(0.0013) (0.0020) (0.0091)
Random walk 518.3668 375.3450 138.0197
[0.0000] [0.0000] [0.0000]
Log likelihood 262.6268 233.0155 81.4528
The results for Thailand and Korea are based on monthly data from January 1977 to December
1994 (216 observations) and the results for Taiwan are from January 1985 to December 1994 (120
observations). For each market, the excess returns on the national market index (r,) is computed
as continuously compounded returns in local currency in excess of local short-term interest rate.
A non-linear filter is used to estimate the equation, r, = I/(s,) + Z" where I/(s,) is the mean return
of the national index in state s,. z, is distributed normally with a mean zero and a variance 0-2(s,).
s, follows a first-order two-state Markov process with transition probabilities I/;,j = Prob(S, =ilS'-1 =
i). Standard errors are in parentheses.
markets have volatilities above 8% per month. In order to verify that infrequent
trading is not a severe problem, we also report autocorrelations of excess
returns. If infrequent trading is a problem, the month-end prices used to
compute the index will be averages of prices observed at different points in
time. This may induce serial correlation in the computed returns. 3 No evidence
of serial correlation is found in any of the excess returns.
Table 2 presents maximum likelihood estimates of the parameters of the
two-state Markov switching representation of equity returns from the three
markets that we are examining. Two states are clearly distinguished in all three
equity return series. In all three cases, the variance of excess returns is signifi-
cantly higher in state 1 than in state O. Only for Thai equity returns do we
find a statistically significant difference in mean returns, although the point
estimates of the mean returns in the two states are quite different for Taiwanese
equities. Interestingly, the diagonal elements of the transition probability matrix
are around 0.9 or higher in all three sets of estimates. Since the probability of
switching states is low, the expected duration of a regime is quite long. The
3Bailey et al. (1990) found evidence of autocorrelation in daily returns computed from local
market indexes for all three of the countries we consider, The absence of any autocorrelation in
our data may be due to the monthly sampling interval or due to differences in the composition of
the indexes,
large and highly significant estimates of nu and noo also suggest that equity
returns are highly dependent on the realization of the state variable in the
previous period. The null hypothesis that the data can be adequately described
by a random walk for equity values (noo = 1 - nu) can be rejected in all three
markets at any reasonable significance leve1. 4
Although a two-state description of the data is superior to a simple random
walk representation, the evidence does little to shed light on the causes of the
change in regime. Our interest in these data and in the procedures we are using
derives from hypotheses about the implications of changes in policies governing
market integration for the behavior of equity values. There is nothing in the
estimates that confirms or contradicts any of these hypotheses. As a result we
expand our model in the next section and consider the link between equity
returns in the three countries and the return on a world index of equities.
II. A TWO-STATE MARKOV SWITCHING MODEL OF MARKET INTEGRATION
The integration of domestic goods and capital markets with those abroad
imposes restrictions on the bivariate stochastic behavior of domestic and world
equity returns. In this section we examine a bivariate two-state Markov switch-
ing model of equity returns and use the estimates to draw inferences about the
extent to which integration of goods and capital markets is behind the behavior
of equity returns that we describe above. In doing so we allow the data to
dictate both when regime changes are observed and how the behavior of equity
returns differs across regimes.
Let r w.t be the return on a world index of equities expressed in local currency
terms and in excess of a short-term local currency interest rate. We will assume
that the distribution of r w.t is independent of the realization of the state variable,
St, so that,
r w.t = /lw + zw.t, Zw.t - N(O, u~).

Combining domestic and foreign equity returns into a vector, Rt> we have,
where the diagonal elements of L(St) are u 2 (St) and O"~ as above. The off-
diagonal element, Uiw(St = 0) = O"iw(O) and Uiw(St = 1) = uiw(I).
If the policies concerning increased market integration are the cause of the
change in the stochastic process governing domestic equity returns, there are
4 The series of short-term interest rates that are available from the three countries we are
examining may diverge from short-term market clearing rates to an extent that varies across
countries and over time. In order to determine if these problems with the short-term interest rate
series were affecting the results in an important way, we have also estimated two-state Markov
switching models for real rates of return on the equity indexes. The results are very similar to
those obtained using excess rates of return.
two sets of restrictions placed on the joint process set out above. First, if
domestic equity markets are segmented in state 0 but integrated with world
equity markets in state 1, a simple version of the capital asset pricing model
implies,
Although the assumptions needed to obtain this simple version of a capital

asset pricing model in an integrated world capital market are implausibly strict,
it will nonetheless be interesting to determine whether this restriction provides
a reasonable approximation of the behavior of equity returns. 5 Second, as
domestic goods markets become more integrated with world markets, one
would expect that the effect of foreign demand and productivity shocks on
domestic firms should increase. As a result, one might expect equity values in
the home market to vary much more closely with those abroad. Increased
goods market integration would therefore imply O"iw( 1) > O"iw(O). In addition,
to the extent that changes in investor's preferences lead to changes in equity
prices, increased capital market integration might also be expected to imply
O"iw(1) > O"iw(O). This increased association might alternatively be expressed in
terms of the 'beta' of domestic equities in the two states, in which case one
would expect Piw( 1) = O"iw( 1)/O"~ > Piw(O) = O"iw(O)/O"~.
Table 3 presents the maximum likelihood estimates of the bivariate two-
state Markov switching representation of excess equity returns, R,. We estimate
three systems, each consisting of the excess returns on equities in one of the
three national markets that we are examining along with the excess local
currency rate of return on the Morgan Stanley Capital International world
index. Table 3 presents the estimates for the unconstrained systems as well as
those for the systems when the CAPM restrictions are imposed on the mean
return in state 1. We believe the results are quite striking and help shed
considerable light on the nature of the change in the stochastic behavior of
equity returns in the three markets.
The first two columns present the results for unconstrained and constrained
systems for Thai equity returns. The estimates of the parameters they have in
common are similar so we focus on the unconstrained estimates. As is the case
with the univariate estimates, two states are clearly distinguished in the data
and the estimated probabilities of changing states are 10% or less. The null
hypothesis that the data can be adequately described by a random walk is
rejected at any reasonable significance level with a X2 ( 1) statistic in excess of
400 for both the constrained and the unconstrained estimates. The mean excess
returns in the two states differ significantly, with the return in state 0 estimated
to be less than zero while the mean excess return in state 1 is estimated to be
nearly 4% per month. The negative estimate of the mean return on Thai
5 As is well known, a sufficient condition for the simple CAPM to be a valid description of
equilibrium real rates of return on equities is that relative purchasing power parity holds. A useful
survey of the main results in international asset pricing is found in Stulz (1992).
Table 3. Two-state bivariate markov switching model
liw 0.0029 0.0029 0.0013 0.0013 0.0038 0.0038

(0.0028) (0.0034) (0.0030) (0.0030) (0.0041) (0.0041)
11(0) -0.0086 -0.0080 0.0104 0.0096 -0.0024 -0.0012
(0.0042) (0.0041) (0.0076) (0.0075) (0.0093) (0.0145)
11(1) 0.0268 -0.0006 0.0383
(0.0094) (0.0113) (0.0283)
1lu 0.9493 0.9722 0.9613 0.9542 0.8983 0.8980
(0.0410) (0.0197) (0.0281) (0.0315) (0.0498) (0.0505)
1100 0.9667 0.9540 0.9582 0.9606 0.9383 0.9303
(0.0234) (0.0266) (0.0285) (0.0282) (0.0498) (0.0377)
~ 0.0017 0.0017 0.0019 0.0019 0.0021 0.0021
(0.0002) (0.0002) (0.0002) (0.0002) (0.0003) (0.0003)
O"iw(O) 0.0000 0.0000 0.0002 0.0003 0.0002 0.0002
(0.0002) (0.0002) (0.0004) (0.0004) (0.0005) (0.0005)
0-2(0) 0.0013 0.0013 0.0036 0.0037 0.0044 0.0044
(0.0002) (0.0002) (0.0009) (0.0009) (0.0009) (0.0009)
O"iw(l) 0.0017 0.0016 0.0010 0.0011 0.0025 0.0024
(0.0002) (0.0004) (0.0004) (0.0004) (0.0005) (0.0011)
0"2(1) 0.0102 0.0106 0.0104 0.0106 0.0399 0.0408
(0.0002) (0.0014) (0.0009) (0.0019) (0.0009) (0.0088)
Random 424.6260 560.2535 435.8500 356.904 141.0099 137.7457
walk [0.000] [0.000] [0.000] [0.000] [0.000] [0.000]
Log- 652.7284 648.9340 608.0681 607.562 285.2918 284.5480
likelihood
p(O) 0.0068 0.1093 0.0766
(0.1096) (0.1419) (0.1635)
p(l) 0.3975 0.2350 0.2720
(0.0773) (0.0856) (0.1113)
P(O) 0.0060 0.1497 0.1119
(0.0967) (0.1980) (0.2387)
P(l) 0.9659 0.5504 1.1988
(0.2116) (0.2120) (0.5161)
Implied -0.0086 0.0102 -0.0029
tax(O) (0.0042) (0.0076) (0.0095)
Implied 0.0241 -0.0013 0.0338
tax( 1) (0.0089) (0.0112) (0.0277)
The results for Thailand and Korea are based on monthly data from January 1977 to December
1990 (168 observations) and the results for Taiwan are from January 1985 to December 1990 (72
observations). For each system, the excess returns on the national market index (r,) and the world
index (r w,,) are computed as continuously compounded returns in local currency in excess of local
short-term interest rate. A non-linear filter is used to estimate the following system, r, = II(S,) + z"
r w,' = IIw + zw,l' where IIw is the mean return of the world index and II(S,) is the mean return of the
national index in state s,' Z, == {z" zw,,} is distributed normally with a zero-mean vector and a
variance covariance matrix L(S,), Vec(L(S,)) = {u 2(s,), Uiw(S,), u~)}, s, follows a first-order two-
state Markov process with transition probabilities 1li.j = Prob(S, = jlS'_1 = i), Standard errors are
in parentheses, In the constrained system, II(S, = 1) = IIwO"iw(S, = 1)/O"~,
equities in state 0 presents some problems. Since we are interpreting state 0 as

one of segmented markets, if investors can choose between riskless borrowing
and lending and risky domestic equities, the expected return on equities should
be proportional to the variance of the return in state 0. 6
The most striking of this set of estimates is the behavior of the covariance
between local and foreign equity returns in the two states. The estimated
covariance in state 0 is close to zero both in an economic and statistical sense.
The estimated covariance rises sharply in state 1 and is highly statistically
significant. Since the magnitude of co variances is often difficult to interpret, it
is useful to consider the Pof Thai equities, which changes from 0.006 in state 0
to 0.966 in state 1, or the correlation of Thai and world equities, which changes
from less than 0.01 to about 0.4. This change in the covariance of Thai and
world equity returns strongly suggests a fundamental change in the degree to
which Thai markets were integrated with those abroad.
Is the behavior of Thai equity returns in state 1 (the integrated state)
consistent with the predictions of a simple CAPM of an integrated world
capital market? Comparing the log likelihood values for the constrained and
unconstrained estimates points to a clear rejection of the constraint, 11( 1) =
I1 wO'iw(1)jO';. Thus, the behavior of equity returns on the Thai stock market
cannot be explained by a simple model of capital market integration. The
reason for this rejection is quite clear. Using the estimates of the unconstrained
model, we can compute an implied value of 11( 1) from the estimated values of
I1w, O'iw( 1), and 0';.
Since the estimate of I1w is 0.29% per month and the P of
Thai equities in state 1 is just under 1.0, the implied value of 11( 1) falls far short
of the unconstrained estimate for 11( 1) of 2.68 % per month.
Stulz's (1981) model of capital market equilibrium with barriers to invest-
ment implies that the difference between the unconstrained and the constrained
estimates of 11( 1),2.41 % per month, can be interpreted as the tax rate equivalent
of barriers to international investment. 7 While this estimate of the extent of
investment barriers is large, Bailey and Jagtiani (1994) report that Alien Board
shares in Thai firms traded at a sizable premium during the 1988-1990 period.s
6 Turner et al. (1989) find negative expected excess returns in one state of their two-state Markov
switching model of US equity returns.
7 Legal restrictions on the proportion of foreign ownership of shares issued by Thai companies
vary across industries and across firms in an industry. In addition, some firms impose restrictions
more stringent than the legal restrictions. In September 1987, the Stock Exchange of Thailand
created an 'Alien Board' for trading by foreigners in the shares of Thai firms with binding foreign
ownership restrictions. Bailey and Jagtiani (1994) study the variation of the premium on Alien
Board shares over time. The Far East Economic Review (2/26/87) reports that the lack of meaningful
English-language research impedes foreign investment in the Thai stock market even when foreign
ownership restrictions are not binding.
S In August 1985, the first of what are now seven closed-end Thai equity funds began trading
in London. This was followed by Thailand fund, which also trades in London, in December 1986.
These two funds are currently the smallest of the closed-end Thai funds and were followed in 1988
by five more funds, one of which trades on the NYSE. At the end of 1990, the net asset value of
Both this sizable premium over identical shares available only to domestic
investors and the difference between the constrained and unconstrained esti-
mates of J1( 1) point to substantial barriers to international investment.
The evidence that investment barriers are important in state 1 is also
consistent with the results of Khanthavit and Sungkaew (1993) who estimate
a latent variables version of a conditional capital asset pricing model with
investment restrictions. They find statistically significant evidence of investment
barriers using Thai stock returns from 1986 through 1989 and their estimates
of the magnitude of implied tax rate are even larger than those obtained here. 9
If Thai equity markets are (at least partially) segmented in both states, the
higher expected equity return in state 1 should be reflected in a larger variance
of returns in state 1 (or in a higher market price of risk).l0 The estimates do
point to highly volatile returns in state 1, with the estimated variance exceeding
the variance of returns in state 0 by a factor of nearly 8 and exceeds the
variance of returns on the world index by a factor of 6. Thus, the very high
estimated mean return in state 1 is associated with a similarly large estimated
variance of returns.
The third and fourth columns of Table 3 present the estimates for the
unconstrained and the constrained bivariate two-state Markov models for
Korean and world equity returns. Again, we will focus on the unconstrained
estimates. As was true with the estimates for Thai equity returns, two states
are clearly distinguished in the data, the probabilities of changing states are
both less than 10%, and again, the null hypothesis that equity prices follow a
random walk is rejected at any reasonable significance level. Unlike the Thai
estimates, the mean return in state 0 exceeds the mean return in state 1,
although both are imprecisely estimated and neither is significantly different
from zero.
Moving from state 0 to state 1 there is a striking increase in the covariance
of Korean and world equity returns just as is the case with the Thai data. In
state 0 the estimated covariance is small and insignificantly different from zero
while in state 1 the estimated covariance is large and highly significant. Once
again it is useful to look at the f3 of Korean equities and the correlation of
Korean and world equity returns as a means of assessing the change in the
these funds amounted to $600 million or 2.5% of the Thai market capitalization. Bosner-Neal
et al. (1990) report that during 1988, a year that is classified by the filter to be, with high probability,
in state 1, the closed-end Thai fund traded in the USA at an average premium over net asset value
of 25.46%. While this premium is consistent with the existence of barriers to foreign investment,
the evidence in Bailey and lagtiani (1994) suggests that there are substantial differences in the
behavior of the premium on the closed end Thai funds and the premium on Alien Board shares.
9 As we discuss below, this period is one that is generally classified by our estimates as
characterized by state 1.
10 An increase in growth rates of output, which might lead to an increase in expected earnings
growth, cannot alone explain a higher average return on equity. Without an increase in the rate
at which future earning are discounted, an increase in the growth rate of future earnings should
lead to a discrete jump in equity values.
estimated magnitude of the covariance. The small covariance in state 0 corres-

ponds to a low state 0 P of Korean equities of 0.15 as well as a low estimated
correlation of Korean and world equity returns in state 0 of 0.11. Neither is
significantly different from zero. In contrast, the state 1 Korean P is 0.55 and
the state 1 correlation is 0.24 and both estimates are highly significant. Although
the state 1 values for both the P and the correlation coefficient are smaller
than the corresponding state 1 values for Thai equities, they nonetheless suggest
substantially greater integration of Korean markets in state 1 than in state O.
Are the estimates consistent with capital markets that are segmented in
period zero and integrated in period one? The evidence in favor of capital
market integration characterizing period one is considerably greater for Korean
equities than it is for Thai equities. The decline in average excess equity returns
in state 1 despite an increase in the estimated variance of excess returns by a
factor of nearly three is consistent with greater integration of capital markets.
In addition, the log-likelihood value changes by less than 0.6 when the CAPM
restrictions are imposed on the data. On the other hand, given the imprecision
with which mean returns for the two states are estimated, one might expect
that the failure to reject the CAPM restrictions is simply a reflection of the
lack of precision. Because the mean excess return on world equities is 0.13%
per month, while the unconstrained estimates of O"iw( 1), and O"~ yield a state 1
P of 0.55 for Korean equities, the implied value of /1(1) is 0.07% per month.
Although this value is well within a 95% confidence interval around the
unconstrained point estimate of /1(1), it exceeds that point estimate by 0.13%
per month. While this tax rate equivalent of the barriers to investment is not
statistically significantly different from zero, it is large relative to the implied
value of /1( 1).
The evidence presented in Bosner-Neal et. al. (1990) indicates that the
closed-end Korea fund traded in the USA at a substantial premium over net
asset value during much of the period,u It is then difficult to draw any clear
implications about the extent of capital market integration in state 1.
Columns five and six in Table 3 present the unconstrained and constrained
estimates of the bivariate two-state representation of Taiwanese and world
excess equity returns. Because the World Bank/IFC emerging markets index
for Taiwanese equities begins only in December 1984, the sample used in
estimation of this third system is considerably smaller than that used to estimate
the other two systems. Once again, we will focus our discussion on the uncon-
strained estimates. The probabilities of changing states are again around 10%
11 While two closed-end Korea funds were created in November 1981, both are small funds and
are not listed on any exchange. The largest of the seven closed-end Korea funds that are now
traded is the Korea Fund, which was created in August 1984 and trades on the NYSE. The second
largest, the Korea Europe Fund was created in March 1987 and trades on the London exchange.
At the end of 1990, the net asset value of the seven funds was $413.6 million or 0.37% of Korean
market capitalization. The evidence presented in Bailey and Lim (1992) and in Bailey and Jagtiani
(1994) suggests that the premium on the closed-end funds might be an unreliable measure of the
degree of investment restrictions, however.
or less and the null hypothesis that Taiwanese equity prices follow a random
walk is rejected at any reasonable significance level. The estimates from the
Taiwanese system have a great deal in common with those from the Thai
system. The estimated mean excess return in state 1 exceeds the estimated mean
excess return in state O. Unfortunately, possibly due to the small sample, neither
mean is estimated sufficiently precisely to allow us to distinguish it statistically
from zero at standard confidence levels.
As is the case in the systems estimated using excess returns on Thai and
Korean equities, the estimated covariance of Taiwanese equity returns with
returns on the world index is sharply higher in state 1. Once again, the
covariance is small and insignificant in state 0 and large and significant in
state 1. The estimated P for Taiwanese equities rises from 0.11 in state 0 to
1.20 in state 1 and the correlation between excess returns on Taiwanese equities
and the excess returns on the world index rises from 0.08 in state 0 to 0.27 in
state 1. The similarities across the three markets in the behavior of the estimated
covariance is striking. In all three markets, there is strong evidence of consider-
ably greater covariance between local and foreign equity returns in state 1 than
in state O. This evidence is consistent with greater integration of goods and
possibly capital markets in state 1 in all three countries.
The restrictions on the mean excess return in state 1 that are implied by a
CAPM do not lead to a sufficiently large increase in the log-likelihood values
to lead to rejection of those restrictions. A number of aspects of the estimates
suggest that this failure to reject is due to the relatively small sample and the
consequent imprecision with which the parameters, especially the means, are
estimated. The value of p( 1) that is implied by the unconstrained estimates of
O"iw(1), and, O"~, along with the estimate of Pw is 0.46% per month. While this
value is well within a 95% confidence interval around the unconstrained point
estimate of p(1), it falls short of that point estimate by 3.38% per month.
Although this tax rate equivalent of the barriers to investment is not statistically
significantly different from zero, it is so large that the failure to reject the
CAPM restrictions should not be interpreted as evidence that they, in fact, hold.
Because the evidence does not support the hypothesis that Taiwanese capital
markets are integrated in state 1, the change in the mean return between
states 0 and 1 should reflect a higher variance of excess returns in state 1. The
estimated variance is substantially larger in state 1. In fact, given the size of
the increase in the estimated variance, the increase in the estimated means is
remarkably small. The much greater proportional increase in the variance of
returns might suggest some partial integration of capital markets in state 1,
although the imprecision with which the means are estimated makes it difficult
to draw any firm conclusions.
Figure 2 presents the estimates of the probabilities that Sf = 1 based on data
through period t, P(St I rp r~ , rt - 1, r~-1' ... ). Three episodes are clearly visible in
the filter probabilities for Thai equity returns. The probability that the begin-
ning of the sample is drawn from state 1 is high. This period corresponds to a
late 1970s stock market boom and subsequent crash that is also reflected in
Filter Probabilities of State::;: 1

Thai Stock Market, 1977 - 1994
0.8
~0.6
~
J::J
0.4
0.2
O-'------------------.----.J
1977 1979 1981 1983 1985 1987 1989 1991 1993
Filter Probabilities of State::;: 1

Korean Stock Market, 1977 - 1994
0.8
~0.6
~
0.4
0.2
q977 1979 1981 1983 1985 1987 1989 1991 1993
Figure 2. Filter probabilities of State = 1.
Figure 1. This period preceded the liberalization measures that have motivated
our examination of the behavior of stock prices, and is commonly attributed
to market manipulation in a what was at the time a rather small and thin
market. During the first part of the 1980s the probabilities that the data are
drawn from state 1 are generally low (apart from a spike in September 1982),
and then rise sharply in mid-1986. In the mid-1980s, the Thai authorities
removed several barriers to foreign investment and pursued policies of deregula-
tion. At the same time they adopted export promotion policies that included
exchange rate changes as well as tax and other incentives for export manufactur-
ing. 12 Exports both grew rapidly and expanded beyond traditional commodity
12 Far Eastern Economic Review (6/25/87) and Economist (11/6/91).

Filter Probabilities of State = 1

Taiwanese Stock Market, 1985 - 1994
0.8
&,0.6
~
.D
0.4
0.2
1986 1987 1988 1989 1990 1991 1992 1993 1994
exports. In the second half of the 1980s, Thailand was the world's fastest
growing economy. Rapid growth was accompanied by a boom in stock prices.
This period of high growth in output and exports as well as high average stock
returns is classified by the data as being drawn from state 1 with high prob-
ability. The filter probabilities and the parameter estimates from the two-state
model provide a consistent and convincing case that changes in behavior of
equity values are consistent with greater integration and these changes coincide
with changes in the economic policies of the authorities. The measures that
began the process of integrating Thai equity markets with those abroad do
not, however, appear to have led to full integration.
These results are also consistent with those of Bekaert and Harvey (1995)
who estimate a model of partially segmented markets (expected returns depend
on both the covariance with a world index and on the variance of returns)
with changes in regimes. They find that probability that the data are consistent
with integration is low in the early 1980s and rises in the mid-1980s.
The estimated filter probabilities for Korean equities exhibit somewhat more
puzzling behavior. The probability that the high variance (and low mean) state
is governing returns is low until the second quarter of 1979 when it rises
sharply. The probability remains high until the fourth quarter of 1982, when
it rises before falling again in the summer of 1988. A final rise and fall in the
probability occurs in the second quarter of 1990 and the first half of 1993,
respectively. It is difficult to fit these estimated probabilities with the conse-
quences of market integration policies. At least three explanations are plausible.
First, political developments have been important in Korea during the sample
and may account for some of the behavior of equity returns. Second, the
parameter estimates seem to suggest that partial capital market integration
played a role in Korean equity values in the sample. Partial capital market
252 RE. Cumby and A. Khanthavit
integration is consistent with foreign participation in the Korean stock market.

Foreign investors were not allowed direct access to the Korean stock market
until the beginning of 1992 and since then have been subject to restrictive
ceilings on foreign ownership. On the other hand, since 1981 foreign investors
have been able to invest in Korean equities through mutual funds. 13 Third, the
export oriented economic policies that seem to play an important role in Thai
equity values were adopted by Korea much earlier and predate our sample. It
may be therefore difficult to tie the behavior of Korean equities to the conse-
quences of policies governing market integration. These explanations suggest
that while there are clearly discernable regimes in Korean equity returns, it is
difficult to attribute these to policies concerning economic integration.
As is the case with the filter probabilities computed from Korean stock
returns, estimated probabilities that the Taiwanese equity return data are drawn
from state 1 do not follow a temporal pattern that is clearly linked to liberalizing
policies. During the first part of the sample, the probability that the data are
drawn from state 1 is small. The probability then rises sharply in April 1987
and, apart from a temporary drop in the fourth quarter of 1989, remains high
until mid-1991. The estimated probability then remains low for much of the
remainder of the sample but there are episodes in both 1993 and 1994 that are
classified as belonging to state 1.
The stock market boom, which occurs during a period generally classified
as state 1, coincided with an export boom and an increase in direct investment
by overseas Chinese in Taiwan. At the same time the authorities adopted some
policy changes that encouraged foreign investment including a suspension of
foreign exchange controls in 1987 and a loosening of restrictions on capital
inflows in 1989. 14 But, like Korea, the adoption export oriented policies in
Taiwan predates our sample and, also like Korea, Taiwan has adopted only
partial capital market opening. Foreign participation in the stock market was
limited to mutual fund for much of the sample. 1s In 1991 foreign institutional
investor were allowed access to the Taiwanese market, albeit subject to owner-
ship restrictions. 16
III. WERE STOCK PRICE RUN-UPS COMMON IN SMALL MARKETS IN THE

1980s?
Are the changes in the behavior of excess equity returns described above due
to changes in policies concerning market integration or are they some feature
of the data that we mistakenly attribute to economic liberalization? To help
13 The Korea trust began in 1981. The number of Korea funds has grown and by the end of
the sample more than 30 Korea funds were trading.
14 Far Eastern Economic Review (1/1/87, 3/26/87, and 5/21/87) and Moreno and Yin (1992).
15 From 1983 until 1991 foreign investors were restricted to four approved funds.
16 Bekaert and Harvey (1995) estimate a fairly stable probability of integration that is close to
one throughout the sample both for Taiwan and for Korea.
answer this question, we look at four additional relatively small national

markets, all of which have long-standing links with external goods and capital
markets, and two of which are Asian. If we find that equity values in these
countries exhibit behavior that is similar to that found in the three national
markets examined in section II, it will be difficult to attribute that behavior to
economic liberalization.
Table 4 presents the estimates of the unconstrained two-state bivariate
Markov switching model obtained using excess rates of return on the national
market indexes for Canada, Netherlands, Singapore and Hong Kong. Once
again, two states are clearly distinguished in the data. The probability of
changing state is estimated to be 12% or less. As described above, the variances
of the excess return on all four national market indexes is substantially higher
in state 1 than in state O. As one would expect, the variance of the Singapore
and Hong Kong markets are larger than the variances of the Canadian and
Dutch market in both states. Apart from these few similarities, the results in
Table 4 differ from the results in Table 3 in important ways.
In all four markets, the estimated covariance is significantly different from
zero in both states. While the distribution of returns differs in the two states,
and the estimates of the P of the local market and the correlation of the local
and world market indexes therefore differ across states, in none of these four
countries do we observe the sharp differences in both P and p that we find in
Table 3. Finally, the unconstrained estimates for all four markets are consistent
with the CAPM restrictions as can be seen by the implied tax terms that are
small and insignificantly different from zero. These results seem clearly to
suggest that the behavior of the equity returns in the Thai, Korean and
Taiwanese markets are not due to stock market boom that is widely shared
across countries and the behavior of returns in those markets differ from the
behavior of returns in countries with long-standing links to world goods and
capital markets.
IV. CONCLUDING REMARKS
We have estimated a bivariate two-state Markov switching model of excess

returns on both domestic equities and a world index of equities for three Asian
countries, Thailand, Taiwan, and Korea. Our reason for doing so is to determine
if changes in the behavior of equity returns can be linked to changes in policies
governing the integration of these economies and their capital markets with
world markets.
We find clear evidence of (at least) two quite different regimes in the stochas-
tic behavior of excess equity returns in all three countries. In all three cases,
one regime is characterized by a low variance of domestic equity returns and
a low P of domestic equities relative to the world index. The other regime is
characterized by a high variance of domestic equity return and a high Prelative
to the world index. The differences across states in the covariance of the local
Table 4. Two-state bivariate Markov switching model for comparison countries
Canada Netherlands Singapore Hong Kong
JI. .. 0.0043 0.0032 0.0035 0.0076

(0.0027) (0.0031 ) (0.0027) (0.0028)
JI.(O) 0.0010 0.0071 0.0098 0.0183
(0.0031) (0.0029) (0.0046) (0.0064)
JI.(l) 0.0074 0.0043 -0.0055 0.0024
(0.0078) (0.0057) (0.0128) (0.0148)
Til 0.9410 0.9593 0.8848 0.9280
(0.0526) (0.0286) (0.0586) (0.0577)
Too 0.9798 0.9772 0.9487 0.9446
(0.0526) (0.0177) (0.0256) (0.0320)
(f2 0.0016 0.0021 0.0016 0.0017
w
(0.0001) (0.0002) (0.0002) (0.0002)
(f;",(0) 0.0008 0.0013 0.0015 0.0011
(0.0001) (0.0002) (0.0002) (0.0004)
(f2(0) 0.0013 0.0014 0.0027 0.0035
(0.0002) (0.0002) (0.0004) (0.0009)
(f;",(1 ) 0.0021 0.0021 0.0014 0.0016
(0.0001) (0.0002) (0.0002) (0.0004)
(f2( 1) 0.0051 0.0037 0.0109 0.0153
(0.0002) (0.0002) (0.0004) (0.0009)
Log-likelihood 801.9077 804.4643 707.8459 615.1453
Random walk 218.7964 579.2031 130.8685 133.4415
[0.000] [O.oooJ [0.000] [0.000]
p(O) 0.5498 0.7695 0.7139 0.4601
(0.0585) (0.0383) (0.0593) (0.1509)
p(l) 0.7402 0.7424 0.3353 0.3197
(0.0554) (0.0475) (0.0923) (0.0970)
P(O) 0.5114 0.6345 0.9312 0.6571
(0.0697) (0.0494) (0.1136) (0.2207)
P(l) 1.3379 0.9760 0.8757 0.9499
(0.1880) (0.1026) (0.2534) (0.3235)
Implied -O.ooll 0.0051 0.0066 0.0133
tax(O) (0.0028) (0.0022) (0.0037) (0.0067)
Implied 0.0016 0.0011 -0.0086 -0.0048
tax(l) (0.0068) (0.0049) (0.0126) (0.0153)
The results are based on monthly data from January 1977 to December 1990 (168 observations).
For each system, the excess returns on the national market index (r,) and the world index (r",.,)
are computed as continuously compounded returns in local currency in excess of local short-term
interest rate. A non-linear filter is used to estimate the following system, r, = JI.(s,) + Z, r ".' = JI. .. +
z""" where JI. .. is the mean return of the world index and JI.(s,) is the mean return of the national
index in state Sr' Z, == {Z" z.,.,) is distributed normally with a zero-mean vector and a variance
covariance matrix 1:(S,). Vec(1:(S, = {(f2(S,), (f;.,(s,), (f~)}. s, follows a first-order two-state markov
process with transition probabilities T;.} = ProbeS, = jl S'-1 = i). Standard errors are in parentheses.
market returns with the world index is consistent with greater integration of
goods and capital markets in the high-covariance, high-P state. We find, how-
ever that the even in the 'integrated' state, equity returns are not consistent
with a simple, single-p model of an integrated world capital market. For all
three countries our estimates suggest that stock returns are higher than would
be predicted by a simple CAPM.
Only for Thailand is the temporal behavior of the probability that the high-
covariance state is generating the data consistent with a change in government
policies leading to greater goods and capital market integration. The estimated
probabilities indicate quite clearly that a regime change occurred in the
mid-1980s. The early 1980s are characterized by the low-covariance state,
'segmented' state and thereafter, the data are generated by the high-covariance,
'integrated' state. The estimated probabilities for Korean and Taiwanese equi-
ties fail to show a sustained change from the low-covariance state to the high
covariance state. But, unlike Thailand, both of these countries adopted export-
oriented trade polices before our sample begins. And both liberalized capital
markets later than Thailand. The temporal behavior of the estimated probabili-
ties for these two countries suggests that differences in regimes are directly
linked to policy changes leading to liberalization. The results seem to be more
consistent with partial integration of capital markets, perhaps with investment
barriers more important in some periods than in others.
ACKNOWLEDGMENTS
Warren Bailey, Mario Crucini, Rene Stulz, John Ammer, seminar participants
at Ohio State University, and participants in this conference on the future of
emerging market capital flows provided helpful comments on earlier versions
of this paper. Those comments along with financial support from the Salomon
Brothers Center for the Study of Financial Institutions and research assistance
from Simi Kedia are acknowledged with thanks.
REFERENCES
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pacific basin stock markets: evidence and implications. In S.G. Rhee and R.P. Chang (eds), Pacific
Basin Capital Markets Research. Amsterdam: North-Holland, 155-171.
Bailey, Warren and Julapa Jagtiani (1992). Time-varying premiums for international investment:
some empirical evidence. Journal of Financial Economics, 36, 57-87.
Bailey, Warren and Joseph Lim (1992). Evaluating the diversification benefits of the new country
funds. Journal of Portfolio Management, Spring, 74-80.
Bekaert, Geert and Campbell R. Harvey (1995), Time-varying world market integration. Journal of
Finance, 50, 403-444.
Bosner-Neal, Catherine, Greggory Brauer, Robert Neal and Simon Wheatley (1990). International
investment restrictions and closed-end country funds. Journal of Finance, 45, 523-547.
Bowring, Phillip (1987). While others falter. Far Eastern Economic Review, June 25, 68-70.
Bowring, Phillip and Carl Goldstein (1987). Profitable pragmatic politics. Far Eastern Economic
Review, May 21, 97.
Carter, Liz (1987). Bangkok beckons despite the hurdles. Far Eastern Economic Review, February
26,68-69.
Engel, Charles and James D. Hamilton (1990). Long swings in the dollar: are they in the data and
do markets know it? American Economic Review, SO, 689-713.
Goldstein, Carl (1987). Their own worst enemy. Far Eastern Economic Review, January 1, 59.
Goldstein, Carl. (1987). A cash-stuffed case for investment. Far Eastern Economic Review, March
26,74-75.
Goldstein, Carl (1987). A promise offreedom. Far Eastern Economic Review, May 21, 66.
Hamilton, James D. (1988). Rational expectations econometric analysis of changes in regime: an
investigation of the term structure of interest rates. Journal of Economic Dynamics and Control,
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Hamilton, James D. (1990). A new approach to the economic analysis of non stationary time series
and the business cycle. Econometrica, 57, 357-384.
Khanthavit, Anya and Jirat Sungkaew (1993). Measuring Thailand's barriers to investment. Pacific
Basin Finance Journal, 1, 355-367.
Moreno, Ramon and Norman Yin (1992). Exchange rate policy and shocks to asset markets: the
case of Taiwan in the 1980s, Federal Reserve Bank of San Francisco. Economic Review, 1, 14-30.
Stulz, Rene M. (1981). On the effects of barriers to international investment. Journal of Finance,
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Stull, Rene M. (1992). International Portfolio Choice and Asset Pricing: An Integrative Survey.
Working paper, Ohio State University.
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World Bank/International Finance Corporation, Emerging Stock Markets Factbook, various issues
DATA ApPENDIX
Domestic Stock Returns: a. Thailand, Korea, and Taiwan: Computed as the

change in the log of the World Bank/IFC Emerging Markets Return Index
(dividends reinvested). Source: World Bank/International Finance Corporation,
Emerging Stock Markets Factbook; b. Canada, Netherlands, Singapore, and
Hong Kong: Computed as the change in the log of the Morgan Stanley Capital
International market index plus the log of 1 plus the ratio of current period
dividends to last period price. Source: Morgan Stanley Capital International,
Perspectives.
Short-Term Interest Rate: a. Thailand: Continuously compounded interbank
lending rate. Source: Bank of Thailand, Quarterly Review; b. Korea:
Continuously compounded call money rate. Source: International Financial
Statistics; c. Taiwan: Continuously compounded discount rate. Source: Central
Bank of China, Financial Statistics; d. Canada and Netherlands: Continuously
compounded one-month Eurocurrency deposit rate. Source: Morgan Guaranty,
World Financial Markets; e. Singapore: Continuously compounded interbank
lending rate. Source: International Financial Statistics; f. Hong Kong:
Continuously compounded three-month deposit rate until February 1985 and
continuously compounded one-month interbank rate after February 1985.
Source: Hong Kong Monthly Digest of Statistics.
Exchange Rate: End-of-period exchange rate in local currency per US dollar.

Source: International Financial Statistics.
World Equity Returns: Continuously compounded rate of return on the
Morgan Stanley Capital International World Index (In [(P,/P,-t)
(1 + +DY,/1200)], where P, is the value of the index at the end of t and DY,
is the period-t dividend yield). Source: Morgan Stanley Capital International
Perspectives.
KISHORE TANDON
Baruch College (City University of New York)
9. External financing in emerging markets:

an analysis of market responses
ABSTRACT
This chapter examines the response of stock prices in emerging capital markets to the
announcement of events highlighting the opening of capital markets. The announcements
analyzed in this research are the private corporate Eurobond offerings and launching of
emerging-market country mutual funds. Corporate Eurobond issues in emerging markets
are associated with positive abnormal returns to the underlying stock around the successful
offering. In addition, the launching of an emerging-market closed-end country fund is
preceded by sharp increases in the underlying stock market index as well as an equally
weighted portfolio of the top firm holdings of the country fund. There are sharp increases
in the month of the fund launching but stock prices decline in the months following the
offering. There is a marked reduction in volatility of stock returns following the introduction
of the country fund, implying that better and more critical monitoring by fund managers
and analysts results in the emerging markets becoming less speculative and more disciplined.
INTRODUCTION
In a fast changing global landscape, the rapid development and deregulation

of their capital markets has led to a pattern in which many emerging economies
have reduced their reliance on traditional forms of external finance, including
commercial bank lending and development financial institutions (DFIs).
The increasing competition for private funds in the 1990s is pressuring these
emerging economies into wooing foreign direct investment, joint ventures,
quasi-equity contracts, licensing agreements, etc. In addition, emerging markets
are starting to become regular issuers of global securities (stocks, bonds and
mutual funds).
The spectacular growth of emerging economies in the south-east Asia, Pacific
and Latin American region is turning corporations from the region into regular
participants to the international fund raising markets. Private capital is being
raised in the form of foreign bonds, Eurobonds, Euroequities, Global and
American Depositary Receipts (ADRs) including Rule 144A ADRs, sponsoring
country mutual stock funds, equity-linked instruments like warrants and con-
vertible bonds and lately through private placements under Rule 144A. With
rapid GDP growth rates in recent years, increasing market liberalization, and
depleted funds at their DFls, the growing need for private capital in emerging
economies has not been fully met by local capital markets. A growing number
259
:> 1998 Kluwer Academic Publishers.
260 K. Tandon
of companies are realizing that overseas offerings can make up for the shortfall,
as well as enhance their exposure in the international markets, despite some
initial bumps for some. The developed world's appetite for global diversification
has made it easier for many to raise offshore funds, while financial deregulation
and economic liberalization aimed at creating strong domestic capital markets
has expanded the list of potential overseas issuers from emerging markets. The
dismantling of domestic barriers to foreign investment, booming stock markets
in Brazil, India, Turkey, Mexico and others, and an impending wave of priva-
tizations are creating worldwide investor demand for the increasing amount of
new paper from these countries. The 'torrid pace' of Eurobond offerings is
expected to continue well into the nineties, with nearly 40 offerings in 1994
from India alone, totalling over $5 billion.
Eurobond offerings started to take off in the emerging markets only in 1990,
while the international equity-related issuances (in the form of global and
ADRs) are also becoming increasingly popular. Such Eurobond offerings had
been popular among the developing economies in the mid-1970s, but private
issuers in emerging markets were locked out in the 1980s, regaining access to
this source of funding in the 1990s. Eurobond offerings in the USA have been
researched by Kim and Stulz (1988,1992) and Kidwell et al. (1985). However,
no study has analyzed such issues by corporations in emerging capital markets.
This study attempts to fill that gap by examining the announcement effect of
such offerings on shareholder wealth.
We also examine the effect on shareholder wealth of gaining access to an
emerging market through a newly created investment instrument like a closed-
end country mutual fund. Sponsored country mutual funds from emerging
markets have become increasingly popular in the last 5 years. Recent research
by Bailey and Lim ( 1992), Diwan, Errunza and Sen bet ( 1993) and Hardouuvelis
et al. (1993) have analyzed the post-offering performance of closed-end country
funds from emerging and developed markets by studying their market prices,
net asset values, the premium/discount patterns and benefits of diversification
to US investors. However, none of them analyze the impact of the fund offering
on the underlying local market index.
Recent research analyzes a number of policy issues pertaining to the macro-
economic effects of large capital inflows and their effect on stock market
behavior (Claessens and Gooptu, 1993). Policy makers are also grappling with
the issue of the effect of portfolio flows on the cost of capital of the issuing
firm, though this research does not address this issue. If these issues are wealth-
generating for shareholders, we may expect more of them.
BACKGROUND AND THEORY
Eurobonds
Several studies have documented the advantages of Eurobonds over domestic

and/or foreign bonds. Bonds issued in the local market and in the local currency
External financing in emerging markets 261
are called domestic bonds, while bonds issued in the international markets are
called foreign bonds or Eurobonds. Eurobonds are underwritten by an inter-
national syndicate of commercial and/or investment banks and sold principally
in countries other than the country in whose currency the bond is denominated.
Eurobonds are unregulated and economically more efficient. Being bearer
securities they provide the holders with anonymity, and their tax considerations
and no withholding tax features make them attractive to several foreign invest-
ors. In addition, bond covenants in Eurobonds are less restrictive than on
domestic issues. With short maturities averaging 3-10 years, they are increas-
ingly popular among small investors as well as with institutions, who prefer
them because of liquidity needs and foreign exchange risk. They are very liquid
in the secondary markets, trading efficiently on Euroclear and Cedel. Given
their unregulated nature, Eurobonds are usually issued only by reputed and
highly rated firms. These special features make them attractive to issuers,
especially since they may reduce borrowing costs by 25-100 basis points relative
to domestic dollar bonds or dollar term loans.
Kim and Stulz (1988) find that US shareholders benefit from Eurobond
issues. They find a small positive average abnormal return of 0.46%
(z-statistic of 3.38) associated with the offering announcement. 1 This result
differs from the literature on stock-price effect of domestic bond issues, which
reports a negative or zero wealth effect. Eckbo (1986), using a sample of 459
straight-debt issues from 1964 to 1981, finds a negative stock-price announce-
ment effect of -0.11 %, with a z-statistic of -0.96 (statistically insignificant).
Mikkelson and Partch (1986), using a sample of 171 straight bond issues from
1972 to 1982, find a negative announcement effect of -0.23%, with a
z-statistic of -lAO (insignificant). However, James (1987) finds the average
announcement effect for a sample of 80 bank loan agreements to be 1.93%,
with a z-statistic of 3.96 (statistically significant). For convertible domestic
bonds, Dann and Mikkelson (1984) find an average (significant) abnormal
return of - 2.31 % between 1969 and 1979. Kim and Stulz (1992) find a
significant average return of -1.66% for domestic convertibles and a significant
-0043% for Eurobond convertibles between 1965 and 1987.
In international markets, emerging economies choose to issue Eurobonds
over foreign regulated bonds like Yankee bonds and Bulldogs, which might be
inaccessible to them anyway. Lack of disclosure requirements and absence of
registration and prospectus make it easier for firms from emerging markets to
issue Eurobonds. With fewer covenants, their bearer nature and no pressure
for rating, emerging markets are increasingly becoming regular players in the
international market vying for private capital. However, only the most presti-
gious firms are able to access the Eurobond market. In addition, being unregu-
lated it is easier to issue the (more popular) convertible Eurobonds by these
firms, since their equity is not internationally listed. Several Eurobonds are
1 Abnormal returns are excess returns over and above risk-adjusted returns. According to semi-
strong efficient market hypothesis, abnormal returns should be zero.
262 K. Tandon
increasingly being privately placed in the developed markets, helped by Rule

144A in the USA and given the growing appetite for emerging market securities
for fund managers in the USA.2
The core focus of this research is to examine the market response to the
announcement of Eurobond issues and launching of country mutual funds. We
examine the effect on shareholders' wealth as a result of Eurobonds issued by
corporations in emerging markets. We use an approach similar to other event
studies to examine the impact of such issues on the stock prices of firms from
emerging markets. Almost all these firms have entered the private global capital
markets for the first time ever - not a small feat. Not surprisingly, the issuers
so far have been the top tier corporations in these emerging markets. (See
Appendix 1 for our sample listing or The World Bank Debt Tables (1993) for
a more complete list.)
Country funds
Firms in emerging markets increasingly raise capital externally through closed-

end country funds which are traded overseas, mostly in London, New York,
Singapore and Hong Kong. These funds have a tendency to invest primarily
in the bigger and more liquid companies in that country, creating a sizable
clientele for these companies. This often leads to a greater monitoring of these
firms, which may be advantageous and may result in lower costs of capital
(but possibly also to greater volatility and turnover). Greater monitoring by
foreign investors and generally stricter disclosure requirements when issuing
claims in industrial countries' capital markets may, on the other hand, lead to
a more critical appraisal of the firm, which may be translated into a higher
cost of capital. We therefore analyze the performance of the portfolio of the
top 10 firms in which the relevant country fund invests. 3
Research on closed-end country funds to date (Diwan et al., 1993;
Hardouvelis et al., 1993) has focused on the post-offering performance of these
funds. They analyzed the determinants of changes in market prices, net asset
values, and the premiums/discounts on these funds. We extend the analysis to
examine the announcement effect of the launching of these country funds on
the local market index and the portfolio of the biggest holdings of these mutual
funds. 4 Being included in these funds can lead to an increase in shareholder
wealth through an enlarged clientele or may even lead to a decrease in stock
prices due to the fear of aggressive and critical scrutiny by more experienced
2 It might be interesting to compare the effects of Eurobond issues to those of GDRs and ADRs
from emerging economies.
3 Such performance is not linked in any way to agency theory or changes in cost of capital of
the top tier firms. Research on financial innovations and cost of capital in emerging countries is
beyond the scope of this research.
4 Kim and Singhal (1993) have analyzed the impact of market openings in South Korea. Bosner-
Neal et a1. (1990) analyzed market openings in five developed and emerging markets on their
country fund prices.
fund managers of these country funds. We analyze these propositions

empirically.
DATA
To examine the stock-price effect of Eurobond issues in emerging markets, we

use a sample of Eurobond issues from 1990 to 1992. 5 We focus only on those
countries that are contained in the IFC weekly data base. Not surprisingly,
90 percent of our sample comes from 1991 and 1992. Only Korean and Mexican
firms had some offerings over 1985-89. Our final sample includes 49 offerings,
constrained by data availability, and is constructed as follows:
1. Data on the individual Eurobond offerings are obtained from Euromoney
Bondware and World Bank estimates. (A complete overview of new interna-
tional and Eurobond issues and their issue and announcement dates is
provided in Gooptu, 1993 and the World Bank Debt Tables, 1993.) A
breakdown of Eurobond offerings in our sample is included in Appendix 1.
2. Only those firms have been included in the sample that have weekly stock
price data contained in our data base: International Financial Corporation's
Emerging Market Data Base (EMDB, 1992). Weekly returns for individual
firm stock prices and the local market index are obtained from the EMDB.
EMDB contains weekly data from late 1988 onwards and in some cases,
like Indonesia, the data is available only from December 1989. The returns
are adjusted for stock splits, rights offerings, etc., based on the capital
adjustment factor available in the IFC data base. Emerging markets tend
to witness a lot of rights and bonus issues, unlike the United States.
3. To analyze the announcement effect we also need data for the estimation
period. The estimation period, to calculate P and predicted returns, in this
study is for week - 56 to week - 5 before the announcement date. With
weekly data in the IFC Emerging Market data base available only from
1988, and an estimation period of nearly one year, this further reduces our
sample of analyzed offerings to 1990 onwards.
4. Closed-end country mutual fund data were obtained from various sources.
The launch date and the composition of the country funds at the time of
launch is obtained from Lipper Analytical Services, a recent research paper
by Smith Barney and from LEXIS/NEXIS database. We could obtain data
only for the top ten holdings in each mutual fund at the time of launching
or very close to launching. 6 However, not all top holdings are necessarily
5 Our data set ends in 1992. In 1993 and 1994 there were an additional 75 Eurobond offerings
from private firms in emerging countries. Preliminary results do not indicate any major changes
when data are updated to mid-1994.
6lt is difficult to obtain the detailed composition of the fund at the time of the launch data. We
obtained the composition of the top ten holdings at a time as close as possible to the launch date.
Some old prospectuses have been made available by Chris Persichetti of Lipper Analytical Services.
Some have been obtained from a recent research report by Smith Barney.
264 K. Tandon
included in the EMDB data base. In addition to the market index, this
research analyzes the pre- and post-launching performance of an equally-
weighted portfolio of the top holdings in the fund, for which we have data
in our IFC data base. For a listing of the mutual funds in our data base
and their composition of top ten holdings, see Appendix 2.
Table 1 offers information about Eurobond offerings by country and some
statistics about our sample. Our final sample of 49 firms included firms from
nine countries over the period 1990-1992: Argentina (4), Brazil (11), Mexico
(7), Venezuela (3), Portugal (2), Indonesia (2), Thailand (1), Korea (16) and
Taiwan (3). There have been additional corporate offerings of Eurobonds in
1993 by firms from India, Chile, Colombia, Malaysia and Philippines, in
addition to the above nine countries. The average size of the Eurobond offering
in our sample is $88 million and the average maturity is 6 years. As evidenced
in Table I, there is a big increase in the number of offerings in 1993. This indi-
cates the increasing popularity of corporate Eurobonds by emerging markets
as a source of private sector funds for growth and development. Several of the
Eurobonds from Asian countries are convertible, while some of them from
Latin America are callable.7 Most have maturities between 2-15 years, with
5-year maturity being preferred by emerging markets.
Table 1. Frequency distribution of corporate Eurobond offerings by country, amount, number and
year of offerings
Amount (in $ millions) and number of offerings
Country 1989-92 1993 Our sample (1989-92)
Argentina 1245 (23) 1620 (17) 236 (4)

Brazil 4029 (56) 3695 (55) 1481 (11)
Chile 186 (2)
Colombia 350 (3)
India 75 (1)
Indonesia 735 30 (1) 105 (2)*
Korea 3998 (75) 1530 (13) 932 (16)
Malaysia 500 (1)
Mexico 5760 (60) 5420 (32) 980 (7)
Philippines 20 (1)
Portugal 403 (9) 150 (1) 197 (2)
Taiwan 315 (5) 60 (2) 165 (3)
Thailand 221 (2) 540 (7) 121 (1)
Venezuela 480 (9) 320 (4) 104 (3)
* Indonesia data are available only from 1989.
7 Due to our small sample, we do not analyze the sub-samples for convertibles, straights and
callables separately in this paper.
METHODOLOGY
Eurobonds
The methodology used in the first part of this study about Eurobonds is similar
to a standard event methodology, often used in the finance literature. This
methodology has been successfully applied to similar problems in the papers
by Kim and Stulz (1988, 1992), Eckbo (1986), Mikkelson and Partch (1986)
and Dann and Mikkelson (1984). It involves measuring the abnormal return
on the firm's stock surrounding the date of issuance.
The impact of the Eurobond offering on common stock of the issuing firm
is estimated using the following market model for stock returns:
where, Rjt = return on stock j over week t, R mt = return on market index over
week t, ejt = error term on security j in week t with the properties, E(ejt) = 0
and E(ejt-l. ejt) = o.
The above equation is estimated for each offering announcement. For each
country, that country's own market index is used. The estimation period is
weekly from t = - 56 to t = - 5, relative to the initial announcement date as
recorded in the Euromoney Bondware data base and The World Bank's World
Debt Tables. The estimated parameters, aj and bj , and the realized (actual)
return on the market index in week t are used to construct predicted returns
around the event date. Excess returns are then computed as the deviation
between realized returns and predicted returns. Specifically, the abnormal return
for firm j in week t is computed as:
ARj, = (Rj, - tlj - bjR m,)
Weekly abnormal returns are calculated for each firm over the interval weeks
t = - 3 to t = + 3. For a sample of N firms, the weekly average abnormal
return (AR) for each week is obtained: 8
1 N
AR, = N j~l AR j ,
We then compute the average standardized abnormal return (SAR,) as:

1 N AR j ,
SAR,=- I-
N j=l (Jjt
8 We first compute the average abnormal return over all firms for weeks - 3 to + 3 surrounding
the announcement date. Cumulative abnormal returns (CARs) are the abnormal returns summed
over weeks - 3 to + 3.
266 K. Tandon
where
and where, (1j = standard deviation of the residuals in the estimation period,
T = number of weeks in the estimation period, Rm = mean return on the market
portfolio over the estimation period, and Rmk = return on the market portfolio
in the kth week of the estimation period.
Assuming normality and independence across securities, the Z-statistic is
computed as follows:
Zt=VNoSAR t
The Z-statistic is then used to test the hypothesis that the average standardized
abnormal return equals zero.
Country funds
The second part of this research examines the impact of the launching of
closed-end country funds (emerging markets only) on the market index of the
reference country and on an equally-weighted portfolio of the top holdings of
the fund at the time of the fund launching. We are interested in an equally
weighted portfolio of the top ten holdings but are often constrained by data
availability of these top tier firms in the Emerging Market Data Base (EMDB).
As a result, our portfolio of top holdings ranges from a low of only four firms
to a high to ten for other funds, except for one of the two Brazil funds with a
high of 14 firms.
We compute the mean and variance of the returns of the underlying market
index and the above constructed portfolio of top holdings for a period of
12 months before and 12 months after the launching of the mutual fund. We
also compute the mean adjusted excess returns on the market index and the
portfolio of top holdings for up to 2 months after the launching of the fund.
To calculate the mean adjusted excess return, we first take the mean of the
returns for 12 months preceeding the launching of the fund. To arrive at the
mean adjusted excess return post-launching, we deduct the mean from the
following month's return after the launching of the country fund. 9
EMPIRICAL RESULTS
The effect of the Eurobond offering on underlying stock price
We measure a firm's stock-price reaction to the announcement of a Eurobond

issue as the abnormal return over a small window that includes the announce-
9 For the portfolio of top holdings, we adjusted the portfolio's return by the mean of the market
index also, but no significant differences are noticed.
ment week and weeks surrounding it. Abnormal returns are computed as
market-model residuals as outlined above. Table 2 presents the abnormal
returns for three small windows for the entire sample of 49 offerings as well as
for each country. Cumulative abnormal returns are presented in column 3 for
week zero (the event date), in column 4 for weeks 0 and + 1 around the event
and in column 5 for weeks -1 and + 1 around the Eurobond offering.
As can be seen from Table 2, the Eurobond offering for the entire sample is
associated with a positive significant excess return on the underlying stock
over windows (0, + 1) and over (-1, + 1). Most of the excess return is driven
by return in week + 1, following the succesful completion of the Eurobond
offering.
A breakdown of the cumulative abnormal returns by country of origin
suggests that the positive returns are all driven primarily by the subsample of
Korean firms. Though positive returns are associated with five countries, only
returns in Korea are statistically significant. However, individual country analy-
sis should be treated with caution, given the small sample size associated with
several of these countries, except Korea and Brazil. .
Interpretation of results
A number of studies have examined the returns on common stock around the
bond offerings in the USA. To summarize, Eckbo (1986) and Mikkelson and
Partch (1986) find a negative stock-price announcement effect associated with
straight-debt issues, while Kim and Stulz (1988) find a small positive announce-
ment effect for straight Eurobond issues. For domestic and Eurobond convert-
ibles respectively, both Dann and Mikkelson (1984) and Kim and Stulz (1992)
find negative abnormal returns.
Table 2. Weekly excess returns on an equally weighted portfolio of stocks around Eurobond
offerings
Sample
No. of offerings CAR (0) (%) CAR (0, 1) (%) CAR (-1, +1) (%)
All firms 49 1.32 2.03 b 2.34-

Argentina 4 -0.45 -1.34 -1.07
Brazil 11 2.97- 4.73- 5.88-
Indonesia 2 -1.04 1.03 -2.14
Korea 16 1.48" 1.98" 3.15-
Mexico 7 -0.69 1.00 1.16"
Portugal 2 0.76 0.55 -0.82
Taiwan 3 -0.31 -1.43 -3.65"
Thailand 1 0.22 0.55 -0.29
Venezuela 2 5.69" 4.90- 6.52"
Denote statistical significance at the 1%, 5% and 10% levels.

b
CAR, cumulative abnormal returns.
268 K. Tandon
Our sample of 49 Eurobond offerings over 1990-1992 is a mix of straight

and convertible Eurobonds. tO Despite the mix, we find positive abnormal
returns around Eurobond offerings, compared with zero or negative returns
for domestic and Eurobond convertibles in the USA. This indicates that the
enhanced exposure and creditworthiness associated with a successful offering
in global capital markets leads to positive abnormal returns for shareholders
from emerging markets, suggesting that there is value associated with such an
offering. This may allow the firm to lower its cost of capital in the future,
though we do not test that link here.
Cross-sectional regressions
We test the source of this gain by estimating a cross-sectional regression of the
abnormal returns on two variables: size and maturity of the Eurobond offering.
Though other variables may be relevant in explaining the abnormal returns,
given the data available, we regress standardized cumulative abnormal returns
(SCARs) against size of the offering (AMT) and maturity (MAT). We find the
following relationship:
SCARs (-1, + 1) = 0.586 - 0.045 AMT - 0.05 MAT
(1.53)(-0.99) (-1.14)
There is no significant relationship between abnormal returns and size or
maturity. (Results for SCARs for other windows are similar.) Although not
statistically significant, abnormal returns are inversely related to size and
maturity, a result similar to that found by Kim and Stulz (1988).
Effect of country fund launching on stock prices
We analyze the impact of the launching of an emerging market country fund

on the overall stock market index of that country and an equally weighted
portfolio of the top holdings of that fund. Country fund launching is the first
attempt at market openness of the economy to outside investors. Since these
country funds invest solely in the biggest and the most liquid firms, we should
observe positive and higher excess returns to the portfolio of the top ten firms
compared to the returns of other securities in that market. Comparing the
returns of the overall market index to a portfolio of the top holdings will allow
us to analyze the beneficial effects of establishing a country mutual fund. Since
overseas fund managers invest only in the most liquid securities, they create a
sizable clientele for these securities, often leading to a greater monitoring of
these firms. This greater monitoring and the additional disclosure and research
that comes with it may be advantageous for firms in this portfolio of top tier
companies and may result in lower costs of capital. On the other hand, greater
monitoring and generally stricter disclosure requirements when issuing claims
10 As mentioned in footnote 7, we are unable to analyze various subsamples for convertible

bonds, straight bonds and callable bonds due to their small sample sizes.
in international capital markets may lead to a more critical appraisal of the

firm. We analyze the performance of the local market index and the portfolio
of top ten holdings. For a composition of the equally-weighted portfolio of top
tier holdings, see Appendix 2.
Table 3 presents summary statistics around the mutual fund launchings in
emerging markets. Panel A presents mean returns over 12 months before and
12 months after the fund launching for the market index and the equally
weighted portfolio of top firms. Panel B presents the effect of the mutual fund
Table 3. Statistics around mutual fund launchings from emerging markets
Market index Portfolio of top holdings
t= -12 t= +1 t= -12 t= +1
Mutual fund to -1 t=O to +12 to -1 t=O to +12
Panel A: Mean returns around fund launching

Argentina (Oct. 91) 20.04 21.86 -2.22 22.91 16.67 -1.09
Brazill (Oct. 88) 23.52 26.32 30.98 11.04 42.97 33.99
Brazil 2 (Apr. 92) 30.96 24.37 17.71 40.32 21.48 20.11
Chile (Sep. 89) 2.41 6.63 4.08 3.61 7.04 3.81
India (Aug. 88)" 12.88 -1.81 3.64 8.22 3.35 3.22
Indonesia (Apr. 90)b 14.92 -2.87 -0.26 16.07 0.28 -0.84
Malaysia (May 87) 5.54 9.05 -0.69 7.32 6.34 -0.22
Mexico (Aug. 90) 5.09 -10.38 6.41 4.83 -8.81 5.24
Philippines (Nov. 89) 6.35 2.65 -5.18 6.12 3.97 -4.53
Portugal (Nov. 89) 3.09 -0.11 -3.84 4.21 2.13 -4.87
Taiwan 1 (Dec. 86) 3.03 4.26 7.69 3.29 3.64 7.81
Taiwan 2 (May 89) 6.42 23.92 -1.58 6.81 19.85 -1.17
Thailand 1 (Feb. 88) 4.68 15.28 1.65 4.56 15.86 0.99
Thailand 2 (May 90) 3.73 15.32 -0.22 4.34 29.43 1.84
Turkey (Dec. 89) 15.65 50.56 3.41 15.70 45.49 2.52
Panel B: Ratio of post- to pre-launching variances
Argentina 0.42 0.53
Brazill 0.995 0.62
Brazil 2 0.66 0.51
Chile 0.98 0.99
India 0.74 1.54
Indonesia 0.33 0.81
Malaysia 1.32 1.23
Mexico 1.47 1.34
Philippines 1.39 1.22
Portugal 0.47 0.59
Taiwan 1 5.28 6.66
Taiwan 2 0.76 0.81
Thailand 1 0.43 0.42
Thailand 2 2.27 3.38
Turkey 0.79 0.73
India data are only for 4 months before and 4 months after.
b Indonesia data are for 3 months before and 3 months after.
270 K. Tandon
launching on the volatility of returns on the underlying market index and the
equally weighted portfolio of top holdings.
Table 3 Panel A shows that the ratio of post- to pre-launching mean return
is greater than one in only four of 15 funds for the market index and in only
two cases for the portfolio of top holdings. In other words, the mean return
decreased in 11 of 15 cases for both the market index and the equally weighted
portfolio of top holdings after the country fund is launched. In fact, the mean
return is positive in all 15 cases before the launching of the country fund but
became negative in nearly half the cases in the months after the fund is launched.
In the month of the fund launching (i.e. t = 0), when overseas fund managers
are busy buying securities in the local market, the mean return' is higher than
the pre-launch return in nine of 15 cases for the market index and in seven
cases for the portfolio of top holdings. Post-launching mean returns declined
sharply. This may be an indication of the so called over-reaction hypothesis in
the capital markets. While stock prices rise some time before and at the time
of the launching of the closed-end country fund on indications of a one time
influx of foreign money in the country's stock market, the stocks tend to cool
down once the fund is launched. The presence of foreign fund managers in an
emerging economy leads to a greater foreign monitoring, making the markets
less speculative.
Table 3 Panel B presents the results of the effects of the country fund
launching on the returns volatility of underlying stocks. The volatility compari-
son is based on the ratio of post- to pre-launching variances computed from
monthly returns 12 months before and 12 months after the fund launching.
Column 2 presents the variance ratio for the market index and column 3
presents the ratio for the equally weighted portfolio of top tier firms in the
country fund. Variance tended to decrease in nine of the 15 cases for both the
market index and the equally weighted portfolio of top holdings. This lends
further support to the above hypothesis that the presence of foreign fund
managers make the emerging capital markets less speculative and that greater
and more experienced monitoring and/or financial analysis makes the emerging
markets less speculative.
In addition to the mean return and the variance of stock prices, we
compute the mean-adjusted excess returns for both the market index and
the portfolio of the top holdings (Table 4). These estimates are obtained
from the mean adjusted returns model, where the estimation period is month
-12 to month -1 relative to the launching of the country fund (month 0).
Similar to Table 3, mean adjusted excess returns are positive in nine cases
for both the market index and the portfolio of top holdings in the month
t = O. However, cumulative excess returns for 3 months from t = 0 to t = + 2
are positive in only half the cases. The mean across all the country funds in
month t = 0 is 2.44% for the market index but 6.20% for the portfolio of
the top holdings. However, the mean for cumulative mean-adjusted excess
returns for months t = 0 to t = + 2 are negative for both the market index
Table 4. Mean adjusted excess returns on market index and portfolio of top holdings post-
launching of country funds (%)
Market index Portfolio of top holdings
Country fund CAR (t=0) CAR (0, +2) CAR (t=O) CAR (t = 0, +2)
Argentina 1.81 -29.64 -6.26 -31.06

Brazill 2.79 28.68 31.93 73.26
Brazil 2 -6.58 -69.17 18.84 -94.56
Chile 4.22 15.61 3.45 5.88
India -4.89 -0.05 0.21 2.41
Indonesia -17.79 -49.23 -15.81 -49.69
Malaysia 3.51 5.29 -0.98 -5.87
Mexico -15.48 -20.91 -13.64 -13.11
Philippines -3.69 -38.57 -2.16 -26.41
Portugal -3.21 -19.65 -2.08 -28.81
Taiwan 1 1.23 12.67 0.35 8.61
Taiwan 2 17.53 0.61 12.69 -2.76
Thailand 1 10.61 14.76 11.31 10.96
Thailand 2 11.61 18.77 25.09 51.08
Turkey 34.91 47.45 29.78 41.11
as well as the portfolio of top holdings, being more negative for the overall
market than the portfolio of top holdings.
Interpretation of results for mutual fund launchings

From Tables 3 and 4, one can conclude that while the local stock market
increases sharply in the month that the closed-end country fund is launched
and a few months preceding it, in anticipation of new foreign money entering
the capital market, mean returns decrease in the months following the launching
of the fund. The mean across all funds is positive in the month of launching
but negative for seven funds in the months following the launching. In addition,
the variance tended to decrease after the fund is launched both for the overall
market index as well as for the portfolio of the fund's top holdings. This
indicates that the launching of a new emerging country fund leads to a greater
monitoring by the fund analysts and a more sophisticated financial research
of the local stock market and the fund's top stock holdings, making the
emerging stock market less speculative and more stable.
To summarize, we find evidence of positive abnormal returns associated
with private corporate Eurobond offerings in emerging markets. For emerging-
market country funds, mean returns are positive in the month of the fund
launching and the months preceding it, but decreased substantially in the
12 months following the fund launching; however, variance of stock prices
decreased in most of the cases following the launching of the fund. This indicates
that foreign funds bring more discipline in the local market by reducing
speCUlation in the market. This may lead to a faster and more responsible
development of the emerging stock market.
272 K. Tandon
CONCLUSIONS AND SUGGESTIONS
This research examines the behavior of stock prices in emerging capital markets
to two announcements related to the opening of that country's capital market.
Eurobond offerings have increased substantially in the emerging markets in
the last 3 years and their offerings are associated with positive abnormal returns
to the underlying stocks around the offering, leading to unexpected gains
for their shareholders and maybe to a lower cost of capital for the firm. This
also implies that there is value associated with the successful completion
of such offerings in emerging markets, since they enhance the exposure and
creditworthiness of the firm in international markets.
We also analyzed an aspect of the opening of emerging capital markets: the
launching of their closed-end country funds. Mean returns in the month of the
fund launching and months preceding it are high and positive in anticipation
and influx of new foreign money in the market; however, the trend reverses
and returns decrease in the months following the launching of the fund.
Increased monitoring and advanced financial research/analysis by fund manag-
ers and analysts leads to a decrease in the speculative behavior in the market,
as evidenced by a decrease in stock market volatility following the launching
of the country fund. This decrease in volatility may ultimately bring discipline
and more responsible development of the emerging stock market by decreasing
speculative bubbles.
Emerging markets are quickly discovering the benefits of the global market
as a source of raising private capital funds and most are now doing it through
equity issues in addition to the Euro-debt issues. They are doing this increas-
ingly through new issues of Global and ADRs. The economic benefits to
shareholders and a greater discipline in the domestic capital market accompa-
nying market openness is encouraging other emerging economies, like China,
Philippines, Pakistan, Sri Lanka, etc,. to open their capital markets to foreign
investors. As a logical extension of this research, it would be interesting to
analyze the economic effects of GDR and Rule 144A ADR offerings on the
stock prices of emerging market firms.
ACKNOWLEDGMENTS
This research has been supported by the Debt and International Finance
Division and the Research Support Budget (RPO 678-49) of The World Bank.
The author thanks Stijn Claessens and Shan Gooptu of IECDI, World Bank,
and Nusret Cakici (Rutgers) and Jahangir Sultan (Benteley) for comments.
I also thank Euromoney for access to their Bondware Data Base and to Chris
Persichetti of Lipper Analytical Services. The findings, interpretations and
conclusions are the author's own and should not, in any way, be attributed to
the World Bank. This research is also printed in Emerging Markets Quarterly
(Summer 1997), New York, 63-73.
REFERENCES
Bailey, W. and 1. Lim (1992). Evaluating the diversification benefits of the new country funds.
Journal of Portfolio Management, 18, 74-80.
Bosner-Neal, c., G. Bauer, R. Neal and S. Wheatley (1990). International investment restrictions
and closed-end fund prices. Journal of Finance, 45,523-548.
Claessens, Stijn and S. Gooptu (eds) (1993). Portfolio Investment in Developing Countries.
Washington, DC: World Bank.
Dann, 1. and W. Mikkelson (1984). Convertible debt issuance, capital structure change and
financing-related information. Journal of Financial Economics, 13, 157-186.
Diwan, I., V. Errunza and 1. Senbet (1993). National index funds - empirical perspectives. In Stijn
Claessens and S. Gooptu (eds), Portfolio Investment in Developing Countries. Washington, DC:
World Bank.
Eckbo, E. (1986). Valuation effects of corporate debt offerings. Journal of Financial Economics,
IS, 119-151.
Gooptu, S. (1993). Portfolio investment flows to emerging markets. In Stijn Claessens and
S. Gooptu (eds), Portfolio Investment in Developing Countries. Washington, DC: World Bank.
Hardouvelis, G., M. La Porta and T. Wizman (1993). Closed-end country funds. NBER Conference,
June 1993.
James, C. (1987). Some evidence on the uniqueness of bank loans: a comparison of bank borrowing
agreements, private placements and public debt offerings. Journal of Financial Economics, 19,
217-235.
Kidwell, D., W. Marr and G. Thompson (1985). Eurodollar bonds: alternative financing for US
companies. Financial Management, 14, 18-27.
Kim, E. Han and Vijay Singhal (1993). Opening up of stock markets by emerging economies: effect
on portfolio flows and volatility of stock prices. In Stijn Claessens and S. Gooptu (eds), Portfolio
Investment in Developing Countries. Washington, DC: World Bank, 393-402.
Kim, Y. C. and R. Stulz (1988). The Eurobond market and corporate financial policy: a test of the
clientele hypothesis. Journal of Financial Economics, 17, 189-205.
Kim, Y. C. and R. Stulz (1992). Is there a global market for convertible bonds? Journal of Business,
65,75-91.
Mikkelson, W. and M. Partch (1986). Valuation effects of security offerings and the issuance process.
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World Bank. World Debt Tables 1992-93, 1993-94.
274 K. Tandon
ApPENDIX 1. CORPORATE EUROBOND OFFERINGS: 1989-92

Country Name offirm Announcement date Amount ($ m) Maturity (years)
Argentina Molinas 901130 21 5

Argentina Siderca 901017 50 5
Argentina Molinas 910531 15 1.5
Argentina Astra Com 920603 100 5
Brazil Petrobras 910710 250 2
Brazil Copene 911212 50 2
Brazil Bradesco 911210 50 2
Brazil Cia Herin 920108 50 2
Brazil Copene 920325 50 2
Brazil Ceval 920604 80 2.5
Indonesia Inti Indorama 920617 43 5
Indonesia Inti Indorama 920921 60 10
Korea Yukong 901119 70 8
Korea Kolon 910225 29 14
Korea Comm Bank 910520 50 3
Korea Goldstar 910611 70 15
Korea Hanil Ban 910522 73 5
Korea Daewoo Corp 911126 150 5
Korea Han Yang 910917 56 15
Korea Hyundai Motor 910830 50 5
Korea Tongyang 910626 30 15
Korea Ssangyong 911029 70 14
Korea Sammi Steel 911105 49 5
Korea Samsung Elect 920121 30 5
Korea Daewoo Corp 920723 50 5
Korea Daewoo Elect 921020 50 15
Mexico Sidek 901130 50 5
Mexico Cemex 910503 338 5
Mexico Apasco 911121 100 5
Mexico Banco Inter 920617 50 3
Mexico Cemex 921021 280 7
Mexico Cydsa 921110 50 3
Mexico Desc 921203 125 5
Portugal Banc Port 910630 90 10
Portugal Banc Port 911107 107 5
Taiwan Far Eastern 910930 50 15
Taiwan Pac Eiec 911014 65 10
Taiwan Walsin Lin 920631 50 10
Thailand Thai Farmers 920720 121 5
Venezuela Coriman 900831 35 5
Venezuela Sivensa 900330 34 2
Venezuela Vanecemos 910821 35 2
ApPENDIX 2. LIST OF MUTUAL FUNDS AND LAUNCH DATE
Launch Initial N umber of top firms

Country Name of fund date size (m) in our portfolio
Argentina Argentina Fund Oct. 91 56 8

Brazil Brazil Fund 1 Oct. 88 150 14
Brazil Brazil Equity Fund 2 Apr. 92 62 7
Chile Chile Fund Sep.89 65 9
Indonesia Jakarta Growth Fund Apr. 90 60 9
India India Growth Fund Aug. 88 60 6
Malaysia Malaysia Fund May 87 87 8
Mexico Mexico Equity & Income Aug. 90 72 10
Portugal Portugal Fund Nov. 89 79 6
Philippines First Philippines Fund Nov. 89 108 4
Taiwan Taiwan Fund Dec. 86 82 5
Taiwan ROC Taiwan Fund May 89 376 10
Thailand Thai Fund Feb. 88 115 10
Thailand Thai Capital Fund May 90 72 9
Turkey Turkish Investment Fund Dec. 89 84 6
* Though we have information on the top ten holdings in each fund at the time of launching, we
do no have data on all ten holdings. This column states the number of firms for which we have
data to form our portfolio of top ten holdings.
ROBIN L. DIAMONTE,I JOHN M. LIEW 2 and ROSS L. STEVENS3
IGTE Investment Management, 2Goldman Sachs Asset Management, 3Integrity Capital
Management
10. Political risk in emerging and developed markets!
ABSTRACT
Using analyst estimates of political risk, we show that political risk represents a more
important determinant of stock returns in emerging than developed markets. Average
returns in emerging markets experiencing decreased political risk exceed those of emerging
markets experiencing increased political risk by approximately 11 % per quarter. In contrast,
the difference is only 2.5% per quarter for developed markets. Further, the difference
between the impact of political risk in emerging and developed markets is statistically
significant. We also document a global convergence in political risk. Over the last 10 years,
political risk has decreased in emerging markets and increased in developed markets. If this
trend continues, the differential impact of political risk in emerging vs. developed markets
may narrow.
INTRODUCTION
Does political risk affect stock returns? The often observed link between dra-
matic political events and large market moves clearly suggests that it can.
However, because quantifying political risk is difficult, little beyond anecdotal
evidence exists which examines its systematic impact on stock returns. We
provide direct evidence on this issue by exploiting analyst estimates of politi-
cal risk.
First, we show that changes in political risk have a bigger impact on returns
in emerging markets than in developed markets. In emerging markets, political
risk changes represent an economically and statistically significant determinant
of stock returns. Average returns in emerging markets experiencing decreased
political risk exceed those of emerging markets experiencing increased political
risk by approximately 11 % per quarter. Changes in political risk represent a
less important determinant of stock returns in developed markets. There is no
statistically significant difference between average returns in developed markets
experiencing decreased political risk and developed markets experiencing
increased political risk.
Second, we document a global convergence in political risk. Over the last
ten years emerging markets have become politically safer while developed
markets have become riskier. If this trend continues, our results suggest that
1 A similar version of this paper was published in the May/June 1996 Financial Analysts Journal.
277
278 R.L. Diamonte et al.
the differential impact of political risk in emerging vs. developed markets

may narrow.
DATA
Political risk data
Several institutions offer country-by-country risk analysis. However, most ser-

vices provide non-quantifiable written reports unsuitable for empirical analysis.
Of the few services that offer quantitative analysis, most offer their estimates
only on an irregular or semi-annual basis. One service, the Political Risk
Services International Country Risk Guide (ICRG), provides an explicit
monthly measure of political risk in over 130 countries. Their overall country
risk ratings consist of economic, financial, and political components. Since we
seek to quantify the importance of political risk in stock returns, we used
ICRG's political component as our proxy for political risk. Our sample period
started in January 1985 and goes through June 1995.
Analyst ratings of 13 political risk attributes combine to form one overall
political risk score for each country. The maximum score assigned to each
attribute is set so that each country's overall score falls between 0 (highest risk)
and 100 (lowest risk). The 13 political risk attributes and their maximum scores
are described in the appendix.
To illustrate the behavior of ICRG's political risk measure we studied its
reaction to a recent dramatic political event: the Persian Gulf War. Iraq invaded
Kuwait on August 2, 1990 and Desert Shield pulled out of Kuwait on
February 27, 1991. Figure 1 presents the time-series of the political risk measure
for Kuwait and Iraq. For both countries, the level of political risk sharply
increased just prior to the invasion and remained high for the duration of the
war. Following the war, Kuwait's political risk decreased sharply while Iraq's
Political Risk
Low 75
I=~II
Risk
65
55
45
35
25
ffiIh Iraq Invasioo of Kuwait
Riok 15
..,
VI
Figure 1. Political risk in Kuwait and Iraq around the Gulf War.
Political risk in emerging and developed markets 279
decreased more slowly. The level of political risk in Iraq has yet to return to
its pre-invasion level.
Figures 2-4 show summary statistics of the political risk measure for the 21
developed and 24 emerging markets for which we have both stock return and
political risk data. We present the average risk, average quarterly risk change,
and standard deviation of the quarterly risk change. 2 Figure 2 shows that
emerging markets have been politically more risky than developed markets. In
fact, the riskiest developed market, Hong Kong, has been politically safer than
all but five emerging markets. ICRG's political sub-component data (described
in the appendix) indicates that relative to the other developed markets, Hong
Kong has suffered from weak political leadership and high external conflict
risk. Within the emerging markets, the two riskiest countries, Pakistan and Sri
Lanka, help make Asia the riskiest region. Pakistan has been plagued by
corruption in government and Sri Lanka has suffered political terrorism and
substantial civil war risk.
Figure 3 documents a global convergence in political risk over our sample
period. Emerging markets have become politically safer while developed mar-
kets have become riskier. The average change in political risk is negative
(riskier) for 19 out of 21 developed markets and positive (safer) for 21 out of
24 emerging markets. Among the emerging markets, Chile has experienced the
largest average decrease in political risk due primarily to its strong political
leadership and consistency of free market reforms. However, in spite of Chile's
gains, the Latin America region has become safer at a slower rate than either
the Aisa or the Europe/Mideast/Africa regions. The Philippines (Asia) and
Zimbabwe (Africa) have been the largest contributors to their respective regions'
decreasing political risk. The Philippines has benefited most from strengthening
political leadership while Zimbabwe has enjoyed a sharp drop in external
conflict risk.
Figure 4 documents large and volatile political risk changes in emerging
markets compared to developed markets. However, emerging market regions
exhibit less volatile political risk changes than most individual developed
countries since political risk changes are not perfectly correlated across coun-
tries. The fact that the changes are larger and more volatile in emerging markets
does not necessarily imply that they represent a more important determinant
of stock returns in these markets.
Stock return data
We used monthly total returns in US dollars on stock indices from Morgan

Stanley Capital International (MSCI) and the International Financial
2We used quarterly, as opposed to monthly, changes for two reasons. First, ICRG's political
risk measure changes slowly over time and it is often the case that a country may not experience
a political risk change over a single month. However, over any quarter virtually all countries
experience changes. Second, the substantial first-order autocorrelation observed in monthly stock
returns for many emerging markets suggests that non-synchronous trading contaminates the
monthly return data. The use of quarterly return data mitigates this problem.
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Figure 4. Volatility of political risk changes: emerging vs. developed markets. The political risk data are from ICRG. The index political risk data are
capitalization-weighted.
Corporation (IFC) to represent the behavior of stock returns in developed and

emerging markets. In most countries, these indices represent a very large
percentage of total market capitalization. To match the time period of our
political risk data, our sample period started in January 1985 for each country
except Portugal (2/86), Turkey (1/87), Finland (1/88), Ireland (1/88), New
Zealand (1/88), India (2/90), Sri Lanka (10/93), Peru (10/93), Hungary (1/94),
and Poland (1/94).
Figures 5 and 6 show the average and standard deviation of each country's
monthly return. We confirm the common knowledge that emerging markets
returns are more volatile and produce more extreme observations than returns
in developed markets. Most emerging stock markets have standard deviations
greater than 10%/month, at least one monthly loss greater than 20%, and at
least one monthly gain over 35%. Among the emerging market regions, Latin
America has produced the highest standard deviation (10.7%), largest monthly
loss (-29.6%), and largest monthly gain (37.3%). The region's impressive
volatilities are driven largely by Argentina and Brazil which, even by emerging-
market standards, stand out as remarkably volatile.
The information in Figures 2-6 hints at a risk-based story for the high
positive and volatile returns in many emerging markets. The overall decrease
in emerging market political risk may explain the magnitude and sign of
average returns and the large risk changes may explain the high volatility.
However, the overall increase in developed market political risk coupled with
the positive average returns we observe in these markets implies that other
factors besides changes in political risk explain developed market stock returns.
We now turn to our central question: are cross-sectional differences in stock
returns driven by changes in political risk?
CHANGES IN POLITICAL RISK AND EMERGING MARKET RETURNS
Test procedure
We divided our sample of countries into two categories (emerging markets and
developed markets) based on their classification by IFC and MSCI. For each
category and each calendar quarter, we form two portfolios. The first portfolio
contains the countries that experienced political risk increases and the second
portfolio contains those that experienced risk decreases. We then calculated
portfolio returns by weighting each country's return by the absolute value of
its contemporaneous percentage risk change. Thus, countries experiencing large
risk changes receive more weight than those experiencing small risk changes. 3
We repeated this procedure each quarter to obtain a time-series of returns to
each portfolio.
3 We obtain similar results with equal-weight portfolios.

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Figure 5. Average stock returns: emerging vs. developed markets. All returns are in US dollars and include dividends. Developed market returns are from
Morgan Stanley Capital International (MSCI). Emerging market returns are from the International Financial Corporation (lFC). Monthly returns start in
1/85 except for Portugal (2/86), Turkey (1/87), Finland (\/88), Ireland (\/88), New Zealand (\/88), India (2/90), Sri Lanka (10/93), Hungary (1/94), and
Poland (1/94). The index returns for the emerging market regions are capitalization-weighted. The MSCI and IFC index returns are based on their
published indices.
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Figure 6. Volatility of stock returns: emerging vs. developed markets. All returns are in US dollars and include dividends. Developed market returns are from 3
Morgan Stanley Capital International (MSCI). Emerging market returns are from the International Financial Corporation (IFC). Monthly returns start in ...s:::.
~
1/85 except for Portugal (2/86), Turkey (1/87), Finland (\/88), Ireland (\/88), New Zealand (\/88), India (2/90), Sri Lanka (\0/93), Hungary (1/94), and ~
Poland (1/94). The index returns for the emerging market regions are capitalization-weighted. The MSCI and IFC index returns are based on their t:i
published indices. N
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Results
Tables 1 and 2 contain our results. For both emerging and developed markets,
Table 1 shows the average return, t-statistic, and the average political risk
change for four portfolios:
Portfolio 1: decreasing risk
Portfolio 2: benchmark index
Portfolio 3: increasing risk
Portfolio 4: decreasing risk - increasing risk (Portfolio I-Portfolio 3)
The average return on the decreasing risk portfolio exceeds that of the bench-
mark and the increasing risk portfolio for both developed and emerging mar-
kets. In emerging markets, returns on the decreasing risk portfolio exceed those
of the benchmark by over 8%/quarter and those of the increasing risk portfolio
by over 11 %/quarter. These differences are far less dramatic in developed
markets where returns on the decreasing risk portfolio exceed those of both
the benchmark and the increasing risk portfolio by less than 3%/quarter.
The risk decreasing minus risk increasing portfolio returns (portfolio 4) are
strongly statistically significant in emerging markets (t-statistic = 3.90), but
only marginally significant in developed markets (t-statistic = 1.84). This evi-
dence suggests that changes in political risk clearly help explain the cross-
section of country returns in emerging markets, but only marginally help in
developed markets.
We also see that emerging markets produce larger average political risk
changes than developed markets. However, this difference (4.02 emerging vs.
Table 1. Changing political risk and stock returns (January 1985-June 1995)
Emerging markets Developed markets
Average Average
return Average return Average
(%/qrt) t-statistic L1 risk (%/qrt) t-statistic L1 risk
(1) Decr. risk 12.42 4.54 2.23 6.44 4.64 1.62

(2) Benchmark 3.92 1.65 0.30 3.94 3.12 -0.14
(3) Incr. risk 1.14 0.51 -1.79 3.98 3.24 -1.72
(4) Decr.-incr. 11.28 3.90 4.02 2.46 1.84 3.34
All returns are in US dollars and include dividends. Developed market returns are from Morgan
Stanley Capital International (MSCI). Emerging market returns are from the International
Financial Corporation (IFC). Monthly returns start in 1/85 except for Portugal (2/86), Turkey
(1/87), Finland (1/88), Ireland (1/88), New Zealand (1/88), India (2/90), Sri Lanka (10/93), Peru
(10/93), Hungary (1/94), and Poland (1/94). The political risk data are from Political Risk Services:
International Country Risk Guide (ICRG). The benchmark for the developed markets is the MSCI
World Index. The benchmark for the emerging markets is the IFC index. The decreasing (increasing)
risk portfolio consists of countries whose political risk decreased (increased) over the period.
Average ~ risk is the equal-weight average quarterly change in political risk for each country in
the portfolio over the full sample period. Within each portfolio, returns are weighted by their
percent change in political risk.
Table 2. Comparative effects of changing political risk on emerging and developed stock returns
(January 1985-June 1995)
Difference in average returns

Portfolio (emerging-developed. %/qrt) t-statistic
Decr. risk 5.98 2.36

Benchmark -0.02 -0.01
Incr. risk -2.84 -1.37
Decr.-incr. 8.82 2.72
All returns are in US dollars and include dividends. Developed market returns are from Morgan
Stanley Capital International (MSCI). Emerging market returns are from the International
Financial Corporation (IFC). Monthly returns start in 1/85 except for Portugal (2/86), Turkey
(1/87), Finland (1/88), Ireland (1/88), New Zealand 0/88), India (2/90), Sri Lanka (10/93), Peru
00/93), Hungary (1/94), and Poland (1/94). The political risk data are from Political Risk Services:
International Country Risk Guide (ICRG). The benchmark for the developed markets is the MSCI
World Index. The benchmark for the emerging markets is the IFC index. The decreasing (increasing)
risk portfolio consists of countries whose political risk decreased (increased) over the period.
Average .1 risk is the equal-weight average quarterly change in political risk for each country in
the portfolio over the full sample period. Within each portfolio, returns are weighted by their
percent change in political risk.
3.35 developed) does not fully explain the larger average quarterly return to
portfolio 4 in emerging vs. developed markets (11.28% vs. 2.46%). Emerging
market returns are also more sensitive to a given change in political risk. In
portfolio 4, the average quarterly return per unit of political risk change in
emerging markets (11.28%/4.02=2.81%) exceeds that in developed markets
(2.46%/3.34 = 0.74%). Thus, the magnitude of political risk changes and the
sensitivity of stock returns to a given change in political risk are both larger
in emerging than developed markets.
Table 2 tests the differential impact of changes in political risk between
emerging and developed markets for statistical significance. We subtract the
developed market portfolio return from the emerging market portfolio return
for each set of portfolios in Table 1. For the set of decreasing risk portfolios,
emerging market average returns exceed those in developed markets by almost
6%/quarter (t-statistic = 2.36). For the set of increasing risk portfolios, emerg-
ing market average returns fall below those in developed markets by almost
3%/quarter, although the difference is not statistically significant (t-statistic =
-1.37). Our bottom line result from Table 2 shows that the differential impact
of political risk changes between emerging and developed markets is economi-
cally and statistically significant. The average return difference between port-
folio 4 for emerging markets and portfolio 4 for developed markets is almost
9%/quarter with a t-statistic of 2.72.
Taken together, our results in Table 1 and 2 support the hypotheses that
political risk represents an important determinant of stock returns in emerging
markets, and political risk affects stock returns more in emerging than devel-
oped markets.
CONCLUSION
This paper quantifies the importance of political risk in emerging and developed
markets.
Our two main results are easily summarized:
1. Changes in political risk have a bigger impact on emerging market returns
than on developed market returns. The average difference in returns between
emerging markets experiencing decreased political risk and those experienc-
ing increased political risk is approximately 11 % per quarter. In developed
markets the difference is only 2.5%.
2. Over the last 10 years we have seen a convergence in global political risk.
Emerging markets have become politically safer while developed markets
have become politically riskier.
These results suggest several prescriptions. In emerging markets, if one can
forecast changes in political risk, one can forecast stock returns. Therefore,
emerging market analysts are well advised to devote considerable resources to
forecasting political risk changes. In developed markets political risk is less
important. Developed market analysts are better off devoting resources to
forecasting other sources of return such as changes in expected future economic
conditions. However, if global political risks continue to converge the large
differential impact of political risk changes between emerging and developed
markets may fade.
ApPENDIX
The International Country Risk Guide (ICRG) Model for forecasting financial,
economic, and political risk was created in 1980 by the editors of International
Reports. Used by banks, multinational corporations, importers, and exporters,
among others, the ICRG model is used to determine the risks of operating in,
investing in, or leading to particular countries using an evaluation system that
examines current political, financial, and economic risk.
The combined political risk score rates countries on a scale from 1 to 100
and consists of the following thirteen components, each assigned a maximum
numerical weighting.
Economic expectations vs. reality (12%)

Measures the perceived gap between popular aspirations for higher standards
of living and the ability or willingness of the government to deliver improve-
ments in income and welfare.
Economic planning failures (12%)

Measures business support for the current government and the ability of the
government to adopt a suitable and successful economic strategy.
Political leadership (12%)

Assesses the viability of the current government based on the degree of stability
of the regime and its leader, the probability of the effective survival of the
government, and the continuation of its policies if the current leader dies or is
replaced.
External conflict (10%)
Measures conflict based on the probability of external invasion, border threats,
geopolitical disputes, and full-scale war.
Corruption in government (10%)
Assesses corruption risk by looking at how long a government has been in
continuous power, whether a large number of the officials are appointed or
elected, and the frequency of bribe demands.
Military in politics (6%)
Reflects the likelihood of military takeover and the degree of military control
over government and governmental policies.
Law and order tradition (6%)
Reflects the degree to which citizens of a country are willing to accept the
established institutions to make and implement laws, the strength of the court
system, and provisions for an orderly succession of power.
Racial and nationality tensions (6%)
Measures the degree of tension within a country attributable to racial, national-
ity, or language divisions and the extent that opposing groups are intolerant
or unwilling to compromise.
Organized religion in politics (6%)
Measures the degree to which religious groups control the government and
governmental policies.
Political terrorism (6%)
Measures the extent to which dissidence is expressed through political terrorism,
such as armed attacks, guerrilla activity, or attempted assassinations.
Civil war risks (6%)
Measures the probability that terrorist opposition to a government or to its
policies will turn into a violent internal political conflict.
Political party development (6%)
Measures broad-based political participation in the determination of changes
in governments and in the formulation of government policies.
Quality of bureaucracy (6%)
Measures institutional strength, the quality of the bureaucracy, and the ability
to govern without drastic changes and policy interruptions in government
services.
PART FOUR
Lending on 'fixed' terms in emerging markets:

bank lending and sovereign debt
PETER AERNII and GEORG JUNGE 2
1 University of Basel, 2 Swiss Bank Corporation
11. Cross-border emerging market bank lending*
INTRODUCTION
The dramatic increase in private portfolio flows into emerging market countries
at the beginning of the 1990s has received a lot of attention. Less well-known
are the changes in cross-border bank lending to these countries. Net short-
term bank flows to major emerging market countries averaged US$ 35 billion
a year from 1993 to 1995, a more than 4-fold increase over the 1988-1990
period. Over the last two years, long-term bank lending to major emerging
market countries also picked up vigorously after years of stagnation. This is
shown in Figure 1, and one might be tempted to conclude that we are facing
a renaissance in lending to developing countries. Today the volume of net bank
lending to major borrower countries exceeds that of 1982, i.e. the year when
such lending peaked and the so-called international debt crisis broke out. Even
when measured in terms of lending as a percentage of GDP, cross-border
lending is higher today than it was in 1982.1 Of course, this raises questions as
to the sustainability of these flows and the efficiency of international lending.
An initial question suggested by Figure 1 is whether history is repeating itself.
Could it even be that the recent Mexican peso crisis was a forerunner of more
general fragilities in the financial systems, similar to what we experienced at
the beginning of the 1980s?
With respect to the major theme of this conference on the history and the
future of emerging market capital flows, two other questions present themselves:
what has changed between 1982 and today? What are the stylized facts and
how do they fit into economic theory? To answer these questions, we first
present the stylized facts of what has changed in cross-border bank lending to
emerging markets over the last decade. We then go on to see how these facts
fit into economic theory. In doing so, we will concentrate on enforcement
problems associated with international loan contracts and leave out the ques-
tion of risk sharing. Finally, combining facts and theory, we might be able to
say something about the future of cross-border bank lending. Will bank lending
* The views expressed in this paper are those of the authors, not necessarily those of SBC.
1In 1982, the ratio of net cross-border lending to GDP for major borrowing countries was
0.7%. In 1994 this ratio jumped to 0.87% and in 1995 it reach a temporary peak of 1.22%.
293
294 P. Aerni and G. Junge
Figure 1. A renaissance of cross-border emerging market bank lending (net flows).
be increasingly crowded out by portfolio investments as IS sometimes

maintained?
STYLIZED FACTS
The answer to the question of whether history is repeating itself is closely

linked to the composition of today's capital flows, the exposure of the lenders
to emerging market countries and the borrowers' economic stability. With
respect to these points, major changes occurred between the 1980s and the
1990s.
Fact 1: Whereas in the 1980s private capital flows to emerging market countries
mainly consisted of loans, in the 1990s cross-border capital flows have been
dominated by investments in tradable securities, i.e. bonds, equities (including
FDI) and money market instruments.
Figure 2 illustrates the magnitude of the changes in the composition of capital

flows. While in 1982, for example, 71 % of private capital flows occurred in the
form of bank lending, ten years later that component was down to 15-20% of
private financial flows to emerging markets. This shift in the composition of
capital flows has implications for the stability of the global financial system.
Portfolio diversification tells us that with today's financing structure the danger
of a breakdown of the international financial system has been reduced, simply
because with more widely dispersed exposure on the part of institutional and
private investors potentially dangerous loss concentrations are eliminated.
Moreover, a closer comparison of the 1990s with the 1980s shows that today
Cross-border emerging market bank lending 295
Figure 2. From unilateral bank lending to diversified private capital flows.
Table 1. From overexposure and fragile borrowers to more systematic stability
Bank exposure in % of capital 1982 1986 1992 1994
All US banks 149 80 26 33

All Swiss banks 96 72 51 56
External debt in % of exports 1982 1986 1992 1994
Developing countries 121 173 125 123

Latin America 270 348 276 266
Asia 89 105 67 66
Source: SBC calculations, IMF economic outlook.
major preconditions of contagion are absent, namely an overconcentration of

exposure on a few investors and widespread economic borrower fragility.2
Table 1 provides evidence of both the major improvement in the banking
system's stability and in the creditworthiness of debtor countries. The upper
part of the Table shows the outstanding exposure of the US and Swiss banks
to developing countries. In 1982 the US banking system had an exposure of
150% of its capital, while the exposure of Swiss banks was close to 100%.
Today these rates are down to 26% for the US banks and 50% for the Swiss
banks. This illustrates the sharp adjustment by the international banks in terms
of both reducing their claims in developing countries and rebuilding their
capital base. International banks in the other leading industrialized nations
2 Today we may face another type of major risk arising mainly from the sheer magnitude of
short-term dollar-linked debt.
such as the UK, France and Germany underwent similar adjustment processes.
For individual banking groups, such as the nine biggest US banks or the three
biggest Swiss banks, which typically were forerunners in syndicated lending to
developing countries, the adjustment was even more dramatic than the averages
in Table 1 suggest.
Fact 2: The exposure of the international banking system to emerging market
countries has decreased considerably.
At the same time as the international banking system's exposure to emerging
market countries decreased, the creditworthiness of these countries, as mea-
sured, for example, by their debt-to-export ratios, has improved substantially
(see Table 1). This change was caused not least of all by growth in exports well
above the world average. The new export strength is one of the fruits of the
liberalization programs in the real economy and the financial sector launched
by most developing countries in an attempt to reinstate their creditworthiness
in the aftermath of the international debt crisis.
Fact 3: The creditworthiness of the emerging market countries has greatly
improved.
Besides fostering international trade, the liberalization programs pursued by
many emerging market countries in the financial sector also lowered the cost
disadvantage of external funds over domestic finance as perceived by the private
sector. This resulted in an increase in the demand for external funds in general
and offered new investment opportunities for international banks. The interna-
tional banking industry accordingly became more interested in securities-
related cross-border activities. More importantly, the financial liberalization
process also allowed banks to shift their policy focus from public to private
borrowers.
Fact 4: International banks concentrate their cross-border lending on the private
sector and to a large extent on the domestic banking sector.
The rediscovery of the private sector in developing countries might be the most
important structural change of recent years. As shown in Figure 3, bank lending
is headed increasingly in the direction of private borrowers and domestic banks.
Specifically, the non-bank private sector's share of total external bank claims
has increased in Asia from 28% to 46% and in Latin America from 28% to
44%. This increase reflects the new boom in trade finance, the large-scale
privatizations and the forgiveness of sovereign debt under Brady-type
agreements, mainly in Latin America. The preference for lending to private
corporations in emerging markets is presumably driven by the better commer-
cial prospects. It also represents a shift away from the old-fashioned, general-
purpose lending to sovereigns and public entities. In the past, lending was all
too often conducted for general purposes under central government guarantees,
witlr important behavioral implications for both borrowers and lenders. For
the borrowing government, a loan to finance a good project often had no
Asia 1985 1995
publk sec:tor 39"/0 public sec:tor 11 %

Total USD 80.0 bn Total USD 307.1 bn
Latin
America 1985 1995
public sec:tor 50"10 publk sector 32%

Figure 3. Bank claims turn to private borrowers. Source: BIS.
higher status than a loan to acquire arms, to raise consumption or to finance

a balance of payments deficit caused by unsound economic policies. Because
of the general purpose character of the loan, risks inherent in a project or in
a borrowing strategy were not evaluated, and responsibility for the success or
failure of a project was diffuse. On the other hand, with government guarantees
the monitoring role of the lending bank was trivialized. Among bankers, the
slogan 'Governments cannot go bankrupt!' made the rounds. This attitude
changed quickly after 1982. As an example of the new attitude of many banks,
we should like to quote an SBC position paper on the Baker Initiative. It
contained the following statement: "It is not the proper function of the commer-
cial banks to engage in broad balance-of-payments financing. The international
banking community should contribute its share, but each individual bank will
have to be able to determine the form its contribution takes. This is essential
to lay the foundations for a future resumption of voluntary lending, a develop-
ment which would also be facilitated by distinguishing between new and old
debt." A bank's new and voluntary contribution under a Baker Initiative
arrangement can only take the form of: "transaction-related financing, i.e. trade
financing, project financing, co-financing and guaranteed export credits." With
this, the foundation was laid for the banks' shift to the private sector. As
countries implemented market reforms in the late 1980s and opened up their
economies, the new flows of lending went to the private sector.
Summarizing the main findings above, we conclude that over the last to-15
years, cross-border lending has lost its pre-eminent role in financing emerging
market countries. Consistently, the exposure of the international banking
system to emerging markets has decreased considerably. This is true despite
the fact that lending in absolute and relative figures is larger today than in
1982. Today, the role of cross-border loans has to be seen and explained within
a mix of other investment instruments, most of them tradable on a market,
such as bonds or equities. It seems to be more and more the case that interna-
tional banks treat their cross-border lending positions as part of an overall
foreign investment portfolio with corresponding implications for exposure
levels. In contrast to the early 1980s, today's international financing of emerging
markets appears to have a better footing: lenders are diversified and there is
no widespread economic borrower fragility. Moreover, the altered relevance of
cross-border lending to emerging markets has been accompanied by a general
shift in the banks' lending policy. Whereas in the 1980s loans were mostly
granted to sovereigns, most notably in Latin America, in the 1990s they have
been redirected to private borrowers in emerging market countries.
How do these findings coincide with economic reasoning and what is to be
expected in the future?
THE ROLE OF CROSS-BORDER LOANS FROM AN ECONOMIC PERSPECTIVE
We tackle the problem of explaining the pattern in cross-border lending as

follows. First of all, we consider possible explanations stemming from a partial
analysis of the cross-border loan market. We then go on to look for explanations
drawn from the international financial markets, in particular alternative routes
for cross-border investment such as foreign direct investment and portfolio
investments in equities and bonds.
To start the partial analysis, it is useful to recall a simple fact applying to
any sort of cross-border financial transaction: on top of the usual asset- and
investor-specific risks and the obvious currency risk, cross-border contracts are
subject to another source of non-performance risk, namely the country risk. It
emerges from the fact that the parties to the contract live in different countries
and are thus subject to different regulatory and political regimes. If a potent
supranational legal system is missing, and if 'gunboat diplomacy' is unavailable
or inappropriate, scope is present for strategic maneuvering motivated by
opportunism on the part of the borrowers in the form of defaults or delayed
repayment. As a consequence, cross-border contracts are typically incomplete,
as it is impossible to include (enforceable) provisions for all eventualities. This
inherent incompleteness drives a wedge between the expected costs of funds to
the borrower and the required expected return to lenders, a wedge we identify
as enforcement costs.
The magnitude of these enforcement costs depends on the internal and

external consequences of opportunistic behavior. Internal consequences mainly
include judicial sanctions on private borrowers and political as well as judicial
sanctions on public borrowers. Externally, the potential gains of opportunistic
behavior have to be weighed against reduced access to international trade and
finance and the ability to export and reap the proceeds.
In general, enforcement costs have an inverse relationship to the degree of
integration of the borrower's country in the international trade and finance
system: The more complex the network of financial and commercial interactions
linking two countries, the higher the internal and external costs of 'strategic'
contract violations. This leads us to our first assertion:
Claim 1: Due to the lack of a supranational legal framework to enforce interna-
tional contracts, cross-border loans cannot fully preclude opportunistic actions
by borrowers resulting in the non-performance offinancial obligations. As a result,
lenders incur enforcement costs which are inversely related to the integration of
the borrower's country in the international trade and finance system.
The problems surrounding the enforceability of cross-border claims are consis-
tent with the observed concentration of cross-border lending to emerging
markets in the private sector (see Fact 4). As argued above, enforcement costs
largely depend on how lenders expect borrowers to weight the pros and cons
of honoring contractual obligations in the future, or, as Lessard (1993) calls it,
on the self-enforceability of a contract.
The risk of a strategic breach of contract seems to be more pronounced in
the case of loans to public borrowers. The benefits of a strategic default by a
private borrower accrue privately, whereas the benefits of a default by a public
borrower are at least partially public. However, the external costs in the form
of reduced access to international trade and finance whether or not the borrower
is private or public, always have to be borne by the country as a whole as the
international business community updates its assessment of the overall per-
ceived potential for such opportunistic actions. Hence, internally we would
expect effective judicial sanctions when a private borrower opts for opportunis-
tic default. The threat of litigation disciplines private borrowers at least par-
tially. Thus, the self-enforceability of cross-border loans to private borrowers
should be higher than in the case of public borrowers.
Claim 2: The self-enforceability of cross-border loans to private borrowers is
higher thanfor public borrowers. The benefits of opportunistic behavior by private
borrowers are 'enjoyed' by the individual borrowers, while the costs are borne by
the country as a whole.
Nevertheless, even with private borrowers there is still a self-enforceability
problem. Whereas the self-enforceability of loans extended within the same
country can be increased through the use of collateral, such a remedy cannot
normally be followed up in court with cross-border loans, or only with great
difficulty. Unless the borrower has physical assets outside the country, as is
the case with multinational firms for instance, the threat that physical assets
will be confiscated in the event of an opportunistic contract violation is only
credible within an international legal framework that enforces such actions.
Accepting that cross-border loans are hard to collateralize, banks can
increase self-enforceability by writing short-term loans. In the short run, regula-
tory and political uncertainty is lessened and there is less room for opportunistic
behavior. Empirical evidence suggesting that banks prefer short-term loans is
given in Figure 4.
Short-term lending also provides a natural device for disciplining borrowers
whenever the loan serves as interim financing for long-term projects. In this
case, the bank not only has the option of periodically renegotiating the terms
of the contract but also commits itself to regularly screening the project. This
latter point is especially important when information about the soundness of
the borrower is scarce, creating potential moral hazard problems on the side
of the borrower. In this case, the bank should check whether the borrowing
firm actually invests as contracted or gambles on investment strategies with a
very low expected return but a small probability of exorbitantly large returns
in some states of the world. As loan repayments are fixed and thus independent
of actual returns where contractual obligations are met, pursuing such 'roulette'
strategies might be attractive to the borrower, but not to the lender.
Claim 3: Short-term cross-border lending as interim financing increases self-
enforceability and provides a credible commitment to monitor the borrower,
thereby reducing potential moral hazard problems.
Monitoring by banks is not only valuable in the presence of moral hazard, but
also in the context of adverse selection, where the need to monitor emerges
from an information advantage for the borrower with regard to the prospects
1980-1982 1993-1995
Long-term bank lending 46% Long-term bank lending 24%
Short-term bank lending 54% Short-term bank lending 76%

Figure 4. Increasing importance of short-term lending. Source: IIF.
of the investment. In such a setting, a bank should only sign a loan agreement
when it has an advantage over its competitors in terms of monitoring. This
could be the case for, instance, if a bank has already financed a lot of similar
projects making it better at evaluating the risk on such loans. A bank with a
monitoring disadvantage will most likely only get to finance very risky, less
profitable projects, since borrowers with highly attractive projects prefer to
negotiate with a bank that does a better job of screening and is therefore able
and willing to offer the loan on better terms.
One way to bridge a 'gap' in monitoring is to finance particular investments
indirectly through better informed competitors. When such indirect financing
involves a cross-border loan, the self-enforceability problem reappears.
However, self-enforceability is not much of a problem if the domestic banking
industry is adequately integrated into the international financial markets and
would therefore face high external penalties in the event of opportunistic
behavior.
Which banks can we expect to have monitoring advantages with respect to
cross-border loans? In general, domestic banks in most industries are better
positioned to outperform their foreign counterparts in monitoring borrowers
as they are more integrated into the relevant information networks. However,
this argument loses weight when the value of a project depends more on world
market conditions than on home market conditions. When world market
information is valuable, it seems reasonable to assume that international banks,
which by definition are integrated into the international flows of trade and
finance, have at least no information disadvantage. Furthermore, as far as self-
enforceabilty is concerned, world markets only matter when potential borrow-
ers are somehow dependent on international trade and thus face high external
penalties for opportunistic behavior.
Claim 4: In the presence of adverse selection, we expect domestic banks to give
loans to home-market-oriented firms whereas foreign banks will either finance
loans indirectly through domestic banks or give loans to world-market oriented
firms.
Fact 4, that domestic banks in emerging market countries hold an increasing

share of external debt, could be interpreted as evidence in support of Claim 4.
The picture outlined above changes slightly when the borrowing firm is able
to finance a large part of the investment project itself. A high degree of self-
financing generates substantial incentives to make the project a success. In this
setting, the self-enforceability problem plays a minor role.
The analysis presented so far may help us to understand the pattern of the
last decade in cross-border lending but provides only a partial answer to the
question of which forces determine the role of loan contracts in today's mix of
international financing instruments (Figure 2). In the modern approach to
financial intermediation, the raison d'etre of banks as providers of loans is seen
in their function as monitors of borrowers on behalf of depositors. Banks as
intermediaries of loans are able to reduce monitoring costs through the econo-
mies of scale inherent in any systematic monitoring. From this theory it follows
that the distinguishing feature of a bank loan as compared to other means of
financing, for instance, foreign direct investment or portfolio investments in
bonds or equities, is the bank's commitment to monitoring the borrower's
activities.
Portfolio investments in bonds and equities lack this monitoring commit-
ment owing to free-rider problems among small investors. An atomistic investor
has little incentive to monitor the company any more seriously than by watching
market prices, since the benefits are enjoyed by all investors while the costs
are borne only by those actively carrying out the monitoring.
The distinction between foreign direct investment and cross-border loans
where the bank's monitoring role is concerned is not so obvious. A direct
investor is typically interested in control, an activity implying monitoring by
its very nature. However, the incentives to take appropriate action in case of
underperformance are quite different for a direct investor than for a lender. In
general, lenders are more able to commit themselves credibly to a tough
liquidation policy than direct investors. A direct investor shares the profits of
a financial enterprise on a pro rata basis and is therefore more vulnerable to
renegotiation in the event of non-performance than a lender sharing in the
profits on fixed terms. Hence, the difference between foreign direct investment
and cross-border loans lies in the credible commitment of the lender to taking
appropriate action in case of opportunistic behavior.
Claim 5: When borrowers have an information advantage over investors concern-

ing the outlook for investment projects, or when information about borrowers is
generally scarce, bank loans have a competitive advantage over other investment
s
instruments due to the bank commitment to monitoring the borrower and, if
appropriate, to penalizing a borrower for bad behavior.
This admittedly narrow view of banks and bank loans seems to fit the empirical
evidence on the financing behavior of firms reasonably well. In general, internal
finance in the form of retained earnings constitutes the greater portion of net
funds, whereas the importance of the various external investment instruments
differs depending on the firm's size. In general, the funding preferences of firms
seem to follow a familiar pattern.
Claim 6: When deciding how to finance new investment projects, firms' funding
preferences follow a pattern akin to a 'pecking order' in which internal finance
(retained earnings) ranks well above external sources. In the latter category,
bank loans rank ahead of tradable securities for small firms, and vice versa for
large firms.
Instructive, representative studies of the patterns of finance found in developed

economies are provided by Fazzari et al. (1988), and Mayer (1988). As an
example of a study looking at emerging markets, see Singh (1995).
The relevance of the pecking order hypothesis to emerging market countries

depends on the development of the financial markets in the country in question.
If, for instance, capital markets or the banking system are underdeveloped or
undercapitalized, it may well be that bank loans also outweigh tradable securi-
ties for large firms. Nevertheless, the pecking order attributed to sources of
finance is in line with Claim 5, as it is to be expected that information
asymmetries between borrowers and final investors are greatest when firms are
small and therefore hardly known. Moreover, informational asymmetries
matter more to small firms, where the impact of single investment projects on
overall performance is generally greater than for large companies, where the
failure of one project does not necessarily jeopardize the existence of the
enterprise. Recalling Claim 4, with respect to international finance, cross-border
lending should therefore be pursued with small, probably immature firms with
investment projects oriented towards the world market.
Summarizing these findings, we conclude that the self-enforceability problem
inherent in any cross-border financial contract explains to a large extent the
concentration of cross-border loans on private-sector borrowers in the 1990s.
In contrast to public-sector borrowers, private borrowers are less likely to
evolve into 'strategic deadbeats'. The upswing in short-term lending might also
be interpreted as an attempt to further increase the self-enforceability of cross-
border loans. When deciding how to finance new investment projects, loans
are preferred over other forms of investment whenever a credible commitment
to monitoring and, if appropriate, to penalizing the borrower is present. As
monitoring needs are most pronounced for small, probably immature firms,
we expect that, on average, domestic banks grant loans to home market-
oriented firms whereas foreign banks either finance loans indirectly through
domestic banks or give loans to world-market oriented firms.
LENDING IS DEAD, LONG LIVE LENDING!
What does the future hold for cross-border bank lending? Will this form of
financing be crowded out as the theory of financial intermediation seems to
suggest or will it continue to boom as in the recent past? The theories of
sovereign lending and financial intermediation can offer only partial answers.
Nevertheless, they do provide a basic framework and, coupled with empirical
observations, permit us to draw the following conclusions.
First, general purpose long-term lending to sovereigns in emerging markets
does not seem to have such a rosy future. Barring major changes in international
law and contract enforcement mechanisms, lenders will most likely be reluctant
to channel massive sums to sovereigns in the form of general-purpose lending
no matter how great the demand in emerging markets might be.
Second, long-term cross-border lending to private borrowers will prob-
ably continue to play an important role in international finance. With the
development of further self-enforcing contract mechanisms, direct cross-border
engagements in the form of structural financing, acquisition financing, project

financing, bridge financing (with take-outs, for example, via subsequent capital
market transactions), leveraged lending and co-financing are likely to playa
more and more important role in financing young companies in emerging
market countries. In principle, a great deal of the hunger for capital in emerging
markets could be channeled through loan contracts incorporating a high degree
of self-enforcement.
Third, short-term cross-border lending with emerging market countries holds
great potential. Its linkage with trade implies a high degree of self-enforceability,
and a further shift towards use as a conditional tool in long-term projects is
possible. But, even if we rule out this form of conditional financing for long-
term projects, the process of globalizing emerging market trade will continue
to be a strong force behind short-term credits. Taking on a conservative view
of international trade, we expect short-term claims vis-a-vis emerging markets
to rise by 50% between 1995 and 2000, with the total amount of short-term
bank claims coming to US$ 495 billion. This is based on 7.5% expansion in
world trade per year. As far as the direction of short-term lending is concerned,
we expect it to be channeled, like most other private capital flows, to the more
creditworthy countries.
Finally, there may also be some surprises in the future. Recent advances in
the quantification of credit risk and cross-border country risk, the new trend
towards securitization of loans and the emergence of credit derivatives may
lead to a more profound revival of the loan business, for at least two reasons.
First, as traditional qualitative customer and country ratings are progressively
replaced by quantitative measures of the likelihood of default, this type of risk
can be priced and managed in loan portfolios in much the same way as market
risk in bond and equity portfolios. With prices and risks aligned, the overall
efficiency of loan portfolios will increase and the supply of foreign lending to
emerging market countries may expand, especially the supply to the more
creditworthy. Second, credit risk and its diversification becomes more manage-
able with the securitization of loans and the ability to write derivatives on debt
instruments. This permits banks to originate and offload loans, to hedge
unwanted exposure with credit derivatives, and to acquire exposures which
provide risk diversifying benefits to their portfolios. Collectively, these changes
offer banks additional flexibility in how they manage their loan books and
thus can result in an outward shift of the lending supply curve.
ACKNOWLEDGMENTS
The comments of Cliff Asness, Rick Buckholtz, Kent Clark, Britt Harris, Brian
Hurst, Antti Ilmanen, Bob Krail, Burt Porter, Rebecca Runkle, and Ingrid
Tierens are gratefully acknowledged. We also thank Laurel Fraser, Uwe
Ketelsen, Bettina Kessel, and Taro Harano for research assistance.
REFERENCES
Fazzari, Steven M., R. Glenn Hubbard and Bruce C. Petersen (1988). Financing constraints and
corporate investment. Brookings Papers on Economic Activity, 1, 141-195.
Lessard, Donald R. (1993). Country risk and the structure of international financial intermediation.
In Dilip K. Das (ed.), International Finance. Contemporary Issues. London, New York: Routledge.
Mayer, Colin (1988). New issues in corporate finance. European Economic Review, 32, 1167-1189.
Singh, Ajit (1995). Corporate Financial Patterns in Industrializing Economies. A Comparative
International Study. International Finance Corporation, Technical Paper No.2, Washington DC:
World Bank.
DONG-HYUN AHW, JACOB BOUDOUKH 2 , MATTHEW
RICHARDSON 2 and ROBERT F. WHITELAW 2
1 University of North Carolina. Chapel Hill. 2 New York University
12. Hedging the interest rate risk of Bradys:

the case of Argentinian fixed and floating-rate bonds
ABSTRACT
While there is significant interest in investing in Brady bonds, the source of attraction is
often the exposure to sovereign risk (and its yield compensation), while the exposure to US
interest rate risk is a 'necessary evil'. This paper addresses the problem of determining the
interest rate sensitivity of Brady debt. We show that the most relevant state variables in
determining the duration of a Brady bond are US interest rates and the bond's strip spread.
Motivated by the difficulty of using structural models to price and hedge Brady debt, we
provide a model-free approach to estimating the hedge ratio. Using our approach to hedge
the Argentinian Par and Discount Brady bonds, we find that only a small fraction (15%
or so) of the total risk is hedgeable, but our hedged portfolio exhibits little covariation with
US interest rates.
INTRODUCTION
Brady bonds are sovereign debt issued to replace commercial bank loans made
to developing countries over the past two decades.! This emerging market debt,
which includes debt of Argentina, Brazil and Mexico, among many others, has
several unique features. First, some of the bonds are highly liquid, giving
investors the opportunity to invest in sovereign credit. Second, the majority of
the Brady bonds are denominated in US dollars, and, credit risk aside, are
therefore closely related to fixed and floating rate US government debt. Third,
most of the Brady Bonds include some type of credit enhancement, usually in
the form of the entire principal and some interest payments being collateralized
by zero coupon US Treasury securities.
To the extent that there are ample opportunities to invest in US government
debt, the primary reason for the success of the Brady bond market is the
opportunity to invest in the sovereign debt of emerging markets. Thus, isolating
the sovereign component of Brady bonds by hedging out the US interest rate
risk of these bonds is especially important to market participants (Telljohann,
1 Since 1990, a substantial number of Brady bonds have been issued, with billions of dollars in
principal currently outstanding. Brady bonds get their name from the then Secretary of the Treasury
Nicholas Brady, who emphasized a market-based approach in providing a plan for reducing
emerging market debt.
307
308 D.-H. Ahn et ai.
1994}. Informal evidence for the appetite investors have for securities which
afford liquid sovereign risk without the US interest rate risk can be found in
the common practice of 'stripping off' Brady bonds (i.e., shorting the guaranteed
component), and the enthusiasm which met the recent plan by the Mexican
government for swapping Brady bonds for purely sovereign debt. This lack of
appetite for US interest rate risk is not surprising since most financial institu-
tions and pension funds consider this risk systematic, while the sovereign risk
is often considered non-systematic. Hence, there is a significant interest in
understanding, quantifying and hedging the interest rate risk of Brady bonds.
In the case of a fixed-rate Brady bond, estimating the bond's interest rate
sensitivity involves knowledge of both the bond's characteristics (e.g., maturity,
coupon and any embedded options) and the level of interest rates. It is impor-
tant to note, however, that even if interest rates are independent of the Brady
bond's default rate, hedging the interest rate risk of the Brady bond requires
additional information regarding default probabilities. This result is true even
in the simple world of a flat term structure and an equal probability of default
each period. Ahn, Boudoukh, Richardson, and Whitelaw, 1997, show that,
under these assumptions, the Macaulay duration of the bond not only changes
as the default probability increases, but that this change may be positive or
negative, depending on the coupon, the interest rate level, and the default
probability.
Given the current values of the interest rate and default probability, one
could dynamically adjust a hedged position by duration matching using, say,
T -note futures, thus, completely isolating the Brady bond from instantaneous
interest rate risk. The problem with this approach is that the assumptions
underlying these theoretical duration measures are generally poor (Cumby and
Evans, 1995; Nadler et ai., 1996). The goal ofthis paper is to develop a different
approach for hedging Brady bonds using interest-rate instruments, such as
T-note futures, following the methodology in Ahn et ai., 1997. The idea is to
estimate a conditional hedge ratio between returns on a Brady bond and
returns on T-note futures. The hedge ratio is conditional in the sense that we
account for relevant current information. This is important for Brady bonds
because, as interest rates and default rates change, the interest rate sensitivity
of Brady bonds will change in a highly nonlinear fashion. In order to estimate
this conditional hedge ratio, a structural model is usually required (as with
most fixed-income valuation approaches). Unfortunately, this requirement
involves making a number of assumptions on the underlying processes which
mayor may not be reasonable.
In this chapter we take an empirical approach to estimating a conditional
hedge ratio for Brady bonds using T-note futures. We take a stand only on
what the relevant state variables are, namely, the level of interest rates and the
strip spread, but not on the precise functional form of their relation to duration.
We implement an out-of-sample experiment, in which we re-estimate the hedge
ratio using a moving window of past data, and compare various methods. We
show that there is some, albeit limited advantage, to the use of conditioning
Hedging the interest rate risk of Bradys 309
information, relative to a simpler procedure of reestimating the hedge ratio

repeatedly, but without any conditioning on state variables. We interpret these
results as a reasonable outcome of the fact that our conditioning state variables
are highly persistent. Overall, we find that only a small fraction of the volatility
of Brady bonds can be hedged away, and most of the volatility (practically all,
for the case of the Brady floater) is asset-specific.
THE HEDGING METHODOLOGY
Theoretical background
How sensitive are Brady bond returns to interest rate changes? Ahn et al.,
1997, address this issue in a formal setting; however, to gain some intuition,
consider a simple economy in which there is a flat term structure with interest
rate r and a constant probability of default p (with no recovery). A fixed-rate
bond paying a coupon c with underlying principal F has a present value equal
to
v= f C(1 - p)' + F( 1 - pf (1)

t~l (1 + r)' (1 + rf
The Macaulay duration of the bond is given by the usual formula, i.e.,
= _ aVIV _ f PVt(C) PVT(F)
(2)
Dmac - ar/l + r - t~l V t + V T,
where PVt (') equals the present value of the cash flow in period t, adjusted for
the probability of default. Thus, the Macaulay duration is simply a value-
weighted sum of the maturities of the bond's cash flows. Both high interest
rates and a high probability of default tend to substantially lower the present
value of payoffs further in the future, thus reducing the duration of the bond.
In fact, changes in the probability of default have much the same effect as
interest rate changes, so that the standard convexity results follow.
Although Brady bonds face default, part of their cash flows are generally
collateralized by US Treasuries. For example, it is standard to guarantee the
principal, and sometimes the more immediate coupon payments (usually 12-18
months worth), using US Treasury strips. As an illustration, consider a fixed-
rate bond with guaranteed principal. The valuation equation analogous to
equation (1) is
v= f C(1 - p)' + F (3)

t~l (1 + r)' (1 + rf'
Note that the present value of the principal payment no longer depends on
the default probability. Consequently, as the probability of default changes, the
Macaulay duration of the bond changes in an indeterminate manner.
310 D.-H. Ahn et al.
The above discussion considers a fixed rate Brady bond. However, a number
of existing bonds offer floating rates. It is well known that floating rate bonds
are relatively insensitive to interest rate changes, as long as the probability of
default is not correlated with interest rates. Here, the guaranteed component
of Brady bonds dramatically changes this result. As the probability of default
increases, only the duration of the guaranteed component matters; thus, in the
above example, the Macaulay duration is the maturity of the bond's principal.
Therefore, in contrast to the fixed rate bond, the duration of the floating rate
note can vary from six months to thirty years, depending on the likelihood
of a default. Consequently, hedging floating rate Brady bonds may require
substantial positions in the bond market, a vastly different result to that
normally found.
METHODOLOGY
Since the interest rate sensitivity of Brady bonds changes with both the term
structure of interest rates and the term structure of default probabilities, it is
crucial to take these into account when forming the hedged position. The
problem of implementing this hedged position is substantial. Specifically, the
assumptions of a flat term structure and constant default probability are clearly
inconsistent with the data. While models have been developed which generalize
this base case (e.g., Cumby and Evans, 1995), these models involve strong
parametric assumptions. Thus, the results can be difficult to interpret to the
extent that these models are forced to fit the current interest rate and default
probability environment.
An alternative method is to allow the model to have more flexibility and to
take an empirical approach to estimating the hedge ratio. The difficulty is that,
as we have seen, this hedge ratio varies substantially with important economic
variables, such as interest rate levels and default probabilities. Thus, standard
regression-based hedges will not be sufficient. Here, we take a different approach
towards estimating the conditional hedge ratio. Using estimates of conditional
comovements between Brady returns and the hedging instrument, we estimate
the conditional hedge ratio directly. That is, we estimate the conditional relation
between the rate of return on a Brady and the return on, say, a T-note futures,
conditional on relevant information available at any point in time. Suppose
we are given T observations, Zl, Z2, ... , ZT, where each Z, is an m-dimensional
vector. Specifically, let Z, == (R~,+ j ' R[i'+ j, x,), where R~,+ j and R[i'+ j are the
j-day returns on the Brady bond and T-note futures, respectively, and x, is an
(m - 2)-dimensional vector of relevant factors known at time t. Given the
discussion above, two prime candidates for the (m - 2)-dimensional set of
variables are the current level of interest rates and some measure of the
probability of default (such as the strip spread between the Brady bond's yield
on the non-guaranteed portion and US Treasury rates).
There are a variety of methods for calculating the conditional relation

between Brady bond returns and the hedging instrument. In particular, we
want to estimate the conditional mean, E[R~t+ll R:'f+l, Xt], i.e., the expected
Brady return given movements in the T-note return, conditional on the current
economic state as described by Xt. While there are a number of parametric and
nonparametric techniques for estimating conditional means, consider one in
particular based on standard regression methods:
(4)
One way of estimating Pt is through a Taylor series expansion, that is, Pt =
g(it, St, t) where it is the current interest rate level, St is the strip spread, and t
is time-to-maturity. Equation (4) can then be estimated using multivariate
linear regression methods.
The interpretation of equation (4) is simple and intuitive. To see this, first
consider an empirical duration method in which the Brady bond return is
regressed on the T-note futures returns, thus the hedge ratio is the resulting
state-independent Pcoefficient. That is, the hedge ratio is constructed by taking
pairs of past Brady and T -note returns, and then equally weighting these pairs'
co-movements (in this case, by the variability of the T-note futures return).
The problem with this approach is that all observations have equal weight.
Thus, in estimating the hedge ratio today, comovements between Brady and
T-note returns in high interest rate or high default probability environments
get the same weight as in low interest rate or low default probability environ-
ments. A static hedge ratio, of course, is not appropriate for hedging Brady
bonds.
The dynamic hedging strategy outlined above also has a clear interpretation.
The state-dependent hedge ratio, Po is estimated by taking past pairs of Brady
and T-note futures returns, and then differentially weighting these pairs'
co-movements depending on the co-relations between R~-i.t+ j_;, R'{!i,t+ j - i and
economic information Xt-i' Equation (4) is similar in spirit to a regression
hedge, except that the weights are no longer constant, but instead depend on
current information. The idea behind this estimation is that these weights are
not estimated in an ad hoc manner, but instead depend on the true (albeit
estimated) relation between the relevant variables. Our approach has a clear
advantage over the regression hedge. The hedge ratio in equation (4) explicitly
takes into account the current economic state. For example, if interest rates
are currently high, but the default probability is low, then more weight will be
given to past comovements between Brady and T -note futures returns in those
states. Thus, the hedge ratio adjusts to current economic conditions.
Note that equation (4) provides a formula for the hedge ratio between an
investor's Brady position and T-note futures. For example, if
Pt=-
oE B I TN
05
[R"'+J R'.'+J,x,1 _
OR TN . -.,
t,t+ J
then for every $1 of a Brady bond held, the investor should short $0.50 worth
of T-note futures. This hedge ratio will change dynamically, depending on the
current economic state described by X" In our specific example, the hedge ratio
should change in response to changes in the interest rate level and the prob-
ability of default.
EMPIRICAL ANALYSIS
Data description
In this study we employed several data sources over the period July 1992 to
March 1996: (i) Brady bond prices of the Argentinian Par bonds (fixed rate)
and the Argentinian Discount bonds (floating rate) from a major investment
bank in the emerging markets area,2 (ii) strip spreads for both of these bonds
from the same investment bank, and (iii) lO-year T-note futures prices and
various term structure information, including the 3-month, I-year, 5-year and
10-year yields from Datastream.
With respect to the Brady bond data, we collected daily data on two
Argentinian bonds: (i) the dollar denominated, $12.7 billion 30-year Par bond,
with fixed rates building up to 6%, and principal and 12 months coupon
interest guaranteed by US Treasury strips, and (ii) the dollar denominated,
$4.3 billion 30-year Discount bond, with an floating rate of LIBOR plus
0.8125%, and principal and 12 months coupon interest (at 8%) guaranteed by
US Treasuries. Both bonds mature on March 31, 2023. (For more information
see Chase, 1995.)
US interest rates and futures returns are taken from Datastream. Specifically,
the I-year and lO-year rates are daily fixed-maturity series, compiled by the
Federal Reserve Board of Governors. The 10-year T-note futures return series
is a series of nearest to maturity futures, spliced at the last day of the month
prior to the expiration month to avoid liquidity-related effects. The maturity
effect in the futures contracts (which are issued in a 3 month cycle) may cause
a seasonal pattern in the data, although this effect is secondary.3
While the Brady market is extremely liquid, data concerns related to non-
synchronous quotes across the markets can be somewhat alleviated by using
a longer measurement period. Throughout the study we analyzed weekly
returns, which strike a reasonable compromise between measurement issues
and the relatively small size of our data sample. We used overlapping data in
2 These results differ somewhat from Ahn et al., 1997, due to the nature of the strip spread
calculation. Here our primary interest is in hedging a particular fixed and floating rate issue. For
this application, the data from the investment bank is of high quality.
3 A simple way to see this is by considering the corresponding forward contract, which is,
essentially, a long position in a long bond financed by a short position in a short bond (for a long
futures position). The first order effect on changes in this forward/futures price will be due to
changes in the long rate due to its much higher duration.
Table 1. Summary statistics
Di:.,+s Rf.'+5 i: ./
Rr.~~s ,
spar
R~~s+s ,
Sdis
"
Mean -0.004 0.033 4.824 6.495 0.227 8.780 0.122 8.733
Std. dev. 0.126 0.842 1.230 0.740 3.386 3.103 3.430 3.207
Di!,t+s 1.000 -0.943 -0.094 -0.082 -0.493 -0.240 -0.235 -0.238
Rf.t+5 -0.943 1.000 0.093 0.082 0.461 0.225 0.222 0.225
s
-0.094 0.093 1.000 0.705 -0.051 0.523 -0.081 0.603
"./ -0.082 0.082 0.705 1.000 -0.100 0.238 -0.127 0.276
"
Rf.~~s -0.493 0.461 -0.051 -0.100 1.000 0.210 0.830 0.198
,
spar
-0.240 0.225 0.523 0.238 0.210 1.000 0.121 0.983
R~~s+5 -0.235 0.222 -0.081 -0.127 0.830 0.121 1.000 0.147
,
Sdis -0.238 0.225 0.603 0.276 0.198 0.983 0.147 1.000
Summary statistics are provided regarding the Argentinian Par and Discount Brady bonds, and
relevant state variables. Return data are for weekly changes, overlapping daily. The sample period
is 10/15/1992 to 2/22/1996. The variables are: Di:.'+5 the weekly change in the 10-year US par
i: i:
yield, Rf.,+, the return on 10-year T-note futures, the I-year US par yield, the lO-year US par
yield, Rf.~~5 the return on the Brady Par bond, sF" the Brady Par bond strip spread, R~;'+s the
return on the Brady Discount bond, s~;' the Brady Discount bond strip spread.
order to use all available information, and where necessary, we adjusted for
the overlap.
Table 1 provides basic summary statistics for our dataset. During the sample
period (October 15 1992 to February 22 1996), there was an average weekly
gain in both the Par and the Discount bonds of 0.23% and 0.12%, respectively.
Some of this return can be attributed to the decline in US interest rates, and
the rest to an improvement in the perceived credit worthiness of Argentina's
debt.
The standard deviations of returns on both bonds are approximately 3.4%
per week, about four times larger than the volatility of the corresponding
T-note futures contract (with a return standard deviation of 0.84% per week).
These standard deviations give us a preview of the results to follow, namely,
that most of the variation in Brady bond prices will not be explained by
variation in US Government bond returns or related derivatives. To see this,
we simply need to recognize that the typical asset underlying a T-note futures
contract is a par coupon-bearing US government bond, with cash flows which
are fairly similar to the promised cash flows of the Argentinian Par bond.
However, this Brady bond is much more volatile, and its correlation with the
T-note futures contract is only 0.46. At the same time, the Argentinian Par
bond is as volatile as the Argentinian Discount bond, and the correlation
between the two Brady bonds is 0.83. This immediately indicates that sovereign
risk is causing most of the variation, not dollar interest rate risk.
The volatility of Brady bond returns over our sample period can be largely
attributed to the events that took place at the end of 1994. The collapse of the
Mexican peso, and with it the decline in the perceived credit worthiness of
Mexican sovereign and Brady debt, had large spillover effects throughout South
CD
N
...
N
Itlllllliltli Ihi
............. 110
~ -- .Cp..
- .Cparl",
lIo
.CdlelN
~ ........Cdlello
I
UJ
!!!
!d\.
~ ~
:g
~
CD ." ~."" ~"
.,............. '-0 ,", ,
\...A........- .................... ..:.~ .....~.~t'
...
o~ ____ ~ ______ ~ ____ ~ ______ ~ ____ ~ ______ ~ ____ ~ ____ ~
1992.5 1993.0 1993.5 1994.0 199. 5 1995.0 19as.5 1998.0 1998.5

Data
Figure 1. The strip spreads on Argentinian Par and Discount Brady bonds and the to-year US
Government par yield. The thick lines denote that the series is above its sample mean.
America. Specifically, during the half year surrounding the collapse of the
Mexican Peso (most of which occurred during last weeks of 1994 and January
1995), the credibility of the Argentinian Peso's peg to the dollar became
doubtful. The resultant impact on Argentinian Brady bonds was due to a
perceived increase in the default probability. This is apparent in Figure 1, which
depicts the path of the strip spreads of the Argentinian Par and Discount
bonds. 4 The strip spread rose from about 6% prior to the event, to an average
level of over 12%, with strip spreads as high as 20% or more at times.
Out-oj-sample hedging
In this section we provide the results from a rolling out-of-sample hedging

experiment, as outlined above. Specifically, for every date in our sample starting
from the 251st date onward, we used the previous 250 observations (approxi-
mately one year of trading data) on Brady returns and T-note futures returns
in order to determine the appropriate hedge ratio based on the covariance and
variances of the variables. We also determined a state-dependent hedge ratio,
which depends on the strip spread, the yield of the 10-year US government
4The strip spread is obtained in the following manner. Using a zero curve imputed from prices
of US government bonds, the guaranteed payments of a given Brady bond are stripped off. The
strip spread is then the difference between the default-free yield on the promised payments, and
the defaultable yield given the value of the stripped bond. Some subtle issues arise with respect to
the proper calculation given the rolling guarantee, which gives rise to some differences in strip
spread calculations across methods. Irrespective of the method of calculation, however, the
strip spread is the single best summary statistic for the market-perceived average default probability
throughout the remaining life of the Brady bond.
par bond, and the Brady's time to maturity. We did so repeatedly using the
250-day window until the last day in our sample.
We experimented with a number of specifications for the functional form
and the relevant conditioning variables in estimating the conditional hedge
ratio, Pt. Our benchmark is a state-independent (although not time invariant)
hedge ratio, which is estimated repeatedly but without any conditioning on the
relevant state variables. We then assume that the function Pt = g(it> St> r) is a
linear function of these variables, and consider hedging first using it only, then
adding St to the set of conditioning information, and last, the time to maturity
r. We also allowed for non-linearities by considering a second order Taylor
expansion on the most interesting set of conditioning information, namely it
and St. This expansion involves the addition of squared and interaction term
of these variables (three additional variables in total) to the original set of two
conditioning variables.
Table 2 documents results for the Par and Discount Brady bonds respec-
tively. For each of the hedging procedures considered we provide two summary
statistics. First we document the volatility of the returns on a hedged portfolio
which involves a long position in the relevant Brady bond, hedged by the
appropriate short position in lO-year T-note futures. The goal is to minimize
the volatility of hedged returns. The second statistic is the correlation coefficient
between hedged returns and the contemporaneous change in the 10-year rate.
Since our experiment is conducted as an out-of-sample experiment, we are not
guaranteed orthogonality between the hedging errors and interest rate changes.
As pointed out in the introduction, one might consider the ability to hedge a
specific source of risk, interest rate risk in our case, important.
With respect to hedging the Par bond, the total unhedged standard deviation
of returns was 3.68% per week, and the correlation between returns and interest
Table 2. Hedging results for the Par and Discount Brady bonds respectively, using 10-year T-note
futures contracts
Conditioning information
f f
f
't,S,
f
't,Sf 't, S" T
Unhedged None "linear linear Taylor linear
Argentinian Par bond

0'(,.,+5) 3.676 3.092 3.136 3.087 3.275 3.094
p(,.,+5, DiL,+5) -0.556 -0.104 -0.010 0.096 0.096 0.018
Argentinian Discount bond
0'(,.,+5) 3.797 3.659 3.714 3.626 3.823 3.617
p(,.,+5' Di:.,+5) -0.296 -0.045 -0.010 0.155 0.101 0.079
Out-of-sample hedging errors are analyzed for the hedge regression R~'+5 = ex + P,R[{':.s + '.'+5'
At any given date starting the 251st date, the previous 250 daily observations are used for
estimation. The hedge ratio p, is allowed to depend linearly or nonlinearly on conditioning
information. Two summary statistics are recorded: (i) hedged return volatility, and (ii) ex post
correlation of the hedging error with changes in the 10-year par yield.
rate changes was - 0.56. These numbers correspond closely, although not
exactly, to the numbers in Table 1, due to the 'missing' 250 days upfront in the
results of this section. The standard error using the state independent hedging
method was reduced to 3.09%, and the correlation reduced to -0.10. With
respect to the state-dependent hedge ratio results, the results overall can be
considered disappointing. Using the to-year rate as a single conditioning vari-
able yields a standard deviation of 3.14% and the correlation of hedging errors
with interest rate changes is -0.01. On the positive side, conditioning on the
level of interest rates reduces whatever correlation with interest rate changes
was left over from the unconditional hedge. This comes at the cost of increasing
the variability of hedged returns.
Adding the spread to the set of conditioning information should, according
to our theory, help to pin down the appropriate duration/hedge ratio. Indeed
this bivariate hedge does yield the lowest return volatility (3.087%), but the
improvement is hardly significant from an economic perspective. A Taylor
expansion of the two-variable conditioning set provides no benefit, and, in fact,
increases the return volatility (3.28%). This latter result is simply an artifact
of estimation error, exacerbated by the highly volatile spread.
The results for the Discount bond were worse. There was very little, if any,
reduction in the return volatility, and the only reduction was in the correlation
coefficient between hedged returns and interest rate changes. This outcome
would not be too surprising if the default probability was very low, since a
default-free floater should exhibit very little volatility. However, the magnitude
and variation of the strip spread suggest that conditioning on this variable
should produce a viable hedge. Consequently, the empirical results are
disa ppoin ting.
The results for both the Par and the Discount bonds are qualitatively robust
to (i) the length of conditioning period, (ii) the hedging horizon, (iii) the specific
subperiods, and (iv) the addition of the I-year US interest rate to the set of
conditioning variables. We also experimented with smoothing methods, which
allow the state-dependent hedge ratio to vary more 'sluggishly'. Specifically,
we considered an exponentially smoothed hedge ratio, with various smoothing
parameters. Another refinement which we considered was the use of Stein
estimators. 5 The results were not remarkably different for either of these
attempted improvements.
CONCLUSION
Our empirical results and their weak link to the theory illustrate the difficulty
in hedging Brady bonds. From an asset pricing perspective the results pose a
5 Stein estimators are also known as 'shrinkage' estimators. They adjust for the signal to noise
ratio by appropriately shrinking the hedge ratio. Stein estimators are often used by practitioners
in the context of fixed income securities hedging and portfolio analysis (for a technical discussion
see Judge et al., 1985).
challenge, and perhaps an opportunity. They call for a further investigation of

the appropriate missing variables and/or trading opportunities.
From a practical standpoint, the results in this paper provide one way to
interpret the seemingly myopic hedging approach common to practitioners. It
is quite common for investors to simply strip off the Brady bond's guaranteed
component by taking a short position in a set of zeros corresponding to the
set of guaranteed payments. Given our results, such a myopically hedged
position would come close to being a pure 'sovereign play'.
The results in this paper also have interesting implications from a risk
management perspective. They demonstrate the weak link which some dollar
denominated bonds may have to the returns on US government bonds. (The
high yield debt area may provide similar results.) Only 20-40% of the variation
in Brady prices can be attributed to changes in dollar discount rates. Such low
explanatory power has meaningful implications for the appropriate value at
risk numbers of trading groups and some financial institutions with high stakes
in anyone specific market.
REFERENCES
Ahn, D.-H., J. Boudoukh, M. Richardson and R.F. Whitelaw (1997). The Interest Rate Risk of Brady
Bonds. Working paper, University of North Carolina, Chapel Hill and New York University.
Chase Manhattan (1995). The Emerging Markets Handbook.
Cumby, R. and M. Evans (1995). The Term Structure of Credit Risk: Estimates and Specification
Tests. Stem School of Business, Economics Department working paper EC-95-14.
Judge, G., W.E. Griffiths, C. Hill, H. Lutkepohl and T.-C. Lee (1985). The Theory and Practice of
Econometrics. New York: John Wiley and Sons.
Nadler, D., P. Tsoucas and C. Wierzynski (1996). Brady Bond Valuation and the Universe of Credit
Term Structures. Goldman Sachs Fixed Income Research Series.
Telljohann, K. (1994). Quantifying and Isolating the US Interest Rate Component of a Brady Par
Bond. Chicago Board of Trade working paper.
IAN DOMOWITZl, JACK GLEN 2 and ANANTH MADHAVAN 3
1 Northwestern University 2 International Finance Corporation 3 University of Southern California
13. Country and currency risk premia:

evidence from the Mexican sovereign debt market
1993-94
INTRODUCTION
With hindsight, the events following the collapse of the Mexican peso in 1994
suggest a major misjudgement of the potential reaction of foreign investors to
a devaluation. This view is clearly ennunciated by Lustig (1995), who also
notes that it is difficult to accept that investors were not aware of the exchange
rate risk in a country with a high current account deficit and low level of
domestic savings. Although there has been extensive factual investigation of
circumstances leading up to and beyond the devaluation in the form of event
chronologies and macroeconomic statistics, little evidence has been presented
with respect to risk and expectations issues.
In Mexico, as elsewhere, interest rates on short-term debt issued by the
government can provide evidence on the beliefs that investors hold with respect
to risk. We examined the interest rates paid to investors by the Mexican
government for short-term debt instruments over the 1993-1994 time frame.
The nature of the data allowed us to decompose risk premia demanded by
investors into two components. The first is based on local dollar-denominated
debt, which we term a country risk premium. This premium is compensation
for the risk that the Mexican government might default on its obligations either
to repay the debt or to allow movement of capital outside the country. The
second is based on both dollar-denominated and peso-denominated debt, rep-
resenting compensation for the risk associated with movements in the exchange
rate, a currency risk premium.
Studies relating to either of these concepts are certainly not new. Work
relating to country premia is manifested in analysis of the spread between
dollar-denominated rates and LIBOR that countries are charged for loans
(Edwards, 1986). Foreign exchange risk premia have been extensively examined;
a recent survey is provided by Lewis (1995). Most work has concentrated
directly on exchange rates and on bank deposits or short-term securities issued
by different entities and subject to different default risk.
By employing only instruments issued by the Mexican government, we
avoided confusing diverse default risks with country or currency risk. Following
Frankel and Okongwu (1996) and Domowitz et al. (1996), we derived country
and currency risk premia directly from information on Mexican sovereign debt,
and analyzed the behavior of those premia over time. Particular attention was
319
Ii:> 1998 Kluwer Academic Publishers.
paid to the behavior of the premia and their underlying instruments around
unusual events in the Mexican political and economic climate, including the
Chiapas uprising, the Colosio assassination, and the enormous increase in the
supply of dollar-denominated debt in the last three-quarters of 1994. With
respect to the devaluation, we found no evidence, based on interest rate move-
ments, the structure of risk premia, or the growth in dollar-denominated debt,
that investors anticipated the devaluation and the crisis that ensued.
Our approach to the expectations issue differed from that of Frankel and
Okongwu (1996), who employed survey data on exchange rate depreciation.
Viewing the risk premia as synthetic tradeable instruments, we applied the
perfect foresight version of the expectations hypothesis (Campbell and Shiller,
1991). We documented the time series behavior of the residuals of that model,
which represent forecast errors under the expectations hypothesis, once again
concentrating on the Mexican political and economic changes over the period.
There is clear evidence from this analysis that investors did not anticipate the
events of December, 1994. On a qualitative basis, reaction to the devaluation
in terms of the forecast errors mirrors that to other unanticipated events, such
as the uprising and assassination.
DEBT INSTRUMENTS AND RISK PREMIA
The federal government of the United Mexican States issues a number of

different fixed-income securities. The most important in recent years have been
Certificados de la Tesoreria (cetes) and Bonos de la Tesoreria (tesobonos), both
of which are short-term pure discount notes issued at weekly auctions for a
variety of maturities. Subsequent to the auctions, a liquid secondary market
for the instruments exists, but our study was limited to the weekly primary
auction prices, which determine a yield to maturity. At the end of 1994, total
Mexican internal public debt was NP171.3 billion, or slightly more than $50
billion at the then-prevailing exchange rate. Of that amount, 55% consisted of
tesobonos, with another 23% accounted for by cetes. Tesobonos were not as
important in previous years, having grown from less than 1% of the total at
year-end 1992, with much of the growth taking place in early 1994. Subsequent
to the December 1994 devaluation of the peso, the market for tesobonos
collapsed and they now account for only a fraction of the total public debt
once again.
The difference between the two instruments lies in the manner in which the
return to the lender is calculated. A cetes is a simple peso-denominated note
whose yield to maturity is determined by the discount demanded at the time
of issue. Payment is made in pesos at the time of maturity with no adjustment
for changes in the value of the peso relative to other currencies or Mexican
inflation.!
I The Mexican government also issues ajustabonos, which are indexed to Mexican inflation, but
these were not as popular as cetes during our same period.
Country and currency risk premia 321
Tesobonos are more complicated. They are also peso-denominated instru-

ments issued at a discount, but with the principal amount paid at maturity
indexed to the peso-dollar exchange rate. 2 As a result of this indexing, the
tesobonos is essentially a dollar denominated security, with an additional risk
that the Mexican government will impose capital controls that prevent investors
from converting pesos into dollars at the market-determined exchange rate. 3
Investors submit bids in dollar terms to the primary market, and the peso
value of the bids is determined the same morning using a (trimmed) average
market exchange rate calculated daily by the central bank. For a nominal
premium, usually of 10-20 basis points, banks sell insurance that guarantees
that customers will receive pesos indexed to this average rate for delivery or
the conversion of the proceeds of maturing tesobonos into dollars.
Define C; as the rate of return on a cetes bill at time t with i periods to
maturity and T; as the rate of return on a tesobonos bill similarly defined.
These rates can be broken into their constituent risk premia as follows:
(1)
r;
where is the risk-free rate on a dollar-denominated bill at time t with maturity
in i periods and Y~t is the risk premium paid to investors by the Mexican
government for the possibility that it will default on its obligation. For cetes,
a similar decomposition produces:
Ct=rt
i - i+ i + i
Ypt Ymt (2)
where Y~t is the risk premium paid to investors for the risk that changes in the
exchange rate will affect the real value of their investment. This specification
obviously assumes that there is a single international risk-free rate that applies
to investments regardless of there currency denomination.
Under the assumption that US Treasury bills are risk free, one can decom-
pose the cetes and tesobonos rates in order to derive the Mexican country risk
premium and peso currency risk premium for any given maturity. Defining the
US Treasury bill rate as r;,
one obtains
and
2 Tesobonos are a reincarnation of a previous instrument, pagafes, which the switchover between
the two instruments taking place in 1991 when exchange controls were eliminated and the controlled
and market exchange rates were unified. For an examination of the links between the cetes and
pagafes markets see Khor and Rojas-Suarez (1991).
3Capital controls were imposed in 1982 following the debt crisis and subsequent devaluation.
See Melvin and Schlagenhauf (1985) for a description of the effect those controls had on eurodollar
interest rates paid by Mexican borrowers. Following the December 1994 devaluation, the govern-
ment offered investors a choice between payment in dollars and payment in indexed pesos in an
attempt to reduce investor concerns over repayment.
We assume that the default risk premium, y~" is the same for both instru-
ments because they are issued by the same entity. One could argue that the
default risk on cetes is lower than for tesobonos because they are peso-denomi-
nated and the government can print an unlimited amount of pesos for
repayment purposes. In fact, Lustig (1995) identified the dollarization of
Mexican short-term debt as an important contributing factor to the peso crisis
in 1994, on the grounds that "it vastly increased the risk of default." However,
tesobonos are, in effect, also peso-denominated, albeit with a link to the
exchange rate. Printing pesos should have an eventual impact on the exchange
rate, but given a willingness to accept high domestic inflation, repayment of
tesobonos would be possible for any reasonable level of indebtedness. From
another perspective, the real default risk inherent in these two instruments is
more political than economic. Even under very severe economic circumstances,
repayment would be possible if the political willpower existed. Default decisions
are more likely to be political than economic and with each of the two
instruments being held by both foreign and domestic investors, any decision
to default would likely apply to both instruments.
In an international context, the currency risk premium, y~" can be further
decomposed into two separate factors: one for expected depreciation of the
peso, and one for unexpected currency movements. The first of the two has
been the subject of some debate because of its expectational nature; Frankel
and Okongwu (1996) discussed three different approaches to estimating this
premium and examine the premium in the Mexican context. The second com-
ponent, commonly called the foreign exchange risk premium, has been studied
extensively, albeit primarily for developed countries. Lewis (1995) reviewed
much of the relevant literature, which concentrates on the foreign exchange
risk premium by subtracting the forward exchange rate from Y~,.
From a purely domestic perspective, however, an alternative decomposition
of the currency risk premium would include a term for expected peso inflation,
with another term for the risk of unexpected peso inflation. To the extent that
purchasing power parity holds, then these two alternative decompositions yield
equivalent results, but to the extent that there is variation in the real exchange
rate, the different investor groups can have divergent opinions on the appro-
priate value of Y~,. The domestic decomposition views interest rates as being
determined by domestic investors who are concerned with the domestic
purchasing power of the peso. In the international decomposition, investors
are concerned with the international purchasing power of the peso.
Unfortunately, we know of no theoretical model that permits one to differentiate
empirically between these two potentially different perspectives. Frankel and
Okongwu (1996) sidestep the issue by concentrating exclusively on the inter-
national decomposition in their analysis, which is equivalent to assuming that
purchasing power parity holds, at least on average in an expectational sense,
over the sample period. Our analysis also evaded the issues by looking only
at the value of Y~, and ignoring the decomposition.
MARKET BEHAVIOR, 1993-1994
Sample statistics for the 91- and 182-day cetes, tesobonos, currency premia and
country premia are presented in Table 1. Observations correspond to weekly
auction prices for the period July 1993 to the end of November 1994. Some of
the discussion that follows will also include observations from the period that
followed the December 1994 devaluation. Those observations are excluded
from the sample statistics, however, because they are markedly different from
the remainder of the sample period. Separate sample statistics are reported for
each of the 2 years in order to give an idea of the effect of the sample period
Table 1. Summary statistics on traded instruments and derived risk premia in the Mexican debt
market for 91-day and 182-day maturities
Standard
Series Minimum Maximum Mean Median deviation
Cetes (91-day)
1993 0.107 0.159 0.136 0.139 0.012
1994 0.091 0.180 0.142 0.145 0.027
Cetes (182-day)
1993 0.106 0.154 0.134 0.137 0.013
1994 0.099 0.176 0.140 0.143 0.022
Tesobonos (91-day)
1993 0.047 0.055 0.051 0.051 0.002
1994 0.040 0.082 0.066 0.068 0.010
Tesobonos (182-day)
1993 0.049 0.059 0.053 0.052 0.003
1994 0.048 0.088 0.071 0.074 0.011
Peso premium (91-day)
1993 0.056 0.104 0.085 0.089 0.012
1994 0.033 0.112 0.076 0.075 0.020
Peso premium (182-day)
1993 0.047 0.095 0.080 0.084 0.013
1994 0.042 0.105 0.069 0.065 0.015
Country premium (91-day)
1993 0.005 0.040 0.022 0.020 0.007
1994 0.005 0.040 0.023 0.024 0.008
Country premium (182-day)
1993 0.014 0.049 0.026 0.024 0.007
1994 0.014 0.050 0.028 0.027 0.008
Data for cetes (governments securities denominated in pesos) and tesobonos (government securities
denominated in dollars, payable in pesos as the official exchange rate) are annualized effective
yields calculated from the Mexico government weekly primary auctions, from the beginning of
July 1993, through the end of November 1994. The currency risk premium ('peso premium') is
calculated as the arithmetic difference between cetes and tesobonos yields. The country risk premium
('country premium) is calculated as the difference between the tesobonos yield and the yield of a
3-month US Treasury security. Data reported are the minimum and maximum yields and premia,
the mean and median yields and premia, and the standard deviation of the yields and premia all
in percentage/l00.
on the results, something that might be important given the political and
economic events that took place in Mexico in 1994. The instruments are issued
with maturities ranging from 7 to 360 days, but not all maturities are issued
every week. For the sample used in this study, 91 and 182 day were the most
common maturities and the analysis is restricted to those two maturities.
As might be expected given the currencies involved, the cetes rates were
substantially larger than the tesobonos rates on average. They were also much
more volatile, although the volatility of both instruments increased markedly
in 1994 relative to 1993. Tesobonos rates rose sharply in 1994 relative to 1993,
with an increase of roughly 34% at the longer maturity and just over 29% at
the shorter maturity. Cetes rates also increased in 1994, but by a much smaller
amount than the tesobonos and without any substantive difference across
maturities. The average growth rate was approximately 4.5% for both
maturities.
Average cetes rates and their volatilities were roughly double their tesobonos
counterparts in 1994, a reflection of the risk that investors associated with peso
inflation and the exchange rate. Given the differences in level and volatility of
rates, it is useful to consider comparisons based on the ratio of mean return
to volatility, however. For example, the 1993 91-day cetes ratio was 11.3,
compared with 25.5 for the tesobonos, in sharp contrast to the simple compari-
sons of yields. Further, the ratios of return relative to risk were virtually
equalized for the 91-day instruments in 1994, with values of 5.3 and 6.6 for
cetes and tesobonos, respectively. Similar results hold for the 182-day maturities,
with 1994 return-risk ratios of approximately 6.5 for both instruments. It is
notable that while rates were rising across years, yields relative to volatility fell
from 38% to 74% across instruments and maturities, with an average drop
of 57%.
Figure 1 displays the time series behavior of the 91-day cetes and tesobonos
yields for the period July 1993-February 1995. The figure confirms the basic
story offered by the sample statistics, but provides additional insight as well.
Of particular note is the behavior of the yields subsequent to the peso devalu-
ation that occurred on December 21, 1994, with no obvious increase in yields
since about April prior to that event. This suggests the success that the Mexican
government had in convincing the market that no devaluation was forthcoming.
In fact, the Bank of Mexico followed a policy of sterilized intervention during
the March-April period, and again in November and December. The decline
in foreign exchange reserves was offset by an increase in the Bank's net domestic
assets. As a result, relatively low interest rates were maintained early in the
year and later, during a period of selling pressure on the peso. Although there
were other signals of potential internal imbalances, there also were positive
moves, including a reduction in inflation and the maintenance of balanced
government fiscal accounts (International Monetary Fund, 1995).
Less obvious, perhaps, is the behavior of the rates at the time of several
other notable events during the sample period. In particular, January 1, 1994
was the date on which the Chiapas rebels occupied that state: no apparent
0.45
0.4
0.35
0.3
g
.... 0.25
~
. ........ ... .... .........;.......,. :;.... ..... ". ... ..~.

. .: A
0.2
~
I 0.15
0.1 _
+-----__________ '-r-~
0.05
0
.....
N
"~
0)
Figure 1. 91-day ceres and tesobonos yields.
change in either yield followed the occupation. On March 23, 1994, (the ruling
party) PRI presidential candidate Colosio was assassinated in Tijuana. The
yield on both debt instruments moved up at that time, but the increase in the
tesobonos rate actually preceded the assassination, whereas the increase in the
cetes yield followed immediately after that important political event. Finally,
Ernesto Zedillo, the candidate of the ruling party, won the presidential election
on August 21. The cetes rate moved down in anticipation of that event and
stayed low until the devaluation; no obvious change in the tesobonos rate
occurred during the period leading up to or after the election.
Table 1 also contains summary statistics for the two risk premia. The peso
premia were roughly four times the level of their country premia counterparts
for both maturities and both years; they were also about twice as volatile.
Volatility increased for both premia in 1994 relative to 1993, but whereas the
average country premium increased in 1994, average peso premia actually
declined for both the shorter- and longer-term bills.
Figure 2 contains time series graphs for the 91-day premia. With the excep-
tion of March 1994 and a brief period in early 1995, the currency premium
greatly exceeded the country premium. The currency premium declined substan-
tially over the 8 months that preceded the March 1994 assassination of presiden-
tial candidate Luis Colosio. In contrast, the country premium remained flat
over most of this time, falling only shortly before the assassination. Both premia
increased at the time of the assassination, although, like the tesobonos rate on
which it is based, the increase in the country premium took place prior to the
assassination and the increase in the currency premium was much larger and
followed the assassination. After the assassination, the country premium
declined until, by the time of the August 1994 presidential election, it had
reverted to its pre-assassination level. The increase in the currency premium
was more persistent, and never quite fell back to its previous low.
326 I. Domowirz er al.
0.25 r------------------------,
g
02
0.15
1==::1 !~\~. ji
,.
;; ; \
e
c
&
-./""
N ...
cc
...... ... ...
<"l 0 cc N N en .... N 0
....... ... ...... ...en... ....... ......cc
N
It) It)
.... c;; 0 g ....

0 0 0 N N N N N 0 0
cc N N <"l It) co cc en 0 N
0 0
;;; ;;; 0 0 0 0 0 0 0 0 0 0 0
<"l <"l
en en ~ <"l
en en en ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ en
It)
Figure 2. Mexican country and currency risk premia.
Also notable in the graph is the effect of the December 1994 devaluation
which led to dramatic increases in both premia, but with the increase being
more spectacular, and more short-lived, for the country risk premium. In fact,
investors retained their holdings of resobonos immediately following the devalu-
ation (International Monetary Fund, 1995). In particular, foreign holdings
increased about 5.5% in the week following the devaluation, and did not
decline until the end of January, 1995.
RISK PREMIA AND THE TERM STRUCTURE
The term structure for each of these bills is expressed using the following
notation:
(3)
(4)
Employing equations (1) and (2), the following term structure variables are
derived for the two risk premia:
(5)
(6)
Equation (5) indicates that the term structure of the peso premium can be
measured using only the observable rates of return from the ceres and tesobonos.
In equation (6), the term structure of the Mexican country risk premium
contains a term for the dollar-denominated term structure. In what follows,

that term is assumed to be equal to zero. 4
The summary statistics in Table 1 suggest that there were substantial term
structure differences between the two instruments. On average, there was only
a rather small term premium in the cetes rates in 1993, with a slightly downward
sloping term structure in 1994, which is surprising given the devaluation that
occurred at the end of the year. Volatility of the rates for the two maturities
of cetes was roughly comparable. The tesobonos term structure was notably
different from its cetes counterpart, with the long rate being slightly higher in
1993, but sharply higher in 1994.
Figure 3 presents the term premium for both the cetes and tesobonos, defined
as the spread between the short and long rates. Both premia displayed a
remarkable level of volatility over time, with substantial shifts taking place
from week to week. Perhaps most notable is the tendency for the cetes premium
to be negative, especially in 1994, whereas the tesobonos premium was generally
positive. Note in particular that there was a significant spike in the tesobonos
premium at the time of the Colosio assassination in March 1994, whereas the
cetes premium actually became more negative at the time. The cetes term
premium also turned sharply negative following the devaluation, whereas the
tesobonos term premium increased sharply.
0.025 .--_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _--,
0.02
0.015
0.01
0.005
o
-0.005 1-~~~.,_\/_..!._,____:_<=_L-V_-4.:._--7""!_'r__~-'I----"-..c..v_,----t
-001 . ... I ,I
. \... I .. 1 "1
-0.015 ii,
" 1
-0.02 , '
-0.025 1/
-0.03 ~...........,....,...~.,....,...,......,..,..,..,...,........,..,..,..,...,..............,....,...,......,..,~............,...,...,...........~,......,..,~.,...,..,..,...........,...,..,..~
E ~
o ~
~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~
~ ~ ~ ~ 0 ~ g g ~ 0 ~ ~ ~ 0
;~ ~ ~ ~
~ ~ ~
~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ m
Figure 3. Cetes and Tesobonos term premia (182 day-91 day).
4 One alternative would be to employ US T bills as proxies for risk-free rates, but it is difficult
to believe that 6-month T bills are viewed as truly risk-free by the investing public because of the
inflation risk that they contain. As a result, the term structure of T bill rates would contribute to
our country risk measure and could actually introduce more noise than it removes. Moreover, as
shown below, under the expectations hypothesis the term premium should be constant over time.
The downward sloping cetes term structure revealed itself again in the
currency/peso premium term structure, which was downward sloping, on
average, in both 1993 and 1994. Like the tesobonos, however, the country risk
premium term structure retained its positive slope in both periods. Volatility
of the peso premium was substantially higher in 1994 than in 1993, whereas
volatility was roughly constant across the two years for the country risk
premium.
Figure 4 contains time series graphs for the term structure of the country
and currency risk premia, defined as the spread between the value of the premia
at 91 and 182 days. The country term premium behaves exactly like its related
tesobonos term premium, which is to be expected under our working assumption
that there is no difference between the short and long-term risk free rate.
Differences between the term structure of the cetes and the currency risk
premium, however, are notable. Even though the correlation between the cetes
and peso risk term premium was 0.86, there were times, especially during the
period just prior to the 1994 devaluation, when the cetes term structure was
upward sloping while the currency term structure was downward sloping.
THE EXPECTATIONS HYPOTHESIS
The expectations hypothesis of the term structure of interest rates describes a

link between a longer-term i-period interest rate, and a shorter-term j-period R;,
interest rate, RI, where i/j is an integer. s The hypothesis has been subjected to
considerable empirical investigation, much of which is summarized in Campbell
and Shiller (1991). In its linear form, the hypothesis states that the longer-term
0.03
0.02
0.01
0 0
....
. ...
0
'. ...
.. . .. ..
";:J
c: -0.01 ' "" ,. \:'
~
' "
" ,
-0.02
1=:r:1
Q.
-0.03
-0.04 ...
-0.05
.... It) 01 C') co ....
N
....
<0 C') ..... .... <0 0
.... 001 N NNco
.... 01
~ C')
.... 0....
N N N 0 0 N N 0 0
..... co 01 N N C') ~ <0 ..... co .... .... ....
0 0 0 0 0 0 0 0 0 0
C') C') C') C;; C')
01 01 01 01 01 ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~
Figure 4. Mexican country and currency term premia.
SA theoretical discussion of the expectations hypothesis is presented in Cox et al., 1981.

rate is a function of the levels of current and expected future shorter-term rates.
In the most simple case where the long instrument has a maturity exactly equal
to the sum of two short instruments, the relationship takes the following form:
R: = (1/2)(E t R/+ j + R/) + c (7)

where i/j = 2. Equation (7) states that the longer-term rate is a linear average
of the current and expected future shorter-term rates, plus a constant term
premium that may vary with i and j but which is assumed to be constant over
time. We ignore that constant term in what follows.
Campbell and Shiller (1991) developed a characterization of the expectations
hypothesis, using what they define to be the perfect-foresight spread. This is
the spread that would obtain between the short and long term rate/preimia,
under the expectations hypothesis, if investors had perfect-foresight about future
interest rates/premia. Domowitz et al. (1996) examined the ability of the expec-
tations hypothesis in general, and the perfect-foresight spread in particular, to
explain Mexican interest rate, country and currency risk premia behavior over
the 1993-94 period. They found evidence in favor of that hypothesis.
We adopted a different approach, assuming that the hypothesis is correct
and using it as a model for generating expected future risk premia. We then
examined the residual errors that represent deviations from the hypothesis and
which take the form:
Gt = (lj2)(Yn91 + Yil) - yt 82 ,
where additional subscripts for country and peso premia have been suppressed.
These residuals are equivalent to what would be generated from the expec-
tations hypothesis using the perfect-foresight spread as the model of expecta-
tions. Under that hypothesis, these residuals should be random errors, although
they will have a moving average component due to the overlapping data used
in the computations. By examining the behavior of these residuals we can learn
something about investor expectations regarding future movements in short-
term risk premia. In particular, when the residuals are positive, it indicates that
the long rate was priced below the rate that would have obtained if investors
had had perfect foresight about the future short rate. Similarly, when the
residual is negative it indicates that investors overpriced the long rate relative
to the rate that would have obtained if investors had had perfect foresight.
Figure 5 presents time series plots of the theoretical perfect-foresight
residuals for both the country and currency risk premia. The residuals have
been standardized by their own standard errors in order to facilitate comparison
across time series. The sample period is constrained to the period ending
October 26, 1994, because of the 13-week lead that is needed in order to
calculate the residual.
At first glance, there is a strong similarity in the behavior of the two time
series, especially the movements that take place just prior to the devaluation.
At that period in time, September 21-0ctober 26 (given the 13-week lead in
the calculations), both long-term risk premia were very underpriced relative to
6r---------------------------------------------------,
5
4
;-
3
"
"
'. . ..... .. --
0 "
-1
-2
.. .., .., ..v; .., ..,
... g ..,~
II I ~ "~ i8 iS
cD
N
It)
I Si Si
('oj It) It) cD cD ('oj
0 ~ ~ N 00 0 ('oj
~ ~ ;::
~ ~
0> ~ Si Si ~ ~ ~ 0
~
0
~ I 0
~
0
~ ~ ~
Figure 5. Standardized theoretical perfect-foresight residuals.
the values which would have obtained with perfect foresight. This provides
clear evidence that the expectations that investors held prior to the devaluation
did not anticipate the large increase in the short-term risk premia that followed
the devaluation.
Closer examination reveals that the period just preceding the devaluation
was somewhat unique with respect to the similarity of the two series. For most
of the remainder of the sample period, their behavior was much different. Two
subperiods merit additional comment because they provide information on the
factors that influence the behavior of the markets. First consider the behavior
of the currency premium residuals over the period January-May 1994. During
that period, the long premium was underpriced, indicating that investors under-
estimated the future short-term rates that were subsequently realized. What
happened is largely a result of a single important political event. On March
23 the ruling party presidential candidate, Colosio, was assassinated and short-
term (and long-term) interest rates on cetes increased sharply, where they stayed
until August. This upturn in rates (and the currency risk premium) led to a
substantial error in the expected value ofthe future short-term rate as measured
by the perfect-foresight model.
Consider now the behavior of the country risk residuals over the period
January-August 1994. In order to understand the behavior of these residuals,
one must also consider Figure 6, which presents the outstanding amounts of
cetes and tesobonos issued by the Mexican government, in millions of new
pesos.6 In the figure, one can readily see that this was a period during which
the outstanding supply of tesobonos increased sharply. Relative to 1994 overall,
and the January-August period in particular, growth in tesobonos supply started
6 Source: Bank of Mexico.

100000
90000
80000
70000
60000
50000
40000
30000
20000
_ _ Celes
10000 ....... Tesebonos
....... - ..
0
~ ~ ~ ~
....co ..
;J;
.:.
::E
!
OJ
::E
1 ;J;
.,Q.
U)
;J;
:>
z0
~..,
OJ
~
.:.
~
Figure 6. Mexican sovereign debt outstanding.
slowly, with a January-April rate of 56%. In contrast, the supply by end of

August was about 10.6 times the January level.
As a result of this supply shock, the country risk premium was underpriced
during the period December, 1993-February, 1994, because the rate increase,
which preceded the Colosio assassination, was not foreseen. In fact, this surprise
was at least in part due to external pressures. The US Federal Reserve raised
the federal funds rate from 3.0 to 3.25% in February, with other increases to
follow later in the year. Available information suggests that the increase in US
rates had the expected adverse effect on net capital flows into Mexico, but the
first sharp decrease in international reserves did not occur until the end of
March. Lustig (1995) notes that the Mexican government had two basic options
at this point. The crawl of the ceiling of the exchange rate band could be
increased (or the band widened discretely), or domestic interest rates could be
raised, together with an increase in the supply of dollar-denominated debt,
without a change in exchange rate policy. The government chose the latter
option.
By late March, the country risk premium had become overpriced as investors
continued to demand high term premia in order to hold the increasing supply
of tesobonos, even though those premia were not justified by the short rates
that were realized ex post. One could argue that the supply impact on rates
should also have been felt in the cetes market, where the outstanding supply
declined over 1994. In fact, the peso premium was underpriced in the period
March-April which, given the lead involved, would represent a period when
the supply of cetes was declining. But the supply then leveled off and the
residuals are scattered more randomly about zero for the next few months
until the devaluation shock occurs.
It also is of interest to examine the behavior of the perfect foresight residuals

surrounding the political events, which clearly affected the financial markets
(Frankel and Okongwu, 1996; Domowitz et al. 1996). An interesting pattern
emerges if one calculates the mean-squared perfect foresight residuals (un stan-
dardized) surrounding the events and the sample overall. 7 For the currency
premium residuals, the full-sample mean-squared error is 0.17. During the
period immediately following the Chiapas uprising, the mean-squared error
rises to 0.37, with a similar increase after the Colosio assassination to 0.46.
This is not necessarily surprising, given that accurate forecasts with respect to
the exchange rate, for example, would be particularly difficult during such
periods of relative uncertainty. This intuition is supported in the statistical
analysis of Domowitz et al. (1996), who showed that the expectations hypoth-
esis for the peso-denominated cetes breaks down during such periods of political
turmoil. The result does stand in contrast to the discussion in Lustig (1995),
however, who reported that the Chiapas uprising did not have a noticeable
immediate effect on the markets. On the other hand, the mean-squared perfect
foresight error for the country risk premium is only 0.022 following Chiapas,
and 0.039 after the Colosio killing, compared with a full-sample figure of 0.044.
Similarly, the mean-squared error is half the full-sample value in the period
during which the ratification of NAFTA was being debated. It appears that,
once attention is closely focused on the political situation, country risk is priced
more accurately by the market, at least within the framework of the expectations
hypothesis.
CONCLUDING REMARKS
We began by noting that despite extensive factual investigations of events

leading up to and beyond the recent Mexican currency crisis, little evidence
has been presented with respect to risk and expectations issues. As in Frankel
and Okongwu (1996), we note that the nature of the different short-term debt
instruments issued by the Mexican government permits one to decompose the
interest rates involved into risk premia that investors demand for currency and
country risk. Together with data on the underlying debt instruments, these
constructs provide interesting information with respect to the time period
leading up to to the December devaluation. The evidence from analysis of the
risk premia, in particular, suggests that the markets displayed no indication
that they expected a peso devaluation to occur.
Along the way, the analysis demonstrates the value of employing the perfect-
foresight version of the expectations hypothesis as a model of expected future
7 For the Nafta ratification, the calculations use the one-month period prior to ratification, but
including the week of the ratification. For the Chiapas uprising and Colosio assassination, the
mean-squared error is produced using data four weeks prior to the events, but including the week
of the event. The full-sample mean-squared error uses all data from 7/93 through 8/94.
short rates. We have used the model in a rather unorthodox fashion, namely
to model the market's reactions to differences in risk premia over different
horizons. The philosophy is that since these premia can be generated from the
returns on market-traded instruments, the term structure of the premia should
be explainable by the same economic models of the term structure that are
used for other fixed-income securities. In fact, since the premia can be extracted
directly from the data, they themselves could be traded, in principle. In other
words, they are tradeable synthetic instruments. The model residuals provide
considerable insight into the extent to which the markets anticipated events
and their reactions to those events. The analysis indicates that there was no
anticipation of the major political developments, as would be expected. It
characterizes, however, the markets' reactions to the supply shocks that took
place over the sample period. Finally, the residual analysis provides additional
evidence that there was no expectation of the devaluation that subsequently
took place.
Was there any other observable indicator of the pending devaluation in
terms of market activity? Lustig (1995) suggested that the answer to this
question is in the affirmative. In particular, she writes that "the systematic
increase in tesobonos held by the public ought to have been seen as an unequivo-
cal sign of the lack of credibility of the exchange rate policy." We disagree, at
least insofar as the claim implies that the markets should have recognized and
acted on this phenomenon. Beyond any evidence presented in terms of our risk
premia constructs, the argument is based on a simple risk-return tradeoff.
The supply of tesobonos, both relative to that to cetes and in absolute terms,
was very limited in 1993. During the last half of that year, the ratio of yield to
risk, measured by the standard deviation of returns, was over 25 for tesobonos
and about 11 for cetes. It is intuitively obvious that tesobonos represented a
good value, relative to risk, and compared to the peso-denominated instrument.
These ratios were not substantially different in early 1994. As the supply of
tesobonos deepened, investors were happy to buy them for reasons unrelated
to the credibility of exchange rate policy. Their holdings of cetes were already
large, and tesobonos, representing a different sort of risk, allowed for portfolio
diversification. More importantly, perhaps, the return-risk tradeoff was such
as to make the tesobonos the more desirable instrument, on a risk-adjusted
basis. Abstracting from exchange rate risk and the diversification issue, one
would expect that investors would buy tesobonos until the return-risk tradeoff
was equalized between instruments. That is exactly what happened. Prior to
the devaluation in 1994, the tesobonos ratio for the longer maturity was 6.5,
compared with 6.4 for cetes. If exchange rate credibility were really the problem,
we also might reasonably expect that the ratio should be larger for the cetes;
i.e. investors would demand more return relative to volatility for the peso-
denominated notes. This phenomenon is not observed in the data. We are left
with the conclusion that despite the difficulty in accepting the fact that sophisti-
cated investors were not aware of the increasing exchange rate risk as develop-
ments unfolded in 1994, their actions, as expressed in market statistics and risk
measures, indicate that the devaluation was rather a complete surprise.
ACKNOWLEDGMENTS
Funding from the World Bank is greatly appreciated. Expert research assistance
was provided by Mark Coppejans. We are grateful to Michael Pettis for his
help in obtaining the interest rate data and to Robert Hodrick for helpful
discussions.
REFERENCES
Campbell, J.Y. and R. J. Shiller (1991). Yield spreads and interest rate movements: a bird's eye view.
Review of Economic Studies, 58, 495-514.
Cox, J.e., J.E. Ingersoll and SA Ross (1981). A reexamination of traditional hypotheses about the
term structure of interest rates. Journal of Finance, 36, 769-799.
Domowitz, I., J. Glen and A. Madhavan (1996). Identification and Testing of a Term Structure
Relationship for Country and Currency Risk Premia in an Emerging Market. Working paper,
University of Southern California.
Edwards, S. (1986). The pricing of bonds and bank loans in international markets: an empirical
analysis of developing countries' foreign borrowing. European Economic Review, 30,565-589.
Frankel, J.A. and C. Okongwu (1996). Liberalized portfolio capital inflows in emerging markets:
sterilization, expectations, and the incompleteness of interest rate convergence. International
Journal of Finance and Economies, I, 1-28.
International Monetary Fund (1995). Evolution of the Mexican Peso Crisis. Background paper,
International Capital Markets Division.
Khor, H.E. and L. Rojas-Suarez (1991). Interest rates in Mexico. IMF Staff Papers, 38, 850-870.
Lewis, K. (1995). Puzzles in international financial markets. In R.W. Jones and P.B. Kenen (eds),
Handbook of International Economics, Volume 3. Amsterdam: North-Holland.
Lustig, N. (1995). The Mexican Peso Crisis: The Foreseeable and the Surprise. Brookings Institution
Discussion Paper No. 114.
Melvin, M. and D. Schlagenhauf (1985). A country risk index: econometric formulation and an
application to Mexico. Economic Inquiry, 22, 601-619.
ROBERT J. BERNSTEIN and JOHN A. PENICOOK Jr
Brinson Partners. Inc.
14. Emerging market debt:

practical portfolio considerations
INTRODUCTION
Emerging market debt (principally the Brady bond market) warrants consider-
ation in diversified portfolios based upon its normal return potential, risk
characteristics and portfolio diversification benefits. While a realistic review of
sovereign credit history discloses occasional periods of extreme duress, there
are several reasons to be optimistic regarding future credit performance.
Foremost is that the Brady plan provided a market response to the debt crisis
of the 1980s, and the resulting bond market, in turn, provides constant market
feedback on fiscal, monetary and exchange rate policies. Market feedback,
combined with a general trend towards more participative government, bodes
well for the overall economic development process.
Fundamental investment analysis of this market requires an understanding
of sovereign credit risk and the compositional complexities of the Brady bonds
themselves. The normal return potential of the market, in conjunction with its
low correlation to other bond and equity markets, offers the opportunity to
improve a portfolio's risk/reward profile. The remainder of this chapter reviews
emerging market debt generally, examines the Brady market specifically and
provides some perspective on the long-term and current attractiveness of this
asset class.
EMERGING MARKET DEBT CHARACTERISTICS
Terminology
In the broadest sense, the group of 'emerging' countries includes all nations
not considered industrialized or already developed. Since the latter group has
only two dozen or so members, the emerging country universe encompasses
most of the world's population and geography. However, because the majority
offer no investable debt securities, only a subset of these countries comprises
the emerging country debt universe. Hence, the more precise terminology is
emerging market, rather than emerging country.
335
336 R. J. Bernstein and J. A. Penicook Jr
While convention and market terminology lump all of these countries into
one market there are profound and fundamental differences among them. Many
Latin American countries have a poor history of macro-economic management
and suffer from deep social inequality, but their recent economic performances
have largely improved. Eastern Europe is recovering from decades of central
planning, but some countries have pre-war histories of success with capitalism
and opening them up to the rest of the world has the potential of producing
outsized growth rates. Africa is generally income-poor, but commodity-rich.
Finally, a number of Southeastern Asian countries have very high savings rates,
resulting in their exporting rather than importing of capital.
Economic significance
Emerging country economic growth rates have far exceeded those of the devel-
oped world recently. Real GDP growth for the major emerging markets has
averaged well in excess of 5% annually over the past decade, versus 2.5% for
the industrialized economies. Although their share of world output and exports
is still relatively small, recent economic reforms, global trade liberalization and
access to the global capital markets have allowed developing economies to
more efficiently utilize their vast natural endowments and to partially realize
their economic potential (see Figure 1). Continued trade integration and a
relatively stable global economic background suggest that developing econo-
mies as a group will continue to grow faster than industrialized nations.
Market growth
Along with the size of their economies, the importance of developing countries'
debt securities in the international marketplace has grown as well. While still
small in comparison to that of industrialized country debt, the overall size of
the market (see Figure 2) has grown to become an important sector of the
global capital markets. Over the last four years alone, total trading volume of
emerging market debt securities has increased by six hundred percent; about
half of this volume was in the Brady bond market (Figure 3).
PUBLIC DEBT INSTRUMENTS
There are four segments of the emerging debt market: bank loans, Eurobonds,
Brady bonds and local issues.
Bank loans
Investor interest in emerging market debt securities pre-dates the creation of

Brady bonds, although the Brady plan and resulting bonds were the catalyst
for the acceptance of emerging market debt into more traditional institutional
portfolios. The series of bank loan defaults in the early 1980s (the euphemistic
Emerging market debt 337
GDP EXPORTS
$27.8 Trillion $5.1 Trillion
Emerging
MRrkets
23% Emerging
Markets
18~/O
De"eloped
Economies
72%
Developed
Economies
77~'o
POPll LATJON LAND AREA

5.7 Billion 133 Million km 2
Dcvd oped
Economies
I:~~ Developed
Fconomies
Emerging 24%
Markets
76%
Emerging
Markets
85%
Figure 1. Emerging economies: share of World economy (Source: World Bank, World Development
Report, 1997, Institute of International Finance).
term then was 'moratorium') by many developing countries forced US and

some foreign commercial banks to write down the value of their loans. Inter-
bank trading of these loans then began as some banks swapped or reduced
sovereign loan exposures. Since banks as a whole were trying to dispense their
remaining loans and few new sources of demand had developed, loan prices
remained quite depressed. Debt-equity swaps were successful to some extent,
but their potential was limited. The non-bank investors in the bank loan market
were typically speculators, as most of the loans were non-performing.
The market for developing country loans still exists today, but the focus of
trading activity has shifted to the Brady sector. Some developing country loans
are performing - Morocco, for example, has continually serviced its obligations
- and are offered to investors as assignments or by way of participations. The
advent of the Brady plan created a new type of loan trading strategy-purchasing
a non-performing loan in anticipation of a Brady restructuring.
Eurobonds
Developing countries have issued bonds to foreigners for at least 100 years.
(Eurobonds are internationally issued securities.) These bonds were serviced
even during the 1980s bank loan crisis. One possible motivation behind such
an admirable repayment history may have been that these obligations were
small compared to bank debt (and now compared to the Brady issues), so that
DCorporale
Sovereign
Olher Bonds USS
20%
Local Currency
5%
8%
Local Currency Hard Currency &

36% USS-Linkcd
5%
Figure 2. Emerging market debt universe as of December 1996 (Source: Salomon Brothers).
1992
LouJ lnstnnnenu
I~,
llXans Irlilrumen~
)1"0
Total: $733 Billion Total: SS,l97 Billion
Figure 3. Emerging market debt trading volume (Source: Emerging Markets Traders Association).
defaulting on them was much less economical. A second possible motivation

may have been to maintain some form of reputation in the capital markets.
But a more fundamental reason may derive from the nature of bonds relative
to loans. Loans involve a small, easily identified and relatively homogeneous
group of creditors, i.e. banks. In default negotiations, the long-term health of
the country is a priority of the bank creditors, since they wish to maintain the
opportunity for future business with the debtor. By contrast, bond holders are
a large and diverse group who, in the event of default, wish to recoup as much
as possible now. In this respect, Brady bonds are more like Eurobonds and
also deserve narrower yield spreads than loans (though the next section dis-
cusses why this is often not the case).
Eurobonds are issued by sovereign governments and their agencies directly,
as well as by state-run and large private corporate entities. Details of the
J.P. Morgan Latin Eurobond Index are presented in Figure 4. Some market
participants prefer Eurobonds over Brady issues because of Eurobonds' lower
return volatility. Figure 5 demonstrates that the Latin Eurobond Index had,
until 1995, manifested slightly lower return volatility than the Emerging
Markets Bond Index, which comprises longer duration Brady bonds. For most
of its history, the Eurobond index had lower return volatility simply due to its
shorter duration. The higher levels of return volatility for both indices after
1993 reflect increased US interest rate volatility, as well as higher credit spread
volatility. The Eurobond index's return volatility is also dampened by the
Eurobond market's illiquidity. Thus, return volatility may be an incomplete
measure when comparing risks.
Eurobond issues typically are less than $300 million and much less liquid
than Brady issues. Typical Eurobond bid/asked spreads range from 0.5% to
2.0% of face value during ordinary market conditions and may balloon to
5.0-7.5% during market panics: consequently less trading occurs in the
Eurobond sector. (Brady bid/asked spreads are typically 0.25% of face value
and remained under 1.0% even in the wake of the Mexican devaluation crisis.)
Argentina Characteristics
29%
Face Value $22 billion
Market Value $23 billion
Average Maturity 7.7 years
Duration 4.5 years
Yield.to-Maturity 9.5%
Mexico
55% Spread vs. U.S. Treasury 3.3%
Sovereign Component 61%
Corporate Component 39%
Figure 4. Latin Eurobond Index (J.P. Morgan), as of December 31, 1996.

2 5 % . - - - - - - - - - - - - - - -________________________________________- ,
--Emerging Markets Bond Index Plus

20%
. _. - - - -latin Eurobond Index
15%
10%
5%
O%~-- ________- - - -__ ----~---- ________- - - -________- - - -__ --~
12191 6192 12192 6193 12193 6194 12194 6195 12195 6/96 12/96
Figure 5. Return volatility. Latin Eurobond Index and Emerging Markets Bond Index Plus
(EMBI +) (trailing 12-month basis). Annualized standard deviation of monthly logarithmic return
premia. Latin Eurobond index, J.P. Morgan: data from 12/31/91-12/31/96.
* Index shown reflects EMBI from 12/31/90-12/31/95 and EMBI+ from 12/31/95-12/31/96.
Moreover, the illiquidity of the Eurobond sector actually induces higher volatil-
ity in the Brady market as Eurobond investors attempt to hedge risk exposures
via Brady short sales. In sum, the Eurobond market has had lower return
volatility than the Brady market because it is less sensitive to interest rate
volatility (lower duration), and because it has been less liquid. Because new
emerging market bonds are issued in the Eurobond format, Eurobonds will
eventually dominate the Brady sector.
The Brady plan and resulting bonds
Narrowly defined, the Brady plan refers to an innovative debt renegotiation

format, whereby defaulted sovereign bank loans were written down and con-
verted into bonds; the bonds themselves also have unique structures which are
detailed below. Mexico was the first participant in 1989. (Former US Treasury
Secretary Nicholas Brady was credited with this approach.) More broadly, the
Brady plan encompasses the entire set of economic policy prescriptions that
developing countries adopted in order to receive additional international aid.
This aid allowed them to meet their responsibilities under the Brady plan.
Today, bonds resulting from a comprehensive sovereign debt restructuring are
generally considered Brady bonds.
Prior to the Brady plan, various attempts were made to resolve the 1980s
LDC debt problem; none had lasting success. Simply extending new loans lost
favor with the creditor banks, as earlier attempts ended with counterproductive
results (the increased supply of loans only depressed prices further).
International lending agencies also resisted providing new funds.
The Brady plan differed from previous approaches in a number of respects.

For the first time, underlying structural problems of the debtor countries were
addressed (such as protected markets and controlled prices). Another key
innovation was the reduction in the absolute amount of debt. In some cases,
the original loan amount was discounted. In other cases, the coupon was set
below market rates or new money was lent (Table I). Typically, the principal
amount of the defaulted loans was effectively reduced by 35-50%; accrued
interest was generally not reduced (Table 2). This principal forgiveness had the
effect of both raising the loans' value in the secondary market and lowering
the borrowers' debt burden. Further, the commercial bank's loans to private
and sovereign entities were transformed into sovereign bonds, thus enhancing
their appeal to investors. Additionally, for some of the bonds a portion of the
Table 1. Typical Brady plan alternative bond formats
Discount bonds
Debt principal reduced by 35-50% of face value
Coupon floats at a spread over LIBOR
Principal collateralized with US Treasury 'zeros'/rolling interest guarantee
Par bonds
Debt exchanged at par
Coupon fixed at below market rate
Principal collateralized with US Treasury 'zeros'/rolling interest guarantee
Debt conversion bonds
Exchange of old bank loans (DCBs) contingent upon 'new money' bonds (NMBs)
NMB and DCB coupons float at a spread over LIBOR
No collateral; pure sovereign risk
Table 2 Debt reduction achieved through Brady plan (in $US, billions)
Country Debt Pre-Brady* Effective Discount Rate
Argentina 29.9 35%

Brazil 45.6 35%
Bulgaria 8.1 50%
Ecuador 8.0 45%
Mexico 33.0 35%
Nigeria 5.8 35%
Panama 3.5 31%
Philippines 4.5 35%
Poland 14.0 45%
Venezuela 19.3 35%
Eastern Europe** 22.1 48%
Latin America** 139.3 36%
Total** 171.7 38%
* Pre-Brady Plan debt figures equal face amount plus interest arrears.
** Sum of Pre-Brady Debt and Equal-weighted average of Effective Discount Rates.
Source: Salomon Brothers, ANZ"
scheduled payments were collateralized in order to improve creditworthiness

and attract investors. High quality money market instruments were purchased
to serve as collateral for two or more coupon payments and US Treasury zero-
coupon securities were purchased to serve as collateral for the bond's principal
payment.
The different bonds arising from Brady loan restructurings are listed in
Table 3. Figure 6 divides the Brady market according to the various security
types. Brady bonds now command the lion's share of emerging market debt
trading volume, having overtaken bank loans. Because Brady bonds are restruc-
tured debt securities the size of this sector will grow only slightly as a few
remaining, small countries conclude their debt restructurings. In contrast, the
Eurobond sector may grow rapidly as new issues employ this uncomplicated
format. Moreover, countries may reduce their Brady debt through buy-backs
and/or exchanges of Brady bonds for Eurobonds due to the wider investor
acceptance of the Eurobond format.
The Brady universe is almost entirely denominated in US dollars, so unlike
the Emerging Market Equity universe or developed foreign bond markets,
currency risk is not a direct consideration for the US-based investor. US
interest rate risk, however, is important to the Brady market, just as it is to
the US high yield and corporate bond markets. Trading is similar to the US
corporate bond market, occurring primarily in New York and secondarily in
London. Most issues settle via the ordinary Euroclear mechanism; costly local
custody arrangements are unnecessary. So while the Brady market has several
characteristics in common with traditional US bond markets, it remains unique
in nature due to sovereign default risk.
The Brady plan is generally associated with overall economic improvement
in the participating countries, but it is not clear that the plan caused this
improvement. Perhaps alternative debt resolutions would have also led to
economic gains, or perhaps positive global economic trends were more impor-
tant than the plan itself. The global economic problems contributing to the
loan defaults of the 1980s have since been reversed: interest rates are sharply
lower (LDC debt was in floating rate form), oil prices have declined in real
terms (most developing countries are net importers) and the world economy is
stronger (spurring LDC exports). While the economic ramifications of the
Brady plan may be debated, it was instrumental in metamorphosizing a bank
loan market into an institutional bond market.
Local issues
A number of developing countries have functioning and relatively liquid domes-

tic debt markets. Because of historically high and variable inflation rates, these
securities tend to be limited to money market maturities and, if longer in term,
are denominated in US dollars. Participation by foreigners in these local money
markets requires better information and institutional infrastructure than is
currently available. For example, the reporting of monetary aggregates is often
Table 3. Bonds issued under loan restructuring
Restructuring plan Issue Instruments issued Maturity (yrs) Rate Principal Interest Principal Interest Debt Interest
exchange Grace (yrs) type collateral collateral reduction reduction Conv/New arrears
data money
Mexico Aztec Exchange May 88 Aztec 2008 bond 20 bullet Floating

Brazil Parallel Nov 88 New Money bond 11/4 Floating
Financing agreement Aug 89 Exit bond 25/11 Fixed
Mexico Brady Feb 90 New Money bond 15/7 Floating

Mar 90 Par bond 30 bullet Fixed
Discount bond 30 bullet Floating
Philippines 1989-90 May 90 New Money bond 15/8 Floating
Financing agreement
Costa Rica Brady May 90 Principal bond A 20/11 Fixed
Principal bond B 25/16 Fixed

Interest bond A 15/0 Floating
Interest bond B 15/0 Floating
Venezuela Brady Dec 90 DCBDL 17/7 Floating
DCBIL 18/7 Floating
FLIRB 17/7 Mixed
Par bond 30 bullet Fixed

New Money A 15/7 Floating
New Money BP 15/7 Floating trl
3

New Money BNP 15/8 Floating
Uruguay Brady Dec 90 DCB 16/7 Floating ""
~
~.

New Money note 15/7 Floating
Par note 30 bullet Fixed

Nigeria Brady Jan 92 Par bond 28 bullet Step Up 3~
....

Philippine Brady Dec 92 DCB 17/5 Floating ;>;-
FLIRB 15/7 Mixed
~
Par bond 25 bullet Step Up ~

Argentine Brady Apr 93 Par bond 30 bullet Step Up ~

Discount bond 30 bullet Floating -
POI bond 12/3 Floating
V>
~
V>
Table 3. (Continued.) ....,
Restructuring plan Issue Instruments issued Maturity (yrs) Rate Principal Interest Principal Interest Debt Interest
t
exchange Grace (yrs) type collateral collateral reduction reduction Conv/New arrears
data money ~
~
Brazil Brady Dec 91 IOU bond 8/1 Floating t:x:l
~
Apr 94 C bond 20/10 Fixed ...::s
~
Eligible Interest bond 12/3 Floating
....'"
;:S.
DCBs 18/10 Floating
FLiRBs 15/9 Mixed
s::.
::s
Par bond 30 bullet Step Up s::....
New Money bond 15/7 Floating ~
10rdan Brady Dec 93 Discount bond 30 bullet Floating
~
PDI bond 12/3 Floating '"tI
~
Par bond 30 bullet Step Up
::s
Dominican Republic Aug 94 Discount bond 30 bullet Floating ;::;.
<:l

Brady POI bond 15/3 Floating <:l
Bulgaria Brady Jul 94 Discount bond 30 bullet Floating ;>:-
FLiRB 18/8 Mixed
:.-
lAB 17/7 Floating
Poland Brady Oct 94 Discount bond 30 bullet Floating

Par bond 30 bullet Step Up

POI bond 20/7 Step Up
DCB 25/20 Step Up

New Money bond 15/10 Floating
Par RSTA bond 30 bullet Step Up
Ecuador Brady Dec 94 Interest equalization 10/1 Floating
Feb 94 Par bonds 30 bullet Step Up
Discount bonds 30 bullet Floating
POI bonds 20/10 Floating
Panama Brady July 96 FLiRB bonds 18/5 Mixed

POI bonds 20/10 Floating

DCB Debt conversion bond lAB Interest accrual bond
FLiRB Front-loaded interest reduction bond RSTA Revolving short-term trade agreements
POI Past due interest Interest is partially capitalized over first six years
IOU Interest due and unpaid Collateral will phase in over time
Fixed
36%
Non-Dollar
U.S. Dollar 7%
93%
Non-
Perfonning
12%
UncoJlateralized
62%
Collateral ized
38%
Figure 6. Brady bond universe compositional profile, as of December 31, 1996.
unreliable and subject to political expediencies. Moreover, developing countries

often implement currency and capital controls that greatly increase risks and
costs. It is expected that large-scale foreign investor interest will grow as local
financial institutions develop.
Emerging market debt indices
The J.P. Morgan Emerging Markets Bond Index (EMBI), was initiated on
December 30, 1990 and became the most widely used index. The EMBI is a
capitalization weighted index of US dollar-denominated Brady and 'Brady-
like' bonds. The latter predates the official Brady program, but exhibit similar
characteristics to Brady bonds and trade in the same market.
In July 1995, J.P. Morgan introduced an index that is broader than the
EMBI, creatively named the EMBI + (Figure 7). The goal was to include a
wider range of markets and debt instruments than the Brady market. The
EMBI + includes five additional markets - Morocco, Panama, Peru, Russia
and South Africa - and expands the December 31, 1995 market capitalization
from $76 to $11 0 billion. The EMBI +, like the EMBI is limited to issues that
are readily accessible to institutional investors and is published daily.
In addition to Brady bonds, the EMBI + contains several similar debt
instruments. The December 1996 EMBI + comprises Brady bonds (70%), loans
(14%), Eurobonds (10%), and local issues (6%). Because most of these loans
Venezuela
South Africa 8.8% Characteristics
0.5%
Face Value $187 billion

Market Value $151 billion
Poland Average Maturity 15.4 years
4.0% Weighted.Average Quality B+/B
Nigeria
Philippines 0.9% Yieldto-Maturity 10.0%
1.6%
Spread vs. U.S. Treasury 3.6%
Peru Sovereign "Stripped" Yield 11.3%
1.4%
Sovereign "Stripped" Spread 4.9%
Ecuador Bulgaria
2.5% 1.6%
Figure 7. Emerging markets bond index (J. P. Morgan), as of December 31, 1995.
have not yet been restructured into 'Brady-like' bonds, these securities are
treated differently than performing bonds for statistical purposes. In short,
while inferences can be made with regard to the loans' yields and spreads based
upon the projected restructuring, the index does not do so in order to remain
objective about the restructuring process. That is, the index treats the pre-
restructured loans as having no yield until the restructuring actually occurs.
Because of the EMBI + 's expanded breadth, it is now the most widely used
index for analytical purposes. We have constructed a composite index compris-
ing the EMBI from 12/31/90 to 12/31/95 and the EMBI + from there forward.
ANALYTICS - NEW MARKET CONVENTIONS
The myriad of bond types in the Brady market-fixed rate, floating, step-up-to-
fixed, step-up-to-floating coupons-together with different collateralization
structures and amortization schedules make standard yield calculations and
comparisons inapplicable. For example, comparing the yield on a collateralized
bond of country A to the yield on an uncollateralized bond of country B does
not provide information as to the yield on the risky sovereign cash flows, which
is important to the investor. As a result, a number of conventions have been
established by market participants in order to facilitate relative value compari-
sons among the different developing country bonds, and between them and
other fixed income securities. Indeed, a new vocabulary has been created for
the developing country debt market. The purpose of these analytical tools is
to evaluate the sovereign portion of the bond independent of the collateral.
'Stripped' yield and 'stripped' spread
Brady bonds are unique in that for a number of these bonds, two (or more)
semi-annual coupon payments are collateralized with money market securities,
while the principal payment at maturity is collateralized with US Treasury

zeros. A purchase of this type of Brady bond is effectively an investment in a
combination of AA money market securities, a US zero coupon government
bond and a series of sovereign payments. Yield-to-maturity, if calculated in the
standard way, is thus a weighted average of the 'riskless' yields of the collateral
and the 'risky' yields of the sovereign payments. 'Stripped yield' avoids this
averaging by solving for the interest rate that the market applies solely to those
cash flows which are sensitive to the sovereign credit risk. Figure 8 illustrates
the stripped yield versus the blended yield for each Brady country.
The correct analytical procedure is to value the collateral by discounting
the collateral cash flows at the appropriate 'spot' interest rate and to subtract
this collateral value from the bond's market price; the remainder is the price
of the sovereign cash flows. 1 Given the sovereign cash flows and their derived
price, the yield to maturity can then be calculated. In short, the bond is
separated into collateral and sovereign components. In December 1996, the
market value breakdown of the EMBI + is approximately 1% interest collat-
eral, 8% principal collateral and 91 % sovereign cash flows.
The term 'stripped yield' is used because the Treasury collateral is stripped
away from the Brady bond for analytical purposes, indicating the interest rate
the market applies to the sovereign's credit. 'Stripped yield', 'sovereign yield'
and 'sovereign stripped yield' are interchangeable terms. The 'stripped spread'
is simply the stripped yield less the equivalent Treasury yield. Figure 9 illustrates
the simplified valuation process for a hypothetical Brady bond. Collateral cash
flows are discounted at US Treasury rates while sovereign cash flows are priced
at Treasury rates plus a sovereign credit spread. Figure 10 provides the EMBIs
stripped yield and stripped spread histories.
Risk measures
In addition to yield calculations, market participants have adapted traditional

price sensitivity measures to the special features of Brady bonds. Interest rate
duration estimates a bond's price responsiveness to yield changes in US interest
rates; all cash flows are revalued given changes in the US yield curve. The
investor is also concerned with isolating the bond's price response to a change
in creditworthiness. Since only a portion of the bond's cash flows are exposed
1 The coupon collateral is a contingent, or rolling, interest guarantee in that if the sovereign
borrower makes its coupon payment, the collateral remains in place and 'rolls forward' to cover
the next scheduled coupon payment. In the event of default, interest collateral would be paid to
the bondholder in lieu of the sovereign's payments. Market participants disagree on the exact
valuation methodology for the interest guarantee because of differing opinions on contingent
valuations. Some use probability models to estimate the timing of the contingent guarantee, others
assume that the immediate coupon payments are riskless, and yet others ignore the rolling interest
guarantee altogether for yield calculations. Just as differing assumptions in option-adjusted mort-
gage models make cross-model comparisons problematic, 'stripped spread' comparisons of various
Brady issues are only meaningful in the context of a particular model.
South 1\ rriC3
l'hilippillC'S _Tolal "Ulcodc"\J- Yicl~,
P(lltUHJ CSove",ign "Slrippc~ - Yidds
M ...\ico
V,,ne7.ucla
Nigeria
Argentina
Panama
Ur.v.il
I'ern-
Mtlrocco
Ecuador
~u.s: s ia
ULJIl:!-~ifi3
EMIlI+
0 2 6 10 12 14 16 18 20
I'uunt
Figure 8. Emerging Markets Bond Index Plus (J.P. Morgan), as of December 31, 1996.
1 Yields for non-performing loans reflect market estimates.
2EMBI+ - Emerging Markets Bond Index Plus, J.P. Morgan (December 31,1996).
3 Note: EMBI + composite blended and sovereign yield calculations exclude non-performing loans.
Cash
Flow SI,::orL~~~~~~'~n~~~~LLLLLLLLLLLLLL~~~ll-ll-ll-U-U-~~~~~~~J

D D
Co!ta ler,'
non n n 0
5 10
0 0 non
15
000 non
20
0 DOD 0 0
25
no
30 Yoo,s
'1 ',
...
1
Sow.,elgn V . ~I d
SO\lefelgl"
l2 - .. Sp,na
Discount U,S. Tre.,sury Yield
Fili;lDJ t tI 'A t
...
20 25
l
30
+
'fUrS
'0 '5
Bond : 7
Cc ll ~lII.ral : Sfj.'5 59.5516
Sovereign: ""ffi
Figure 9. Brady bonds valuation - an illustration. Note: Valuing the collateral by discounting the
collateral cash flows at the appropriate US 'spot' interest rate, allows the present value of the
collateral ($16) to be subtracted from the market price of the bond ($47) to derive the present
value of the sovereign cash flows ($31). Given the timing of these sovereign cash flows, a yield-to-
maturity on the stripped sovereign portion can then be calculated.
Percent
2 5 , - - - - - - - - - - - - - - - - - - - - -________________________________- ,
- - Stripped Yield Stripped Spread
20
15
.,
10 ...
~ ... ..
'
...
"
,",
,.,
....
12190 6191 12191 6192 12192 6193 12193 6/94 12194 6/95 12195 6/96 12/96
Figure 10. Emerging Market Brady Index Plus, stripped yield and stripped spread history. Index
shown reflects EMBI from 12/31/90--3/31/96 and EMBI+ from 3/31/96-12/31/96.
to sovereign credit risk (in some cases as little as 50%), a change in stripped
spread will result in the repricing of only a subset of the cash flows (the
sovereign cash flows).
Thus, in addition to the standard interest rate duration measure, 'spread
duration' measures the bond's price responsiveness to movements in the
stripped spread. If an overall widening of credit spreads is expected, the portfolio
manager now has the tool to estimate which bonds will be more or less
adversely affected. A Brady bond's spread duration is a function of the collater-
alization level, stripped yield level and maturity. Since most Brady bonds were
issued in the last 5 years, maturity (typically 20-30 years) has less impact upon
spread duration than does collateralization and stripped yield levels.
Spread duration is a particularly important portfolio management tool
because 'stripped spreads' are themselves so volatile. The historical volatility
of EMBI + stripped spread changes is approximately 42% and is higher for
individual countries (Table 4). Again, this volatility is due both to the perceived
default risk of the countries, as well as the limited investor base of these
securities.
Attribution of returns
As previously noted, Brady bonds are issued in a myriad of formats (various

combinations of floating/fixed rate and collateralized/uncollateralized). The
characteristics of one country's Brady bonds may differ greatly from another
country's because of aforementioned differences in collateralization level,
stripped yields and maturity. In short, investors should be careful when compar-
w
VI
0
Table 4. Emerging Markets Bond Index Plus 'stripped' spread history
(:l
Index Stripped spread Maximum Minimum Average 31/12/96 ~
start date volatility spread spread spread stripped spread tx:I
II>
..,
:s
EMBI + Index 31/12/90 42% 15.6% 4.0% 7.9% 4.9% '"~
Argentina 30/4/93 58% 16.3% 3.6% 8.5% 4.9% S
Brazil 31/12/90 52% 14.3% 4.3% 8.7% 5.2% s::.
Bulgaria 30/11/94 33% 21.5% 11.2% 15.3% 12.1% :s
s::...
Ecuador 30/6/95 36% 19.3% 7.1% 13.2% 7.1% ~
Mexico 31/12/90 53% 16.4% 2.7% 6.9% 4.8%
~
Morocco 31/3/96 22% 8.3% 4.8% 6.7% 4.8%
Nigeria 31/1/92 53% 27.0% 6.3% 16.9% 6.3% ~
:s
Panama 31/7/96 22% 5.1% 3.6% 4.5% 3.6% o
0
Philippines 30/6/91 58% 9.1% 1.7% 5.9% 1.7% 0
;.;-
Poland 30/11/94 48% 8.6% 1.7% 4.4% 1.7%
South Africa 31/3/96 40% 1.7% 1.0% 1.3% 1.0% !:;<
Venezuela 31/12/90 52% 21.4% 4.5% 10.8% 4.7%
Yield Maximum Minimum Average

US Treasury strips Start date volatility yield yield yield
I-Year 31/12/90 21% 7.1% 3.1% 5.0%

10-Year 31/12/90 14% 8.6% 5.7% 7.1%
2S-Year 31/12/90 10% 8.7% 6.3% 7.6%
aAnnualized standard deviation of monthly stripped spread changes, logarithmic basis.

bAnnualized standard deviation of monthly yield changes, logarithmic basis.
Data through 12/31/96.
* Index shown reflects EMBI from 31/12/90-31/3/96 and EMBI + from 31/3/96-31/12/96. J.P. Morgan.
ing total returns across Brady countries because of the significantly different
bond formats. Because investors can manage or hedge general US interest rate
exposure outside of the Brady market, a Brady bond's total return can most
usefully be separately attributed to US interest rate exposure and to sovereign
spread performance.
To illustrate these distinct effects, Table 5 reviews December 1996 EMBI +
returns. December's rising US interest rates (approximately 35 basis points)
had varying impacts on returns due to differing interest rate sensitivities across
countries. For example, the rise in US interest rates had a relatively large
negative return impact on Nigeria because of its low, fixed rate coupon. In
contrast, the same rise had a positive impact on Bulgaria since its bonds are
predominantly floating rate issues. Moreover, evolving assessments of credit-
worthiness also had differing return impacts on each country. For example,
during December, investors became much more optimistic regarding Nigeria's
creditworthiness and consequently bid up prices aggressively to reflect perceived
lower credit risks. In contrast to the large positive return due to credit spread
effects in Nigeria and other countries, the market's assessment of Peru's credit-
worthiness deteriorated slightly and modestly decreased returns.
SOVEREIGN CREDIT ANALYSIS
Economic and financial considerations
Many economic measures are relevant to assessing the credit risk of a develop-
ing country. One manner of organizing economic and financial considerations
is to compartmentalize measures into three categories: structural, solvency and
serviceability. In addition to making the analysis more manageable by removing
redundancies, this categorization produces a 'term structure' of credit risk, akin
to the well-known notion of the term structure of interest rates. Political
analysis also is required to assess policy stability.
Structural
Measures belonging to this category describe the long-term fundamental health
of the country. They include economic variables such as reliance on a particular
commodity for export earnings, welfare indicators such as per capita GNP,
and social/economic measures such as income distribution. These variables
generally are not directly linked to default, but countries with poor structural
fundamentals are likely to develop economic problems. Further, given two
countries with similar other variables, the one with the inferior structural
measures will likely have a lower tolerance to adverse economic shocks.
Solvency
In contrast to the structural variables, the solvency class contains intermediate
term measures of a country's economic health. In particular, these variables
should reflect the country's ability, over time, to meet its central government
Table 5. Emerging Markets Bond Index Plus factor returns - December 1996
Spread factor u.s. yield curve factor Total return
Nigeria 4.41% Bulgaria 1.03% Bulgaria 5.25%

Bulgaria 4.23% Morocco 0.76% Panama 3.24%
Panama 3.38% South Africa 0.11% Morocco 2.85%
Venezuela 2.30% Peru 0.00% Nigeria 2.77%
Morocco 2.09% Russia 0.00% Venezuela 2.09%
Russia 1.55% Ecuador -0.02% Russia 1.56%
Brazil 1.45% Brazil -0.08% Brazil 1.37%
EMBI+ 1.36% Argentina -0.09% EMBI+ 1.20"/0
Mexico 1.13% Panama -0.13% Argentina 1.00%
Argentina 1.09% EMBI+ -0.16% Mexico 0.78%
Ecuador 0.70% Venezuela -0.21% Ecuador 0.68%
Philippines 0.45% Philippines -0.26% Philippines 0.19%
Poland 0.06% Mexico -0.35% South Africa 0.13%
South Africa 0.02% Poland -1.03% Poland -0.97%
Peru -1.69% Nigeria -1.65% Peru -1.69%
Sovereign credit spread (incremental income) plus spread change effect (principal)
debt obligations. Both internal and external debt are included. Countries with
inferior solvency measures, all else being equal, have higher default risk because
international debt service competes with local economic constituencies for
resources.
Serviceability
The factors in this category are of short-term, if not immediate, concern. They
reflect the country's foreign exchange reserve position relative to its immediate
obligations (and are therefore usually presented in ratio form). Despite good
or improving fundamentals and strong solvency measures, a developing country
may be forced into a crisis if its reserves are (or will become) deficient, or if
alternative reserve sources, such as the International Monetary Fund, are
circumscribed. Serviceability then would be analogous to a company's ability
to meet payroll or lease payments with sufficient working capital.
Political considerations
Peculiar to analyzing developing country investments are certain critical political

issues such as international aid and policy instability. The USA and international
agencies such as the World Bank and International Monetary Fund have invested
a good deal of political and financial capital in the recovery of developing countries
and their return to the global marketplace. Therefore, an event which would
ordinarily raise the likelihood of default may actually induce international organ-
izations to assist the emerging country and reduce the probability of default.
Alternatively, the movement to representative government and open markets is a
recent phenomenon, and in many developing countries, there are few institutions
in place to serve as anchors to these policies. The resignation or death of one key
policy maker may be enough to alter economic policy. In sum, political factors
can cut both ways: the politics of individual countries are often fragile, but interna-
tional politics often act as counterbalances.
While nascent representative governments may suffer from institutional
instability, it is important to recognize that these countries have undergone
profound political change in a short time period. Several countries have moved
from military rule to competitive, multi-party democracies within the decade.
For example, in 1982, 92% of the EMBI + countries' popUlations were under
communist or military rule; now 80% are governed by democratic rule.
Willingness to pay
Some argue that sovereign risk analysis is doomed to failure because, notwith-
standing its ability to pay, a country may be unwilling to pay. Distinguishing
sovereign risk from corporate or municipal credit risk on this basis alone exposes
a deficient understanding of default risk. Borrowers default when their competing
economic interests override the damage done by default, and default is never a
casual decision. Corporations and municipalities are faced with the same decision
as sovereign borrowers: at what point are you willing to capitulate and damage
your reputation? Few wait until they are completely destitute to make this deci-
sion. For example, Columbia Gas Systems found the burden of high-priced, long-
term gas 'take or pay' supply contracts of the 'energy shortage era' so damaging
to its future that management declared bankruptcy and forced its suppliers to
re-negotiate the supply contracts to lower prices. Similarly, Orange County
California viewed the financial implications of their failed investment scheme so
negatively that they too declared bankruptcy. Orange County taxpayers perceived
little 'ownership of the problem' because of the obscure nature of the investment
scheme and its genitor. Most important, both borrowers were willing to default
even though the debtors had substantial resources available to pay creditors and
suppliers. The point is that economic strain creates a 'willingness' issue for borrow-
ers of all types.
Sovereign credit perspective
Table 6 provides some perspective on the economic performance and credit

quality of the primary emerging market debt countries relative to developed
countries. With the exception of inflation, developing country debt measures
compare favorably with those for industrialized countries and the Maastricht
hurdles for the proposed European Monetary Union.
In particular, the average central government debt/GDP ratio of 68% com-
pares well with the 85% average debt/GDP ratio for the industrialized countries
However, the external debt (public and private, foreign currency-denominated
debt) of developing countries is much higher. This juxtaposition highlights the
fact that the major risk in emerging economies is often not the debt load of
the govenment; access to foreign exchange earnings needed to service foreign
debt may be the primary risk. Because of previous poor policy management
Table 6. Sovereign credit perspective v.>
VI
.,.
GDP Growth Inflation
Central Gov. Total External Budget Balance Annual (;:l
Debt/GDP Debt/GDP /GDP Current 5 year Savings/GDP Current 5 year
~
txl
Argentina 28% 34% -2.0% 4.4% 5.0% 17.5% 0.0% 6.1% ~
Brazil 48% 24% -3.9% 2.9% 3.3% 20.6% 9.1% 966.7%

...
::s
Bulgaria 160% 107% -11.0% -10.0% -3.1% 17.1% 314.9% 122.7% '"~
Ecuador 73% 73% -4.0% 1.3% 2.7% 15.5% 26.0% 33.0% 5
Mexico 55% 51% 0.4% 4.7% 1.7% 16.5% 27.4% 21.2% I:l
Morocco 92% 61% -1.6% 12.0% 2.2% 14.8% 5.3% 5.0% ::s
I:>...
Nigeria na 131% -6.0% 3.3% 2.8% 21.7% 14.3% 52.3% ~
Panama na 89% 0.1% 1.0% 3.6% 21.8% 0.9% 1.1%
Peru 33% 52% 0.0% 3.2% 5.4% 18.3% 12.5% 26.9% ;to.
Philippines 70% 56% -0.5% 5.5% 3.4% 24.2% 5.9% 8.1% "tj
~
Poland 51% 33% -2.5% 5.0% 4.7% 21.5% 18.8% 30.4% ::s
;:;.
Russia na 28% -7.7% -4.0% -8.8% 28.0% 21.7% 747.4% 0
South Africa 62% 25% -5.8% 3.1% 1.7% 44.4% 9.4% 9.1% 0
;.;-
Venezuela 74% 55% 4.0% -1.2% 0.9% 16.1% 103.1% 61.6%
Belgium 130% -7% -3.4% 1.3% 1.3% 23.6% 2.1% 2.2% ~
Canada 100% 44% -1.8% 1.5% 2.3% 19.6% 1.6% 1.5%
France 63% 5% -4.2% 1.5% 1.3% 19.7% 2.0% 1.9%
Germany 62% 2% -3.8% 1.4% 1.3% 20.8% 1.4% 2.4%
Italy 125% 5% -6.7% 0.7% 1.1% 21.9% 3.8% 4.3%
Japan 86% -7% -4.4% 3.7% 1.9% 31.8% 0.1% 0.4%
Netherlands 79% -13% -2.4% 2.7% 2.3% 24.1% 2.1% 2.3%
Sweden 80% 35% -3.6% 1.1% 1.6% 18.0% 0.8% 2.1%
U.K. 61% 2% -4.4% 2.1% 2.5% 14.9% 2.4% 2.5%
U.S. 64% 11% -1.6% 2.4% 2.5% 15.7% 2.9% 2.8%
Maastricht* 60% -3% **
* Maastricht Hurdles for European Economic and Monetary Union

** Maastricht: Not more than 1.5% above the average of the three lowest inflation rate EU members
Sources: International Monetary Fund, International Institute of Finance, JP Morgan; 1996 data
Total External debt is equal to net external debt for developed economies and gross external debt for emerging economies.
Inflation is measured on an annual average basis for Panama; Inflation is measured as CPI price change year-over-year for all other countries.
and ineffective leadership, many emerging countries are forced to borrow in

foreign currency (usually US dollars). Developing countries access foreign
currency through foreign direct investment, exports, portfolio investment and
official loans, all of which depend upon sound economic management and
stable political leadership. This access to dollars, or 'serviceability' issue, can
largely be a matter of investor confidence in policy makers and is a unique
risk to this market.
Several 'macro' trends might cause investors to be optimistic that emerging
countries will continue their economic development process and eventually
become better credit risks. First, the retreat of communism and the Soviet State
signal an end to dismal economic incentives for much of the world. Second,
the movement to more democratic forms of government should, in the long
run, stimulate a more competitive marketplace of ideas and policies. Third,
real commodity prices are currently at the low end of their historical range.
Major commodity deflation is unlikely to cause dislocations in these resource
based economies similar to the early 1980s. Lastly, the high rate of integration
(trade, tourism, information technology, etc.) and the rapid pace of technologi-
cal change make economic isolation more costly and less acceptable to the
populace.
In summary, the current economic position of emerging countries is in some
ways not radically different from their dflveloped counterparts. What differenti-
ates them, though, is that emerging market borrowers have less institutional
stability, less demonstrated commitment to free market principles and less
reliable access to foreign exchange.
PORTFOLIO CONSIDERATIONS
Since the beginning of 1991, when Brady bonds became viable assets for
institutional investors, the EMBI has outperformed the broad global and US
bond markets by an extremely wide margin. Figure 11 displays EMBI return
premia (defined as total return less cash return) along with return premia for
other market indices. Of course, given the nature of the risk inherent in these
bonds and the immaturity of the market, volatility is also greater. Sovereign
credit spreads themselves are volatile, as noted in Table 4, and have low
correlations to US interest rates (Table 7). Consequently, this unique credit
risk translates into low return correlations with the other major markets
(Table 8) and suggests potential portfolio benefits. These portfolio benefits are
illustrated in Figure 12, which shows a simplified 'efficient frontier', including
emerging debt markets. The efficient frontier including emerging debt markets
dominates the developed markets alternative since 1990. Other major indices
are also plotted for comparative purposes.
Return volatility
Monthly log returns are presented for the EMBI in Figure 13. Figure 14 pro-
vides a perspective on return premia volatility. Returns are volatile for two
18%
16% Retum Premia

13.9% 14.0% OVolalility
14%
12%
10%
8%
6%
4%
2%
0%
EMSI... WGBI BIG GIM
Figure 11. Market indices, return premia and volatility - 5 years (December 31, 1990-December
31, 1995). EMBI, Emerging Markets Bond Index Plus, J.P. Morgan. Index shown reflects EMBI
from 12/31/90-12/31/95 and EMBI + from 12/31/95-12/31/96. BIG, Broad Investment Grade
index, Salomon Brothers. WGBI, World Government Bond Index, Salomon Brothers. GIM, Global
Investable Markets index, Brinson Partners. Return premia equals total return less cash return
calculated on a logarithmic basis in US dollars. Volatility equals annualized standard deviation
based on monthly logarithmic return premia.
Table 7. Emerging markets bond index spread changes and US treasury yield changes correla-
tion table
Index U.S. Treasury

Start date I-Year IO-Year 25-Year
EMBI + Index 31/12/90 0.18 0.18 0.13

Argentina 30/4/93 0.30 0.38 0.31
Brazil 31/12/90 0.14 0.21 0.15
Bulgaria 30/11/94 0.42 0.39 0.40
Ecuador 30/6/95 0.55 0.34 0.34
Mexico 31/12/90 0.11 -0.01 -0.05
Morocco 31/3/96 0.34 0.20 0.12
Nigeria 31/1/92 0.03 -0.01 -0.04
Panama 3117/96 -0.08 0.32 0.43
Philippines 30/6/91 0.04 0.04 0.01
Poland 30/11/94 0.01 -0.15 -0.17
South Africa 31/3/96 0.30 0.19 0.03
Venezuela 31/12/90 0.16 0.18 0.11
Calculated on a logarithmic basis.

EMBI, emerging-markets bond index, J.P. Morgan.
US treasury rates for zero coupon bonds.
Data through December 31, 1995.
distinct reasons. First, the economic development process in these countries is

inherently volatile. These countries are attempting to abandon long-ingrained
social, economic and political structures in a very short period of time. Second,
return volatility often has less to do with the credit risk of the borrowers than
the perspective of the investors. A casual observer of this market's return
pattern might draw the conclusion that sovereign credit risk itself fluctuates
Table 8. Market indices return premia correlation matrix, 5 years (December 31, 199O-December
31, 1995)
EMBI WGBI BIG GIM
EMBI+ LOO
WGBI 0.43 LOO
BIG 0.37 0.86 LOO
GIM 0.54 0.61 0.53 LOO
EMBI +, Emerging Markets Bond Index Plus. Index shown reflects EMBI from 31/12/90-31/12/95
and EMBI+ from 31/12/95-31/12/96, J.P. Morgan.
BIG, Broad Investment Grade Index, Salomon Brothers.
WGBI, World Government Bond Index, Salomon Brothers.
GIM, Global Investable Markets Index, Brinson Partners.
Return premia equals return less cash return.
Correlations based on monthly logarithmic return premia calculated on a logarithmic basis in
US dollars.
10.0% , - - - - - - - - -_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _- ,
8.0%
7.0%
o
3.0%
1.0%
--
0~'-0%-----3.....0 % - - - - -
.-. ...-----5.....0 % - - - - -.. . . , - - - - - 7.....0%----~8.0%
Figure 12. Efficient fronllier, full period (March 1990-August 1995).

I Developed debt markets and emerging debt markets included in 14 DMs, 6 EM Brady indices,
6 EM Euro indices, the components of BIG and international dollar bonds.

2 Developed debt markets only frontier includes Australia, Austria, Belgium, Canada, Denmark,
France, Germany, Italy, Japan, Netherlands, Spain, Sweden, Switzerland, UK, the components of
BIG and international dollar bonds. Note: Frontiers based on monthly logarithmic return premia
from December 1990, or index inception, to August 1995. Frontier percentage constrained at 25%
maximum for Australia, Canada, France, Germany, Hong Kong, Japan, Switzerland, UK, compo-
nents of BIG and international dollar bonds. All other countries constrained at 5% maximum.
wildly. A closer examination would reveal the dearth of long-term investors,

despite the inappropriateness of this sector for those with brief time horizons
and high liquidity needs.
The winter of 1994/1995 in the emerging debt market resembles the precipi-
tous price declines in the US High Yield bond market in 1989 and the mortgage
1 5 % , - - - - - - - - - - - - - - - - - - - - - - -____________________________________- .
10%
10%
15% - ' - - - - - - - - - - - - - - - - - - - -________________________________________- - '

3111/91 30/9/91 3115192 3111/93 30/9/93 3115194 3111/95 3019195 3115196
Figure 13. Emerging markets bond index, monthly returns, 5 years (December 31, 1991-December
31, 1996), calculated on a logarithmic basis in US dollars.
~%,------------------------------------------------------------,
--Tnoiling ~'" SIlInd.... DeYi8tion

30% -"-~'"Treiling 1 2 _ - . . . . DeYi8tion
Averago 14,24%
25%
20%
15%
10%
5%
Figure 14. Emerging markets bond index, return volatility, 5 Years (December 31, 1991-December
31, 1996), volatility equals the annualized standard deviation of monthly logarithmic return premia.
market in 1994. In both cases, investors had taken on more risk than they
understood or appreciated (corporate credit risk and interest rate option risk,
respectively) and had enjoyed very good absolute returns for a significant
period of time. However, these securities were particularly ill-suited for their
respective owners. In the case of high yield bonds, the investment horizon of
retail mutual fund investors was a poor match for this illiquid and volatile
market. In the case of the mortgage market, portfolio managers of retail-
oriented, short-term government bond funds (and others) were heavily invested
in securities with extreme prepayment sensitivity. When interest rates began to
rise, reversing a 3-year trend, homeowner prepayments slowed abruptly. The
value of many sensitive securities declined precipitously as prepayment assump-
tions were reassessed. The emerging debt market mirrored these two examples
in two respects: it had produced uniformly stellar returns over a preceding
three year period, and mutual fund managers had placed billions of dollars of
these securities in retail-oriented mutual funds that have liquidity and risk
tolerances inconsistent with the nature of the securities. The panic liquidation
of these investments after the Mexican peso devaluation caused tremendous
illiquidity in the market, pushing prices down well below fundamental value.
Figure 15 outlines the changing participation in the emerging debt market.
While this data is estimated, long-term investors such as pension funds and
insurance companies are gradually replacing banks, flight capital and hedge
funds as the primary holders of these bonds. As the investor base evolves,
volatility due to liquidity panics should lessen.
Correlations
An attractive feature of the Brady market is its low correlation to other asset
classes, including other US bond markets, as illustrated in Table 8. The limited
performance history of individual Brady countries, however, blunts the oppor-
tunity to distinguish among countries with statistical confidence.
Asset allocation
Figure 16 highlights the equilibrium risk/reward position of emerging market

debt as a class relative to other financial markets (risk defined as beta - the
asset class volatility relative to that of a globally diversified portfolio). The
risk/reward position is much closer to traditional equity markets than other
bond markets. The estimates of 20% annualized standard deviation of return
premia and 0.55 correlation to the global market translate into an estimated
13 of 1.28, given an 8.6% global market risk assumption. In light of these
portfolio characteristics, limited performance history and judgments regarding
liquidity and sovereign risks, risk premium in equilibrium is estimated at 4.0%
per year (i.e. the incremental return over cash required by a globally diversified
investor). Consequently, despite the high estimate of volatility, emerging market
debt as an asset class provides an attractive portfolio risk/reward trade-off in
equilibrium. One manner of framing this trade-off is the Treynor ratio, or risk
premium relative to 13; from this viewpoint, emerging market debt compares
favorably to other asset classes.
Expected return
The long-term expected return on the sovereign, or risky, cash flows is a

function of yield, default probability and recovery value. Default probability is
1990
165 billion US$
Banks
97%
on-Banks
30/0
1995
179 billion US$
Banks. Flight Capital

& Others Pension Fund
66% 3%
Insurance Companies
3%
Dealers
5%
Local Banks
4%
Hedge Funds & Other

Investment Advisors
6%
Figure 15. Global distribution of total emerging market debt (in SUS) (Source: Salomon Brothers).
Risk Premia (%)

8 .-----------------------------------------------------,
o Equity Markets
o Bond Markets Emltrgin, EIIUi1W
Emerging Debt
J~P~O
o <> u_s EquIty
~--------~----~--~----~----~--------~~--~--~
o0.0 0.5 1.0 1.5 2.0 2.5
RiSk (8eta)
Figure 16. Equilibrium risk/reward. Global market beta as risk equilibrium risk premium.
crucial to expected returns, but is a very difficult decision area. International

bond defaults have occurred since the 1820s (including US borrowers). Other
major default episodes occurred in the 1870s, 1930s and 1980s. Generally, past
crises were due to poor use of loaned funds or worldwide economic depression
or recession. Table 9 reviews the circumstances of previous debt crises ..
In this light, current trends suggest a benign credit environment. As more
investment is being privately channeled rather than publicly placed, borrowers
are no longer wasting resources on armaments or huge 'white elephants'. Brady
debt is not 'fresh money' public sector loans, but the remnants of previous
public sector borrowing and economic planning. Moreover, as the issuers of
emerging market debt expand, the probability of simultaneous economic diffi-
culties should diminish. In addition, implicit sovereign default expectations
should be consistent with the economic assumptions girding the emerging
markets earning estimates of multinational corporations. In short, if multina-
tional corporations and equity investors prosper, host country defaults are
unlikely.
Few investors are familiar with the outcomes of the debt renegotiations in
the aftermath of past sovereign default episodes. While it is difficult to predict
precipitating events, experience allows estimation of post-default recovery value,
albeit with less statistical support than the US High Yield bond market. Brady
plan sovereign participants received debt relief, on average, of approximately
38% in the form of either reduced principal or reduced future interest payments.
Again, past due interest generally has not been reduced. (Russia is currently
negotiating rescheduled payments, not reduced payments.) The amount of relief
is predicated upon each borrower's requirements to restart the economy and
resume repayments. The history of sovereign lending indicates that while the
debt renegotiation process is a drawn-out and often acrimonious affair, deals
are ultimately consummated.
W
0'1
tv
~
~
Table 9. Composition of the four major international debt crises

b::7
~
...;:or
en
....
1820s 1870s 1930s 1980s ~
;;.
s:::.
Countries of major Britain Britain USA USA ;:or
private creditors France Britain European countries s:::....
Germany Netherlands Japan ~

Switzerland Canada ~
Major defaulters Latin America Egypt Germany Latin America ;;,0
Greece Turkey Eastern Europe Eastern Europe ;:or
(';.
Spain Latin America Africa c
Latin America c
~
Systemic factors Lending to belligerents Lending to belligerents Worldwide depression Oil and interest !:;-
Lack of lending experience or profligate rulers Trade wars rate shocks
and information Strong political influence Poor economic Worldwide
management recession
Main instrument Bonds Bonds Bonds Bank loans
Settlement process Private negotiations Private bondholders' Private bondholders' IMF
councils council Paris Club
Bank committees
Brady Plan
Source: Salomon Brothers.

In the short run, the discount rates applied to bond cash flows will drive
prices and returns; but in the long run, the cash flows themselves determine
the return performance. That is, for long-term horizons, the actual receipt of
cash flows is the critical issue in realizing expected returns. Presuming that the
recent Brady plan debt relief would be sufficient to resume debt repayments,
cash flows can then be estimated by projecting the probability and timing of
any future default/renegotiation. Holding the discount rate constant, a cash
flow reduction roughly translates into a proportional return reduction. Thus,
if a debtor immediately reduced its coupon payments on a 30-year obligation
by 40% (and then made all future payments), the expected holding period
return would decrease by approximately 43%. For example, if the stated cash
flows were priced to return 18%, the 40% coupon reduction would drop
expected returns to approximately 10.3%. Each year that passes without a
rescheduling significantly boosts return: the expected return climbs to 14.8%
if rescheduling does not occur until year seven.
Figure 17 examines return scenarios given varying recovery rates and varying
pricing yields. (The pricing yield is simply the yield to maturity given the price
of the cash flows.) The top graph illustrates that at the currently high pricing
yields, holding period returns climb rapidly as renegotiation is avoided. Also,
after 10 years of payments, returns are relatively insensitive to recovery assump-
tions, due to high compounding rates. The bottom graph indicates that for a
given principal recovery assumption of 60%, returns are more variable at
higher pricing yields.
Another manner of assessing prospective returns is to consider the implied
conditional probability of default (conditional upon no previous default and
equally probable in any year). That is, given market pricing, recovery estimates
and required return, what is the implied annual probability of default? Figure 18
plots probability-weighted return versus annual default probability (for three
pricing scenarios), assuming a 60% recovery value. Also, for each conditional
default probability, a corresponding cumulative 5-year equivalent is plotted on
the right scale. For example, if the sovereign cash flow is priced to yield 18%,
the recovery assumption in the event of default is 60% and the required return
is 10%, then the implied conditional default probability assumption is 15%;
the corollary assumption is that the probability of default within 5 years is
55%. Framed in this manner, the investor can judge the reasonableness of this
default assumption in light of intermediate global economic trends and portfolio
diversification effects.
In summary, sovereign default episodes are relatively rare and no easier to
anticipate than large macro-economic shifts. Pricing yields, recovery value
assumptions and default probabilities determine expected returns.
Active management opportunities
All fixed income sectors (mortgage, investment grade corporates, high yield
and Brady bonds) are exposed to the risk that spreads over US Treasury rates
Long-Term Returns
Varying Rate of Recovery (40%. 50%. 60%)
Pricing Yield 016%
20%
18%
16%
14%
12%
E
i 10%
~
II:
8% %
- - - -- - 50%
6%
-40%
4%
2%
0%
0 4 8 12 18 20 24 28
y_untII~
Long-Term Returns
Varying Pricing Yield (10%. 14%. 18%)
Recovery Rate .60%
20%
18%
18%
14% .............. . .. _........ _.... .

12%
E
i
II:
10%
8%
b3
6%
4% - - - -- - 14%
-10%
2%
0%
0 4 8 12 16 20 24 28
y .... until Renegotiation
Figure 17. Long-term return scenarios.

18%r-__~----------------------~~~~~~~-.90%
16% 80%
1 14% 70%:a ~
-ij, 12% 60%~~
li 11)111
:= ~10% 50%111 '8
> ..
~1i
= II: 8% 40%~~
.D ::J::J
11 6% 30%E,!
e
0.. 4%
::Jill
20%OQ
2% 10%
0% +-~~+-----~----~----~-----+----~-----+O%
0% 5% 10% 15% 20% 25% 30%
Conditional Default Probability (annual)
Figure 18. Return vs. conditional default probability, recovery rate assumption = 60% (varying
pricing yield).
change. That is, despite a constant Treasury curve, incremental yield (spread)
above this curve may increase or decrease for a number of reasons related to
perceived risks in the sector. The change in spread impacts total returns just
as a change in the underlying Treasury curve does.
Active management opportunities exist because spreads across countries are
less than perfectly correlated and because bond structures vary within a country.
Table 10 shows the correlation of stripped spreads across countries. Again, for
some countries, the performance history is brief. Nonetheless, each country's
perceived creditworthiness does not move in lock-step with the overall market,
as noted in the discussion of return attribution. This variation translates into
active management opportunities as investors compare the price of sovereign
credit risk (spread) versus their own assessment of that sovereign credit risk
(value).
Opportunities also arise due to the variety of Brady bond structures. For
instance, Argentine issues differ in that the Par bond is a fixed rate instrument,
while the FRB is a floater. Hence, the spreads on the two Argentine issues may
move differently as investors use the bonds to manifest opinions on general
interest rate trends. For example, if investors anticipate declining interest rates,
they may overwhelmingly prefer the fixed rate Par bond over the FRB, notwith-
standing the relative spreads on the two issues, which are illustrated in Figure 19.
The point is that investors focusing solely on relative spread characteristics of
the issues may capitalize on these market phenomena by swapping into the
higher credit spread issue and hedging differing interest rate sensitivities.
RELATIVE VALUE
As mentioned earlier, the Eurobond market is heavily populated with corporate

issues. Rating agencies usually limit a corporation's debt rating to its country's
......
0'\
0'\
~
~
Table /0. Emerging Markets Bond Index stripped spreads, correlation matrix five years (December 31, 1990-December 31, 1995)
Index
f
~
'";:S.
Start Date EMBI Argentina Brazil Bulgaria Ecuador Mexico Morocco Nigeria Panama Philippines Poland S. Africa Venezuela Latin NonLatin
I:>
EMBI+* 12/90 1.00 5.

~
Argentina 4/93 0.92 1.00
Brazil 12/90 0.75 0.70 1.00 ~
Bulgaria 11/94 0.69 0.56 0.51 1.00 :;p
Ecuador 6/95 0.67 0.63 0.29 0.63 1.00 ::s
;::).
Mexico 12/90 0.82 0.74 0.49 0.43 0.51 1.00 c
Morocco 3/96 0.79 0.82 0.05 0.07 0.63 0.78 1.00
c
~
Nigeria 1/92 0.70 0.58 0.50 0.48 0.53 0.48 0.76 1.00 ~
Panama 7/96 -0.80 -0.64 -0.90 -0.05 0.42 -0.88 -0.39 -0.67 1.00
Philippines 6/91 0.71 0.61 0.57 0.27 0.30 0.55 0.18 0.59 -0.89 1.00
Poland 11/94 0.62 0.36 0.43 0.50 0.42 0.57 -0.11 0.62 -0.38 0.62 1.00
South Africa 3/96 0.63 0.61 -0.24 -0.05 0.27 0.63 0.54 0.27 -0.84 0.28 0.65 1.00
Venezuela 12/90 0.85 0.74 0.63 0.65 0.67 0.56 0.63 0.72 -0.65 0.60 0.34 0.23 1.00
Latin 12/90 0.99 0.93 0.75 0.65 0.63 0.83 0.80 0.67 -0.80 0.68 0.57 0.61 0.85 1.00
Non-Latin 12/93 0.80 0.65 0.57 0.76 0.67 0.55 0.32 0.76 -0.69 0.79 0.90 0.64 0.73 0.77 1.00
EMBI, emerging markets bond index, J.P. Morgan.

Correlations of stripped spread changes, logarithmic basis.
Stripped Spread Dlfferonce

~) 2,-----------------------------------------------------,
FRB Spread minus Par Spread
'.5
0.5
-0.5
.,
".5
2.5
-3
:;: .,
~ ~ <a ~ m ~ m ~ ~ ~
Figure 19. Argentine brady bonds, stripped spread comparison - floating rate bond vs. par bond
(data through December 31, 1996).
sovereign credit rating because corporate debt manifests specific corporate

business risk in addition to the sovereign risk of its government. In effect, a
'sovereign ceiling' limits corporate credit ratings. The theory behind the sover-
eign ceiling is that the sovereign entity ultimately controls the corporation's
access to foreign currency and its tax burden. Essentially, the corporation exists
at the pleasure of the sovereign government and, therefore, is never a better
credit risk than the country itself.
The popular counter-argument is that a particular international corporation
may be so vital to the country's access to foreign currency, that the corporation's
credit reputation may supersede the country's ability to access international
capital markets. This counter-argument is, however, unsupported by history
and would, in any case, be narrow in application. Moreover, while a nationally
vital corporation may receive government assistance, it does not follow that
its bondholders will prosper. Thus, one would expect corporate issues to offer
higher yields than their sovereign counterparts. Surprisingly, however, many
of these corporate Eurobonds yield less than their sovereign counterparts.
A more credible explanation for this mis-pricing of some corporate versus
sovereign issues is market/investor segmentation. For example, most US High
Yield corporate bond managers are more likely to purchase an Argentine oil
company's bonds than the Republic of Argentina's Eurobond. Sovereign bonds
may not be included within their investment fund guidelines, or these managers
may be unfamiliar with sovereign credit risk in general. Figure 20 illustrates
the yield spread between sovereign and corporate Argentine Eurobonds - the
Republic of Argentina 8.375% of 2003 ($1 billion issue) versus the YPF 8.0%
CredIISP*(IOifIerenCe('IIo)
4.5 ,----'-'-------=--:-::~-c:__----------------__,
Repubtic of Argentina
Spread Minus YPF Spread
3.5
2.5
1.5
0.5
Figure 20. Argentine Eurobonds, sovereign vs. corporate yield spread comparison (Republic of
Argentina 2003 vs. YPF 2004) (data through December 31, 1996).
of 2004 ($350 million issue), respectively. YPF was the Argentine national oil
monopoly and remains its largest corporation after being privatized. Due to
the sovereign risks noted above, the corporate issue should be priced at a
higher credit spread than its sovereign counterpart; currently, the situation is
grossly reversed and this is observed in other countries as well. This is the
equivalent of accepting a lower yield for IBM, Ford or J.P. Morgan than the
US Treasury. Hence, sovereign Eurobonds are far more attractive than their
corporate counterparts given a longer term, more fundamental view.
Some market participants argue that, under duress, countries may choose
to service Eurobond obligations over Brady obligations, just as they discrimi-
nated against the old bank loans. Others believe that since the preceding bank
loans were already renegotiated, the resulting Brady bonds suffer some genea-
logical defect and are more vulnerable than Eurobonds. This concern misses
the more important dynamic that Eurobond investors and bank creditors of
the 1980s were distinct investor groups. Today, the same creditor community
holds both Eurobonds and Brady bonds, so sovereign issuers no longer benefit
from discriminating among their repayment priorities. In short, the borrowers
have less leverage with their creditors now.
If default risk and volatility distinctions do not warrant higher credit spreads
on Brady issues, perhaps the sheer complexity of the Brady formats may explain
the relative mis-pricing. Just as US High Yield bond portfolio managers are
often unfamiliar with sovereign credit analysis, others are equally uncomfortable
with the unique analytical aspects of the Brady market, as discussed earlier.
Figure 21 plots the sovereign (stripped) spread of an Argentine Brady bond
versus the spread of the previously mentioned Republic of Argentina Eurobond.
Credit Spread Difference (%)
Argentine Discount Spread (Brady)

Minus Republic of Argentina Spread (Eurobond)
Figure 21. Argentine sovereign yield spread, Brady vs. Eurobond (Argentine discount vs. Republic
of Argentina 2(03) (data through December 31, 1996).
Despite having identical sovereign credit risk, the Brady issue's sovereign
exposure is currently priced much more attractively.
Sovereign credit risks are obviously different in nature from corporate credit
risks. Nonetheless, they are viewed as similar in degree by the credit rating
agencies (generally rated BB/B). Figure 22 outlines the spread history of the
Brady market versus the US High Yield market. On this basis, Brady spreads
are currently attractive not only relative to Eurobonds but also to US High
Yield alternatives.
CONCLUSION
The Brady bond market is the largest and most actively traded US dollar
segment of the emerging debt market. While developing countries began adopt-
ing the Brady plan in 1989, institutional investors have just begun taking an
active interest in the resulting bonds. In order for interest to expand, investors
must become familiar with this market's important diversification benefits, its
unique analytics and the peculiar aspects of sovereign credit analysis.
As presented here, new analytical methods are required to accurately mea-
sure the pricing of Brady bonds' credit risk. Sovereign credit analysis, or the
assessment of fundamental value, also requires an understanding of the unique
serviceability risk of US dollar-denominated, emerging market debt. Due to
currency denomination, investor segmentation, liquidity and analytical com-
plexities, the Brady sector is currently the most attractive segment of the
emerging debt market - more attractive than foreign corporate debt and
370 R. 1. Bernstein and 1. A. Penicook lr
erad" Spread DIIIe..nco ('II)

12,-----------------------________________________________________-,
_ Brady Sovereign Spread
Minus High Yield Spread
Figure 22. Brady market vs. high yield market (data through December 31, 1996. Source:
Salomon Brothers).
sovereign Eurobonds. At year-end 1996, it was also currently more attractive

than the similarly rated US High Yield bond market, although relative spreads
have narrowed considerably as this goes to press. Most important, the emerging
debt market's normal return potential and low correlation to other markets
offer the opportunity to improve a diversified portfolio's risk/reward profile.
REFERENCES
Conybeare, John A.C. (1990) On the repudiation of sovereign debt: sources of stability and risk.
Columbia Journal of World Business, Spring/Summer.
Dym, Steven (1992). Global and local components of foreign bond risk. Financial Analysts Journal,
March/April,83-91.
Dym, Steven (1994). Identifying and measuring the risks of developing country bonds. Journal of
Portfolio Management, Winter, 61-66.
Eichengreen, Barry and Richard Portes (1988). Setting Defaults in the Era of Bond Finance. Centre
for Economic Policy Research, Discussion Paper No. 272.
Fridson, Martin S. (1994). International emerging markets debt in the asset allocation process. High
Yield Securities Research, Merrill Lynch, October 28.
Fridson, Martin S. (1994) Political Risk versus Corporate Risk: A Phony Comparison. Merrill Lynch.
Grief, Avner (1994). Cultural beliefs and the organization of society: a historical and theoretical
reflection on collectivist and individualist societies. Journal of Political Economy, 102,912-950.
Johnson, Bryan T. and Thomas P. Sheehy (1994). The Index of Economic Freedom. The Heritage
Foundation.
Purcell, John F. H. and Jeffrey A. Kaufman (1993). The Risks of Sovereign Lending: Lessonsfrom
History. Emerging Markets Research, Salomon Brothers.
KENNETH ROGOFF
Princeton University
Comment on 'Cross-border emerging market lending'

by Peter Aerni and Georg Junge
As capital reflows to the developing world in general, and to Latin America in

particular, the big question is are these countries reaping rewards for all their
gains in liberalizing their economies or are we witnessing a rebuilding on a
flood plain? This paper offers an cogent if perhaps optimistic overview of the
issues, reviewing the basic empirical facts and theoretical considerations. 1
Though generally careful, the paper sometimes slips into lumping all emerging
markets together, which perhaps masks some important issues. The problems
in Africa are quite different from those of Latin America, and the fast-growing
countries of Asia face very different obstacles from those confronting the debt-
crisis countries. I will focus my remarks on Latin America, since that region
appears to be the locus of the most dramatic swings in investor sentiment.
It is no mystery that investors retain an appetite for investment in Latin
America despite the traumas of the 1980s. First and foremost, there is a clear
theoretical case for international diversification. Admittedly, if one looks only
at the gains from reducing the variance of portfolio returns, it is debatable how
large these are relative to the magnitude of transactions costs (see Obstfeld and
Rogoff, 1996; chapter 5). Even ignoring portfolio diversification, however, one
can construct ample arguments for re-evaluating investment in Latin America.
These countries have as a whole engaged in dramatic economic and political
restructuring. Moreover, the decline of the Soviet empire has permanently
changed the region's political interactions with the West. This undoubtedly
affects the three-way bargaining between debtor countries, creditors, and credi-
tor-country governments, arguably reducing the risk of debt renegotiation. 2
Junge and Aerni stress that a great deal of the new lending to debt crisis
countries is now going to private rather than public borrowers. They believe
that from both a theoretical and practical perspective, this is encouraging. To
the extent that greater reliance on private borrowing reflects the growing
importance of the private sector in Latin America, I would tend to agree.
Whether lending to private borrowers really reduces the political/sovereign
risk of foreign borrowing is less obvious. Theory is fairly hazy and ill-developed
1 For overview of the theory of sovereign debt see Obstfeld and Rogoff (1996, chapter 6), and
Eaton and Fernandez's (1995).
2 For a model of debt renegotiation that encompasses both debtor and creditor governments,
see Bulow and Rogoff (1988). That model focuses on creditors' ability to interfere with the gains
from trade that both debtor and creditor-country taxpayers enjoy.
371
o 1998 K luwer Academic Publishers.
372 K. Rogoff
on the distinction between private and government borrowers, though I predict

that it will evolve considerably - after the next debt crisis, anyway. The problem
is that the legal rights of creditors within debtor countries are ill-defined and,
ultimately, depend on government discretion. As a consequence, pools of loans
that appear to have very disparate and diversified risks may in fact be linked
in ways that are not obvious.
The World Bank's experience with project lending provides important les-
sons in this regard. Until the mid-1980s, the World Bank tended to emphasize
loans for individual projects, loans that, in theory, were largely independent of
one another. The repayment record on these loans indeed tended to be
extremely good; the World Bank argued that this reflected its ability to picking
strong projects. To some extent, this was no doubt true. But it was also typically
true that if one looked at each country as a whole, every year new loans tended
to exceed the total required repayments on old loans. That is, as old projects
paid off their debts, the World Bank would find more than enough good new
projects to replace them. So the borrowing country government had a strong
incentive not to interfere with the process. Once the World Bank attempted to
reverse the overall net flows in the early 1990s, the fragility of some its country
loans became more apparent. 3 Admittedly, this interpretation of World Bank
lending is a vast oversimplification. Some countries (most notably Japan) have
'graduated' and repaid their debts. But they are the exception not the rule.
The analogy with the new flows to private borrowers is apparent. For the
moment, overall net flows are positive. If and when they suddenly reverse, as
for example occurred in Mexico, apparently independent loans may all of a
suddenly appear closely linked.
The Mexican experience also raises the spectre of multiple equilibria. As a
variety of recent theoretical models show, it is perfectly possibly to have a
high-lending and a low-lending equilibrium rest on the same set of fundamen-
tals. If investor sentiment is positive, the country will have access to significant
lending, and its consequent growth will ratify their positive expectations. On
the other hand, if investor sentiment suddenly turns negative, it will become a
self-fulfilling prophecy, as a liquidity crisis forces widespread bankruptcy (see
Obstfeld and Rogoff, 1996; chapter 9). In the case of bank runs, the possibility
of multiple equilibria provides a rationale for government intervention (e.g.,
deposit insurance). Here, it is less clear whether government intervention is the
cause or the cure. Theory suggests that countries with high levels of government
debt are more susceptible to runs and that countries with very low government
debt are virtually immune to them.
Ultimately, the fundamental question is whether today's emerging markets
will grow and whether their outputs per worker will eventually rival those of
the industrialized countries. If so, investor returns on today's lending to Latin
America will be high indeed. The evidence in support of convergence is mixed
3 Bulow et al. (1992) argued that the market value of World Bank loans was well below book
value for the reason given in the text.
Comments 373
at best, however, so investors cannot rely too much on this mechanism (see
Obstfeld and Rogoff, 1966; chapter 7). I conclude only by restating the obvious;
these new loans may produce very high profits, but they are risky.
REFERENCES
Bulow, Jeremy and Kenneth Rogoff (1988). Multilateral negotiations for rescheduling developing
country debt: a bargaining-theoretic framework. International Monetary Fund Staff Papers, 35,
644-657.
Bulow, Jeremy, Kenneth Rogoff and Afonso Bevilaqua (1992). Official creditor seniority and burden
sharing in the former Soviet bloc. Brookings Papers in Macroeconomic Activity, 1,195-222.
Eaton, Jonathan and Raquel Fernandez (1996). Sovereign debt. In Gene Grossman and Kenneth
Rogoff (eds.), Handbook of International Economics. Amsterdam: Elsevier Science Publishers,
1995.
Obstfeld, Maurice and Kenneth Rogoff (1996). Foundations of International Macroeconomics.
Cambridge: MIT Press.
MARTIN D. EVANS
Georgetown University
Comments on 'Hedging the interest rate risk of Brady

bonds' by Ahn, Boudoukh, Richardson and Whitelaw
INTRODUCTION
This paper studies the sensitivity of Brady bond returns to movements in US

interest rates. This is an important issue for investors wishing to eliminate all
but the sovereign risk associated with the bonds. As such, the authors have
made a timely contribution to the growing Brady bond literature that distils
some of the insights from academic research into a form directly relevant to
market participants.
The authors begin with a discussion of the theoretical factors affecting the
interest sensitivity of Brady bonds. The key insight to be drawn from this
analysis is that the duration of the bonds will generally depend upon both the
level of US interest rates and credit risk (measured by the probability of default)
even when these factors are independent of one another. Based on this observa-
tion, a regression method for estimating the dynamic hedging ratios associated
with the bonds is proposed that allows for the impact of changes in credit risk
and the level of interest rates on the bond's duration. When the authors
applying this method to the Argentinean Par and Discount bonds, they find
that returns are quite insensitive to movements in US rates. From these results,
they conclude that the Argentinean bond returns primarily compensate invest-
ors for sovereign risk.
POTENTIAL PITFALLS
In view of the admirable clarity with which the paper is written, I have few
criticisms of the analysis. Therefore, in these comments, I will focus on the
interpretation of the paper's empirical results and place them in perspective
against other Brady bond research. In particular, I wish to point to some
potential pitfalls of the methodology employed and consider whether these
could impact upon the central conclusion concerning the importance of sover-
eign risk.
The identification of state variables
The authors' methodology is based on premise that in estimating the duration

of a Brady bond we can confine ourselves to a limited set of state variables,
375
:> 1998 Kluwer Academic Publishers.
376 M.D. Evans
namely, credit risk as measured by a single default probability, and the level
of an appropriate US interest rate. Although this squares with the bond pricing
model, other state variables may also impact upon the bond's duration in more
general models (see, for example, Claessens and Pennarchi, 1992; Longstaff and
Schwartz, 1993; Cumby and Evans, 1995).
In general, the price of a Brady bond will depend on the probability that it
will default at any future point in time. These probabilities describe the term
structure of credit risk for the bond. In the author's model, the term structure
of credit risk has a simple structure because current and anticipated future
credit risk are assumed to be identical. That is to say, the probability at period
t of a default between periods t + hand t + h + 1 is the same at every horizon
h > O. Under these circumstances, when new information about the credit risk
comes to the market, the resulting variations in the term structure can be
captured by movements in a single factor. Alternatively, it is possible that the
market responds to new information that has implications for current or future
credit risk alone. Under these circumstances, there could be changes in both
the 'shape' and 'level' of the term structure that cannot be represented by
movements in a single factor. In this case, the duration of the bond will depend
on all the factors needed to represent the movements in the term structure.
With this perspective, it seems to me that the theoretical justification for
focusing on just two state variables is a little weaker than authors suggest. It
may well be that the choice is entirely appropriate for the Argentinean bonds
given the behaviour of their term structures, but this cannot be determined
purely on theoretical grounds.
Could the possible omission of relevant state variables significantly affect
the author's results? While it is hard to answer this question definitely, I doubt
that this is the case for two reasons. First, the authors demonstrate that their
results a quite robust to changes in the dependency between the hedging ratio
and the included state variables. Such robustness is unlikely if an important
state variable has been omitted. Second, their results appear consistent with
other research that uses quite different methods to study the Brady bond data.
I shall discusses these findings below.
Poor measurement of default probabilities
A second potential pitfall concerns the use of the strip spread (the difference
between the yield on a Brady bond stripped of its guarantees and the yield on
a US Treasury) to proxy the probability of default. The accuracy of this proxy
depends in a large part on the method used to value the guarantees. Although
a number of different methods are used by financial institutions for this purpose,
they generally assume that current and anticipated credit risk are identical.
While this implies a simple structure for the term structure of credit risk that
considerable simplifies valuation, there is little a priori reason to believe that
this restriction holds true for a particular bond. Thus, in the absence of empirical
evidence supporting these restrictions, and hence the valuation model, there
Comment 377
must be some question over the accuracy of the strip spread as a proxy for the
probability of default.
Some recent research by myself and Robert Cumby (Cumby and Evans,
1995) examined this issue. After estimating alternative valuation models that
used different specifications for the behaviour of the term structure of credit
risk, we concluded that market participants differentiated between current and
anticipated future credit risks when pricing five of the six bonds in our sample.
For these bonds, our findings imply that the strip spreads calculated from
standard models contain valuation errors.
Figure 1 gives some visual evidence on the importance of these valuation
errors. The market price of the Mexican Discount bond between the beginning
of 1990 and the end of 1992 is plotted against the left hand axis. According to
our tests, the behaviour of these prices is inconsistent with a simple valuation
model in which current and anticipated credit risk are identical. The second
series, plotted against the right hand axis, is an estimate of the error in valuing
the guarantee. This is the difference between the estimated values calculated
from our preferred model (that allows for differences between current and
anticipated future credit risk) and a standard model (where the risks are
identical). As the figure shows, the difference between the value of these guaran-
tees is quite variable and economically significant. From these results it appears
that the standard way of calculating the strip yield for the Mexican Discount
bond would introduce a significant measurement error.
The plots in Figure 1 are quite representative of our results for Venezuelan
and Costa Rican bonds. Thus, while I have no direct evidence on the accuracy
of the Argentinean bond strips, it seems reasonable to doubt their accuracy in
the light of these findings. In principle this could have quite an impact on the
results. For if the authors' regression methodology is unable to pick up much
of the true variations in the dynamic hedge ratios because the state variables
are inaccurately measured, it is possible that their results understate the true
sensitivity of the Brady's to interest rate risk. Fortunately, the evidence cited
below suggests that this assessment is unduly pessimistic.
60 .
0.2
~". "'"90.06"""""
5590.03 90.09 "'"90.12."""91.03
,,,. '" 91.06
" " '''' 91.09
,,,,,. " 91.12
" "" .. " 92.03
,,' "" .. 92.06
'''' ", .. """, ... """,,)0
92.09 92.12
Figure 1. Mexican discount bond. ---- Price; - Difference in guarantee.

378 M.D. Evans
Non-fundamental factors
The authors interpret their findings to mean that sovereign risk is the dominate
factor in explaining Brady bond returns. Strictly speaking, this interpretation
says more about their priors than about the data because in effect we are
labelling a regression residual. It is quite possible that other non-fundamental
factors unrelated to the factors present in bond pricing models have a significant
impact on actual returns. In other words, the finding that Brady bond returns
are insensitive to interest rate variations does not in itself demonstrate that the
returns primarily compensate for sovereign risk.
To gain some insight into the possible importance of non-fundamental
factors it is useful to consider how well structural models for the pricing of
Brady bonds perform. For the case of the Mexican Discount bond shown in
Figure 1, the preferred model in Cumby and Evans (1995) implies that 96%
of the price variations are explainable in terms of fundamentals, i.e. the term
structure of credit risk and US interest rates. Since similar results were found
for the other Brady bonds studied, it appears that fairly simple pricing models
can relate a very large proportion of the price variations to fundamentals
factors. This evidence suggests that non-fundamental factors do not have a
dominant influence on Brady returns.
The structural model estimates can also be used to directly examine the
importance of sovereign risk for price variations in Brady bonds. In the case
of the Mexican Discount bond, changes the term structure of credit risk account
for approximately 95% of the explainable price variations. Once again, similar
results apply to the other Brady bonds studied. Thus, the evidence from these
structure models appears to support the authors' conclusion that Brady bond
returns primary reward investors for sovereign risk.
CONCLUSION
Discussing an interesting paper can be a difficult job when there is little of

substance to take issue with. This paper proved no exception. Although there
are some questions regarding the theoretical justification for the empirical
methodology and the reliability of the data, in the end there is very little of
substance to argue with here. In fact, given the results from my own research
on structural Brady bond models, I feel quite confident in endorsing the
authors' conclusions.
REFERENCES
Claessens, Stijn and George Pennacchi (1992). Deriving Developing Country Repayments for the
Market Prices of Sovereign Debt. Working paper, World Bank.
Comment 379
Cumby, Robert E. and Martin D. Evans (1995). The Term Structure of Credit Risk: Estimates and
Specifications Tests. Financial Markets Group discussion paper, London School of Economics.
Longstaff, Francis A and Eduardo S. Schwartz (1993). Valuing Risky Debt: A New Approach.
Working paper, The Anderson Graduate School of Management, UCLA.
RICHARD CANTOR
Federal Reserve Bank of New York
Comments on 'Identification and testing of a term

structure relationship for country and currency risk
premia in an emerging market' by Ian Domowitz,
Jack Glen and Ananth Madhavan
This study analyzes the term structure of interest rates in Mexico. 1 Domowitz,
Glen and Madhaven (DGM) find that, during the 18 months leading up to
the devaluation in December 1994, the term structure was broadly consistent
with the expectations hypothesis. In addition, they find that market expectations
of default on Mexican securities were fairly stable, and currency risk premia
were actually declining immediately preceding the devaluation.
This study should attract a broad audience, including both economists who
study term structure relationships in other countries and those interested in
improving their understanding of market conditions leading up to the peso's
devaluation. DGM's finding that the expectations hypothesis is supported by
the data is of particular interest because many studies find that the US data is
not entirely consistent with the theory. Once again, we are reminded that the
volatile time series data from emerging markets sometimes provide the best
testing grounds for our most important economic propositions. DGM's findings
regarding market expectations are also important since they provide some
support for the view that the attack on the peso was not fully grounded in
observable fundamentals and therefore somewhat arbitrary.
My comments are limited to three concerns I have with the paper. First,
the study's sample size is quite small and may bias the test results in favor of
the expectations hypothesis. Second, the available data on the Mexican term
structure have a number of shortcomings that may distort their information
content. Third, the Campbell-Shiller (1991) tests of the expectations hypothesis
used by DGM may not be valid in an environment with 'peso problems', where
the market expects large, but infrequent, asset price movements. More generally,
the Campbell-Shiller tests (which are normally applied to US Treasury securi-
ties) may be inappropriate for testing term structure for securities with default
and devaluation risks.
1 Babatz and Conesa (1994) and Lederman and Sod (1996) have also written on this subject.
381
(I 1998 Kluwer Academic Publishers.
382 R. Cantor
Is THE SAMPLE SIZE ADEQUATE?
The sample consisted of seventy observations on average yields at weekly

auctions for 3- and 6-month cetes and tesobonos between July 1993 and
November 1994. For many of the tests, 13 observations are absorbed by
required lags. The infonnation content of the remain 57 observations is further
limited by overlapping observations. The sample contains only six non-overlap-
ping 3-month bill observations. Bekaert et al. (1996) have shown that, in small
samples, standard tests of the expectations hypothesis are biased toward accep-
tance. They also showed how to correct the standard errors for this small
sample bias.
Do THE DATA REFLECT MARKET CLEARING INTEREST RATES?
Since secondary market data are not available, DGM use the average yields
at auctions for 3- and 6-month tesobonos and cetes. The authors' methodology
requires that these yields reflect true market clearing rates, embodying the
marginal investor's expectations of both expected peso depreciation and poten-
tial default. A number of factors, however, suggest that these auction yields do
not represent true market rates.
Bidder collusion may have contaminated some of the observed data. During
the sample period, the government conducted both discriminatory price and
unifonn price auctions. Umlauf (1993) showed that collusion has been common
in Mexican discriminatory price auctions but has been absent in unifonn price
auctions.
Government interventions may have contaminated the observed spreads
between cetes and tesobonos rates, the so-called currency premium. During
1994, the government sharply scaled back cetes issuance and increased teso-
bonos issuance. Moreover, in November 1994 alone, the authorities spent
almost $5 billion buying up peso-denominated securities. Both actions likely
suppressed the observed cetes-tesobones spread and created a false impression
that the expectations of a devaluation were declining going into December
1994. In fact, these actions themselves suggest that concern about a devaluation
were more likely increasing.
Government actions may have also contaminated observed tenn spreads.
On 11 occasions when the cetes yield curve was inverted, long-tenn debt
offerings were increased relative to short-tenn offerings. On another 11 occa-
sions, actual cetes sales were less than originally scheduled because of weak
investor demand at auction. Similarly, on 17 occasions, actual tesobonos sales
were less than originally announced. Finally, on 10 occasions the government
exercised its 'green shoe' option and sold more tesobonos than originally
scheduled.
Comment 383
THE PESO PROBLEM
Given the enormous devaluation and near default that occurred just after the
sample period, one might reasonably expect that interest rate fluctuations
during the preceding months reflected changing expectations about the timing
and magnitude of the potential devaluation or default. DG M essentially ignore
these concerns and simply end their sample period one month prior to the
devaluation. A pessimist might despair that an accurate test of the expectations
hypothesis was impossible: one would never try to test uncovered interest rate
parity with this dataset. DGM's approach, however, can be justified if the
devaluation or potential default were wholly unexpected. Moreover, their
approach is satisfactory if the market placed equal probability of devaluation
and default on the first 3-months and the next 3-months throughout the sample.
It seems more reasonable, however, that observed term spread fluctuations
were dominated by changing expectations about the timing and magnitude of
devaluation and default risks. Around the December devaluation, the peso fell
by 50%. To keep investors whole, quarterly cetes rates would have needed to
be 100%, or 1500% measured at an annual rate! If the market had expected
that this event might occur with just a 1% probability, that alone would have
justified a 15% currency premium. Expectations of a default would have had
similar consequences.
Bekaert et al. (1995) showed that for the US, standard expectations hypothe-
sis tests are biased against acceptance. Markets may infer from rising short
rates that a long-term shift to a high interest rate regime has become more
likely. Because such regime shifts occur less frequently in the data than in the
market's expectations, the long-rate appears to overreact to changes in the
short-rate.
Standard expectations hypothesis tests for Mexico may however be biased
in favor of acceptance. Investors may have required extra compensation to
hold Mexican assets going into a devaluation or default, but may not have
expected extraordinarily high interest rates to follow these events. In DGH's
dataset, inverted yield curve observations may reflect large near-term default
and devaluation risks. When these events did not occur, short rates fell back
and validated the prior inverted yield curve. But this validation was driven by
unfulfilled rather than fulfilled expectations! Properly accounting for the peso
problem should increase estimated standard errors and affect interpretations
given to term structure variations.
Even if the sample were large enough so that peso problem were not present
(if the large, infrequent events occurred in the sample with the correct fre-
quency), the direct application of the Campbell-Shiller tests to Mexican data
might still be inappropriate. These tests were designed for use on US Treasury
data where default and devaluation risks are assumed irrelevant. For Mexican
data, this assumption is clearly inappropriate. When studying the term structure
of the currency term premia, the efficiency of the term structure imposes a
384 R. Cantor
relationship between expected dollar returns on long- and short-term securities,

including losses due to defaults or devaluations.
CONCLUSIONS
DGM are right to test an important proposition with the volatile data from
emerging markets. The data are interesting but have shortcomings. The sample
is small but corrections can be made for the resulting small sample bias. More
troubling, however, is the possibility that the auction yield data may poorly
reflect true market yields due to bidder collusion and government interventions.
Lastly, it is unclear whether the Campbell-Shiller tests of the expectations
hypothesis should be applied to this sample. The implications of the peso
problem need further exploration, and the tests need to be restructured to
explicitly take into account default and devaluation risks.
REFERENCES
Babatz, G. and A. Conesa (1994). The Term Structure of Interest Rates: An Empirical Analysis for
Mexico. Mimeo, Harvard University.
Campbell, 1. and R. Shiller (1991). Yield spreads and interest rate movements: a bird's eye view.
Review of Economic Studies, 58, 495-514.
Bekaert, G., R. Hodrick and D. Marshall (1996). On Biases in Tests of the Expectations Hypothesis
of the Term Structure of Interest Rates. NBER Technical Working Paper #191, January.
Bekaert, G., R. Hodrick and D. Marshall (1995). Peso Problem Explanationsfor the Term Structure.
Mimeo, Federal Reserve Bank of Chicago.
Lederman, A. and G. Sod (1996). Risk Premia and the Term Structure of Interest Rates in Mexico.
Mimeo, Yale University.
Umlauf, S. (1993). An empirical study of the Mexican treasury bill auction. Journal of Financial
Economics, 33, 313-340.
LAWRENCE GOODMAN
Comments on 'Emerging market debt: practical portfolio

considerations' by Robert J. Bernstein
and John A. Penicook Jr.
Bernstein and Penicook's paper thoroughly covers a well-developed process

for emerging-markets debt analysis and investing. They point to the unique
characteristics of emerging market instruments, special analytics developed for
the Brady market, the art of sovereign credit analysis, and use of portfolio
tools to structure investments and understand relative value trades.
In the course of outlining the emerging market portfolio decision making
process, Bernstein and Penicook tackle two of the great debates in the market-
place: the notion of the sovereign ceiling or whether corporate credits should
trade through their sovereign counterparts and the value of Euro versus
Brady bonds.
My comments will center on four issues: sovereign credit analysis, Brady
bond analytics and portfolio implications, the sovereign ceiling, and Euro
versus Brady bonds.
SOVEREIGN CREDIT ANALYSIS
The paper conceptually links sovereign credit analysis to spreads, relative value,
and portfolio dynamics. Sovereign credit analysis begins with economic and
financial dynamics, which are broken into elements of structure, solvency, and
serviceability. Politics and willingness are identified as further complicating
sovereign analysis. The authors cite Columbia Gas Systems and Orange
County's movement toward bankruptcy based on willingness. It is important
to note that recent parallels exist in the emerging markets. Coincident with the
Brady negotiations, debt reduction often exceeded the nation's capacity to
service external obligations.
At Salomon, we take a multipronged approach to the measurement of
sovereign risk. In terms of structural and solvency issues, we begin with an
assessment of key macro-variables including growth and interest rates in the
developed world as well as commodity prices. Major assumptions regarding
future developments in the industrialized world and commodity prices are
integrated into a country-by-country modeling process. The analytic frame-
work evaluates the nation's ability to meet internal and external financing
requirements in the short and medium term. Likewise, we evaluate short-term
385
386 L. Goodman
payments pressures through the use of an analytic framework that assesses a

country's vulnerability to liquidity and foreign exchange rate strains. This
combines potential economic constraints with a qualitative assessment of the
possibility of a destabilizing political event and the willingness or ability of a
government to exercise discipline in the event of a payments crisis.
An area for further application would be the integration of a quantitative
assessment of sovereign risk with discreet trading and portfolio recom-
mendations.
BRADY BOND ANALYTICS AND PORTFOLIO IMPLICATIONS
Bernstein and Penicook outline structural peculiarities of Brady instruments;

namely varying coupon types, principal collateral, and rolling interest guaran-
tees. They also highlight conventions and vocabulary unique to the Brady
market.
The authors note that only 76% of the average instrument in the Emerging
Markets bond index relates to sovereign cash flows and in some cases only
50%. In other words, hybrid instruments are difficult to price. The authors
discuss the methodological approach to pricing uncollateralized cash flows
through 'stripping' the instrument of Treasury collateral to provide investors
with a notion of the stripped yield. However, the most important notion relates
to varying methodologies for valuation of rolling interest guarantee. In fact,
uncertainty surrounding the valuation of interest guarantees and implied
returns remains an old problem dating back to the Brady debt restructuring
process beginning in the late 1980s. Today, investors will comment that stripped
spreads calculations provided by varying financial institutions can differ by as
much as 100 basis points. The recommendation here would be the formulation
of an industry standard. This would simplify the thought process for instrument
ownership and bolster the maturation of emerging debt markets.
The authors clearly demonstrate how over a period of 5 years emerging
markets bonds outperformed investment grade and other government bonds
(note the inclusion of the Peso Crisis). Bernstein and Penicook demonstrate
how low correlations to US rates compensate for the higher risk profile of
emerging market instruments. The authors dissect return volatility into two
components: an inherently volatile economic development process and a more
volatile investor base. The report contains two pie graphs that demonstrate
the broad shift in ownership from banks to 'other' types of investors pointing
to two periods, 1990 and 1995. In fact, since the beginning of this year anecdotal
evidence reaffirms the trend toward participation of longer-term investors,
especially as the market perception of recovery in Argentina and Mexico
mounts.
Analytics play an important role in the formulation of portfolio decisions
with expected returns being dissected into probability of default and salvage
value. The authors demonstrate how varying salvage values, yields, and the
Comment 387
probability of default interacts in the instrument valuation process. The authors

extend instrument valuation into a correlation matrix of multiple emerging
market securities. An application for future work would be the integration of
global macro fundamentals into instrument valuations and optimal portfolio
profiles.
THE 'SOVEREIGN CEILING' DEBATE
Bernstein and Penicook also tackle the great debate relating to the 'sovereign
ceiling' or whether corporate credits should trade through their sovereign
counterparts. The authors suggest the discrepancy relates to market segmenta-
tion, namely high yield investors demonstrating a greater comfort level with
corporate credits relative to less familiar sovereign credits. An interesting area
for further study would be theoretical work examining the potential effect of
the globalization of corporations i.e. the move toward nationless entities on
credit quality. In other words, the study could determine the impact on corpo-
rate credit quality of the geographic distribution of earnings and assets.
BRADY VERSUS EURO DEBATE
The authors draw our attention to the distinction between Brady and Euro-
bonds. Raising the question of why Brady yields exceed comparable Euro's?
One answer is the 'genealogical defect' or the fact that they were previously
tarnished with restructuring. Moody's recently eliminated their credit distinc-
tion rating Brady's inferior to Euros as: (1) Brady trading volumes have
advanced dramatically, (2) the small denominations of Brady bonds ($250,000)
results in wide distribution complicating potential debt restructuring, (3) instru-
ments held by bond funds are less malleable creditors, and (4) the amount of
Brady's outstanding will decline relative to Euro's over time.
CONCLUSION
The implications are clear that, over time, with a heightened and broadened
analysis as presented in the Bernstein and Penicook paper, emerging-markets
debt will represent an increasingly viable adjunct to a bond portfolio.
Nonetheless, volatility will remain omnipresent, as the risk of default fails to
vanish. In fact, no instruments are immune. In other words, an altered classifi-
cation e.g. loans, Brady's, or Euros will fall short of fully-insulating creditors.
The most likely instruments for restructuring will be represented by a combina-
tion of factors such as the relative seniority of the obligations and the cash
flow burden or potential economic gain to the debtor from restructuring.
PART FIVE
Topics in corporate debt and emerging markets

EDWARD I. ALTMAN,l JOHN HARTZELU and MATTHEW PECK 2
'New York University, 2Sa/omon Brothers Inc
15. Emerging market corporate bonds - a scoring

system
ABSTRACT
In this article we discuss a scoring system (EMS model) for emerging markets corporate
bonds. The scoring system provides an empirically based tool for the investor to use in
making relative value determinations. The EMS model is an enhanced version of the
statistically proven Z-score model (Altman, 1968) designed for US companies. Unlike the
original Z-score model, our approach can be applied to non-manufacturing companies and
manufacturers, and is relevant for privately held and publicly owned firms. The adjusted
EMS model incorporates the particular credit characteristics of emerging markets compa-
nies, and is best suited for assessing relative value among emerging markets credits. The
EMS model combines fundamental credit analysis and rigorous benchmarks together with
analyst-enhanced assessments to reach a modified rating, which can then be compared with
agency ratings (if any) and market levels. We have included a summary of Mexican
companies for which we have applied the EMS model.
The emerging market scoring model (EMS model) for rating emerging markets
credits is based first on a fundamental financial review derived from a quantita-
tive risk model and second, by analyst assessments of specific credit risks in
order to arrive at a final analyst modified rating. This rating can then be
utilized by the investor, after considering the appropriate sovereign yield spread,
to assess equivalent bond ratings and intrinsic values. The foundation of the
EMS model is an enhancement of Altman's Z-score model, described in the
body of this report, resulting in an EM score and its associated bond rating
equivalent.
The EM score's rating equivalent is then modified based on four critical
factors including: the firm's vulnerability to currency devaluation, its industry
affiliation, its competitive position in the industry and its market to book
equity value. Unique features of the specific bond issue should also be consid-
ered. These modifications are an important complement to the EM score.
The resulting analyst modified rating is compared to the actual bond rating
(if any). Where no agency rating exists, our modified analyst rating is a means
to assess credit quality and relative value both to credits within a country and
to US corporates. These results are listed in Table 1 for Mexican corporates
based on year-end 1994. The results have since been updated as of mid-1996
financials. The implied yield spread based on the analyst modified rating can
be observed from the US Corporate bond market. Steps 1-7 outline the process
391
R. Levich (ed.), Emerging Markee Capital Flows, 391-400.
I 1998 Kluwer Academic Publishers.
Table 1. Mexican corporate issuers - EM scores and modified ratings based on end 1994 w
1.0
tv
EM Bond-rating Modified Ratings
Company Industry score equivalent rating M/S&P/D&P
tTl
~
Aeromexico Airlines -4.42 D D NR/NR/NR ~
Apasco Cement 8.48 AAA A Ba2/NR/NR -~
CCM Supermarkets 4.78 BB- B+ NR/NR/NR s::.
Cemex Cement 5.67 BBB- BBB- Ba3/BB/BB ;:s
Cydsa Chemicals 4.67 BB- B+ NR/NR/NR ~
DESC Conglomerate 4.23 B BB+ NR/NR/NR s::.
:--
Empresas ICA Construction 5.96 BBB BB Bl/BB-/B+
Femsa Bottling 6.37 A- BBB+ NR/NR/NR
Gemex Bottling 5.40 BB+ BB+ Ba3/NR/NR
GIDUSA (Durango) Paper and forest products 4.61 B+ BB Bl/BB-/NR
GMD Construction 4.85 BB B- B3/NR/NR
Gruma Food processing 5.56 BBB- BBB+ NR/NR/NR
Grupo Dina Auto manufacturing 5.54 BBB- BB+ NR/NR/B
Hylsamex Steel 5.51 BBB- BB- NR/NR/NR
IMSA Steel 5.45 BBB- BB- NR/NR/NR
Kimberly-Clark de Mexico Paper and forest products 8.96 AAA AA NR/NR/NR
Liverpool Retail 9.85 AAA A+ NR/NR/NR
Moderna Conglomerate 5.28 BB+ BB+ NR/NR/NR
Ponderosa Paper and forest prod ucts 6.64 A BB NR/NR/NR
San Luis Autoparts 2.69 CCC CCC- NR/NR/NR
Sidek Conglomerate 4.68 BB- B NR/NR/CCC
Simec Steel 4.42 B+ B- NR/NR/CCC
Situr Hotel and tourism 5.17 BB+ B NR/NR/CCC
Synkro Textile/apparel 1.59 CCC- CCC NR/NR/NR
TAMSA Steel pipes 3.34 CCC+ B NR/NR/NR
TELMEX Telecommunications 9.57 AAA AA- NR/NR/NR
Televisa Cable and media 7.29 AA BBB+ Ba2/NR/NR
TMM Shipping 5.34 BB+ BB+ Ba2/BB-/NR
Vitro Glass 5.18 BB+ BB Ba2/NR/NR
NR: No rating. M: Moody's. S&P: Standard and Poor's. D&P: Duff and Phelps. Note: Ratings are for senior long-term foreign debt unless otherwise specified.
EM scores were calculated using fiscal year end 1994 financials.
Source: Salomon Brothers Inc.
Emerging market corporate bonds - a scoring system 393
by which we use the EM score to reach an analyst modified rating. Note that
our analyst modified rating is not constrained in any manner by the so-called
'sovereign-ceiling'. We do advocate, however, factoring in the appropriate cur-
rent sovereign yield spread differential between the emerging market country
and comparable duration US Treasuries (Step 7). In most cases, the full
sovereign 'haircut' should be added to the stand-alone issuer spread. There are
instances, however, where the full sovereign spread is not appropriate because
of unique attributes of the issuer or the issuer's sovereign affiliation. For
example, investor portfolio considerations may swell the demand for a firm in
a key industry, such as telecommunications. Or, the sovereign's huge supply of
outstanding debt relative to investor demand may widen that security's spread
vis-a-vis a more modest supply of a particularly attractive corporate bond. The
resulting spread may indeed be below that of the sovereign as a result of
technical factors rather than fundamental credit characteristics.
STEP I - US BOND RATING EQUIVALENT
Score each bond by its EM score and classify it relative to its stand-alone US
bond rating equivalent. Emerging market corporate credits should initially be
analyzed in a manner similar to traditional analysis of US corporates. This
involves the examination of measures of performance in such a manner as to
establish a rating equivalent of the particular issuer. Instead of using a new
ad hoc system, which may not be based on a rigorous analytical examination
of credit worthiness, we will use an established and well-tested system. Since it
is not yet possible to build such a model from a sample of emerging market
credits, we suggest testing the applicability of a modified version of the original
Z-score model. It is based on a comparative profile of bankrupt and non-
bankrupt US manufacturers, however, our modification can be applied to non-
manufacturing, industrial firms and for private and public entities.
The original Z-score model is based on at least two data sources that make
it difficult to use for all emerging markets corporates: it requires the firm to
have publicly traded equity and it is primarily for manufacturers. In more than
25 years of experience in building, testing and using credit scoring models for
a variety of purposes, the original model has been enhanced to make it applica-
ble for private companies and non-manufacturers. The resulting model, which
is the foundation for our EMS model approach, is of the form:
EM score = 6.56(Xd + 3.26(X2 ) + 6.72(X3) + l.05(X4 ) + 3.25

where Xl = working capital/total assets, X2 = retained earnings/total assets,
X3 = operating income/total assets, X4 = book value equity/total liabilities.
The constant term in the model (3.25) enables us to standardize the analysis
so that a default equivalent rating (D) is consistent with a score of zero or below.
394 E.1. Altman et al.
Table 2. Average EM-score variables by bond rating - US industrials 1994
(Xl) (X 2 ) (X4 )
working retained (X3 ) stockholders
Bond Capital/ earnings/ oper. income/ equity/
rating total assets total assets total assets total liabilities
AAA 0.175 0.470 0.187 1.120

AA+* 0.150 0.450 0.166 1.085
AA- 0.142 0.439 0.150 1.025
A+ 0.138 0.359 0.114 0.970
A 0.127 0.350 0.107 0.866
A- 0.120 0.276 0.099 0.755
BBB+ 0.114 0.226 0.088 0.701
BBB 0.103 0.184 0.080 0.636
BBB- 0.081 0.065 0.075 0.546
BB+ 0.065 0.040 0.070 0.444
BB 0.060 (0.031) 0.065 0.328
BB- 0.055 (0.040) 0.062 0.305
B+ 0.050 (0.091 ) 0.055 0.287
B 0.040 (0.149) 0.050 0.272
B- 0.025 (0.200) 0.045 0.169
CCC+ 0.010 (0.307) 0.025 (0.052)
ccc (0.044) (0.321 ) O.ot5 (0.099)
CCC- (0.052) (0.561 ) (0.025) (0.256)
D (0.068) (0.716) (0.045) (0.325)
* There were insufficient data points to calculate the average AA + ratio.

Source: In-Depth Data Corp. Results are based on over 750 US industrial corporates with rated
bonds outstanding; 1994 data.
Major accounting differences between the emerging market country and the
United States must be factored into the data used in the calculations of our
measures. For example, our calculation of retained earnings is based on the
sum of retained earnings and capital reserve, the surplus (deficiency) on restate-
ment of assets, and the net income (loss) for the current period.
The model has been tested on samples of both non-manufacturers and
manufacturers in the US and its accuracy and reliability have remained high.
We have also carefully calibrated the variables and the resulting score with US
bond rating equivalents. These equivalents (Tables 2 and 3) are based a sample
of more than 750 US firms with rated bonds outstanding.
Step 2 - adjusted bond ratingfor forex devaluation vulnerability
Each bond is analyzed as to the issuing firm's vulnerability to problems in

servicing its foreign currency denominated debt. Vulnerability is assessed based
on the relationship between non-local currency revenues minus costs compared
to non-local currency interest expense, and non-local currency revenues versus
non-local currency debt. Finally, the level of cash is compared with the debt
coming due in the next year.
Table 3. US bond rating equivalent based on EM score
US Average Sample
equivalent rating EM score size
AAA 8.15 8
AA+ 7.60
AA 7.30 18
AA- 7.00 15
A+ 6.85 24
A 6.65 42
A- 6.40 38
BBB+ 6.25 38
BBB 5.85 59
BBB- 5.65 52
BB+ 5.25 34
BB 4.95 25
BB- 4.75 65
B+ 4.50 78
B 4.15 115
B- 3.75 95
CCC+ 3.20 23
CCC 2.50 10
CCC- 1.75 6
D 0.00 14
Source: In-Depth Data Corp. Average based on over 750 US industrial corporates with rated debt
outstanding; 1994 data.
If the firm has high (weak) vulnerability, that is, low or zero non-local
currency revenues and/or low or zero revenues/debt, and/or a substantial
amount of foreign currency debt coming due with little cash liquidity, then the
bond rating equivalent in Step 1 is lowered by a full rating class, such as, BB +
to B +. There is no upgrade for a low (strong) vulnerability and we apply a
one notch (BB + to BB) reduction for a neutral vulnerability assessment.
STEP 3- ADJUSTED FOR INDUSTRY
The original (Step 1) bond rating equivalent is compared to a generic industry

safety rating equivalent (Table 4). We utilize the Salomon Brothers Inc's
industries' ratings. For up to each full letter grade difference between the two
ratings, Step 2's bond rating equivalent is adjusted up or down by one notch.
For example, if the rating from Step 1 is BBB and the industry's rating is
BBB -, BB +, or BB, then the adjustment is one notch down; if the difference
is more than one full rating class but less than two full ratings, there is a two-
notch adjustment, and so on. Finally, the industry environment in the specific
emerging market country is factored into the analysis.
Table 4. Average credit safety of industry groups - Salomon Brothers
Average sector credit safety
Telecommunication High A
Independent finance High A
Natural gas utilities High A
Beverages High A
High quality electric utilities High A
Railroads High A
Food processing Mid A
Bottling Mid A
Domestic bank holding Low A
Tobacco Low A
Medium-quality electric utilities Low A
Consumer products industry Low A
H.G. diversified Mfg./conglomerate Low A
Leasing Low A
Auto manufacturers Low A
Chemicals Low A
Energy Low A
Natural gas pipelines High BBB
Paper/forest products Mid BBB
Retail Mid BBB
P&C insurance Mid BBB
Aerospace/defense Mid BBB
Information/data technology Mid BBB
Supermarkets High BB
Cable and media High BB
Vehicle parts High BB
Textile apparel High BB
Low-quality electric utilities MidBB
Gaming Mid BB
Restaurants MidBB
Construction MidBB
Hotel/leisure MidBB
Low quality manufacturing MidBB
Airlines Low BB
Metals High B
Source: Adapted from six-month credit quality overview, Salomon Brother Inc., January 18, 1995.
STEP 4- ADJUSTED FOR COMPETITIVE POSITION
Step 3's rating is adjusted up (or down) one notch if the firm is a dominant
(or not) company in its industry or if it is a domestic power in terms of size,
political influence and quality of management. It is possible that the consensus
competitive position result is neutral (no change in rating).
STEP 5- EQUITY MARKET VALUE CONSIDERATION AND IMPACT
From time to time we consider modifying the system to consider other impor-
tant factors. One such ingredient that we now feel is relevant to evaluating the
credit risk of a company is the market to book value of the firm's equity.
Despite the inefficiencies in emerging markets equity valuations, a company
whose stock is valued highly by the financial community can usually borrow
more easily and raise new equity or sell assets at better prices than one which
is being discounted by investors. Since the corporate bonds of emerging market
companies are, by rating agency definitions, almost all non-investment grade,
their yield and volatility patterns at times are more correlated with equity
market activity than are investment grade corporates.
There are two ways that we can introduce a market value of equity factor
into our system. First, a new variable reflecting the market to book value of
equity, or some similar measure, could be added to the existing four variables.
Since the original data base used to construct the EM system did not contain
that variable, it is impractical to re-estimate the equation using a new data
base. The second approach is to add an additional phase to our modified
equivalent bond rating process - one that incorporates a comparison of the
bond rating equivalent using the book value of equity to total liabilities (X4 in
the model) versus the same variable with the market value of equity (number
of shares outstanding times the stock price) substituted for the book value.
This second approach is what we actually have done. The procedure we
followed is to calculate the bond rating equivalent in the traditional manner,
which involves the initial bond rating based on the multi-variate model, and
modifications based on currency devaluation vulnerability, industry affiliation
and competitive position. The final phase now is to compare the bond rating
equivalent using book equity to the rating equivalent using the market value
of equity.
If the two systems give the identical rating or are different by only one
notch, then the modified rating is unchanged. If, however, the two versions
result in a two-notch differential, then we increase or decrease the final modified
rating by one notch. Finally, if the difference is a full rating class (three notches)
or more, the modified rating is changed by two notches.
We first applied this further modification in 1996. Based on six months
ended June 1996 data, 17 of 38 Mexican firms had higher bond rating equiva-
lents when using the market value compared to the book value equity. Of the
17 firms, six had the same modified rating since the difference was one notch;
one had a one notch upgrade and 10 had a two notch upgrade. Seven firms in
total had lower EM scores using market value compared to book value of
equity, with five resulting in a one-notch downgrade and the other two not
changed. Fourteen firms had the identical rating using the book and market
value of equity measures.
The impact of using the market value of equity versus the book value can
have a major impact in the final modified rating for a company. Such an
impact reflects the often inefficient market for Mexican companies' equity. The
volatility of the Mexican peso and its impact of the Mexican equity market
can mask the intrinsic values of Mexican equities. In addition, inflation account-
ing can distort the book value of equity of Mexican firms because of income
statement non-cash charges and the consequent changes in retained earnings
and stockholders equity. We believe that despite these inefficiencies, the
Mexican equity market has rallied sufficiently to begin to incorporate the
market equity value in our model.
STEP 6- SPECIAL DEBT ISSUE FEATURES
If the particular debt issue has unique features, such as collateral, a bona fide,
high-quality guarantor, or a restricted cash trust to payoff bondholders, then
the issue should be upgraded accordingly.
STEP 7- COMPARISON TO THE SOVEREIGN SPREAD
The analyst modified rating is then compared to what US corporate bonds of

the same rating are currently selling for. The US corporate credit quality spread
is then added to the appropriate option adjusted spread of the sovereign bond.
How TO USE THE EMS MODEL
Unique features of the EMS model
An important distinction must be made between this model and the original
Z-score model. First, this model, referred to by Altman (1993)1 as the Z"-score
model, is applicable for non-manufacturers and private firms in addition to
manufacturers and public firms. Second, the model applies our analysts' sub-
jective measures of credit strength as outlined in Steps 2-4, and the relationship
between the equity value based on market prices vs. book values.
It is important to remember that the stand-alone rating generated in Step 1
is based on the specific operating performance and financial characteristics of
the company. The analyst modified rating likely will change with the operating
environment within which a company functions. For US firms in mature
industries, this environment does not typically change dramatically. For
Mexican firms, however, their respective operating environments are subject
to major changes, such as the peso crisis of December 1994. Outlined below
1 See E. Altman, Corporate Financial Distress and Bankruptcy, 2nd edition, John Wiley & Sons.
N.Y., 1993, Chapter 8.
are some of the unique characteristics of the operating environments for

Mexican firms.
Foreign exchange risk

One of the largest credit risks facing Mexican Eurobond issuers at this time is
their non-local currency debt service capacity. Two critical factors affecting a
firm's debt service capacity are their export revenues and non-peso cost struc-
ture. The extraordinary political and economic events of 1994-95 undoubtedly
raised the default risk of Mexican companies. Firms with low export revenues
became particularly vulnerable to exchange risk, given their dollar liabilities
and associated debt service. In addition, those firms with a high percentage of
raw materials sources from abroad have experienced reduced margins and debt
service capacity.
Accounting anomalies
The high inflation environment in Mexico precludes Mexican firms from the
standard credit analysis applied to US companies (the original Z-score model
was for US companies only). For example, the impact of noncash foreign
exchange losses on pre-tax earnings is dramatic for Mexican firms. Analysis of
retained earnings and the book equity, and therefore leverage ratios of Mexican
firms, is subject to more careful analysis and appropriate adjustments.
Government intervention
The Mexican Government has recently pro-actively supported certain sectors
of the Mexican economy in order to prevent default. Examples of this include
the support of the banking system through programs like Procapte; the facilita-
tion of providing short-term financing for Grupo Sidek (the Mexican conglom-
erate which defaulted, and subsequently made payment, on its commercial
paper); and the government's renegotiation of construction sector concessions.
Despite its recent support of the private sector, the Mexican Government's
continuing presence in crisis situations cannot be assumed with certainty.
Bank financing environment

Short-term financing became prohibitively expensive in Mexico in 1995. Interest
rates for short-term financing soared to above 80% and cetes rates to the 60%
level. Many Mexican firms could not economically access short-term capital.
Historically, Mexican firms maintained high levels of short-term liabilities to
finance working capital, in part, because longer-term financing was unavailable
given Mexico's high inflation rate. The current government support of the
banking system has enabled many banks to avoid liquidity problems since the
devaluation. However, the Government's continuing support of the banking
system in the future, while highly likely, cannot be guaranteed.
Market share dominance

Most of the Mexican Eurobond issuers represent the largest of Mexican compa-
nies. Most of these companies were either owned by the Government prior to
the late 1980s and subsequently privatized, or they were controlled by wealthy
families for decades. Therefore, most Mexican Eurobond issuers have typically
dominated their respective markets. With the advent of NAFTA, and the
economic weakness brought about since the devaluation, we expect Mexican
firms will see greater competition and shrinking market shares in the future.
Our analyst modified rating embodies these particular Mexican credit fea-
tures. Together with timely sovereign and economic research, we can adjust
the analyst modified rating to incorporate changes in the Mexican economic
and corporate landscape.
Applying the analyst modified rating to the current market
The analyst modified rating (Table 1) should be used to evaluate whether

current market levels for bonds appropriately reflect the credit risk implied by
the rating. Since the devaluation, the Mexican corporate market has traded
with extreme volatility. Market levels have often been driven by technical
factors (more sellers than buyers) rather than fundamental credit-worthiness.
The analyst modified rating should be used to provide a clear measure of
relative credit risk independent of market technicals.
The EMS model is not a bankruptcy predictor
The EMS model is not a predictor of emerging markets company bankruptcy

for two reasons. First, when we constructed the model, the current issuers of
Mexican Eurobonds had not experienced defaults on their dollar Eurobond
liabilities (nearly all of the Eurobonds have been issued within the last five
years). It should be noted that in the subsequent 2 years, four Mexican issuers
defaulted and our EM score model had given all four companies' bonds either
a CCC- or D rating prior to default. 2 Second, the unique characteristics of
the Mexican political and economic environment make bankruptcy prediction
more difficult than it is for US firms. The Mexican Government's potential
involvement in the corporate restructuring process is a variable which cannot
be reasonably built into the model. Our model is a means to estimate equivalent
bond ratings and intrinsic fixed income values.
CONCLUSION
The EMS model should be used to assess relative value among credits in the
inefficient trading environment for emerging markets credits. The model is
flexible, allowing for future modifications depending on the operating and
financial environment and sovereign risk. Early empirical results indicate that
the model has been extremely accurate and continued testing and use would
seem to be a reasonable conclusion.
2The four Mexican defaults involved Grupo Synkro, Situr, Sidek and GMD. The first three
defaulted in 1996 and the latter in 1997.
OLIVER HART, RAFAEL LA PORTA DRAGO,
FLORENCIO LOPEZ-DE-SILANES and JOHN MORE1.t
* Harvard University, t London School of Economics
16. Proposal for a new bankruptcy procedure in

emerging markets
ABSTRACT
There is widespread dissatisfaction with existing bankruptcy procedures around the world.
We propose a fast and cheap bankruptcy mechanism which leaves little room for court
discretion and meets the desiderata of a good procedure. Our scheme has four essential
building blocks. The first part consists of the reorganization offers for the firm and/or its
pieces. Reorganization offers can be made not only in cash but also in non-cash securities,
which facilitates the best allocation of assets in the presence of capital market imperfections.
Additionally, since reorganization offers may be placed by both firm insiders and outsiders,
our mechanism preserves the ex-ante bonding role of debt by penalizing poor management
while granting debtor protection when financial difficulties are the result offortuitous events.
In the second part of our scheme, the insider cash auction, the various claims on the firms'
assets are transformed into one common security, reorganization rights (RRs), thereby
aligning the objectives of all claimants. The insider cash auction has the goal of offering
preferential treatment to existing claimants, protecting them in cases where bad functioning
or non-competitive auction markets may allow third parties to reap benefits at their expense.
The third part of our procedure consists of a public cash auction for RRs, which reduces
the probability that credit constraints will result in a bankruptcy allocation that is unfair
to claimants. The final part ofthe procedure consists of a simple vote by the newly assembled
group of shareholders on which reorganization offer to accept.
INTRODUCTION
Problems of bankruptcy procedures in developed economies
There is widespread dissatisfaction with existing bankruptcy procedures around

the world. Reorganization and liquidation are the two bankruptcy mechanisms
most often used by various countries. Both have well known problems.
1. Liquidation (e.g., Chapter 7 in the US):2 If capital markets were perfect,
selling the firm to its highest bidder would guarantee an efficient outcome.
However, when capital markets are not efficient the best managers may not
1 We are grateful to Lemma Sembit, Andrei Shleifer and the participant of the conference on
"The Future of Emerging-Market Capital Flows" for their comments. We are also grateful to
Fernando Salas for helpful conversations. Part of this paper draws on our proposal to modify
bankruptcy law in Mexico (Hart et al., 1995).
2 The liquidation procedure involves closing down the firm's operations and organizing a cash
auction for its assets. The receipts from the auction are distributed among claimants according to
absolute priority.
401
402 O. Hart et al.
be able to raise the cash necessary to buy the firm. Capital markets imperfec-
tions may have dire consequences if firms are inefficiently dismantled and
their assets sold off cheaply at fire sale prices.
2. Reorganization (e.g., Chapter 11 in the US):3 Existing reorganization pro-
cedures address two questions simultaneously: (1) Who should get what?;
and (2) What should be done with the firm? The coupling of these issues
introduces conflicts of interest and may cause assets not to be put to their
most productive use. For example, a senior creditor may press for a speedy
liquidation (since he or she will then be paid off for sure), whereas junior
claimants may encourage protracted bargaining (since they enjoy upside
changes in the firm's value, but not the downside risk).
Main problems of the present bankruptcy procedures in emerging markets
Most emerging markets have liquidation and/or reorganization procedures

similar to those in place in developed countries (American Bar Association,
1989, 1993). Thus, our critique of Chapter 7- and Chapter ll-type procedures
also applies to emerging markets. In addition, bankruptcy procedures in these
countries may present further problems. Since capital markets in emerging
economies are less developed the deficiencies outlined for liquidation-type
procedures may be more severe. It should also be noted that the effectiveness
of court procedures is impaired by the low efficiency of the judicial system and
widespread corruption which characterize emerging markets (Keefer and
Knack, 1993). Court procedures in some of these nations are slow not only as
a result of less efficient courts, but also because the law is underdeveloped and
vague (see, for example, Price Waterhouse, 1995 for Russia and Martinez, 1993
for Mexico). Contributing to a long and uncertain court bankruptcy procedure
is the fact that title to property is difficult to ascertain as many of these
countries have a poor registry of property systems. Finally, the deficient
accounting standards which characterize financial reporting of companies in
emerging economies (see Center for International Financial Analysis and
Research, 1994) make it harder to sort out the claims and determine if bond
covenants have been breached.
The practical consequence of the deficiencies outlined above is that creditors
in some emerging markets, like Indonesia, Mexico, Thailand and Russia, are
able to recoup a very small fraction of their claims at the end of a very long
procedure (Martinez, 1993; Lipkin, 1995).4 Given the high costs of the present
procedures, there are very few court-sanctioned reorganizations as firms typi-
3 The reorganization process encourages creditors and shareholders to bargain about the future
of the company. A plan is implemented if it receives approval by a suitable majority of each
claimant class.
4 The resolution of a bankruptcy procedure may take anywhere from 3 to 7 years in Mexico
and even decades in Thailand.
Proposals for a new bankruptcy procedure 403
cally prefer informal solutions to their financial problems. s Personal property,

which can be seized more easily because it is not subject to the provisions of
the bankruptcy law, is commonly used as collateral in commercial transactions.
Unfortunately, personal property can back only so much debt. In addition,
although out-of-court settlements can be an effective means of coping with
financial distress, the bargaining position of creditors is compromised by the
lack of an effective collective procedure. 6 Moreover, in some cases the parties
may not achieve an out-of-court settlement, particularly if there are many
creditors. Gilson et al. (1990) in a study of the companies listed on the New
York and American Stock Exchanges that were in severe financial distress
during 1978-87, found that workouts fail more than 50% of the time and are
more likely to fail the larger the number of creditors (see also John, 1993).
The above discussion suggests that bankruptcy procedures may impose
substantial deadweight loses as assets get dissipated throughout the process
and out-of-court settlements are expensive (Cutler and Summers, 1988; Gilson
et al., 1990). The deadweight loss associated with bad bankruptcy procedures
may be significant in emerging markets and may prevent solvent firms from
undertaking some positive NPV projects. The lack of external financing and
its high cost hardly support investment and employment growth. A lower cost
of external borrowing may be a significant benefit of adopting our procedure.
THE MAIN FEATURES OF OUR PROPOSED REORGANIZATION PROCEDURE 7
The key feature of the proposed reorganization procedure is that it disociates

the decision on the allocation of the assets from the decision on the destination
of the proceeds from reorganization. This is achieved by transforming the firm
into an all equity firm. The mechanism used to achieve this end is one that
preserves absolute priority while taking into account that capital market imper-
fections may be pervasive. Our proposed reorganization procedure involves
four main steps:
5 During the period between 1993 and July 1995, the total number of decisions made by the
Court of Arbitration in all of Russia totaled 613 (data provided by the Organizations Department
of the Court of Arbitration). This number is very low compared to OECD countries. In England,
for example, the number of court decisions for a similar period of time would be close to 15,000.
Another example is Mexico, where during the period 1989-1992, the average annual number of
firms filing for bankruptcy in Mexico City was less than 120. There have been virtually no major
Mexican bankruptcies since AHMSA (1986) and Aeromexico (1988), both of which were govern-
ment-owned firms. The number of firms successfully reorganized through court procedures is
surprisingly low. In fact, only thirty Mexican reorganizations have taken place in court in the last
twenty years.
6 In fact, the experience of the few litigated cases of firms filing for bankruptcy in Mexico shows
that debtors reap the benefit of the law's weaknesses (Lipkin, 1995; McHugh, 1995).
7 The procedure is a (significant) modification of the one developed by Aghion et al. (1992,
1995) and draws on the proposal made for bankruptcy reform in Mexico (see Hart et al., 1995).
404 O. Hart et al.
1. A court-appointed receiver starts the claim resolution process and solicits

reorganization offers in cash and/or non-cash securities for the whole firm
or its parts. Three months later, the receiver announces the list of creditors
and makes public all reorganization offers received. At the same time, the
receiver issues Reorganization Rights (RRs), each one representing an owner-
ship stake in the firm and conferring the right to vote at the meeting of
holders of RRs that will later be assembled to decide the future of the firm.
2. The debtor firm's insiders are given preferential treatment to continue to
participate in the firm by granting them special conditions for buying RRs.
The basic idea of this 'insider' auction is that an insider can buy 1% of the
firm if he is willing to cancel 1% of the claims that have higher priority.
3. In order to further accommodate pervasive capital market imperfections,
the receiver organizes a public cash auction for RRs. The goal of the public
auction is to sell all RRs that could not be assigned to insiders and to call
(i.e., purchase) RRs held by insiders if outside investors are willing to offer
a price such that the claims of its holders are paid in full.
4. Holders of RRs meet to vote and select the best reorganization offer submit-
ted. The proposed reorganization procedure has effectively transformed
claimants with diverse goals into a homogeneous group whose sole purpose
is to maximize the value of the firm. This concludes the reorganization
process with the firm having been reorganized in less than 6 months.
It is worth noting that the above procedure differs from that proposed by
Aghion et al. in one main respect. The new feature is the public cash auction
for RRs. This means that insiders who are liquidity constrained and cannot
exercise their options may still receive compensation from the sale of RRs to
outside investors. We will discuss this feature in detaillater.8
Advantages of this proposal
The advantages of this proposal can be divided into eight different areas:
1. RRs eliminate conflicts between different classes of claimants regarding the
future of the firm. All holders of RRs are equal and have only one objective:
to maximize the value of firm.
2. The ability to make offers in cash and/or non-cash securities, for the firm
as a whole or for parts of it, makes it more likely that the assets of the firm
will be put to their most productive use.
3. The procedure pays particular attention to capital market imperfections.
The proposal allows outsiders to participate in the process by placing
reorganization bids for the firm or its parts. This feature ensures that debt
acts as a bonding device since it provides a tool to discipline poorly perform-
ing management. Debt can be a particularly valuable way of mitigating the
corporate governance problem and imposing discipline on management in
8 It is not suggested that our procedure, if adopted, should be mandatory. Anybody who wishes
to deviate from it and design their own procedure should be aJlowed to do so.
countries with no takeovers and insufficient protection of investors' rights.

Another advantage of allowing outside bids for the firm is that it reduces
the probability of strategic behavior of debtors by making it harder for them
to declare bankruptcy and buy the firm cheap. Our procedure also allows
outsiders to participate in the process by placing bids for RRs thus reducing
the probability that credit constraints will result in a bankruptcy allocation
that is unfair to claimants. Note that, in contrast to current liquidation
schemes, our proposal mitigates liquidity constraints by requiring claimants
to raise cash to cover only a fraction of the value of the firm.
4. The proposed procedure minimizes the reliance on the judicial process which
is weak in most emerging markets, and yet achieves the 'fair outcome' in
terms of absolute priority.
5. The uncertainty associated with the restructuring process is significantly
reduced given the overall simplicity of the proposed reorganization scheme
and the limited scope for arbitrary decisions by the judge.
6. Since the firm is restructured in less than 6 months, the speed of the process
minimizes the loss of value created by financial distress and the depletion
of assets which usually follows the declaration of bankruptcy or suspension
of payments in most countries. The preservation of the firm's value means
higher cash flows for those claimants who are entitled to the assets while it
also increases the likelihood of achieving a successful reorganization.
7. Our procedure allows for debtor protection by giving existing management
and shareholders the opportunity for proposing one or several reorganiza-
tion plans to be voted by the holders of RRs. Additionally, shareholders of
the firm are allowed first priority to exercise their options to buy RRs. The
preferential treatment offered to shareholders protects them when financial
difficulties are the result of bad luck and not of poor management. In such
cases, shareholders are required to pay only the value of the debt and are
shielded from outside competition.
8. An additional advantage of our proposal over existing reorganization pro-
cedures is that contentious claims need not hold up the reorganization
process. The judge can draw a provisional ranking of recognized claims and
postpone a final decision on claim disputes allowing the reorganization
procedure to continue. This feature makes our proposal particularly attrac-
tive for emerging markets with a poor registry of property and/or lengthy
court proceedings.
THE PROPOSED REORGANIZATION PROCEDURE
The key feature of the proposed reorganization procedure is that it disociates

the decision on the allocation of the assets from the decision on the destination
of the proceeds from reorganization. This is achieved by transforming the firm
into an all equity firm. The mechanism used to achieve this end is one that
406 O. Hart et al.
Rcorpni ...atinn Process Swts IReorpniulion Off.:" AnnounceJ Holders of RRJi VOle Reorganiution Plan
Slay Put on Creditors Claims
(I) Insiders E)(en:ise Optiom I The Firm E'Xib ReorJllnization I

(1) Public Cub Auclion far
Reorganization Offers Solicittd Reorganization Rights (RRs)
:111m RC$oIUlion .Process SIII1$
Figure 1. Schedule for the different stages of the proposed reorganization procedure (months).
preserves absolute priority while taking into account that capital market imper-
fections may be pervasive. Figure 1 provides a summary of the discussion.
The trigger and the effects of the declaration of reorganization
A debtor who is unable to meet its obligations may seek the protection offered
by the bankruptcy law. Alternatively, a firm may be pushed into bankruptcy
by unpaid creditors. Either way, our procedure is triggered by the declaration
of a firm's bankruptcy. The initial step involves canceling all debts and placing
an automatic stay on the firm's assets that prevents secured creditors from
seizing their collateral. 9 Claimants, however, do not walk away empty handed.
Instead, as described below, they receive options to participate in the reorgani-
zation process. The essential feature of the process is that the firm is transformed
into an all-equity company.
In the context of an emerging market, it may be optimal to allow the debtor
to retain the power to manage, dispose of his estate and carryon his business
pending reorganization under the supervision of a court appointed receiver.
Alternatively, the firm's day-to-day operations may be conducted by the
appointed receiver.lO
The two parallel processes
The receiver analyzes the financial statements of the firm to determine whether
the level of its assets is sufficient to cover reorganization expenses. If this is the
case, two parallel processes are started:
First process: solicitation of reorganization offers

The receiver invites creditors and shareholders of the firm and the general
public to submit reorganization offers for the debtor firm as a whole or for
9 An application by a debtor for reorganization can be made even after foreclosure proceedings
have begun.
10 Lsck of specialized managerial talent as well as the absence of a receivership profession, as
in England, may make it hard to find qualified individuals to substitute for their existing pending
reorganization.
fractions thereof, within a ninety day period. Reorganization offers can be made
in any combination of cash and non-cash securities. In a non-cash bid someone
offers securities in the post-bankruptcy firm. Some illustrative examples of
acceptable bids are:
the old management team proposes to continue running the firm and offers
claimants equity in the post-bankruptcy firm;
the same financial arrangement can be offered by an outside management
team;
management (old or new) may offer claimants a combination of shares and
bonds in the post-bankruptcy firm.
Second process: determination of the seniority of debt

While the receiver solicits reorganization offers, the judge has the task of
determining the validity and ranking of creditors' claims. At the end of 90 days,
the judge will make public a list of recognized claims and announce their
relative standing. This list need not be definitive, as some claims may be
contentious. An advantage of our procedure is that it does not require an exact
ranking of all claims of the firm for it to proceed. We see the fact that
contentious claims need not hold up the reorganization procedure as a key
advantage of our procedure in emerging markets where the registry of property
tends to be poorly organized. An appropriate ex-post settlement will take place
at the end, but our procedure treats this provisional ranking as if were the
true oneY
At the same time that the receiver announces the provisional priority of
creditors, he also makes the reorganization offers publicly known. 12
Reorganization rights
The judge settles the list of admitted claims which result in the identification
of n classes of creditors who are owed (in total) the amounts D 1 , , D n ,
respectively, with class 1 having the most senior claims, class 2 the next most
senior claims, and so on. The firm's shareholders form the (n + 1)th class, with
a claim junior to all others.
Having identified these classes, the receiver can proceed to issue 100 reorgani-
zation rights (RRs), each one representing a 1% ownership stake in the post-
bankruptcy (all-equity) firm and conferring the right to one vote at the meeting
of holders of RRs that will later be assembled to decide the future of the firm.
11 The fact that contentious claimants do not participate in the latter stages of the procedure is
not too serious, since they probably share the same objectives as the rest of the claimants of their
class and would probably have voted in the same way as recognized creditors when deciding on
the future of the firm. Contentious claims may be sorted out in court as the reorganization
procedure continues, or they may be set aside and dealt with, together with late claims, once the
company has emerged from insolvency. At this stage, validated claims can be discharged with cash
and/or securities in line with the average receipts of other former claimants of the same class.
12 The receiver has the task of combining partial offers to assemble offers for the whole firm.
To package a whole bid it may be necessary to request supplementary bids for parts of the firm.
408 O. Hart et al.
Initially, the receiver allocates 100% of the equity in the post-bankruptcy

firm, i.e. 100 RRs, to the most senior class; however the receiver has the right
to 'redeem' or call that equity at a unit price equal to D 1 /100. Each claimant
in the next most senior class (class 2) is allocated options to purchase up to
his pro rata share d2/D2 RRs at a unit price P2 equal to (DdlOO); however the
receiver has the right to call RRs held by class 2 claimants at a unit price
equal to (Dl + D 2)/100. Similarly, a claimant in class I who is owed d i has the
right to buy up to (ddDd. 100 RRs at a unit price of Pi equal to
(Dl + D2 .... + D i - d/100. RRs held by class I claimants are callable by the
receiver at a unit price equal to (Dl + D2 .... + D j )jl00. Finally, a shareholder
(class n+ 1) who has x% of the shares is given the option to buy up to x% of
non-callable RRs at a unit price of P,,+l equal to (Dl + D2 .... + D,,)j100.
Insiders are allowed to exercise their options to buyout more senior claimants
(insider auction)
Once the 3 months are up, the receiver makes public all outside reorganization
offers (described above) placed for the firm. Insiders are given an additional
month to analyze the reorganization offers received for the firm and to decide
whether they are going to exercise their options to purchase RRs. The insider
auction is designed to assure that no member of a class j is allowed to retain
cash unless all members of class j - 1 have been fully paid. Our procedure
deviates from Bebchuk's (1988) scheme only in the case that some but not all
members of a class decide to exercise their option to buy RRs.13
A detailed description of the insider auction is provided in Appendix 1. Here
we give a rough idea and some illustrations. We start the insider auction by
allowing the most junior class of claimants (class n + 1) to exercise their option
to buy RRs at the insider price of P,,+l (call this round 1). If shareholders
exercise all their rights to buy RRs, then the insider auction generates proceeds
that are sufficient to retire all the existing debt of the firm. The insider auction
then terminates. Of course, proceeds from the insider auction are going to be
insufficient to retire all the debt if shareholders choose to exercise only some
of their options. Suppose shareholders exercise their right to buy q" + 1 < 100
RRs. Then the funds generated (equal to C,,+l = P,,+lq,,+l) are handed to class n
claimants in return for an obligation to supply q" RRs to class n + 1. The
class n claimants are then compelled to use the cash received to exercise their
options to acquire RRs at the inside price p" from class n - 1. In turn class
n - 1 claimants use the cash they receive to exercise their options to acquire
RRs from class n - 2.
13 Bebchuk's scheme has the unpalatable feature that junior claimants may receive cash from
the insider auction even when senior claimants have not been fully paid. Our scheme avoids such
an outcome.
Thus, there is a cascading effect: cash moves up the hierarchy from junior
to senior claimants and RRs move down the hierarchy from senior claimants
to junior claimants (cash and RRs are always transferred on a pro rata basis).
At the end of round 1, either class n - 1 claimants have been fully paid off
in cash or they have not. If they have, the insider auction ends. If not, in a
second round of the insider auction members of class n are given an opportunity
to exercise any remaining options to buy RRs from class n - 1. We stop when
we reach a class k of claimants such that everybody senior to them has been
fully paid off in cash. (If k = 1, no class is fully paid off.)
To illustrate the proposed procedure consider a firm which has three classes
of creditors that are owed $100 each; that is Db D2 and D3 are all equal to
$100 (Figure 2 illustrates this example). The receiver has solicited reorganiza-
tion offers in cash and/or non-cash securities for the whole firm or its parts.
Assume that the best reorganization offer received is perceived to be worth
$250. The receiver issues 100 RRs and asks shareholders if they are willing to
exercise their right to buy RRs at a unit price of $3. No shareholder is willing
to exercise her option to buy RRs in the insider auction since the value of the
best reorganization offer falls short of the face value of the debt of the company.
In contrast, class 3 claimants would like to exercise their option to purchase
all RRs since they are able to do so at a unit price of $2. Class 2 claimants
receive a total of $200 from class 3 claimants in exchange for the promise to
deliver to them the 100 units of RRs. In turn, class 2 claimants are compelled
to exhaust the cash received by calling RRs held by class 1 claimants at a call
price equal to $1 each. Class 2 claimants, therefore, purchase the 100 RRs held
by class 1 creditors in exchange for the $100 that are owed to class 1 claimants
Initial Capital Structure:
Shareholders ClaSlil Class 1 ClaSliI

Shares=loo Debt=Sloo Debt=Sloo Debt=Sloo
RRs=O RRs=O RRs=O RRs=loo
REORGANIZATION OFFERS:
Assume the best reorganization offer received/or the!"m is worth $250.
INSIDER CASll AUCTION:
Step 1: Shareholders Do NOI Exercise the Option to B1I)' RRs since the firm is worth $250.
Step 2: Class 3 Exercise their Option to Buy 100 RRs:
$200 $100
Shareholders Class 3 CI8S112 Class I

Shares=O Debt=$O Debt=$(} Debt=SO
RRs=O RRs=IOO RRs=O RRs=O
Cash=$-200 Cash=$IOO Cash=$loo
100RRs 100 RRs

@2 @1
Figure 2.
410 o. Hart et al.
and retain $100 in cash for themselves. After having paid class 1 claimants in
full for $100, class 2 claimants hand over all RRs to class 3 claimants. This
concludes the inside auction part of the procedure as both class 1 and 2
claimants have been fully paid.
Note that in the above example, each class 3 claimant needs to raise cash
only to cover his or her pro rata share of Dl + D2 This feature of the proposed
procedure may be especially attractive in emerging markets to the extent that
it mitigates liquidity constraints. 14 Although the proposed procedure alleviates
liquidity constraints it probably does not eliminate them. This is the motivation
for calling a public cash auction to settle the final allocation of RRs.
Public cash auction for RRs
The receiver will rank the cash bids from highest to lowest forming a demand
schedule for RRs by outsiders. To form the supply curve of RRs the receiver
will rank the RRs held by insiders by their call price. The call price of an RR
held by a class 1 claimant is Pi + 1. We arbitrarily assign a call price of infinity
to any RR held by a shareholder (class n + 1) as they are the residual claimants.
Figure 3 illustrates the discussion. The figure corresponds to a situation where
ql RRs (held by class 1) have a call price of P2, q2 (held by class 2) have a call
price of P3 and the remainder, 100 - ql - q2 (held by class 3) have a call price
of P4.
The receiver will determine the equilibrium price for RRs where supply and
demand intersect (P* = P4)Y Suppliers of RRs will be paid their respective call
prices and in this fashion will receive satisfaction of their claims. The surplus
cash generated by the difference between P* and the call price paid to suppliers
(area A) is used by the receiver to payoff impaired claimants in accordance
with absolute priority. In Figure 3 this means that nonparticipating class 2
claimants (i.e., those who did not participate in the inside auction) are paid off
with the surplus cash first, followed by nonparticipating class 3 claimants.
To illustrate the usefulness of the outside public auction, consider once more
the firm that was presented in our previous example, keeping all assumptions
in that example but imagining that class 3 claimants are unable to raise any
of the $2 in cash needed to bid for RRs. However, the class 2 claimants are
not liquidity constrained. In the absence of an outside cash auction, all RRs
will end up in the hands of class 2 creditors who will have paid $100 for
securities that are valued at $250. The receiver hands the 100 RRs to the class 2
claimants and pays off class 1 debt in full. Therefore, the supply of RRs is
14 The fact that the insider auction is initiated at the top may also mitigate liquidity constraints.
If, for example, all shareholders exercise their options then more senior claimants are not required
to raise cash. This feature may make it less likely that liquidity constraints become binding.
15 If there are multiple equilibria, the receiver chooses the smallest price at which supply equals
demand. An alternative allocation rule would use price discrimination to capture the entire
consumer surplus. However, price discrimination may distort the incentives of outsiders to bid high.
p Supply
Demand
100 Q
Figure 3.
perfectly elastic at $2 (i.e., the call price for class 2 claimants) for quantities
that are smaller than 100 RRs and becomes perfectly inelastic at 100 RRs.
To continue with the example, the receiver assembles the demand for RRs
by inviting outsiders to place bids for them. For simplicity, assume that demand
is perfectly elastic at $2.5 and that the receiver is presented with bids for 100
RRs at $2.5 dollars each. Outside bidders pay the equilibrium unit price of
$2.5 in exchange for each of the 100 RRs. To meet the demand for RRs, the
receiver calls the 100 RRs held by class 2 claimants, each at a price of $2.
Class 2 creditors are now paid in full. The surplus cash of $50 is prorated
among all class 3 claimants of the firm. Without the public cash auction, class 3
creditors facing liquidity constraints would have been penalized since the RRs
would have been left in the hands of class 2 claimants. Through the public
cash auction, class 3 creditors fare as well as in our previous example where
they are not liquidity constrained.
In more realistic settings, some members of the impaired class, but not all,
may choose to exercise their options. The appendix illustrates how an efficient
outside market for RRs makes it possible for all members of the impaired class,
whether they are liquidity constrained or not, to fare equally well.
The reader may wonder why the public cash auction does not make the
inside auction superfluous. The insider auction is unnecessary if outsiders bid
the true value of the firm in the public cash auction. However, imagine that
412 O. Hart et al.
Shareholders Class 3 Class 2 Class I

Shares=IOO Debr-SIOO Debr-SIOO DebI=SIOO
RRs=O RRs=O RRs=O RRs=tOO
REORGANlZATION OFFERS:
Assume the best reorganizDtkm offer received for thefirm is worth $150.
INSIDER CASH AUCTION:
SUp 1: Shareholders Do Not Exercise the Oplion 10 BIIJI RRs since the firm is WOI1h $150.
Step 2: Class J Cannot Exercise lheir Oplion 10 Bvy RRs as they are liqllidily constrained.
Stq J: Sen/or, Exercise lhelr Option 10 BllJlloo RRs:
$100
Shareholders Class 3 Oass2 Caul

Sharer-tOO Debr-SIOO Debt-SO Debt=SO
RRs=O RRs=O RRs=IOO RRs=O
Cash=$-IOO Cash=SIOO
lOORRs
@I
Figure 4.
outsiders are able to place winning bids at only a fraction of the true value of
an RR possibly as a result of lack of competition in the public cash auction
market. Then, in the absence of an insider auction, outsiders would be able to
buyout the RRs of liquidity-constrained claimants at a fraction of their true
value. The insider auction allows a shareholder, for example, to buy an equity
stake in the post-bankruptcy firm by bidding her pro rata share of the debt
rather than by exceeding the bid placed by outsiders. Similarly, the insider
auction allows a member of the most senior class of creditors, for example, to
retain her RRs by bidding more than $0 rather than by surpassing the bid
placed by outsiders (assuming the outside bid is less than her call price).16
The meeting of holders of RRs
The allocation of RRs eliminates conflicts across classes of claimants and gives
new investors in the surviving entity the sole goal of maximizing the firm's
value. Holders of RRs can now proceed to meet and vote, on the basis of one-
16 We have constructed the supply curve for RRs for the public auction under the assumption
that no holder of RRs wishes to relinquish them for less than their call price. This need not be the
case, however. Consider Figure 3. One could imagine that some class 3 creditors, who are either
risk averse or relatively short of cash, may be willing to part with their RRs for a price between
P3 (the price they paid to get them) and P4 (their call price). The procedure could easily be modified
to accommodate this. Creditors could be asked to communicate to the receiver the lowest price at
which they are willing to sell and the receiver could construct a modified supply curve that
incorporates this information. The receiver would then use this modified supply curve to compute
the equilibrium price. Suppliers of RRs would be paid the smaller of the equilibrium price and
their call price.
PUBLIC CASH AUCTION:

Bids-Us
Clus 1
Debt=SO
RRs=O
Cash=Sloo
S2oo Class 1
Debt=SO
J 100 RRs RRs=O
Outside IDvestors Reeeiver @2 Casb=$loo
RRs=loo Casb=$SO
Cash 5-250 Class 3
S2S0
Debt=Sloo
looRRs RRs=O
Cash=$O
Shareholders
Shares=loo
RRs=O
SettUnmrt:
Class 1
Debt=SO
RRs=O
Casb=$loo
Class 1
Debt=SO
RRs=O
Cash=$loo
Receiver
Cash=$O Class 3
SSO Debt=SO
RRs=O
Cash=$SO
Shareholders
Shares=O
RRs=O
Cash=SO
share one-vote, to select one of the following two alternative restructuring

plans 17: accept a proposed reorganization offer, in which case, holders of RRs
receive securities in exchange for their reorganization rights; and reject all
reorganization offers and liquidate the firm's assets, in which case, liquidation
proceeds are prorated among holders of RRs.
The winning restructuring plan is the one that receives the most votes. If
the legal provisions have been met, the restructuring plan which received the
most votes is implemented, thereby concluding the reorganization proceedings.
Clearly, the treatment of minorities can be of concern in countries with
underdeveloped corporate laws and inefficient judiciary systems. For example,
17 Where there are more than two competing reorganization offers, there are several possible
ways in which the holders of RRs may select among competing restructuring plans. One possibility
is to conduct two polls. In the first poll, all restructuring proposals are submitted to a vote, while
only two restructuring proposals which have received the most votes on the first round will be
voted on in the second round.
414 O. Hart et al.
Shareholders Class 3 Class 1 Class 1

Shares=IOO Debt=SIOO Debt=$IOO Debt=$lOO
RRs=O RRs=O RRs=O RRs=IOO
A.r.sume the best reorganization offer received/or thefirm is worth $350.
Step I: Shorehclders Exercise the Option to BIIJI60 RRs:
5180 5180 5100

Shareholders Class 3 C.... l Class 1
eo
Shares=4O Debt=510 Debt=SO Debt=SO
RRs=60 RRs=30 RRr=10 RRs=O
Cash=$-180 Cash=$80 Cash=$IOO
60RRs@3 90RRs 100RRs

@2 @I
Step 2: Class 3 Exercise the Optio" to BIIJIIO RRs:
$20
Shareholders Class 3 CIassl Class 1

Shates-40 Debt=SO Debt=SO Debt=50
RRs=60 RRs-40 RRs=O RRs=O
Cash=$-180 Cash-$-20 Casb-SIOO Cash=$IOO
10RRs
@2
Figure 5.
an investor may accumulate a control stake in RRs and vote through a

reorganization offer that favors her at the expense of minorities. Bankruptcy
law may incorporate special rules to address the protection of minority invest-
ors, although these cannot substitute for an effective corporate law. For exam-
ple, holders of RRs may be required to abstain from voting on reorganization
offers made by them or related parties. Similarly, only the highest cash offer
may be voted on by holders of RRs. Another possibility is to grant a suitable
sized minority the power to veto any non-cash reorganization offer.
CONCLUSION
There is a widespread dissatisfaction with existing bankruptcy procedures in

emerging markets as well as in developed economies. Our proposal is more
flexible than current liquidation procedures (Chapter 7), since it allows cash
1,,1Ii8/ Copllo/ Strllcture:
Shareholders Class 3 ClassZ Class 1

Sbares=IOO Debr-SIOO Debr-Sl00 Debt=$IOO
RRs=O RRs~O RRs=O RRs=lOO
Assume the best reorganization offer receivedfor the firm is worth $250.
Stq.l: Shareholders Do Not Exercise the Option to Buy RRs since theftrm~' worth $250.
Stq 2: Class 3 Cannot Exercise their Option to Buy RRs as they are liquidity constrained
Stq 3: Semors Exercise their Option to Buy 100 RRs:
$100
Shareholders Class 3 ClassZ Class t

Shares=l00 Debr-SIOO Debt=$O Debr-SO
RRs=O RRs=O RRs=IOO RRs=O
Casb=$-IOO Cash=$IOO
IOORRs
@1
Figure 6.
and non-cash reorganization offers for the firm or its parts. When measured
against existing reorganization procedures (Chapter 11), our scheme is less
cumbersome, since the complicated voting systems of these procedures is substi-
tuted by a simple vote by a homogenous class of security holders whose sole
objective is the maximization of the firm's value. Finally, the public cash auction
for RRs increases the likelihood that the claimants of the firm will receive a
fair value in the presence of capital market imperfections.
Many specific characteristics and rules of our proposal may be adapted to
suit particular concerns or legal issues in different countries, as the results
achieved by our scheme rest on only four essential building blocks. The first
part of our scheme consists of the reorganization offers for the firm and/or its
pieces. Reorganization offers can be made not only in cash but also in non-
cash securities, which facilitates the best allocation of assets in the presence of
capital market imperfections. Additionally, since reorganization offers may be
placed by both firm insiders and outsiders, our mechanism preserves the ex-
ante bonding role of debt by penalizing poor management while granting
debtor protection when financial difficulties are the result of fortuitous events.
In the second part of our scheme, the insider cash auction, the various claims
on the firm's assets are transformed into one common security, reorganization
rights (RRs), thereby aligning the objectives of all claimants. The insider cash
auction has the goal of offering preferential treatment to existing claimants,
protecting them in cases where bad functioning or non-competitive auction
markets may allow third parties to reap benefits at their expense. The third
part of our procedure is the public cash auction for RRs, which reduces the
416 O. Hart et al.
probability that credit constraints will result in a bankruptcy allocation that

is unfair to claimants. Many of the capital market imperfections that our
proposal addresses are not unique to, but are certainly more pervasive in,
emerging markets. The final part of the procedure consists of a simple vote by
the newly assembled group of shareholders on which reorganization offer
to accept.
In brief, our proposal for a new reorganization procedure meets the desider-
ata of a good working procedure: (1) it is fast, cheap, and leaves as little
discretion as possible in the hands of the judiciary; (2) it maximizes the total
value of the proceeds received by existing claimants; and (3) it preserves
absolute priority. These characteristics make it attractive, as the reduced uncer-
tainty and stronger protection of investors' rights will be reflected in a higher
willingness to lend to a firm in the first place.
REFERENCES
Aghion, P., O. Hart, and J. Moore (1992). The economics of bankruptcy reform. Journal of Law,
Economics and Organization, 8, 523-546.
Aghion, P., O. Hart and 1. Moore (1995). Insolvency reform in the UK: a revised proposal.
Insolvency Law and Practice, 11, 67-74.
American Bar Association (1989 and 1993). Multinational Commercial Insolvency. Wisconsin: MG
Publishing.
Bebchuck, L. (1988). A new approach to corporate reorganizations. 101 Harvard Law Review,
775-804.
Center for International Financial Analysis and Research, Inc. ( 1994). International Accounting and
Auditing Trends.
Cutler, D. and L. Summers (1988). The cost of conflict resolution and financial distress: evidence
from the Texaco-Pennzoillitigation. Rand Journal of Economics, 19, 157-172.
Gilson, S., K. John and L. Lang (1990). Troubled debt restructurings: an empirical study of private
reorganization of firms in default. Journal of Financial Economics, 26, 315-353.
Hart, 0., R. La Porta Drago, F. Lopez-de-Silanes, J. Moore and F. Salas (1995). Proposal for a New
Bankruptcy Procedure in Mexico. Mimeographed, Harvard University.
John, Kose (1993). Managing financial distress and valuing distressed securities: a survey and
research agenda. Financial Management, 2, 60-78.
Keefer, P. and S. Knack (1993). Why Don't Poor Countries Catch Up? A Cross Country National
Test of an Institutional Explanation. Working paper No. 60, Center for Institutional Reform and
the Informal Sector, University of Maryland at College Park.
La Porta Drago, R., F. Lopez-de-Silanes, A. Shleifer and R. Vishny (1996). Law and Finance. NBER
working paper #5661.
Lipkin, A. (1995). Legal framework for bankruptcy and reorganization proceedings in emerging
markets. In M. McHugh (ed.), The 1995 Bankruptcy Yearbook and Almanac. New Generation
Research, Inc. Boston, MA: George Putnam, III, publisher.
Martinez, Gabriel (1993). Propuesta de Reforma a la Ley de Quiebras y Suspension de Pagos.
SECOFI, Mexico, D.F. Mexico.
McHugh, M. (ed.) (1995). The 1995 Bankruptcy Yearbook and Almanac. New Generation Research,
Inc. Boston, MA: George Putnam, III, publisher.
Price Waterhouse (1995). Bankruptcy Law in the Russian Federation. Report to the Russian
Federation, Moscow, Russia.
ApPENDIX 1
In this appendix we describe the insider auction in greater detail.

We start the insider auction by allowing the most junior class of claimants
(class n + 1) to exercise their option to buy RRs at the insider price of Pn+ 1
(Call this round 1.) If shareholders exercise all their rights to buy RRs, then
the insider auction generates proceeds that are sufficient to retire all the existing
debt of the firm. In this case class n + 1 ends up with all the RRs and the
insider auction terminates.
Suppose next that shareholders choose to exercise only some of their options,
e.g., they exercise the right to buy qn+l < 100 RRs. Then the funds generated,
equal to Cn+ 1 = Pn+lq.+l, are handed to class n claimants in return for an
obligation to supply q. RRs to class n + 1. The class n claimants are compelled
to use the cash received to exercise their options to acquire RRs at the inside
price P. from class n + 1. If Cn+ 1 ~ 100Pn, then all claimants senior to class n
(i.e., classes 1,2, ... , n - 1) will be fully paid off, class n claimants will receive
(100 - q.) RRs and Cn + 1 -lOOp. in cash, and class n + 1 claimants will receive
q. RRs. If Cn+ 1 < 100Pn, class n -1 claimants are compelled to use the funds
Cn + 1 to exercise their options to acquire RRs at the inside price Pn-l from
class n - 2; in return they have an obligation to supply Cn+t/Pn RRs to class n.
And so on, until either a point is reached where everybody senior to some
class I ~ 2 has been fully paid off, or all the cash is in the hands of class 1.
So far we have described round 1 of the insider auction. At the end of
round 1, if everybody senior to class n has been fully paid off, the insider
auction ends. If they have not, there is a second round in which members of
class n are given an opportunity to exercise any remaining options to buy RRs
from class n - 1. And so on. We stop after round j, where j is such that
everybody senior to class n - j + 1 has been fully paid off. (It is possible that
j = n, which means that no class is fully paid off.)
ApPENDIX 2
Maintain the assumptions of our first example in the text where a firm has a
total debt of $300 equally divided among three classes of creditors. As in that
example the receiver solicits reorganization offers in cash and/or non-cash
securities for the whole firm or its parts. Assume now that the best reorganiza-
tion offer for the firm is $350 and that some shareholders are liquidity con-
strained and therefore cannot place bids for RRs. As before, the receiver issues
100 RRs and proceeds to conduct the insider cash auction.
Insider cash auction
Assume that only 60 shareholders (out of 100) are able to exercise their options
for RRs since liquidity constraints bind for the rest of them. Each exercising
418 O. Hart et al.
shareholder is promised one RR unit at a price of $3. Class 3 creditors get

$180 in cash from the shareholders in exchange for the promise to deliver to
them 60 units of RRs. In turn, class 3 members are compelled to exhaust the
cash received by purchasing RRs at the insider price of $2 each. In this fashion,
class 3 creditors acquire 90 units of RRs. They deliver the 60 units of RRs
promised to acquiring shareholders and retain the remainder 30 units, each
having a call price equal to $3. In exchange for the RRs retained by class 3
claimants, their claims are reduced by $90, which is equivalent to the call value
of the RRs they received. There is no surplus cash for class 3 creditors to keep
since class 2 and class 1 creditors have not been paid in full.
Class 2 claimants receive the $180 in cash from class 3 creditors in exchange
for their promise to deliver to them 90 units of RRs. In turn, class 2 members
are compelled to exhaust the cash received by purchasing RRs at the insider
price of $1. Therefore, class 2 claimants acquire all 100 units of RRs. They
deliver the 90 units of RRs promised to class 3 creditors and keep the remainder
10 units, each with a call price equal to $2. In exchange for the RRs retained
by class 2 creditors, their claims are reduced in an amount equivalent to the
call value of the RRs they have received, that is by $20. Class 2 claimants offset
their claims with the $80 in cash remaining after paying class 1 creditors in full.
Up to this point class 1 claims have been paid in full, and 80% of class 2
claims have been paid while class 2 members have in their possession 10 RRs
callable at $2, which is equivalent to having received full payment for their
claims once these RRs are called. Finally, class 3 claimants have no cash but
hold 30 RRs callable at $3.
Now the receiver would meet the demands of RRs of class 3 claimants. They
would all like to exercise their options placing bids for 100 units of RRs, but
there are only 10 RRs still held by more senior claimants at a call price of $2
each. Therefore class 2 claimants get $20 in cash from class 3 creditors in
exchange for the promise to deliver to them 10 units of RRs. In this fashion,
class 2 claimants have also been fully paid. Class 2 claimants do not get to
exercise their options as their claims have been paid in full.
Public cash auction
The receiver organizes a public cash auction and 100 bids come in at a price
of $3.5 each resulting in a perfectly elastic demand for RRs at that price. As a
result of the insider cash auction, the supply of RRs is perfectly elastic up to
the point where it reaches 40 RRs at which point it becomes perfectly inelastic,
as there are no more RRs in the possession of creditors of the firm. The receiver
accepts 40 bids and calls the 40 RRs still held by class 3 claimants at a price
of $3 per unit. The receiver gives $120 in cash to class 3 claimants who have
been fully paid off, since their debt was $100 and they paid $20 from their
pockets to exercise their options. Finally, the receiver has $20 left which he
distributes among the 40 non-participating shareholders, each receiving $0.50.
Both participating and non-participating shareholders (liquidity constrained)

fare equally well in this reorganization procedure.
When the firm is reorganized, holders of RRs vote for the best reorganization
offer ($350). Therefore, the procedure allows the three classes of claimants to
be repaid while shareholders receive the remaining value of the firm.
GORDON M. BODNAR
The Wharton School
Comment on 'Evaluating the credit risk of firms from

the emerging market' by E.I. Altman et al.
The measurement and analysis of accounting ratios are a common feature of

credit analysis. As discussed in the paper by Altman et ai., credit rating models
based upon accounting ratios appear to do rather well in providing an appro-
priate credit rating for debt issued by domestic borrowers. An extension of this
approach is being offered as a means of evaluating the credit risk of dollar
debt offered by private firms in emerging market economies. The evaluation of
the credit risk of firms from emerging markets is a difficult problem, combining
the problems of evaluating the credit risk of the individual firm as well as the
implication of sovereign risk for repayment of the debt (the difficulty of this
latter issues has been addressed by several previous papers in this volume). In
evaluating the credit risk of emerging market firms issuing US dollar-denomi-
nated debt, two basic features complicate the basic methodology used in
analyzing the credit risk of US firms: different financial measurement and
reporting methodologies and the increased importance of exchange rate
exposure.
International accounting textbooks are full of examples of how accounting
methodologies of measuring and reporting financial performance differ across
countries. The implication of this is that financial ratios read directly off local
financial statements may not be comparable across countries. This can be a
problem as financial ratio analysis is an important component of the current
credit analysis models used for emerging market firms. The direct impact of
this problem is apparent when one considers that the current methodologies
compare accounting ratios for foreign firms against previously tested guidelines
for financial ratios of US firms (measured using US GAAP). Under a system
where the rating for a foreign firm is based upon a comparison of its financial
ratios to established guidelines for financial ratios from US firms, it would
seem both important and sensible to worry about adjusting the financial ratios
of the emerging market firms for differences between their local GAAP and
US GAAP before applying the guidelines. While research on the importance
of this adjustment is limited, there is some evidence that such accounting
adjustments do affect the credit rating of emerging market firms (see Sondhi,
1995), although the effects do not appear overly large.
However, adjusting foreign accounting figures for differences between local
and US GAAP is not a costless activity. While gross adjustments to some
421
R. Levich (ed.), Emerging Market Capital Flows, 421-424,
422 G.M. Bodnar
financial ratios for fundamental differences in accounting methods can be made

commonly across all firms from a particular country, adjusting all the necessary
accounting items is not as simple. Determining the appropriate adjustments to
each specific account is a difficult activity, requiring detailed knowledge about
local accounting techniques and firm-specific information. Fortunately, many
emerging market firms involved in the US dollar debt market also have equity
claims traded on major US exchanges in the form of American depository
receipts (ADRs). These firms must either file US GAAP financial statements
or a Form 20-F, a limited reconciliation of foreign and US GAAP measures,
with the US Securities and Exchange Commission. In such cases it can be
relatively low cost for an analyst to calculate the necessary financial ratios
based upon the US GAAP figures (being either directly provided or more
easily estimated). This clearly should be done before comparing the financial
ratios to the US GAAP based guidelines. However, what should an analyst do
in cases where the foreign firm provides no reconciliation of their financial
statement to US GAAP? In these cases, determining the necessary US GAAP-
based financial ratios for the foreign firms may be a costly and time consuming
activity. If the resources available for credit analysis are limited, this may not
be the best use of these resources. These resources may be more effectively
used analyzing in more detail (than appears is currently done) the other issue
that makes the credit analysis of emerging market firms more difficult that
domestic firms: the increased importance of exchange rate exposure.
Exchange rate exposure will play an important role in the credit risk to US
investors of lending to an emerging market firm. This is not because of a direct
currency exposure to the investor, as most of the public debt issued by emerging
market firms is denominated in US dollars, but rather because exchange rate
changes directly affect the firm's ability to repay these US dollar liabilities.
Although exchange rate exposure will be fundamental for analyzing the credit
risk of emerging market firms, it is likely that US credit rating professionals have
less experience with it as it is commonly less important for the evaluation of the
credit risk of US firms. Thus some discussion of its analysis is merited.
There are two reason why exchange rate risk is more important to the credit
risk of emerging market firms than the credit risk of US firms. First, emerging
market firms are more likely to have significant exposures to exchange rates.
This is because they typically operate in smaller, more open economies than
the US and have more direct links to the international market (i.e., are more
dependent upon exporting/importing and face proportionally more interna-
tional competition). Second, exchange rate changes in emerging markets are
often large with occasional sudden movements. Emerging market currencies
tend to appreciate in real terms slowly over time due to nominal exchange rate
rigidities in the presence of inflation differentials, and then, experience sudden
and large real depreciations in order to re-establish equilibrium. These exchange
rate dynamics mean understanding the exchange rate exposure of emerging
market firms will be important to credit analysis of these firms.
Comment 423
Exchange rate changes have two impacts on the emerging market firm's credit-
worthiness, one that can be generalized and the other that cannot. First, exchange
rate changes can affect the local currency value of the US dollar debt. Real
appreciations, which generally occur during fixed nominal exchange rates regi-
mens, have no impact on the local currency value of the US dollar-denominated
debt. Real devaluations, typically due to a large nominal devaluation of the local
currency, increase the local currency obligation of the firm's US dollar-denomi-
nated debt, raising the firm's debt burden in local currency. The accounting
response to the devaluation records the full increase in the local currency value
ofthe US dollar obligation as part of income for the current period, thus generat-
ing serious accounting losses for the firm in the period immediately following any
devaluation. This partial effect of exchange rate changes on creditworthiness,
common to all firms with foreign currency debt, is easy to measure and, everything
else fixed, either does not affect the firm's creditworthiness (and possibly improves
it slightly) in the case of a real appreciation, or worsens the firm's creditworthiness
in the case of a real devaluation.
Second, and often less carefully analyzed, is the fact that exchange rate
changes affect the firm's ability to generate current and future cash flows, and
thus also affect the ability of the firm to repay its debt. The impact of this
effect on the firm's creditworthiness, unfortunately, is not generalizable and
requires a careful analysis of the individual firm's cash flow sensitivity to foreign
currencies values, as it may be either positive or negative as well as large or
small, for a given exchange rate change. As a first approximation it is useful
to know the current extent of the firm's foreign currency activities such as
exporting, foreign sales, and importing, as well as the currencies in which these
activities are based. This provides some idea of the likely current period impact
of an exchange rate change on the current cash flows of the firm. However, it
is also necessary to have some understanding of the structure of the firm's
input and output markets to determine how the firm's ability to generate cash
flows will be affected by the exchange rate change.
This is not an easy task, it involves a detailed analysis of each firm carried
out as part of the 'economic audit' that should be done diligently by the credit
analyst. While accounting data may provide some help for determining the
current foreign currency cash flow situation of the firm, it provides little help
in determining the changes in these cash flows in response to a devaluation. A
simple cash flow model of the firm must be developed in order to estimate the
effects of exchange rate changes on the firm's ability to generate cash flows,
both currently and in the future periods.
The overall exchange rate exposure of the emerging market firm then is a
combination of these two effects: a direct and easily observable valuation
impact on the US dollar liability and more difficult to determine impact of the
exchange rate change on the firm's ability to generate cash flow. Ultimately
the creditor is worried about the ability to the firm to meet debt service
requirements in various states of the world, and such an evaluation requires
analysis of the firm's ability to generate cash flows relative to its obligations
424 G.M. Bodnar
for different exchange rate realizations. Thus while the credit analyst should
be interested in the current foreign currency cash flow coverage of the interest
expense, she should also be concerned about how this cash flow coverage will
change when the exchange rate changes. 1
While the effect of exchange rate exposure effect may be difficult to evaluate,
its impact on creditworthiness in reality is not difficult to observe. Compare
the results of two Mexican companies that are part of Mexican holding com-
pany Grupo Sidek following the December 1994 Mexican peso devaluation.
One company, Situr, which in involved in real estate and hotels, experienced
significant accounting losses as a result of the devaluation (as did all Mexican
firms with dollar debt as the entire capital loss on the dollar debt is passed
through income for that period), but more importantly, it also suffered a serious
decrease in it ability to generate cash flow because of the devaluation. As a
result, it ended up defaulting on some of its dollar denominated debt earlier
this year (1996). On the other hand, Simec, which is a steel company, also
experienced a significant accounting loss due to the devaluation; however,
because of its ability to export its production, and the competitive nature of
the world market for steel, the devaluation increased its ability to generate
cash flows. In fact for the first quarter of 1995 Simec reported record results,
and has had little trouble making payments on its debt. Prior to the peso
devaluation Simec had been rated two notches below Situr.
Thus determining the credit rating of firms from emerging markets is a
formidable task. Aside from the issue of sovereign risk, credit analysis of firms
from emerging markets face two additional forms of complexity. Foreign firms
do not always report financial figures based upon US GAAP and financial
ratios based upon foreign GAAP may not provide an accurate rankings of the
firm's credit risk when compared to guidelines based upon US GAAP-based
financial ratios. Thus whenever possible foreign firms' figures should be made
consistent with US GAAP measurements before comparing financial ratios.
However, efforts to adjust financial ratios should not be done at the expense
of a careful analysis of the exchange rate exposure of emerging market firms
and the implications that exchange rate depreciations have for the future cash
flows of the firms. Given the increased importance of exchange rates for firms
in emerging markets, the issue of exchange rate exposure in credit analysis,
while less important domestically, becomes an issue of primary importance
when considering the creditworthiness of emerging market firms.
REFERENCES
Sondhi, A.C. ( 1995). Analyzing the credit risk of emerging market debt securities. In: Credit Analysis
of Nontraditional Debt Securities (A.C. Sondhi (ed.)). Charlottesville, VA: AIMR.
1 Such an analysis would also want to take into account the cash flow implications of any
currency hedging that the firm is doing.
WILLIAM J. CHAMBERS
Standard & Poor's
Comments on 'Rating the risk of corporate debt from

emerging markets' by E.1. Altman et al.
Standard & Poor's believes that there is a strong potential for modeling to
complement more detailed assessments of credit quality. We do not see this as
competition for traditional, full-fledged debt ratings, since models serve to
analyze one portion of the wide array of information surveyed in producing a
full rating. While potentially easier for insurance companies and banks, where
there is more homogeneity across the industry, the task is much more difficult
for corporates where sectoral differences make using a single standard regres-
sion equation more problematic, particularly if the model encompasses only
financial information. In different industries, various factors take on greater or
less importance and should weigh more or less heavily on the determination
of creditworthiness.
Most of these general issues regarding modeling have been discussed pre-
viously, and the focus of this discussion will be on the applicability of modeling
to credit risk determination in emerging markets. The Altman/Hartzell paper
employs something of a hybrid, using the purely quantitative model and then
consciously adjusting the results by applying certain qualitative factors.
SEVERAL KEY QUESTIONS
To evaluate the effectiveness and applicability of the model, several critical

issues must be addressed.
1. What exactly is the model predicting? At this point, there is ambiguity about
what the model actually attempts to measure. The paper states that it is a
measure of 'relative value', which implies a tradeoff between risk and return.
The model itself, however suggests a more narrow definition of underlying
credit risk alone. What do the ratings or rankings which flow from it really
mean? Is it a predictor of default; an indicator of relative protection afforded
to debtholders, or an indicator of relative financial strength?
2. What is the time horizon for this determination? The nature of the model
and the information or 'advice' which it provides will determine to whom
the information will be useful. A trader functioning with a short-term horizon
might well be more interested in different assessments of creditworthiness
than would a buy and hold investor. The model is ambiguous on this as
425
II) 1998Kluwer Academic Publishers.
426 WI. Chambers
well, though, as discussed below, the rapid and frequent changes in its values
suggest that it might be more useful to short-term traders than longer-term
investors.
Even more fundamentally, there are several essential questions that must be
addressed.
1. Is it possible to model credit risk? We believe that it is, but we're still some
considerable distance from that objective.
2. Is it possible to model emerging market credit risk? If modeling is difficult
in mature markets, it represents a much harder objective to attain in emerg-
ing markets. Almost by definition, the length of experience on which to
build a credible model is much shorter; the similarities to better established
markets is still doubtful; more volatile business conditions and the varied
elements which might affect creditworthiness in these markets are still much
more poorly understood.
3. Finally, and perhaps the most important of all these questions, is it possible
to develop a single comprehensive model which would deal with all emerging
markets, without having to be completely recalibrated each time for each
country and each industry? The present model makes an attempt at this
objective, but my view is that it is currently not possible to achieve this
objective.
PARTICULAR CHALLENGES IN EMERGING MARKETS
If the task of modeling future creditworthiness on the basis of historical financial

information is difficult in a developed market, the problems are compounded
in emerging market. The more volatile emerging market means that the ability
to gauge future performance on the basis of a snapshot of the financial position
is extremely limited. Mexico, during 1995, was a particularly difficult laboratory,
illustrated by the number of changes of ratings during the three tests of the
model in May, July and December of that year.
The fundamental structure of the model, though, also raises questions regard-
ing its applicability to emerging markets. The basic model is based on four
primary explanatory variables, all of which are driven by asset values. In three
of the four, total assets is used as the denominator of the explanatory ratio,
and the fourth ratio uses book equity to total liabilities as the measure. The
model then employs the same coefficients calculated and used in applying the
model in the USA. To utilize the same coefficients for arguments in the USA,
which are based on historical accounting values, in a Mexican application,
where the accounting values are significantly affected by inflation adjusted
accounting methods, is problematic. Under Mexican GAAP all asset and
liability values are adjusted annually according to an inflation index. The
resulting net difference then flows through the income statement of the firm's
annual accounts, and is credited to the firm's equity base. The level of inflation
thus will have a significant impact on the calculation of each of the four ratios
Comment 427
used as arguments in the equation apart from any real impact on the firm's
operations or underlying creditworthiness. If the inflation rate thus affected
all modeled companies equally, it could be argued that, apart from obvious
differences from results obtained in the USA in absolute terms, the relative
creditworthiness of the Mexican firms would remain the same, and a simple
recalibration between model results and implied ratings would be possible.
However, the relative effect of inflation on the list of rated companies, which
vary significantly in the nature of their business and resulting asset bases and
the types and amounts of various liabilities incurred by each firm, e.g. the
relative amounts of local currency versus foreign currency denominated debt,
makes this assumption untenable.
QUALITY OF DATA
Quality of information is essential to any modeled approach to credit assess-

ment. This includes the extent of information, its timeliness, consistency, and,
perhaps most important, whether that information truly conveys a clear sense
of the company's position. In any market, but particularly in emerging markets,
there are significant differences in level of disclosure. This affects both the
amount of data as well as its accuracy and usefulness in undertaking an
analysis. Of course, this is true in performing any analysis, but where a model
is used and this quantitative information is the only input into the determina-
tion, the quality of the input is critical to the quality of the output.
Professor Sondhi in his paper has described in considerable detail the need
to make adjustments to place results reported under different accounting stan-
dards in proper perspective. 1 These differences highlight the difficulty in using
similar parameters in the basic equation to derive hopefully similar results
across countries.
Especially under a system of inflation accounting, there is great latitude for
a company to adjust asset values. In addition, these adjustments have significant
impact on reported earnings. All of these elements enter into the four ratios
utilized as independent arguments in the basic model. As a consequence of
these potential disparities in the ways that various companies report financial
positions would be affected by different approaches to these inflation adjust-
ments. Standard & Poor's has found cash flow information to be the most
accurate and comparable, and the least susceptible to the vagaries of accounting
conventions and practices. Cash flow is not an input into the basic model in
this case, but would be reflected in the first of the adjustment factors used to
modify the statistical model results.
One of the difficulties endemic to a model such as the one proposed arises
with the use of information from just one period of historical numbers. Using
I Editor's note: Professor Ashwinpoul Sondhi presented his paper 'Accounting Perspectives in
Emerging Market Debt' at the conference, but it is not included in this book.
428 w.J. Chambers
this approach, there can be no recognition of, or adjustment for, cyclical swings.
In markets such as these, and with many of the companies focused on resource
based industries, such cyclical swings are significant and can substantially affect
the results for any given period without necessarily affecting the position of
the company longer term. As well, obviously in 1995 the test year for the model
there were a lot of 'one-off' effects in Mexico which hopefully will not be
repeated. Again, there may be the need to adjust for these.
ADJUSTMENTS TO THE BASIC MODEL
To the numerically derived score, the authors make four key adjustments or
modifications to amend the model's results. These partially address some of
the concerns noted above.
Vulnerability to foreign exchange devaluation
This factor reflects both the nature of the company's sales in terms of currency
exposure and foreign currency costs, both interest and operating. This has
obviously proven to be a key factor in how different companies have fared
over the past year in Mexico with the position of some having been enhanced
and some having deteriorated. The difficulty with using this factor for scoring
or modeling purposes is the detailed information which it requires. Indeed,
public disclosure, particularly in emerging markets, but elsewhere as well,
seldom contains sufficient information to properly assess varying degrees of
susceptibility to foreign exchange gains or losses. This is especially true for
operating revenues and expenditures. Proxies, such as proportion of goods sold
abroad, exist, but these are subject to significant error. Hence, while this element
is critical in cases such as Mexico the lack of adequate information makes its
use extremely difficult.
How to weight this factor is also problematic. Ideally, the weighting should
reflect the likelihood and potential extent of devaluation in that particular
country. A high susceptibility to devaluation is much more important if the
risk of devaluation is high, and, indeed, if the chances of currency appreciation
are high, might actually become a positive rather than negative element. Should
a company located in, say, Malaysia be equally affected by this factor as a
company in Brazil? While this latter concern is less relevant to comparisons
only within a country, comparing the results with full-fledged ratings in the
US and the extension of the model to other markets such as Argentina as
planned, make cross-border comparisons inevitable.
Industry risk
Again, this is clearly a key factor. However, Mexican industry risk is quite
different from that in the US or other countries. One example is the cement
Comment 429
industry where the structure of industry is much superior in Mexico than in

the USA. In the USA the industry is marked by a large number of relatively
small firms, high cost bases, high levels of competition, undifferentiated products
and low prices. In contrast, the Mexican industry is marked by a small number
of firms, low cost base, moderate competition, relatively high prices, and
differentiated products. Clearly the industry risk is not the same. Different
industry structure, the state of Mexican economy, which differentially affects
the demand for luxuries vs. necessities, or the definition of what is a necessity
for that matter, the level of competition, and the like, all contribute to make
industry risk quite different. Thus, industry risk needs to be country specific,
not global. Telmex traditionally has been in a very different position than US
telecommunications companies. As Mexico deregulates, this may change, but
certainly the result will not necessarily mirror the American situation. Hence,
using US industry risk factors in the model to reflect the Mexican situation is
problematic at best.
Competitive position
This adjustment factor takes into account a myriad of elements, including the
company's size, the degree of political influence (and implicitly the amount of
political support it may enjoy) and the company's quality of management. All
are important factors and are taken into account in performing a full-fledged
rating. As noted in the discussion of devaluation above, however, it is extremely
difficult to model or score some of these elements in the absence of a large
amount of detailed information. Nor is there an indication in the discussion
as to how these elements can be quantified, monitored or adjusted over time.
Special debt issue features
This adjustment factor encompasses collateral, guarantees, and the like accruing
to specific debt issues. We would argue that these are critical elements to
examine when adducing the creditworthiness of a particular debt issue.
However, the whole rest of the model seems designed to provide general
indications of the issuer's creditworthiness, not an analysis of a particular debt
issue. As a result, while important, it is unclear whether, how, and to what
degree such considerations should be factored into the model generated ratings.
Overall effect of adjustments
The overall magnitude of these four adjustments can be quite significant. 2 For
Apasco and Ponderosa, the May adjusted rating is two full rating categories
below that which the ME score alone would indicate. For DESC the adjusted
2 The difference between, say, 'BBB' and 'A' is a category difference. The difference between a
'BBB -' and a 'BBB' is a notch difference, where there are three notches to each category.
430 w.J. Chambers
rating is 4 notches higher and for Tamsa the rating is 2 notches higher. All in
all, five of the sample of 29 ratings are higher than that indicated by the raw
score, while 19 are lower. The distribution of adjusted ratings vis-a.-vis the
unadjusted is quite different. The quantitative measures alone predicted only
82% of the final rating decision, leaving 18% to the other adjustment factors.
Could the adjustments be modeled? To a greater or lesser degree, the first
three, devaluation risk, industry risk and special debt features, could be. It
would be much more difficult with the fourth item. While size, market share,
and similar elements falling within the ambit of this category can be quantified
and hence modeled, the remaining elements such as management and political
influence are much more complex.
It is not clear how other factors such as group membership are factored in.
For example, the model produces ratings for Tolmex and Cemex, where the
former is a subsidiary of the latter and clearly is subject to the strategic decisions
of its parent. However, Tolmex's rating of A - is significantly different from
Cemex's BB +. Similarly, Sidek and Situr are both rated CCC - while another
member of the group, Simec is rated at B +. While certainly different members
of a group could enjoy different ratings, the substantial difference in these
ratings raises again the question of what, exactly the model is attempting to
measure.
Results of the Altman/Hartzell model have been published three times, in
May, July and December, 1995. The ratings for individual companies have
gyrated considerably from one period to the next. While not surprising given
the tumultuous economic environment in Mexico during the year, extreme
volatility in the ratings may affect their usefulness to investors. It should be
remembered that financial results incorporated in the May 1995 iteration of
the model included the first big effect of devaluation. Thus, one might have
expected less volatility in the model's output during the remainder of the year.
However, of the 29 original, adjusted ratings published in May, only three
remained constant as of the December, 1995 iteration. Between May and
December, 10 ratings were upgraded by between one and seven notches, while
16 were downgraded by up to 4 notches. The changes seem to be independent
of the original rating. Of the top-rated 8 companies in May, 6 were subsequently
downgraded while two were stable. At the other end of the spectrum, of the
10 lowest rated companies, 5 were up-graded while 5 were downgraded. The
original May rating results after adjustment predicted only 58% of the final
results at the end of the year. Frequent rating adjustments may be useful for a
trader who actively and frequently adjusts her portfolio, but are much less
useful to a medium and longer-term investor.
ACCOUNTING PERSPECTIVES ON EMERGING MARKET DEBT
Perhaps a few brief comments on Professor Sondhi's paper on Accounting

Perspectives on Emerging Market Debt are also appropriate. As the author
Comment 431
notes, in undertaking his analysis Standard & Poor's does not adjust the
company's reported results automatically to US GAAP. While we would review
US GAAP numbers if available, we believe that it is preferable to examine the
company's finances using figures prepared under its own, local accounting
standards.
On the surface, adjusting all numbers to a standard accounting framework
would make comparisons easier and eliminate the need to adjust for accounting
differences. However, the results of this, and even the process, are potentially
misleading. Clearly, companies located outside the US are not operated to
maximize results under US GAAP. They are operated in a manner to bring
forth best results under their own system. Standard & Poor's, in undertaking
an analysis, wishes to understand how companies are run, how decisions are
made within their own context.
Analysts must also be cautious in regarding US GAAP as necessarily the
only or even the best system. Other accounting systems are in some regards
more conservative, such as the UK insistence on amortizing all goodwill arising
from an acquisition immediately upon purchase, or more reflective of the actual
environment in which emerging companies operate, such as the inflation-
adjusted accounting utilized in much of Latin America. There are long and
serious debates as to how to properly reflect a company's financial position,
as evidenced by the extended and contentious debates of FASB and its equiva-
lents around the world. Nevertheless, few would argue that the policy in the
UK affects how a UK acquirer would view and values an acquisition or that
the use of historical accounting values properly reflects a company's position
in an environment of hyperinflation. Indeed, around the world, the US GAAP
is often the odd man out since it is one of the few, if not the only one, which
totally ignores real asset revaluation.
While examining companies in their own context, Standard & Poor's must
nevertheless make comparisons across systems to ensure the comparability of
our ratings. Generally, we have found that cash flow numbers are the best in
making comparisons, and, indeed for undertaking our analysis at all. In any
context, we've found that dynamic indicators such as cash flow provide superior
insight into the ability of a debt issuer to meet its debt obligations than static
indicators such as balance sheet ratios. In terms of comparisons, cash flow
information is also less susceptible to the peculiarities of a particular accounting
system than are income numbers, for example, which can be affected by depreci-
ation and other non-cash items or balance sheet information where asset
valuation, decisions to display certain items on the balance sheet as opposed
to off-balance sheet, such as pension obligations, can materially affect the
results.
SUMMARY
In summary, we believe that the modeling of credit risk will continue to be a

challenging field over the next several years. Apart from the use of improved,
432 WJ. Chambers
reliable data, both in terms of the business and financial positions of the
companies to be examined, and sophisticated quantitative tools, the develop-
ment of such models will require close definition of their objectives and conse-
quent interpretation of their results. Inclusion of 'soft', subjective variables adds
useful input to the realism of such models in reflecting the broad spectrum of
factors which affect creditworthiness, but understandably add a 'black box'
dimension to the model's results. Application of such models to the emerging
markets is particularly difficult due to the added volatility of these markets
compounded by higher uncertainty as to information quality. Differences in
accounting and reporting standards alone, makes cross-border comparisons of
credit quality difficult, and exacerbate any efforts to model or score such
differences absent significant interpretation of the information.
LEMMA W. SENBET
University of Maryland
Comment on 'Proposal for a new bankruptcy procedure

in emerging markets' by Hart et al.
INTRODUCTION
A growing consensus among economists, lawyers, and corporate executives is

that the existing bankruptcy procedures in the advanced economies (e.g. the
USA) are flawed, and there have been numerous calls for the reform of these
procedures. As a consequence, emerging economies, which need to codify
entirely new bankruptcy procedures, cannot rely on outright importation of
the existing procedures from the advanced economies. This problem actually
parallels the view that emerging economies, which would import the banking
regulatory systems, such as the defective deposit insurance system of the US,
would risk financial instability. Consequently, we should welcome attempts to
propose new bankruptcy procedures for emerging markets from scratch. The
paper by Hart et al. just does that. The authors should be commended for
such a bold task.
In my discussion, I will highlight the motivation of the paper, restate the
core of the proposed bankruptcy procedure, and provide commentary and
suggestions. As a motivation of this paper, let me begin with a brief description
of some of the more common observations about the pitfalls of the current
bankruptcy procedure in the USA. Although I focus on bankrupt or imminently
bankrupt firms, it should be recognized that the apparent inefficiencies of the
existing system could have industry-wide spill-overs. For example, some US
airline company executives were known to have complained about the
Bankruptcy Reform Act of 1978 as prolonging the survival of inefficient carriers
and hence artificially lowering the cost structure of bankrupt firms, while
decreasing the profitability of otherwise healthy firms in the industry. A similar
phenomenon had been argued to occur in the retail industry.
The current bankruptcy procedure has general shortcomings beyond the
industry-specific complaints mentioned above. Appendix A provides an outline
of the more common observations about the disadvantages of the current legal
approach to the resolution of financial distress. These shortcomings detract
from an economic objective of an idealized bankruptcy system. In principle,
the economic objective of a well-designed bankruptcy law is relatively straight-
forward. The bankruptcy procedure would be structured so that economically
efficient firms, whereby asset values are currently employed in their highest
433
434 L.MI. Senbet
value use, and going concern firm value exceeds liquidation value, are reorgan-
ized and continue to operate, while inefficient firms are liquidated, with proceeds
distributed among claimants, in accordance with the promised debt obligation
and the seniority of claims.
Unfortunately, conflicts of interest between the firm's diverse claimant classes
lead to divergent preferences for resolving financial distress. In general, senior
claimants will favor premature shutdown of the firm (even if there is a loss of
going concern value) in order to preserve the value of their claims. The residual
and junior priority claim holders (e.g. equityholders), on the other hand, will
favor continued operation of the firm. Past attempts to reform the bankruptcy
process have generally lead to one of two undesirable outcomes: either ineffi-
cient firms were reorganized and survived, or viable firms were prematurely
(and inefficiently) liquidated. It should be noted here that the provisions of the
1978 Bankruptcy Act effectively lead to the former outcome, while the previous
bankruptcy laws led to the latter.
There are also problems of managerial entrenchment and free ridership in
workouts and restructuring. The voting process for the approval of a reorgani-
zation plan may be advantageous to the incumbent management and the
shareholders. Restructuring of public debt outside of the bankruptcy process
(i.e. informal or private workouts) is governed by the Trust Indenture Act of
1939. Curiously, the Act mandates that any changes to the terms of outstanding
public debt, such as interest, principal, or maturity, may be made only upon
unanimous approval of the issue's holders. In practice, this virtually precludes
any change in these terms directly. Consequently, informal restructuring of
public debt generally takes the form of an exchange offer. Thus, the Bankruptcy
Code impacts the balance of power among managers, equity holders, and the
firm's remaining stakeholders, with potentially high impact on the allocation
of resources and wealth distribution among the claimholders.
Moreover, it should be recognized that the existing bankruptcy procedure
can have important impact (indirectly) on the initial contractual process and
even private resolution of financial distress outside the court system. Since the
Code specifies the set of rules under which claimants bargain for their entitle-
ments, it also influences the behavior of the various stakeholders outside the
formal bankruptcy process. This observation is important because it suggests
that any reform of the Code or codification of an entirely new bankruptcy
procedure (say in an emerging economy), must also consider its impact on the
behavior of corporate stakeholders outside the formal bankruptcy process. This
is a point that I will return to in a later section in evaluating the proposed
procedure of the current paper under discussion.
CORE OF THE BANKRUPTCY REFORM PROPOSAL
In this section I wish to highlight the salient features of the reform proposal.
The next section will provide an evaluation of the proposed bankruptcy pro-
cedure. The core of the reform proposal is designing a bankruptcy procedure
Comment 435
that separates real asset allocation, particularly whether the firm should be
restructured or liquidated, from financial claims structure. In the parlance of
corporate finance, the procedure calls for separation of investment and financ-
ing decisions, while preserving absolute priority rule. The separability is accom-
plished by the expedient of converting a company in bankruptcy essentially
into an all-equity firm, or unifying claims into firm value maximization as an
appropriate objective. This is in the same vein of the private workout proposal
of Haugen and Sen bet (1978, 1988), whereby claims structure of an imminently
bankrupt firm would be unified or restructured into an all-equity firm either
through informal reorganization or through a takeover mechanism. While the
Haugen-Senbet proposal is in the context of private workouts, the current
paper seeks to codify it in the bankruptcy law.
How is the separability property achieved in the bankruptcy procedure?
Reorganization rights (RRs), which are effectively equity ownership rights in the
post-bankruptcy firm, are issued by a court-supervised receiver. Insider claimhold-
ers have preferential treatment and hold options to purchase these rights at
exercise prices determined on the basis of priority structure. Another way to
appreciate the procedure is to reverse the exercise process from the most senior
claims to the lowest in the pecking order. Using the authors' example, the most
senior claimants receive RRs free and sell them to the next at their claim value
($100), who then buy at $100 and sell it to the next group in the pecking order at
$200, obtaining the difference as their full claim. Thus, the most junior claimants
buy at $200 and get the difference between the reorganization value ($250) and
the exercise price ($200). Their total claim is, of course, impaired, because the
total claims outstanding ($300) exceed the reorganization offer of $250. Note also
that RRs are subject to public auction, which will mitigate the liquidity constraint
problem. This is important, which I will return to later.
Thus, at the end ofthe game, you have all claimants holding RRs, or effectively
a new group of shareholders, in an all-equity firm. These claimants vote for an
optimal investment policy, since there are no conflicts of interests. That is, an
optimal reorganization or liquidation of a bankrupt firm will take place.
Presumably, the firm will then be relevered to an optimal level of debt financing
to take advantage of the benefits (e.g. tax subsidy) associated with debt.
EVALUATION OF THE REFORM PROPOSAL: COMMENTARY AND SUGGESTIONS
In evaluating the proposed bankruptcy procedure, I wish to focus on three

areas: the cost efficiency of the procedure, interaction between bankruptcy
procedures and private workouts or market solutions, and issues of contract
enforcement and informational problems in emerging markets.
Cost efficiency
Assessing the cost efficiency of a bankruptcy procedure should be thought

through more carefully. We need to make sure that economic costs that are
436 L. W. Sen bet
inherent in the existing institutional framework and market systems are not
confounded with the actual costs of the bankruptcy procedure. For instance,
there is a prevailing concern that Chapter 11 reorganizations take too long
and cost too much. However, this view may be confounding the economic
costs of reorganizations with the costs of Chapter 11. That is, the costs of
reorganizations might have been incurred even in the absence of Chapter 11.
In this context, Eisenberg (1992) argues that Chapter 11 proceedings did not
take longer than receivership reorganizations that preceded the Chapter in the
earlier days of bankruptcy settlements.
The issue of confounding of economic costs of reorganization and costs of
bankruptcy procedures is important, and it has an analogy to the confounding
of potential liquidation and bankruptcy costs in the determination of optimal
financial structure. Liquidation and bankruptcy can be thought of as indepen-
dent events, but when bankrupt firms also get liquidated, the costs are often
incorrectly attributed to bankruptcy costs. Or alternatively, there is a tendency
to confound economic and financial distress. Fundamentally bankruptcy does
not cause poor performance, although it is tempting to infer from news reports
of financially and economically distressed firms and contend that their economic
distress is caused by financial distress (see Haugen and Senbet, 1978 and Senbet
and Seward, 1995 for further discussion on these issues).
The deviations from absolute priority rule (APR) are also often viewed as
inefficient features of current bankruptcy procedures. Are APR violations
inefficient? There is growing literature that is shedding light on this question.
It is my view, though, that the absolute priority rule (APR) is an inappropriate
benchmark to judge the efficiency of Chapter 11. It is interesting to note that
large reorganizations involved deviations from APR even prior to Chapter 11
(see Eisenberg, 1992). Of course, we have a growing evidence in empirical
finance for frequent violations of APR in Chapter 11 reorganizations. Eberhart
et al. (1990) report an average deviation of 7.6% from APR, and there is
evidence that market participants anticipate the magnitudes of APR violations.
This suggests that, if APR violations are fully internalized and priced out in
the initial contract, there are no efficiency losses from APR deviations.
The authors of the current paper require adherence to the APR in allocating
claims. I agree with them that there ought to be prioritization of claims so as
to preserve the role of debt in disciplining management. However, why should
this priority be absolute? As above, the deviations from the APR can be
internalized in bond pricing; also, the relative priority rules may be beneficial
in mitigating risk incentives of financially distressed firms.1 Reliance on the
APR has the danger of dismissing the other simple alternatives of recapitaliza-
1 There is work suggesting that APR violations have a beneficial effect of mitigating risk shifting
costs of debt financing under financial distress (e.g. Eberhart and Senbet, 1993). Consequently, the
APR violations can be viewed as an implicit feature of an efficient, rather than distortionary, bond
contract, and policy calls for abolition of Chapter lion the ground of APR violations may be
unwarranted.
Comment 437
tions and restructurings in private workouts, where APR violations may, if

fact, occur (see below; 3b; also see Altman (1993) for an eloquent discussion of
how APR violations might have been inappropriately used in criticizing the
current bankruptcy procedures).
The cost efficiency issue is also relevant in the context of emerging economies,
where it is presumed that bankruptcy procedures entail heavy dead-weight
costs (and take too long). The relevant costs should be the actual costs of
resolution of financial distress both within and outside the bankruptcy system.
High costs of the court system may actually encourage more private workouts
and innovations in the design of securities privately. It is not clear that a
bankruptcy procedure, which is designed to be a 'cake-walk', actually diminishes
the overall costs of resolving financial distress. One needs to make a careful
assessment of the overall cost efficiency, taking account not only the settlements
within the bankruptcy court system but private workouts and market mecha-
nisms, which are indirectly influenced by the features of the formal bankruptcy
procedure. This is an issue that I wish to turn to.
Interaction between bankruptcy procedure and private workouts/market solutions
Proposals for a new bankruptcy procedure, or calls for the reform of an existing
one, should take careful account of two considerations. First, the bankruptcy
code determines not only how financial distress is resolved within a formal,
court-supervised framework, but also exerts influence on how corporate claim-
ants (e.g. bondholders, stockholders, trade creditors, managers) attempt to work
out privately outside the legal court system. Thus, any attempt at legislative
reform must be undertaken by considering its economic impact on various
claimants both inside and outside the formal bankruptcy process.
Second, it is important to recognize that markets play a vital role in the
reorganization of distressed firms. That is, legislative and judicial rules can
exert a significant influence on the efficiency of markets in resolving financial
distress. A ruling in January 1990 by a bankruptcy judge in the LTV case
illustrates clearly the process by which judicial discretion within the current
bankruptcy procedure can substantially change the cost of resolving financial
distress (Senbet and Seward, 1995). A private workout was arranged in which
a segment of bondholders volunteered for bonds with market value below the
original face value, and subsequently LTV filed for Chapter 11 in 1986. Under
the judge's ruling, the participants in the swap gave up their original claim,
while the holdout bondholders ended up with a larger reward per bond. The
ruling can be thought of effectively skewing the resolution of financial distress
towards the costlier court-supervised, formal bankruptcy procedure, and away
from successful private workouts. The basic point here is that markets must
be allowed to operate sufficiently unencumbered so as to achieve efficient
resource allocation, regardless of whether the firm is financially solvent or
distressed. Thus, it is important to assess whether a bankruptcy process, includ-
ing precedents established through judicial rule-making, weakens the influence
438 L. W. Senbet
of the functioning of markets in resolving financial distress. Any weakening of

market influences is likely to diminish social welfare by impeding the flow of
resources (both capital and human) to their highest value use.
Now consider the role of markets in mitigating financial distress: (a) the
capital market (viewed broadly to include mechanisms for informal reorganiza-
tion; recapitalization; private workout; takeover); (b) the interfirm asset sale
market; and (c) the managerial labor market. A key determinant of which
market(s) will be most useful in resolving financial distress is to recognize that
bankruptcy per se does not cause economic distress or poor performance. This
distinction is important because, for example, defaults on debt obligations are
often cited, particularly in news stories, as the fundamental cause of the firm's
economic distress or misfortune. Although improper financial policies, such as
excessive use of debt financing, may certainly cause the onset of financial
distress, the accompanying economic distress may be caused by numerous
other causes as well, such as suboptimal utilization of some portion of the
firm's existing assets, managerial inefficiency, incompetence or entrenchment,
or dynamic changes in the industry economy in which the firm competes.
Simple financial restructurings will not ensure long-term firm viability, if the
sources of economic inefficiency persist.2
I wish to focus on the first category of markets, namely capital and takeover
markets. In fact, a great deal of attention, in both the popular press and the
academic literature, has recently been devoted to the informal reorganization
of corporate financial structures through debt restructurings. Consider a debt
restructuring as an agreement by the firm's creditors to modify any term(s) of
an outstanding financial claim currently held against the firm. It should also
be noted that the method for restructuring financial claims depends on whether
corporate debt is private (i.e. loans from financial intermediaries, such as
commercial banks, insurance companies, or institutional investors), or public
(i.e. publicly-traded bonds issued by the firm). Private debt can be restructured
through direct debtor-creditor negotiation and bargaining. However, alteration
of any initial offer terms (i.e. maturity, interest rate or principal) of public debt
is severely constrained by the 1939 Trust Indenture Act. This is an example of
the Code adversely affecting resolution of financial distress through private
workouts. In particular, under the Act, any change in the issue terms requires
unanimous consent by the holders of the bonds. As a result, the restructuring
of public, or outside, debt is implemented through an exchange offer, often in
conjunction with a covenant modification.
An alternative to debt restructuring in private workouts or exchange offers
is resolution of financial distress via a takeover of a financially distressed firm.
Although corporate control contests do not appear to occupy a particularly
2 Conversely, it should be clear that the firm that is efficiently run may go bankrupt, or face
financial distress, just on the basis of carrying excessively high debt in its capital structure. See
Haugen and Senbet (1978) and Senbet and Seward (1995) for further elaboration of the dangers
of confounding economic distress and financial distress.
Comment 439
important role in resolving financial distress, there is remarkable similarity

between them and a mechanism for resolving financial distress via a takeover
as originally advanced by Haugen and Senbet (1978), i.e. acquisition of a
financially distressed firm's debt and equity by outside arbitragers. The takeover
mechanism can be outlined as follows. Suppose that the market values of a
distressed firm's publicly traded securities reflect the expectation that significant
bankruptcy costs would be incurred as a result of the claimant's failure to
successfully implement an informal reorganization. This creates an incentive
for outside arbitragers to buy up the outstanding securities at prevailing market
values to prevent the costly alternative of a formal reorganization. The potential
arbitrage profit would be the bankruptcy costs, net of the transactions costs,
of informal reorganization. 3
Thus, the ultimate forum for resolving financial distress depends on the
relative costs and benefits of the market system and the court system. While
existing empirical evidence suggests that the costs of informal reorganization
are substantially less than the costs of formal bankruptcy (Gilson et al., 1990),
the latter may provide some important benefits. Here it is important to recog-
nize that the attraction of informal reorganizations is influenced by the rules
and structure of the formal bankruptcy process. Indeed, efficiently designing
or reforming the procedure within formal bankruptcy is perhaps one of the
most efficient ways to influence how reorganization takes place outside bank-
ruptcy. Thus, I am concerned that the proposed bankruptcy procedure of the
current paper is silent about its impact on the resolution of financial distress
in private workouts and market mechanisms. Moreover, the cost dimension in
assessing the proposed procedure seems narrowly centered around the formal
bankruptcy system, rather than the overall costs of resolving financial distress
through both formal and informal mechanisms. Consequently, an important
role of any reform of the formal bankruptcy process should be to introduce
innovations that facilitate the role of markets and informal reorganizations in
privatizing bankruptcy outside the court system.
Contract eriforcement and informational issues in emerging markets
The last issue that I wish to raise, which is particularly acute in emerging
economies characterized by severe informational problems, has to do with the
3 Note that the mechanism of acquisition under financial distress entails more than simply
acquiring ownership of the firm through acquisition of equity. The reason is that, if an outside
arbitrageur were to acquire the firm, and then implement a value-enhancing operating strategy,
the gains would accrue primarily to the debt holders. Thus, in order to retain the benefits of the
value enhancement, the bondholder claims must generally be extinguished at market value at the
time when the equity is purchased. An additional issue to note here is the existence of potential
impediments which are identified and analyzed in the literature, such as the free rider problem
and informational issues, and the solutions thereof. See, for instance, Haugen and Senbet (1988)
and Senbet and Seward (1995). In a nutshell, while the potential impediments often assume that
the form of debt finance is exogenously specified, their solutions view security design and corporate
capital structure decisions as endogenous to redressing the problems that may arise in the bank-
ruptcy process.
440 L. W. Sen bet
identification of the priority and size of individual entitlements. I believe the

proposed procedure of the current paper sidesteps the issue of correctly identi-
fying the priority, the size of individual entitlements, and the status of tort
claims. The procedure, while circumventing the valuation problem through an
auction, gives the judge considerable discretion in deciding who gets what or
who gets what options. Moreover, as a related issue, the auction mechanism
itself is essentially transforming the financial distressed or bankrupt firm into
something like an initial public offering (IPO), with potentially large informa-
tional costs as reflected in the frequently documented underpricing of initial
issues. When reorganization rights are sold to outsiders, there is a potential
'lemon's problem', which needs to be resolved for an efficient bankruptcy
procedure. The entitlement issues (and the attendant conflicts of interests among
varying classes of claimants, prior to an all-equity transformation) and pricing
issues (and the attendant informational problems) are further reenforced in the
context of emerging economies where contract enforcement is particularly
weak. I really wish such a bankruptcy procedure deals with contract enforce-
ment which, I think, is at the core of problems in emerging economies.
CONCLUDING NOTE
I regard the proposed bankruptcy procedure as a useful alternative to the

existing procedures. I need some more persuasion though, before I accept it as
the most efficient alternative to the available procedures due to the concerns
that I expressed earlier. In particular, in the emerging market context, contract
enforcement and informational gaps are issues that need to be addressed in
designing a new bankruptcy procedure. Further, any such proposal needs to
consider its impact on private workout and market mechanisms in resolving
financial distress, and its cost efficiency cannot be evaluated in isolation from
such mechanisms. I find that the basic premise of coming up with a proposal,
that allows for separation of asset allocation and claims structure, is a good
one. Further, I believe that the innovative and provocative thoughts in the
proposed procedure will stimulate the debate on the issue of bankruptcy reform
or design.
REFERENCES
Altman, E. (1993). Evaluating the chapter 11 bankruptcy-reorganization process. Columbia

Business Law Review, I, 1-25.
Eberhart, Allan, William Moore and Rodney Roenfeldt (1990). Security pricing and deviations from
the absolute priority rule in bankruptcy proceedings. Journal of Finance, 45,1457-1469.
Eisenberg, T. (1992). Baseline Problems in Assessing Chapter 11. Mimeo, Cornell University.
Eisenberg, T. and Lemma W. Senbet (1993). Absolute priority rule violations and risk incentives for
financially distressed firms. Financial Management, Autumn, 103-116.
Gilson, Stuart, Kose John and Larry Lang (1990). Troubled debt restructurings: an empirical study
of private reorganization of firms in default. Journal ofF inancial Economics, 27, 285-314.
Comment 441
Haugen, Robert A. and Lemma W. Senbet (1978). The insignificance of bankruptcy costs to the
theory of optimal capital structure. Journal of Finance, 33, 383-393.
Haugen, Robert A. and Lemma W. Senbet (1988). Bankruptcy and agency costs: their significance
to the theory of optimal capital structure. Journal of Financial and Quantitative Analysis, 23,
27-38.
Roe, M. (1983). Bankruptcy and debt: a new model for corporate reorganization. Columbial Law
Review, 83, 527-602.
Senbet, Lemma and James Seward (1995). Financial distress, bankruptcy and reorganization. In
R. Jarrow et al., Handbooks in OR and MS (Finance). Amsterdam: Elsevier, 921-961.
ApPENDIX A: PROBLEMS WITH CURRENT BANKRUPTCY PROCEDURES
Operational problems
Management is burdened by rules and restrictions
Heightened conflicts of interest among management, bondholders, and
equity holders
Public scrutiny (suppliers, customers)
Deadweight costs
Direct costs (lawyers, accountants, etc.)
Indirect costs: Hard to estimate, potentially high
Allocational inefficiency
Too many liquidations/continuations
Managerial entrenchment
Deviations from absolute priority rule
Inefficient capital structure for emerging firm
Agency and free rider problems
Impediments to private workouts
List of contributors
PETER AERNI
Peter Aerni is working at the Economic Theory Unit (Abteilung Wirtschafts-

theorie) at the University of Basel, where he currently finishes his PhD thesis
on multilateral bargaining theory. His research interests are market microstruc-
ture, corporate finance, and game theory.
EDWARD I. ALTMAN
Edward I. Altman is the Max L. Heine Professor of Finance at the Stern School
of Business, New York University. Since 1990, he has directed the research
effort in Fixed Income and Credit Markets at the NYU Salomon Center and
is currently the Vice Director of the Center. Prior to serving in his present
position, Professor Altman chaired the Stern School's MBA Program for 12
years. He has been visiting Professor at the Hautes Etudes Commerciales and
Universite de Paris-Dauphine in France, at the Pontificia Catolica Universidade
in Rio de Janeiro, at the Austrian Graduate School of Management in Sydney
and Luigi Bocconi University in Milan. Dr. Altman has an international
reputation as an expert on corporate bankruptcy and credit analysis. He was
named Laureate 1984 by the Hautes Etudes Commerciales Foundation in Paris
for his accumulated works on corporate distress prediction models and pro-
cedures for firm financial rehabilitation and awarded the Graham & Dodd
Scroll for 1985 by the Financial Analysts Federation for his work on Default
Rates on High Yield Corporate Debt. He is currently an advisor to the Centrale
dei Bilanci in Italy and a member of its Scientific and Technical Committee.
He was named to the Max L. Heine endowed professorship at Stern in 1988.
He received his MBA and PhD in Finance from the University of California,
Los Angeles.
Professor Altman is Editor of the Journal of Banking and Finance and a
publisher series, the Wiley Frontiers in Finance Series. Professor Altman has
published over a dozen books and numerous articles in scholarly finance,
accounting and economic journals. He is the current editor of the Handbook
of Corporate Finance and the Handbook of Financial Markets and Institutions
and the author of the recently published books Recent Advances in Corporate
Finance; Investing in Junk Bonds; Default Risk, Mortality Rates and the
Performance of Corporate Bonds; Distressed Securities: Analyzing and Evaluating
Market Potential and Investment Risk and his most recent work, Corporate
Financial Distress and Bankruptcy, second edition. His work has appeared in
many languages including French, German, Italian and Japanese.
443
444 List of contributors
Professor Altman's primary areas of research include bankruptcy analysis

and prediction, credit and lending policies, risk management in banking, corpo-
rate finance and capital markets. He has been a consultant to several govern-
ment agencies, major financial and accounting institutions and industrial
companies and has lectured to executives in North America, South America,
Europe, Australia-New Zealand and Asia. He has testified before the US
Congress, the New York State Senate and several other government and
regulatory organizations and is a Director and a member of the Advisory
Board of a number of corporate, publishing, academic and financial institutions.
GEERT BEKAERT
Geert Bekaert is Associate Professor of Finance at the Graduate School of

Business, Stanford University and a Faculty Research Fellow of the National
Bureau of Economic Research (NBER). He received his PhD in 1992 from
Northwestern University's Economics Department. During his studies, he was
supported by a Sloan Dissertation Fellowship and an NBER Dissertation
Support Award. His thesis won the 1994 Zellner Thesis Award in Business and
Economic Statistics. Before entering graduate school, he worked in the Research
Department of the Kredietbank in Belgium (1986-1987).
Geert Bekaert has published in Emerging Markets Quarterly, Journal of
Economic History, Journal of Business and Economic Statistics, The Journal of
Finance, Journal of Financial Economics, Journal of International Economics,
Journal of International Money and Finance, Journal of Monetary Economics,
Review of Financial Studies and World Bank Economic Review. His research
focus is international finance with a particular interest in foreign exchange
market efficiency, exchange rate determination and international equity mar-
kets. Geert is currently supported by an NSF grant to study government
policies and asset return dynamics. He has also been involved in several projects
on emerging equity markets, some of which were sponsored by the World
Bank, the Catalyst Institute or the Davidson institute. Geert is an Associate
Editor for Emerging Markets Quarterly, Journal of Empirical Finance, Review
of Financial Studies and Pacific-Basin Finance Journal.
ROBERT J. BERNSTEIN
Robert J. Bernstein gained his BSE from Wharton School of Finance. He

is now Global Emerging Markets Group Director at Brinson Partners, Inc.,
where Mr Bernstein is responsible for all aspects of the management of emerging
markets assets, including research, investment policy, strategy and staffing.
Prior to joining Brinson Partners, Inc. in 1994, Mr Bernstein spent more
than 10 years as a principal of Philadelphia-based international money manage-
ment firm. As Senior Vice President, Director of Institutional Fixed Income,
Mr Bernstein developed and directed research, product development, invest-

ment strategy, staffing and client service. He was also a member of that firm's
Executive Committee and a founding director of its London-based international
subsidiary.
Mr Bernstein is also a frequent lecturer and current member of the Advisory
Board of the Salomon Center of Finance at New York University's Stern
School of Business.
Mr Bernstein began his career in 1976 as an industry representative of a
major computer company, specializing in manufacturing, distribution and
financial services. From 1979 to 1983, he was a principal of a $600 million
oil/gas exploration and production company.
GORDON M. BODNAR
Gordon M. Bodnar is an Assistant Professor of Finance at the Wharton School,

University of Pennsylvania. Before coming to Wharton, he taught for 3 years
at the Simon Graduate School of Business at the University of Rochester. In
1991, he graduated from Princeton University with a PhD in economics. His
research interests are in the areas of international finance and corporate finance
and include topics such as corporate exchange rate exposure and risk manage-
ment, exchange rate variability and firm value, the valuation of multinational
firms, and the informativeness of multinational financial disclosures. His papers
have appeared in the Journal of Finance, Journal of Financial Economics,
Financial Management, Journal of Monetary Economics, Journal of International
Money and Finance and Accounting Review. Dr Bodnar is a junior research
fellow at the National Bureau of Economic Research and has been a visiting
scholar at the International Monetary Fund.
JACOB BOUDOUKH
Jacob (Kobi) Boudoukh graduated from Stanford University's Graduate School

of Business in 1991, and is currently an Associate Professor of Finance and
International Business at the Stern School of Business, New York University.
He teaches courses in international financial management, including such topics
as exchange rate determination and forecasting, corporate hedging strategies
using currency and fixed income derivatives, as well as international taxation
and transfer pricing. His current research interests are primarily in the area of
empirical asset pricing and the pricing of derivative securities with particular
focus on fixed income markets. Other topics include asset allocation techniques
and the predictability of returns on financial assets. Professor Boudoukh's work
has been published in both academic journals such as the American Economic
Review, Journal of Finance, Journal of Financial Economics and Review of
Financial Studies, as well as practitioner's journals such as the Journal of

Fixed Income.
ROBERT WHITELAW
Robert Whitelaw is Assistant Professor of Finance at the Stern School of

Business, New York University. He holds a PhD in Finance from Stanford
University. His research interests include empirical asset pricing and the relation
between risk and return in the stock market, stock returns and inflation, and
the application of nonparametric estimation techniques to risk management,
and to the hedging and pricing of derivatives. Prior to this, he worked as a
Financial Analyst in the Public Finance Department of Shearson Lehman
Brothers.
MATTHEW RICHARDSON
Matthew Richardson is Associate Professor of Finance at the Stern School of

Business, New York University. He holds a PhD in Finance from Stanford
University. His research interests include the analysis of mortgage derivative
valuation models, the valuation and hedging of emerging market debt, and the
study of stochastic behavior of interest rates.
PABLO CABEZAS
Pablo Cabezas is a PhD candidate at New York University.
RICHARD CANTOR
Richard Cantor is a Vice President/Senior Analyst at Moody's Investors Service.

He received a PhD in Economics from Johns Hopkins University in 1984.
Following graduate school, Mr Cantor was an Assistant Professor of Economics
at Ohio State University and a Research Officer at the Federal Reserve Bank
of New York. In recent years, Mr Cantor has published articles concerning the
lending activities of banks and nonbanks, bank capital requirements, the
1990-92 credit slowdown, baby boomer saving rates, and credit rating agencies.
WILLIAM J. CHAMBERS
Dr Chambers is a Managing Director in the Corporate Finance Department

of Standard & Poor's Ratings Group where he oversees the ratings of all
corporate debt issuers domiciled outside the United States.
He joined Standard & Poor's in 1983 working initially on sovereign and

municipal ratings principally in Canada, Australia, New Zealand and Sweden.
He helped establish S&P's international asset backed rating effort. In 1989 he
moved to Melbourne to work on the acquisition of Australian Ratings and its
integration into the S&P network. In 1992 he returned to New York to head
the international corporate finance group.
Dr Chambers holds a PhD in Economics from Columbia University. A
Canadian, prior to joining S&P he worked as an economic and financial
consultant in Toronto.
STIJN CLAESSENS
Stijn Claessens is at the World Bank and is currently one of the principal
authors of the 1996 World Development Report on Transition Economies. He
holds a PhD in business economics from the Wharton School of the University
of Pennsylvania. He has worked in the World Bank's Finance complex, the
Chief Economist's Office, the Debt and International Finance Division, and
the Finance and Private Sector Development Division for the Europe and
Central Asia regions. His assignments in the Bank have included operational
work on external debt management and financial sector development in various
countries, and policy work on external finance for developing countries.
His research interests are how countries can manage external risks; alterna-
tive forms of external finance, including portfolio flows; and financial sector
and enterprising restructuring in transition economies. He has published extens-
ively in these areas.
ROBERT E. CUMBY
Robert E. Cumby is the Marcus Wallenberg Professor ofInternational Financial

Diplomacy. Prior to joining Georgetown's Economics Department in 1994,
Professor Cumby was a Senior Economist with the Council of Economic
Advisers and Professor of Economics and International Business at the Stern
School of Business at New York University and received his PhD in Economics
from Massachusetts Institute of Technology. He is co-editor of Journal of
International Economics and Associate Editor of Journal of International
Financial Markets, Institutions and Money. He is also a Research Associate with
the National Bureau of Economic Research.
IAN DOMOWITZ
Ian Domowitz is a professor of Economics at Northwestern University. He

received his PhD in Economics from the University of California in 1982. He
is a member of the research faculty of the Institute for Policy Research at

Northwestern.
Professor Domowitz's areas of expertise include Finance, Econometrics,
Statistics, and Industrial Organization, including work on the regulation of
trading market structures. Extensive research and publication in these areas
have been supported by the Alfred P. Sloan Foundation and the National
Science Foundation. He is a consultant to various government and international
organizations, including the Federal Reserve System, the Commodity Futures
Trading Commission, the International Monetary Fund, and the World Bank.
MICHAEL DOOLEY
Michael Dooley is a Professor of Economics at the University of California,

Santa Cruz and a Research Associate at the NBER. He was an assistant
director in the Division of International Finance at the Federal Reserve Board
from 1971-1982 and a division chief at the Research Department of the
International Monetary Fund from 1982-1992. He has published numerous
articles and books dealing with exchange rate determination, international
capital movements, capital controls, and issues associated with sovereign debt.
He consults with the IMF, the World Bank, the Federal Reserve Board and
others. He is an editor of the International Journal of Finance and Economics.
BARRY EICHEN GREEN
Barry Eichengreen is the John L. Simpson Professor of Economics and Political

Science at the University of California, Berkeley, Research Associate of the
NBER, and Research Fellow of the CEPR. Together with Richard Portes, he
wrote Crisis? What Crisis? Orderly Workouts for Sovereign Debtors as a back-
ground report for the G-10 Sherpas.
CLA UDE B. ERB
Claude B. Erb is a Managing Director in First Chicago NBD Investment

Management Company's Global Investment Strategy and Asset Allocation
Group. He is responsible for the day-to-day management of global asset allo-
cation portfolios. Mr Erb has co-authored over a dozen articles that have
appeared in journals such as the Financial Analysts Journal and Journal of
Portfolio Management. Mr Erb has received two Graham and Dodd Awards
for excellence in financial writing from the Association for Investment
Management and Research. Mr Erb is on the advisory board for Emerging
Markets Quarterly, and is on the board of the Chicago Quantitative Alliance.
Mr Erb received an MBA from the University of California at Los Angeles,

and an AB in economics from the University of California at Berkeley.
VIHANG ERRUNZA
Vihang Errunza is Professor of Finance and International Business at McGill

University, Montreal, Canada. He received his BSc(Hons.), BSc(Tech.) degrees
from Bombay University, and an MS in Chemical Engineering from University
of California at Berkeley. After working as a consulting engineer (1964-70),
he earned his PhD in international finance from the University of California
at Berkeley in 1974. He taught at INCAE, a Harvard initiated gr~duate school
of business in Central America from 1974 to 1976 and has been on the Faculty
at McGill University since 1976. He has served as the research director, chair-
man of the finance and international business area as well as the co-director
of a management development project in India sponsored by the Canadian
International Development Agency.
Professor Errunza's principal areas of academic and consulting activities
include international equity pricing, emerging markets, portfolio management,
valuation of the multinational firm and risk management. He serves on numer-
ous editorial boards of academic journals and has written extensively on
international capital markets.
He has served as an advisor to international institutions such as the World
Bank and UNCTAD and major fund managers such as the Templeton
InvestmenCCounsel Inc., Rosenberg-Alpha Inc. and Brinson Partners Inc.
MARTIN D: EVANS
Martin D. Evans is Associate Professor of Economics in the Department of

Economics at Georgetown University, Washington, D.C.
RENE GARCIA
Rene Garcia has a PhD in economics from Princeton University. He is an

associate professor in the Department of Economics, University of Montreal
and a researcher in CRDE and CIRANO. In the financial field, he is developing
dynamic capital asset pricing models; in econometrics, he is studying time series
and non-linear models. In the field of emerging markets, he has worked on
testing conditional asset pricing models for Brazil and testing for structural
breaks in a GMM framework.
JACK GLEN
Jack Glen earned a PhD in Finance at Northwestern University, after which

he was an assistant professor of finance at the Wharton School. More recently
he has been a senior economist in the Economics Department of the
International Finance Corporation, where he conducts research on a variety
of topics related to emerging markets.
WILLIAM N. GOETZMANN
William N. Goetzmann is Professor of Finance and Real Estate at Yale School

of Management. He is an expert on a diverse range of investments, including
stocks, mutual funds, real estate, and paintings. His research topics include
global investing, forecasting stock markets, selecting mutual fund managers,
housing as investment, and the risk and return of art. His work has been
featured in the Wall Street Journal, New York Times, Business Week, Economist,
Forbes, and Art and Auction.
Professor Goetzmann has a background in arts and media management. As
a documentary film maker, he has written and co-produced programs for
'Nova' and the 'American Masters' series, including a profile of the artist
Thomas Eakins. A former director of Denver's Museum of Western Art,
Professor Goetzmann co-authored the award winning book West of the
Imagination.
LAWRENCE GOODMAN
Lawrence Goodman is Head of Latin America Economic Research at Salomon

Brothers Inc. He has primary responsibility for economic research of Latin
America, which is geared toward identifying strategies for fixed-income and
equity investors. He works closely with sales and trading and Investment
banking at the firm and directs a group of economists who analyze develop-
ments in the region. Mr Goodman also serves on the advisory board of the
Emerging Markets Quarterly Journal, published by Institutional Investor.
Prior to joining Salomon Brothers, Mr Goodman worked at Bank
of America in the Foreign Exchange Trading and Economic Research
Departments. He advised on hedging strategies in the emerging markets and
provided commentary on industrialized nation exchange rate movements. He
served as an economic and financial advisor to international bank advisory
committees negotiating foreign debt and Brady agreements with a variety of
countries in Latin America. He assessed risk and return tradeoffs in the
Bank's Sovereign debt portfolio and evaluated country risk in Latin America,
Europe, the Middle East and Africa. He also worked with country manage-
ment to enhance the institution's activities in Latin America. Prior to
BofA, Mr Goodman analyzed European and North American financial markets

at Wharton Econometrics.
OLIVER D. HART
Oliver D. Hart has been a Professor of Economics at Harvard since July 1993.
Prior to that he taught at the London School of Economics and Massachusetts
Institute of Technology. At Harvard he is teaching a graduate course in
Contract Theory and also part of the first-year graduate microeconomics
sequence. His research interests include the theory of the firm, corporate gover-
nance, the bankruptcy reform. He is a research associate of the National Bureau
of Economic Research and is a former managing editor of the Review of
Economic Studies. He recently published a book, entitled Firms, Contracts, and
Financial Structure (Oxford University Press, 1995).
JOHN HARTZELL
John Hartzell is a Director of Emerging Market Corporate Bond Research at

Solomon Brothers. Prior to this he was an investment officer at John Hancock
and was a corporate bond trader at Drexel Burnham.
CAMPBELL R. HARVEY
Campbell R. Harvey is the J. Paul Sticht Professor of International Business

and the Finance Area Coordinator at the Fuqua School of Business, Duke
University. He is also a Research Associate ofthe National Bureau of Economic
Research in Cambridge, Massachusetts.
Professor Harvey obtained his doctorate at the University of Chicago in
business finance. His undergraduate studies in economics were conducted at
the University of Toronto. He has served on the faculties of the Stockholm
School of Economics, the Helsinki School of Economics, and the Graduate
School of Business at the University of Chicago. He has also been a visiting
scholar at the Board of Governors of the Federal Reserve System.
Professor Harvey is an internationally recognized expert in portfolio man-
agement and global risk management. His work on the implications of changing
risk and the dynamics of risk premiums for tactical asset allocation has been
published in the top academic and practitioner journals.
Professor Harvey is currently an Associate Editor of The Journal of Finance
and The Journal of Financial Economics and has served as Associate Editor of
The Review of Financial Studies. He is the Editor of Institutional Investor's
Emerging Markets Quarterly. In addition, he is a member of the Editorial
Boards of The Journal of Financial and Quantitative Analysis, The Journal of
Empirical Finance, The Journal of Fixed Income, The Pacific Basin Finance
Journal, The Journal of Banking and Finance, The Journal of International
Financial Institutions, Markets and Money, and The European Journal of
Finance.
Professor Harvey received the 1993-1994 Batterymarch Fellowship, an
annual award given to the person most likely to establish a new area of research
in finance. He has also received the R.L. Rosenthal Award for Innovation in
Investment Management as well as three Graham and Dodd Scrolls for excel-
lence in financial writing from the Association for Investment Management
and Research. The American Finance Association awarded him a Smith-
Breeden prize for his publication The World Price of Covariance Risk and he
has received the American Association of Individual Investors' Best Paper in
Investments Award for Predictable Risk and Returns in Emerging Markets.
PHILIPPE JORION
Philippe Jorion is Professor of Finance at the Graduate School of Management

at the University of California at Irvine. He has also taught at Columbia
University, Northwestern University, the University of Chicago and the
University of British Columbia. He holds an MBA and a PhD from the
University of Chicago, and a degree in engineering from the University of
Brussels. He is currently Associate Dean for the Executive Degree Programs
at UCI.
Professor Jorion has authored more than fifty publications directed to
academics and practitioners on the topics of risk management and international
finance. Recent work addresses the issue of forecasting risk and return in global
financial markets, as well as managing exchange rate risk with derivative
instruments. He has also written a number of books, including Financial Risk
Management: Domestic and International Dimensions, a graduate-level textbook
on the global dimensions of risk management, and Big Bets Gone Bad:
Derivatives and Bankruptcy in Orange County, the first account of the largest
municipal failure in US history. He recently completed Value at Risk: The New
Benchmarkfor Controlling Market Risk, which is aimed at finance practitioners.
GEORG JUNGE
Georg Junge is Managing Director and Head of the Industry and Country
Risk Analysis Group at Swiss Bank Corporation in Basel. He is specialized in
country risk analysis and designed the bank's system of country risk assessment.
More recently he has worked on models with which to quantify credit risk.
Before joining Swiss Bank Corporation in 1984 he was Research Fellow at the
Kiel Institute of World Economics. In 1983 he completed his studies in
Economics with a PhD at the Graduate Institute of International Studies in
Geneva. His dissertation dealt with the transmission of inflation under fixed
and flexible exhange rates.
TIMOTHY J. KEHOE
Timothy J. Kehoe received his doctorate in Economics from Yale University

in 1979. He is currently Distinguished McKnight University Professor of
Economics at the University of Minnesota. He previously taught at Wesleyan
University, the Massachusetts Institute of Technology, and the University of
Cambridge, England. He has been Co-Director of the MEGA (Models
d'Equilibri General Aplicat) Project at the Universitat Autonoma de Barcelona
since 1985 and has done extensive work analyzing the impact of Spain's entry
into the European Community. He has written numerous articles which have
appeared in such journals as Econometrica, Journal of Mathematical Economics,
Journal of Economic Theory, and Journal of Public Economics. He has also
written a book with Patrick Kehoe which surveys applied general equilibrium
research related to the North American Free Trade Agreement.
ANYA KHANTHAVIT
Anya Khanthavit is Assistant Professor of International Business and Finance

at Thammasat University in Thailand. He received his PhD in International
Finance at New York University. He also currently serves as an Advisor with
the Stock Exchange of Thailand, and as a Financial Advisor with the Bank of
Agriculture, and Agricultural Cooperatives. Since 1992 he has lectured for the
Joint Doctoral Program in Business Administration.
RAPHAEL LA PORTA
Raphael La Porta is a Financial Engineer Advisor at Farallon Asset

Management. He currently serves as a Consultant in the Ministry of Commerce
in Mexico City, and as an Economic Advisor to the National Banking and
Stock Market Commission of Mexico City. His fields of interest include asset
pricing and corporate finance.
RICHARD M. LEVICR
Richard M. Levich is Professor of Finance and International Business at New

York University's Leonard N. Stern School of Business. From 1984-1988 he
served as the Chairman of the International Business Program at the Stern
School. He is also a Research Associate with the National Bureau of Economic
Research in Cambridge, Massachusetts, and he currently serves as Editor of

the Journal of International Financial Management and Accounting.
Professor Levich has been a visiting faculty member at many distinguished
universities in the USA and abroad including Yale University, the University
of Chicago, Ecole des Hautes Etudes Commerciales (HEC) in France, the
Australian Graduate School of Management at the University of New South
Wales, and City University Business School in London. Professor Levich has
lectured in many executive education programs including the Wharton,
Executive MBA Program, Kiei (Germany) World Institute, International
Center for Money and Banking (Geneva), J.P. Morgan, Chase Manhattan
Bank, and Bankers Trust. He has been a consultant or visiting scholar at the
Federal Reserve Board of Governors, the International Monetary Fund and
the World Bank.
Professor Levich has published more than fifty articles on various topics
dealing with international finance, and is the author or editor of nine books
including The International Money Market: An Assessment of Alternative
Forecasting Techniques and Market Efficiency (JAI Press, 1979), Exchange Risk
and Exposure: Current Developments in International Financial Management
(Lexington Books, 1980), ECU: The European Currency Unit (Euromoney
Publications, 1987), The ECU Market: Current Developments and Future
Prospects (Lexington Books, 1987), and The Capital Market Effects of
International Accounting Diversity (Dow Jones-Irwin, 1990) co-authored with
Frederick Choi. He is now completing his next book, International Financial
Markets: Prices and Policies (New York: Irwin/McGraw-Hill Publishing, 1998
forthcoming).
Professor Levich received his PhD from the University of Chicago.
JOHN M. LIEW
John M. Liew joined Goldman Sachs Asset Management in July 1994 and is
a member of the quantitative research team. Prior to joining Goldman Sachs,
he was a global equity trading analyst with Trout Trading Company where he
developed quantitative trading strategies. He received a BA from the University
of Chicago in 1989, an MBA in 1994 and a PhD in 1995 from the University
of Chicago Graduate School of Business.
FLORENCIO LOPEZ-DE-SILANES
Florencio Lopez-de-Silanes is Assistant Professor of Public Policy at Harvard

University. He is currently an Economic Advisor to the National Banking and
Stock Market Commission in Mexico, and is a Faculty Research Associate at
the National Bureau of Economic Research.
ANANTH MADHAVAN
Ananth Madhavan is Professor of Finance and Business Economics at the

University of Southern California. He was the W.P. Carey Term Assistant
Professor at the Wharton School of the University of Pennsylvania from
1988-1994.
Professor Madhavan's research interests include security market microstruc-
ture, econometrics, and corporate finance. He has worked on theoretical and
empirical aspects of these problems. Madhavan's recent research concerns the
economics of institutional trading. He has examined the process of large-block
trading in the upstairs market and analyzed the trading strategies and associ-
ated execution costs of institutional traders. He is also interested in emerging
markets, and has studied issues concerning international cross-listing and
market segmentation.
Professor Madhavan received his BA from the University of Delhi, and an
MA from Boston University. He received his PhD in Economics from Cornell
University. He has worked as a consultant on various issues of security market
structure. From 1993-1994, he was on leave to visit the New York Stock
Exchange. He is a member of the NASD's economic advisory board.
Madhavan is an associate editor of Review of Financial Studies, Journal of
Financial Intermediation, European Finance Review, and the Journal of Financial
Markets.
JOHN H.H. MOORE
John H.H. Moore gained a BA (hons) in Mathematics at Cambridge in 1976,

and an MSc and PhD from the London School of Economics. He is currently
Professor of Economic Theory at the LSE, a Fellow of the Econometric Society
and a Member of Council of the Econometric Society. He has held visiting
appointments as Assistant Professor at the Massachusetts Institute of
Technology, and as Professor of Economics at Princeton, Heriot-Watt and
Edinburgh universities.
He has held editorial appointments on the Review of Economic Studies.
MATTHEW PECK
Matthew Peck is a financial analyst with the Emerging Market Corporate

Bond Division at Salomon Brothers. He is a graduate of Dartmouth College.
JOHN A. PENICOOK, JR
John A. Penicook gained a BS and BA from the University of Illinois, and an

MSIA from Purdue University. He currently heads the Emerging Markets
Debt Group at Brinson Partners, Inc. and is responsible for macroeconomic

country analysis, sovereign risk assessment and portfolio management. He is
a certified public accountant and a member of the Institute of Chartered
Financial Analysts.
As Head of Emerging Markets Debt for Brinson Partners Inc., Mr Penicook
is responsible for macroeconomic country analysis, sovereign risk assessment
as well as all related portfolio management functions. These functions include
determination of relative value, portfolio structure, security analysis and
trading.
Mr Penicook was previously co-manager of the US Fixed Income Group's
Long-Term Bond Unit and was responsible for the management and trading
of mortgage-backed securities for discretionary, actively-managed accounts.
His portfolio management duties included the determination of relative value
in the mortgage-backed securities market, as well as the analysis of the interest
rate term structure and overall management of specific accounts.
Prior to assuming the long-term duries, Mr Penicook was primarily responsi-
ble for the investment activities of the commingled short-term investment funds.
These responsibilities included daily trading, portfolio maintenance and opera-
tions, credit selections, market analysis, arbitrage activities, master note activi-
ties and bond account cash management.
KENNETH S. ROGOFF
Kenneth S. Rogoff gained a BA (hons) in economics from Yale University in

1975 and a PhD from Massachussetts Institute of Technology in 1980. He is
currently Professor of Economics and International Affairs and Charles and
Marie Bradley Professor of International Affairs at Princeton University. He
has previously held positions at the University of California - Berkeley,
University of Wisconsin - Madison, the Federal Reserve System and the
International Monetary Fund, as well as visiting positions at New York
University, The Bank of Japan, the World Bank, and the University of
Stockholm.
LEMMA W. SENBET
Lemma W. Senbet is the William E. Mayer Chair Professor of Finance at the

University of Maryland. Previously he held two endowed professorships at the
University of Wisconsin - Madison as the Charles Albright Professor of
Finance (1987-90) and as Dickson-Bascom Professor (1983-87). As Visiting
Professor, he taught at the University of California - Berkeley (1984-85) and
Northwestern University (1980-81). He was also Distinguished Research
Visitor at the London School of Economics in June 1994. Professor Senbet is
internationally recognized for his extensive contributions to corporate and
international finance and has received numerous honors and awards. He has
been an elected member of the Board of Directors of the American Finance
Association and past President of the Western Finance Association. Professor
Sen bet has served on numerous journal editorial boards, including the Journal
of Finance, the Journal of Financial and Quantitative Analysis, the Journal of
Banking and Finance, and Financial Management. He has also produced a string
of doctoral graduates and placed them in major research universities in the
USA. He is a recipient of the 1994 Allen Krowe Award for Teaching Excellence
at the University of Maryland Business School. Professor Sen bet has been
a consultant for the World Bank, the International Monetary Fund, United
Nations Economic Commission for Africa, and various government agencies
in USA, Canada, and Africa. He has also served as a resource person for the
African Economic Research Consortium.
Roy C. SMITH
Roy C. Smith has been on the faculty of the Stern School of Business at New
York University since September 1987 as a professor of finance and inter-
national business. Prior to assuming this appointment he was a General Partner
of Goldman, Sachs & Co. specializing in international investment banking and
corporate finance. At the time of his retirement from the firm to join the faculty,
he was the senior international partner. During his career at Goldman Sachs
he set up and supervised the firm's business in Japan and the Far East, headed
business development activities in Europe and the Middle East and served as
President of Goldman Sachs International Corporation while resident in the
firm's London office from 1980 to 1984.
Mr Smith received his BS degree from the US Naval Academy in 1960, and
his MBA from Harvard University in 1966, after which he joined Goldman,
Sachs & Co. He is a frequent guest lecturer at other business schools in the
USA and in Europe. His principal areas of research include international
banking and finance, global capital market activity, mergers and acquisitions,
leveraged transactions, foreign investments, and finance in emerging markets
and Eastern Europe.
In addition to various articles in professional journals and op-ed pieces, he
is the author of The Global Bankers (E.P. Dutton, 1989), The Money Wars
(E.P. Dutton, 1990) and Comeback: The Restoration of American Banking Power
in the New World Economy (Harvard Business School Press, 1993). He is also
co-author with Ingo Walter of Investment Banking in Europe: Restructuring in
the 1990s (Basil Blackwell, 1989), Global Financial Services (Harper and Row,
1990) and Global Banking (Oxford University Press, 1996).
Mr Smith is currently a Limited Partner of Goldman, Sachs & Co., a former
Director of Harsco Corporation and Tootal pIc, a UK Corporation, and a
founding partner of Large, Smith & Walter, a European financial services
consulting company. He is also a Director of the Atlantic Council of the United
States and a member of the Internal Research Council of the Center for
Strategic and International Studies, Washington, DC.
Ross L. STEVENS
Ross L. Stevens is the Managing Principal and Chief Executive Officer of

Integrity Capital Management. He directs Integrity's multi-strategy relative
value investment process which involves long/short trading among global
equity, fixed income, currency, and commodity markets and among individual
stocks within the world's major equity markets. Prior to founding Integrity,
Mr Stevens worked in the Quantitative Research Group at Goldman Sachs
Asset Management, where, together with other members of the Quantitative
Research Group, he had portfolio management responsibility for various global
asset allocation managed accounts, including its Global Alpha Strategy.
Mr Stevens earned a PhD from the University of Chicago Graduate School of
Business and a BSE from the Wharton School of Business at the University of
Pennsylvania.
PHILIP J. SUTTLE
Philip J. Suttle is Managing Director and currently Head of J.P. Morgan's

Emerging Market Economic Research Group, based in New York, a position
he has occupied since March 1994. Before this, he was Morgan's Senior
International Economist covering the OECD area in New York. Mr Suttle
was transferred to New York in 1992 from Morgan's London office, where he
had been Head of the European Economic Research Group. He joined Morgan
in October 1988 from the Bank of England, where he had worked for 5 years.
Between 1985 and 1987, Mr Suttle was seconded to the Institute oflnternational
Finance in Washington DC. Mr Suttle holds BA and MPhil degrees in
Economics from Oxford University.
KISHORE T ANDON
Kishore Tandon is a Professor of Finance at Baruch College (City University

of New York) and an Adjunct Professor of Finance and International Business
at New York University. His teaching and research interests focus on interna-
tional capital markets and foreign exchange derivatives. His recent publications
include Foreign Acquisitions in the United States (coauthored, Journal of Banking
and Finance, 1996), Options Listings in Foreign Exchange Markets (coauthored,
Journal of International Money and Finance, 1996), Anomalies or Illusions?
International Evidence (coauthored, Journal of International Money and Finance,
1994), and Impact of International Cross-Listings: Evidence from ADRs
(coauthored, Journal of Banking and Finance 1993). He has served as a senior

consultant in emerging capital and stock markets for the United Nations
(UNDP) and The World Bank.
ANDRES VELASCO
Andres Velasco is currently Associate Professor of Economics at New York

University, having previously held Economics positions at Harvard and
Colombia Universities. He held the posts of Chief Economic Advisor to the
Government and Chef de Cabinet to the Minister of Finance in Chile and was
Latin American analyst for Multinational Strategies, New York. He has also
held positions with the World Bank and Chase Manhattan Bank. He gained
a BA in Philosophy and Economics and an MA in International Affairs from
Yale University, and his PhD in Economics from Columbia University.
T AD AS E. VISKANTA
Tadas E. Viskanta is a Vice President in First Chicago NBD Investment

Management Company's Global Investment Strategy and Asset Allocation
Group. He is responsible for global asset allocation research. Mr Viskanta has
co-authored over a dozen articles that have appeared in journals such as the
FinancialAnalysts Journal and Journal of Portfolio Management. Mr Viskanta
has received two Graham and Dodd Awards for excellence in financial writing
from the Association for Investment Management and Research. Previously
Mr Viskanta was a First Scholar for the First National Bank of Chicago. He
holds an MBA with honors from the University of Chicago, and a BA with
highest distinction from Indiana University.
INGO WALTER
Ingo Walter is the Charles Simon Professor of Applied Financial Economics

at the Stern School of Business, New York University, and also serves as
Director ofthe New York University Salomon Center, an independent academic
research institute founded in 1972 to focus on financial institutions, instruments
and markets. He has also held a joint appointment as Swiss Bank Corporation
Professor of International Management, INSEAD, Fontainebleau, France.
Professor Walter received his AB and MS degrees from Lehigh University
and his PhD degree in 1966 from New York University. He taught at the
University of Missouri - St. Louis from 1965 to 1970 and has been on the
faculty at New York University since 1970. From 1971 to 1979 he was Associate
Dean for Academic Affairs and subsequently served a number of terms as
Chairman of International Business and Chairman of Finance. His joint

appointment with INSEAD dates from 1985.
Professor Walter's principal areas of academic and consulting activity include
international trade policy, international banking, environmental economics,
and economics of multinational corporate operations. He has published papers
in various professional journals in these fields and is the author or editor of
25 books, the most recent of which is Global Banking co-authored with
Professor Roy C. Smith (New York: Oxford University Press, 1997). A new
book entitled Street Smarts: Linking, Professional Conduct and Shareholder
Value in the Securities Industry (also with Roy Smith) was also published in
1997 by Harvard Business School Press. At present, his interests focus on
competitive structure, conduct and performance in the international banking
and financial services industry, as well as international trade and investment
issues.
He has served as a consultant to various government agencies, international
institutions, banks and corporations, and has held a number of board
memberships.
HOLGER C. WOLF
Holger C. Wolf is Assistant Professor of Economics and International Business

at New York University and faculty Research Fellow, National Bureau of
Economic Research. He gained his BSc from the London School of Economics,
in 1986, and a PhD from Massachusetts Institute of Technology in 1992. He
teaches macroeconomics and international trade and finance. Research interests
include: dynamics of large groups of heterogeneous interdependent actors, and
exchange rates. He has served as consultant to the International Monetary
Fund, the World Bank, the Group of Thirty, USAID, UBS and other private
and public institutions. Professor Wolf joined NYU in 1992.
Index
Note; Page numbers in italics refer to tables sterilization 45

and figures. volatility 114,123
Asia 51
abbreviations, BMV traded stocks 179,180 political risks 279
abnormal returns 261nl,265-7 reforms 88-9, 90-1, 237
country funds 268-72, 270-1 Asness et al 159, 160, 166
Eurobonds 267, 268, 272 assets
absolute priority rule (APR) 436-7, 436nl see also capital asset pricing model
accounting pricing theory 156-7
anomalies, Mexico 399 returns, portfolio risk 91
inflation 427, 431 attribution of returns 349, 351
ratios 166 auditing standards, inferiority 96, 99
standards, deficiencies 96, 99, 402 autocorrelation 108, 242n3
ADR see American Depository Receipts autoregressive conditional heteroskedasticity
Aerni, Peter 293-305,371-73 (ARCH) 131
aggregate capital stock 18
Aghion, et al 403n7, 404 Babatz and Conesa 381nl
Ahn, Dong-Hyun 307-17 Bagehot, Walter 14-15,232, 232n15
Air Force Office of Scientific Research 3n Bailey and Chung 189
Alesina et al 205 credit rating 196
Alien Board shares 246-7, 246n7 n8 Bailey et al 242n3
Altman, Edward I. 437 Bailey and Jagtiani 246n7, 247n8, 248n11
EMS 391-400,421-31 Bailey and Lim 248nll, 260
Altman's Z-score model 391-93,398 bailout package, Mexican crisis 77
American Bar Association 402 Baker Initiative 297-8
American Depository Receipts Bakshi and Chen 159
(ADR) 175-92, 175nl, 180, 181, 187, balance of payments
207-10 Chilean/Mexican comparison 24, 28-9
see also Rule 144A Latin America and Europe
Errunza's comments 214-15 (1920/30s) 58-9, 59, 60
amortization, goodwill 431 Baliiio and Sundarajan 43n16
analytics Banco de Mexico
Brady bonds 386-7 'bank run' 5, 14
debt 346-9,347-8,350-1 credit expansion 7-8
APR see absolute priority rule exchange rates 33
arbitral tribunals 63-5 Monetary Program (1995) 44
ARCH see autoregressive conditional peso support 6-8
heteroskedasticity tesobonos 9-10
Argentina Banker 22005
Brady debt restructuring 89 bankruptcy 79-80
capital inflows 24, 25 see also reorganizations
correlations 132,149,211,212 EMS prediction limitations 400
equity surge 90 market necessity 64
exchange rates 59, 61 procedures 401-419,433-41
IFC/MSCI differential 11 0, 111 concluding remarks 414-16
kurtosis 132, 141 cost efficiency 435-7
returns 114, 115 current problems 401-403,433-4,
skewness 132, 133 441
461
462 Index
Bankruptcy Brady bonds 8, 67n13, 86, 89, 203, 335-69

procedures (continued) analytics 386-7
new proposals 403-19,434-40 attractiveness 367-9, 368-9
private workouts 437-9 background 307-9
tort claims 439-40 compositional profile 345
Bankruptcy Code 434, 438 correlations 356, 358
Bankruptcy Reform Act 1978 433 default probabilities 376-8
banks definition 307, 340
behaviour, Chilean/Mexican empirical analysis 314-16,314-15,
comparison 40-4,46 315-16
Chilean crisis (1982-83) 61 Evans' comments 375-9
corporate credit sources 41 formats 341
Corporation of Foreign hedging 307-17,311-12
Bondholders 66-7 methodology 311-14
finance, economic growth 103 public debt instruments 340-42, 341,
gold standard constraints 60 343-4
lending, public debt instruments 336-7 sovereign risk 378
lending, cross-border 293-305,371-73 state variables 376
restructured debt 61-2 types 343-4
viability necessity 98-9, 98n12, n13 valuation 347
weaknesses 42 volatility 316-17
Banz, Rolf W. 160 Brazil
Bebchuck, L. 408,408nI5 capital inflows 24, 25
Bekaert et al 196, 197,214,382,383 correlation 132, 149
Bekaert, Geert 107-73 floating rates success 60
Bekaert and Harvey 193,251, 252n16 kurtosis 132, 141
Bera-Jarque 131 returns 114, 115
Berk,Jonathan 160 skewness 132, 133
Bernanke and James 60 volatility 114, 123
Bernstein, Robert J., debt/portfolio Brennan, M. J. 131, 221
considerations 335-69, 385-7 Bretton Woods System 53
beta values 108,113,156-7,156 broad sterilization, Chilean/Mexican
bivariate Markov switching model see comparison 35
Markov switching model Brown et al 195
Black, Fischer 131 Buckberg, Elaine 220, 222, 260
BMV see Bolsa Mexicana de Val ores budget deficits 56, 57
board keys, BMV traded stocks 179,180 Bulow et al 372n5
Bodnar, Gordon M., credit risk 421-24 Bulow and Rogoff 371n2
Bolsa Mexicana de Valores (BMV) 176-91, buybacks 61, 61n9
180, 187
bondholders
buybacks (1930s) 61-2 Cabezas, Pablo 23-48
G-I0 reform proposals 67-73 Calvo et al 34,35, 37n7, 55
steering committees 63, 76-8 Calvo, G. 41n13
Bondholders Council 65-7 Calvo and Reinhart 231
bonds Campa, J.M. 59n7
see also Brady bonds; corporate bonds; Campbell and Shiller 320,328,329,381-82
government bonds Canada, Markov switching models 253,
covenants 63-5 254
loan comparison 339 Cantor, Richard 381-84
market collapses (1823-1989) 86,87 capital account liberalization 43
Bosner-Neal et al 247n8, 248, 263n4 capital asset pricing model (CAPM) 156-7,
Boudoukh,Jacob 307-17,375-9 237,239,244-55,244n5
Index 463
capital controls committees, bondholders 65-6, 76-8

Chilean/Mexican comparison 38-40, commodity prices, Latin American/Asian
45-6 post-war boom 51
investment assessments 99-100 competitive hypothesis 181-2,184,207-10
necessity 205 competitive position, EMS model 396, 429
objectives 39-40 Conrad and Kaul 159
tesobonos 321, 321n3 consumers
capital inflows, Chilean/Mexican budget constraint 15
comparison 23-48,24,29 utility function 15, 20
Capitalization,IFC 111, 112 contagion 220-33
CAPM see capital asset pricing model cross-border bank lending 295
Cardenas and Barrera 40, 205 definition 220
cash flow, importance 427, 431 sectoral composition link 233
causality effects 230-1,230-1 contentious claims 407,407n11
Center for International Financial Analysis contracts 79-81
and Research 402 renegotiation, Rey Committee 70-1
cetes 34-5, 36 self-enforceability 299-301
debt outstanding (1988-95) 330-41, corporate bonds, scoring system 391-400,
331 392,394-6,421-31
risk premia 320-34, 320n1, 321n2, 323, corporate credit, bank sources 41-3
325-7,382-3 Corporation of Foreign Bondholders 66-7
Chambers, William J. 425-31 corporations
Chan et al 157,160, 175n2 overhaul
Chen et al 157, 163 investment assessments 99
Chile requirements 204-5
bank behaviour 40-4, 46, 61 correlations 211-15,223
capital controls 38-40,45-6, 100, Brady market 356, 358
100n17 contagion link 220-6,232-3
capital inflows 24, 29 country effects 228, 229
correlation 132, 149 country stripped spreads 364-6, 365
exchange rate history 30-1, 32-3 determinants 219-35
floating rates success 60 emerging markets 132,149-55, 156,
kurtosis 132, 141 169-70
Mexican comparison 23-48 stylized facts 226-32
political risks 279 cost efficiency, bankruptcy
returns 114,115 procedures 435-7
skewness 132, 133 costs, trading portfolios 167-8, 167
volatility 114, 123 countries
China 104 attributes 161
Chowdhry and Nanda 176, 182 components 226-8, 227
Christie, A. A. 131 effects, correlations 228, 229
Chuchan et al 55 risk premia 319-34
Chuchan, Punam 222 definition 323
Claessens and Gooptu 260 risks 298
Claessens, Stijn 199-205 country funds 263-4
clauses, loan agreements 67-73 background 262-3
Cline, William 225n11 list 275
Cole and Kehoe 4, 12-22 methodology 266
Colombia stock price effects 268-72, 270-1
correlation 132, 150 coupon collateral 347-8,348n1
kurtosis 132, 142 crash, (October 1987) 211, 213
returns 114, 116 credit
skewness 132, 134 see also creditworthiness; rating
volatility 114,124 analysis 385-6
464 Index
credit (continued) instruments, risk premia 320-22

booms, banking crises 41-4,42, 42n14, management
46 Chilean/Mexican comparison 35-8,
risks 349-54,353,421-24,425-31 45
exchange rates 422-4 Mexican crisis 8-14
credit cards 42 portfolio considerations 335-69,
creditworthiness 196, 304 355-66
Brazil 349 public instruments 336-46
historical comparisons 295-6 relative values 366-8
risk 348-9 sovereign credit analysis 349-54, 353
crises trading volume 338
debt history 360, 361 default probabilities 360-64, 361, 364
G-IO reform proposals 67-73 Brady bonds 376-8
international lending (20th demographics 159, 163-6, 164-5
century) 50-62 deregulation
recurrence 64 credit boom link 43, 46
reforms 76-8 Europe 88-9
crisis zones determinants, correlations 219-35
Cole and Kehoe definition 19,21 devaluations
government debt 4, 13-14,13 Chile 30
maturity 21 Mexican crisis 3-6, 8, 14
cross-border lending 293-305 developed economies
economic perspective 298-303, 300 bankruptcy procedures 401-402
enforcement costs 298-9 economic performance
future prospects 303-4 comparison 352-4,353
historical comparisons 294-8, 295, 297 political risk effects 277, 279, 280-2,
renaissance 293, 294 283,284-7
Rogoff's comments 371-73 Diamonte et a1 158
stylized facts 294-8, 295, 297 Diamonte, Robin L. 277-88
cross-listing 175-92,207-10,214-15 dissenting creditors 63, 68
cross-sectional evidence 188-90 distribution, returns 109-56
Cumby and Evans 308, 312, 377, 378 Divecha et al 193, 227
Cumby, Robert E. 237-57 Diwan, Errunza and Senbet 260, 262
currency see foreign currency domestic banking sector
current accounts cross-border lending 296-8, 297, 301-2
capital inflows 25 Mexican fragility 15
Chilean/Mexican comparison 28-9 domestic consumers, Cole and Kehoe
Cutler and Summers 403 model 12, 15-22
domestic debt, Mexican maturity 38
Dann and Mikkelson 265, 268 domestic government debt, Mexican
Dart Family 70n16 crisis 8-14, 9
debt 330-41, 331 domestic loans, Mexican banking
analytics 346-9, 347-8, 350-1 industry 7-8
bankruptcy seniority 407-8 Domowitz, Ian 175-92,207-10,214-15,
characteristics 335-6 319-34,381-84
crisis preventability 3-22 Dooley et a1 55
defaults (1823-1989) 86, 87 Dooley, Michael 49nl, 205
dimensions 338 Dornbusch and Werner 3
distribution comparison Drago, Rafael La Porta 401-419,433-41
(1990/1995) 358, 359 dual exchange rates, Mexico 10, 12
equity risk/reward comparison 358, 360,
360 East Asia
Goodman's comments 385-7 currency management 55-6
historical crises 360, 361 economic growth 52-3
indices 342, 346 exchange rates (1978-92) 56,58
Index 465
Eaton and Fernandez 371n1 see also portfolios; returns

Eckbo, E. 265,267 bubble burst 93-4, 100-2
Economic Consequences of the Peace debt risk/reward comparison 358, 360,
(Keynes) 226 360
Economist 219n4 future prospects 94-7, 100-5
economy lessons learned 97-100
considerations, credit risk analysis 349, market development, economic
351-54,353 growth 103-4
growth market value, EMS !)lodel 397-8
Brady plan 342 Mexican global effect 86
developing world 52-3 performance 94, 94
equity market development 103-4 surges (1990s) 86-8
importance 101-2 causes 88-93
investor requirements 104-5 Erb, Claude B. 107-73
Thailand 250-2 Erb et al 168, 196
perspective, cross-border Errunza and Losq 107, 193
lending 298-303,300 Errunza, Vihang R. 108,211-15
reforms estimation issues 180-5
Asia 237 estimations, liquidity and volatility
Chilean/Mexican record 24-5,26-33 changes 183-4
equity surge 89-91, 93 Eun et al 215
post Mexican crisis 203 Eun and lanakiramanan 176n3
significance, emerging countries 336, Eurobonds 260
337
background 261-2
Edelstein, Michael 49n2
corporate offerings 274
Edwards, S. 56n5,319
cross-sectional regressions 268
efficient frontier 91, 94, 356, 356
data 263-5, 264
Eichembaum et al 209
methodology 265-6
Eichengreen, Barry 49-81
public debt instruments 337-9, 339-40
Eichengreen and Portes 14
Eisen berg, T. 436 spread comparisons 366-8,367-8, 387
EMBI see Emerging Markets Bond Index stock price effects 267-8, 267, 272
Euromoney's country credit risk
EMCCR see Euromoney's country credit risk
EMDB see Emerging Markets Data Base (EMCCR) 158-9,160,161,163-5,
Emerging Markets Bond Index 164-5
(EMBI) 342, 345, 346 Evans, Martin D. 375-9
Emerging Markets Data Base exchange rates
(EMDB) 226, 227 see also foreign currency
country funds 266 Argentina 61
Eurobonds 263-4 capital inflows 25
Emerging Markets Global (EMG) 109 Chilean/Mexican comparison 28, 28,
emerging-market scoring model 30-3,44-5
(EMS) 391-400,392,394-5,425-31 credit risks 422-4
bankruptcy prediction limitations 400 currency management (20th
modification factors 391, 394-8,428-30 century) 55-62
score variables 393-4, 394 East Asia (1978-92) 56, 58
usage 398-400 empirical significance 228-30, 230
EMG see Emerging Markets Global inflation 32, 32n3
EMS see emerging-market scoring model Latin America (1978-92) 56, 58
enforcement costs 298-9 Mexican inflexibility 33, 33n4,n5
Engel and Hamilton 240 sterilization 33-5
entitlement issues 439-40 Exchange Stabilization Fund 63
equilibrium, Cole and Kehoe model 17-22 expectations hypothesis 328-32,330,331,
equities 85-105,175-92,199-205,207-15 381-84
466 Index
exports surges (1990s) 86-93

emerging economies 337 foreign investors 14
growth 295,296 see also international investors
external financing Cole and Kehoe model 12, 15-22
background and theory 261 fickleness 219-20
data 263-5 Korean market access 251-2
empirical results 267-72 Mexican crisis 203
market responses 259-75 selection criteria 203-4
methodology 265-6 foreign ownership restrictions 175-92,
207-10,214-15
Fama and French 160 Form 20-F 422
Far Eastern Economic Review 252n14 fragmentation 176-7,182,184,207-10
Fazzari et al 302 Frankel, J. 35n6
Feis, Herbert 49n2 Frankel and Okongwu 34
Fernandez-Ansola et al 7On15 risk premia 319,320,322, 332
Fernandez-Arias, Eduardo 55 'free lunch' story 193, 196, 197
Ferson and Harvey 157, 158, 159, 160, 166, free markets
168 adoption 103-4
filter probabilities, state equals one 249-52, disillusionment 100-5
250-1 fund managers 97
filtering algorithm 240-1 rule violations 94-6
financial figures, GAAP 421-24 fundamental valuation measures 160
financial flows, USA/developing countries
(1956-80) 50,51 G-I0, reforms proposals 67-73
financial infrastructures GAAP, financial figures 421-24,426-7,
importance 204 430-31
investment assessments 98-9 Garcia, Rene 207-10
investor requirements 104-5 Gavin and Hausmann 61, 61n8
financial instability 60 GDP 337
Financial Times (IT) 231-2 capital flow 104
fiscal policies Chilean/Mexican comparison 26
capital inflows 25 Cole and Kehoe model 20-1
Chilean/Mexican comparison 27-8, 28 current account deficits 23
developing world (19905) 56 developed countries comparison 352-4,
Fishlow, Albert 49nl, 49n2 353
fixed exchange rates explaining returns 168-71,169-70
Argentina 61 portfolio investment 163-6, 164-5
sterilization 33-5 post Mexican crisis 203, 203
Foerster and Karolyi 176, 188 generalized method of moments
Foreign Bondholders Protective (GMM) 185-6, 187,209
Council 66, 67 George et al 185
foreign currency Germany
see also exchange rates crisis (1930s) 60
management types 55-62 interest rates 76
Mexican regulations 39, 46 moral hazard concerns 71
problems reunification 89
banking link 40-4 Ghysels and Garcia 108
overvaluation 44-5 Ghysels and Hall 209
risk premia 319-34, 381-84 Gilson et al 403, 439
risks, Mexico 398-9 GKN 185
vulnerability, EMS model 394-5,428 Glen, Jack 175-92,207-10,319-34,
foreign dollar loans, USA (1923-31) 50,51 381-84
foreign investment GMM see generalized method of moments
Mexican crisis 5, 5, 7-8 Goetzmann and lorion 107, 111, 114,214
Index 467
Goetzmann, William N., risk 193-7 Heston et al 157

gold standard 55-8, 60 Heston and Rouwenhorst 227
Goodman, Lawrence 385-7 Hong Kong 253, 254, 279
goodwill, amortization 431 Howell, Michael 222
Gooptu, Sudarshan 232 Hume, David 33-4
governments
banking liability guarantees 41 ICRG see International Country Risk Guide
bankruptcy 64 idiosyncratic components 226, 228, 230
bonds idiosyncratic noise 224-6
Mexico 9-14,9-11,13 IFC see International Finance Corporation
reserves (Mexico) 10 IICCR see Institutional Investor's Country
budget constraint 16 Credit Rating
Cole and Kehoe model 12, 15-22 IMF 63, 76-8, 80-1
debt conditionality 64
crisis zones 4, 13-14, 13 Rey Committee 68-73
lenders of last resort 14-15,21-2 India
maturity/crisis zone relationship 21 correlation 132, 150
Mexican crisis 3-22 correlations 211, 213
national product, ratios 3, 3 kurtosis 132, 142
intervention, Mexico 399 returns 114,116
investor requirements 98-100, 103-5 skewness 132, 134
Rey Committee proposals 70 volatility 114, 124
utility function 20 Indonesia
Granger causality tests 230-1,230-1 correlation 132, 151
Greece kurtosis 132, 143
correlation 132, 150 returns 114, 117
kurtosis 132, 142 skewness 132, 135
returns 114,116 volatility 114, 125
skewness 132, 134 industry affiliation, EMS model 395-6,
volatility 114, 124 396,428-9
Grinblatt et al 221 inflation
Grossman, Richard 60 accounting 427,431
bank deposit link 43
Hamilton, James D. 241 Chile 30-1,33
Hansen, L. GMM estimates 185-6 Chilean/Mexican comparison 27, 27
Hansen, Lars P. 131 control 44
Hardouuvelis et al 260, 262 credit-worthiness 159
Harlow, W. Van 158 developed countries comparison 352-4,
Hart et al 403n7 353
Hart, Oliver, bankruptcy European stabilization 50
procedures 401-419,433-41 exchange rates 32, 32n3
Hartzell, John, EMS 391-400,421-31 foreign exchange gluts 99-100
Harvey, A. C. 185 Latin America (post 1980s) 52
Harvey, Campbell R. 107-73,193 Mexico 31-2,33
Haugen and Sen bet 435, 438n2, 439, 439n3 peso expectations 322
Hausmann and Gavin 42, 46 policy, Mexico 37
hedging insider cash auctions 404,406,408-10,409,
Brady bonds 307-17 410nI4,412-15
Evans' comments 375-9 technical details 417-18
empirical analysis 314-16,314-15, institutional features, contagion 221-2
315-16 Institutional Investor's, Country Credit
methodology 309-14,311-12 Rating (IICCR) 158,160,161,163-5,
out-of-sample 313-16,315 164-5
Helpman et al 30 institutions, reforms 62-3, 76-81
468 Index
interest rates post Mexican crisis 100

Brady bonds 307-17,312 interventionism, Chilean/Mexican
capital controls 39-40, 46 comparison 38-40
Chile 30-1 investment
Chilean/Mexican comparison 36-7 finance, pecking order hypothesis 302-3
credit booms 44 fund manager rule violations 94-5
domestic government debt (Mexico) 10, fundamental principles 211
11 rates, Chilean/Mexican
global picture 76 comparison 29-30,30
Markov switching model 243n4 investors
Mexico 319 confidence loss 96
mortgage market decline (1994) 358 current requirements 104-5
short term debt link 75-6 lessons learned 97-100
USA movements IPD see international portfolio
(1920s) 53 diversification
(1970s) 53, 54 Iraq, political risks 278, 278
(post 1986) 53-5, 54 James, C. 261
intermediation 49 Jayaraman et al 186
International Country Risk Guide Jegadeesh and Titman 159
(ICRG) 158,160,161,163-5,164-5, Jordan
278-89 correlation 132, 151
components 288-9 kurtosis 132, 143
explaining returns 168-71, 169-70 returns 114, 117
international cross-listing 175-92,207-10, skewness 132, 135
214-15 volatility 114, 125
International Finance Corporation Jorion, Philippe, risk 193-7
(IFC) 107, 109-14, 100nl n2 n3 Jorion and Schwartz 182n8, 207
see also Emerging Market Data Base Junge, Georg 293-305,371-73
bias 194, 214 junk bonds 93n8
correlations 212-13
Kaminsky and Reinhart 41
explaining returns 169-70
Kandel and Stambaugh 157
global composites
Keefer and Knack 402
correlations 132,149-55
Kehoe, Timothy J. 3-22
kurtosis 132, 148
Keppler and Traub 160
skewness 132, 140 Kessel, Bettina 293n
total return 114, 122 Ketelsen, Uwe 293n
volatility 114, 130 Keynes, John Maynard 220,221,226
market weights 111, 112 Khanthavit, Anya 237-57
MSCI comparison 109-11,110 Khor and Rojas-Suarez 321n2
political risks 279-88 Kidwell et al 260
summary statistics 111, 113 Kim and Singhal 263n4
international investors Kim and Stulz 265, 268
budget constraint 16 Eurobonds 260, 261
utility function 16 Klug 61n9
international lending 14,49-81,293-305, Kolomogorov-Smirnov 131
371-73 Korea 241-2, 245
20th century crises 50-62 cumulative returns (1977-93) 238
comments 75-8 filter probabilities 249-52, 250
G-I0 reform proposals 67-73 Markov switching models 237-57
orderly workouts 62-7 Krugman, Paul 88, 100, 102
sovereign debt defaults (1823-1989) 86, kurtosis 131-2,141-8,169-70
87 Kuwait 196, 278, 278
international portfolio diversification Kuznets, Simon 50n3
(IPD) 91-3, 92n7, 96 Kyle, A. 183
Index 469
Laban and Larrain 40 Macmillan, Rory 66, 68

land area, emerging economies 337 macroeconomic policies, investment
Lary, Hal B. 53 assessments 98
Latin America 51 Madhavan, Ananth 175-92,207-10,
see also individual countries 319-34,381-84
balance of payments (1920/30s) 58-9, Malaysia 45-6
59,60 correlation 132, 151
boom/bust overview 23-5 kurtosis 132, 143
currency management 55-62 returns 114, 117
economy 52, 89-90 share prices 97
exchange rates (1978-92) 56, 58 skewness 132, 135
Financial Times 231-2 volatility 114,125
inflation (post 1980s) 52 management opportunities, portfolio
reforms 88-91 considerations 364-6, 366
Royal Institute of International markets
Affairs 232 definition 335-6
Latin Eurobond Index 339, 339-40 growth 336, 338
Lederman and Sod 381nl integration 159, 237-57, 245, 254
lenders oflast resort 4, 14-15,21-2,41, responses, external financing 259-75
80-1 segmentation 175-92, 193,207-10,
lending, cross-border 293-305,371-73 214-15
lending into arrears, IMF 68, 71 share dominance, Mexico 399-400
Lessard, Donald R. 299 weights,IFC 111,112
Levine, Ross 103 Markov switching model
Lewis, Cleona 49n2 equity returns 240-3, 242
Lewis, K. 317,322 market integration 237-57,245, 254
Liew, John M. 277-88 Martinez 402
Lintner, John 156 Mayer, Colin 302
Lipkin 402 Meltzer, Allan 72n18
liquidation 401-402 Melvin and Schlagenhauf 321n3
liquidity 176 Merton, Robert C. 157
BMV traded stocks 186-7,187,207-10 Mexican crisis 3-22, 61, 76-8, 199-205
change estimates 183-4 bailout package 62-3, 77
economic growth 103 causes 203
inferiority 96-7 Cole and Kehoe model 12-14, 15-22
Littler and Malouf 85 debt management 8-14,45
loans 7-8 foreign investment 5, 5, 7-8
see also international lending global equity effects 85-6, 86
agreements, G-IO reform lenders oflast resort 14-15,21-2
proposals 67-73 market solution 72n18
bond comparison 339 monetary policy/reserves 6-8
mutual funds 221-2,222
USA/Mexico 14
logit models 188-9, 189 overview 4-6
political instability 4-6, 7, 9
long-term, cross-border lending 300-1, 300,
share prices 94, 96
303
volatility 107
Lopez-De-Silanes, Florencio 401-419,
Mexico 175-92,207-10
433-41
bank behaviour 40-4, 46
Lustig, N., risk premia 319, 322, 331, 332,
Brady debt restructuring 89
333
capital inflows 24, 29
Chilean comparison 23-48
Macaulay bond duration 308-10,311-12, corporate ratings 391, 392, 426-30
312,314 correlation 132,152
formula 309 currency risk premia 319-34
470 Index
Mexico (continued) Pagano, M. 176

domestic debt maturity problems 38 Pakistan
dual exchange rates 10, 12 correlation 132, 152
exchange rate history 30, 31-2, 33 kurtosis 132, 144
foreign exchange regulations 39, 46 returns 114, 118
government debt, categories 8-9 skewness 132, 136
high-inflation policy 37 volatility 114,126
kurtosis 132, 144 PB see price to book
multiple equilibria 372 Peck, Matthew 391-400,421-31
returns 114, 118 pecking order hypothesis 302-3
skewness 132, 136 Penicook, John A., Jr 335-69, 385-7
stock market performance 95n9 pensions 98
unique characteristics 398-400 perfect-foresight spread 329-30, 330, 332,
volatility 114, 126 333
Mikkelson and Partch 261, 265, 267-8 peso
monetary policy, Mexican crisis 6-8, 8 premium, definition 323, 323
monitoring advantages, cross-border problems 196-7, 383-4
lending 301 support, Banco de Mexico 6-8
Moore, John 401-419,433-41 Philippines
moral hazard 64-7, 65n11, 71, 300-1 capital inflows 25
Moreno and Yin 252n14 correlation 132, 153
Morgan, J. P. 75, 339, 339-40, 342, 345, kurtosis 132, 145
346 returns 114, 119
Morgan Stanley Capital International skewness 132, 137
(MSCI) 109, l09nl n3 volatility 114,127
beta comparison 156-7, 156 Pinon-Farah 7On15
correlations 132, 149-55 political considerations, credit risk
IFC comparison 109-11, 110 analysis 352
political risks 279-88 political instability
summary statistics 111-14,113 Cole and Kehoe model 12
world kurtosis 132, 147, 148 eq uity surge 90
world skewness 132,139,140 Mexican crisis 4-6, 7, 9, 38
world total return 114, 121, 122 Mexican exchange rates 33
world volatility 114, 129, 130 risk premia 324-7,330-32
Morgan Stanley Group Emerging Market political risks 277-88
Index 85n2 change effects 283, 286-7, 286-7
mutual funds 93,98,221-2, 221n7 n8, 222 data 278-83,278,280-2,284-5,286-7
summary 288
Ponzi 16
Nadler et al 308
population, emerging economies 337
narrow sterilization 34, 35
Portes, Richard 49nl, 63
Nelson, Daniel B. 131
portfolios 42, 91-3, 96, 100
Netherlands, Markov switching
analytics 386-7
models 253, 254
capital flows, economic growth role 103
Nigeria
considerations, debt 335-69, 355-66
correlation 132, 152
flows, post Mexican crisis 199, 200
kurtosis 132, 144
Goodman's comments 385-7
returns 114,118
investment
skewness 132, 136
selection criteria 160-71
volatility 114, 126
strategies 163-6, 164-5
Portugal
Obstfeld and Rogoff 371nl, 372 correlation 132, 153
orderly workouts, international kurtosis 132, 145
lending 62-7 returns 114,119
Index 471
Portugal (continued) 94) 50. 52

skewness 132, 137 restructuring 61-2,64-5,76-8
volatility 114, 127 returns 211-15,212-13
Powers, Mary 91 abnormal 261nl, 265-72, 267, 270-1
predictability, return behaviour 114, 131 attribution 349,351
price to book (PB) 166,168-71,169-70 behaviour 107-73,214
private flows 219, 219n2 beta values 108
domination 232 distribution 109-56
post Mexican crisis 199-203,200 structure instability 108
private sector, cross-border lending 296-8, emerging markets
297,299-300, 303-4, 371-73 totals 114, 115-22
private workouts, bankruptcy volatility 97
procedures 437-9 expectations 360-64, 363, 364
privatizations 87, 99, 99n16 interpretation 107
attractiveness 90 long-term studies 194
carefulness 205 Markov switching model 237-57, 242
Chilean/Mexican record 26 portfolios
global 260 investment criteria 160-71
Latin America 43 risk 91
public cash auctions 404,406,410-12,413, predictability 108
418-19 premia 354-60,355-7
public debt definition 354-5
instruments 336-46 risks 91-2,92,94,95,96,102
maturity, Chilean/Mexican attributes 168-71,169-70
comparison 36-7, 36, 37 measurement 156-60
public sector, cross-border summary statistics 111-14, 113
lending 296-300,297, 303, 371-73 for excesses 241-2,241
US/emerging-market
qualified majority voting 69, 71 correlations 100, 101
Rey Committee 67-73
rating 196, 366-8 Rey, Jean-Jacques 67
see also creditworthiness Richardson, Matthew 307-17,375-9
corporate bonds 391-400,392,394-6, risk premia 319-34
421-31 Cantor's comments 381-84
receivers 404, 406-12, 406, 406nl0, 407n12, concluding remarks 332-4
410n15 debt instruments 320-22
recovery rates, returns 362, 363, 364 expectations hypothesis 328-32, 330,
regulatory authorities 98-9, 98n13 331
Reorganization Rights (RR) 404-16,435 market behaviour (1993-94) 323-6,
reorganizations 402-3, 402n3, 403n5 323,325-6
new proposals 403-16, 406 term structure 326-8, 327-8
advantages 404-5 risks 214
concluding remarks 414-16 see also political risks
debt seniority 407-8 attributes, returns 168-71,169-70
insider cash auctions 408-10 beta values 108
public cash auctions 410-12 countries 298
receivers 406-12 definitions 358
RRs 404-16,435 emerging markets 193-7
solicitation of offers 406-7 ICRG components 288-9
reserves measurement, returns 156-60
Chilean/Mexican comparison 24, 28-9 measures 348-9
government bonds (Mexico) 10 portfolio investment criteria 160-71
Mexican crisis 6-8, 7, 8 returns 91-2,92,94,95,96,102
resource flows, developing countries (1989- survey-based measures 158-9
472 Index
Rodriguez, C. 43 South Korea

Rogoff, Kenneth 371-73 correlation 132, 153
Rojas-Suarez and Weisbrod 44n17 kurtosis 132, 145
Roll, R. 185,208,224 returns 114, 119
Roll and Ross 157 skewness 132, 137
Royal Institute of International Affairs 232 volatility 114,127
RR see Reorganization Rights sovereign ceilings 366, 387, 393
Rule 144A 259, 262, 272 sovereign credit analysis 349-54,353,
385-6
Sachs et al 30n2, 40, 4On11 sovereign credit spreads, volatility 355, 355
credit booms 43n15 sovereign debt defaults, (1823-1989) 86,87
currency overvaluation 44-5 sovereign risk, Brady bonds 378
lenders of last resort 41 sovereign spread, EMS model 398
Sachs, Jeffrey 14, 61 sovereign stripped yields 346-8, 347, 348
Salomon Brothers 86n3 spread 207-10, 355, 355, 398
savings rates, Chilean/Mexican see also stripped spreads
comparison 29-30,30 changes 187-8, 187
Scharfstein and Stein 221 comparisons 366-8,367-8
scoring systems, corporate bonds 391-400, computation 184-5
392,394-6,421-31 duration 349
sectoral composition 224-8,224, 225nl0, perfect-foresight 329-30, 330, 332, 333
227,233 trading portfolios 167-8,167
securities state variables, Brady bonds 376
current domination 294-5,295 steering committees, bondholders 63, 76-8
industry, regulatory necessity 98-9, Stein estimators 316, 316n6
98n13 sterilization 56, 56n6
securitization 72, 304 see also broad sterilization; narrow
segmentation hypothesis 182, 182n8, 184, sterilization
207-10 Chilean/Mexican comparison 33-5, 45
self-enforceability, contracts 299-301, 303 debt management 35-8, 45
self-interested bargaining, creditors 79-80 instruments 35-6
Senbet, Lemma 401nl, 433-41 Stevens, Ross L. 277-88
Sharpe, William 156 stock exchanges, founding dates 194-5, 194
Shleifer, Andrei 401nl stock prices
short-term debt effects
cross-border lending 300-1,300,303, country funds 268-72, 270-1
304 Eurobonds 267-8, 267, 272
interest rates link 75-6 run-ups, small market
shrinkage estimators 316, 316n6 universality 252-3
side payments, problems 80-1 stock return data, political risks 279, 283,
Simpson, John L. 49nl 284-5, 286-7
Singapore, Markov switching models 253, stockmarket, Keynes' depiction 220
254 stripped spreads 346-9, 347, 348, 348nl,
Singh, Ajit 302 386-7
size of firm, returns 160, 164-5, 166 Brady bonds 376-8, 377
skewness, emerging markets 131-2,133-40, country correlations 364-6, 365
169-70 par bond/FRB 366, 366
small market universality, stock price run- volatility 350
ups 252-3 stripped yields 346-8, 347, 348
Smith, Roy C. 85-105, 199-205,211-15 Stulz, Rene 157
Solnik, Bruno 157 Stulz and Wasserfallen 178, 188
Solnik and Longin 108 stylized facts, correlations 226-32
Sondhi, A. C. 421, 427, 430 summary statistics 160, 161-2
Soto, M. 40, 4009 sunspot variables 12,16-17,18
Index 473
supply curve, RRs 412n16 returns 114, 120

survey-based measures, risk 158-9 skewness 132, 138
survivorship 195-6 volatility 114, 128
Suttle, Philip 49nl, 75-8 Turner et al 246
turnover, trading portfolios 168
T bills 327n4
T-note futures 308-9,313-15,315 US High Yield bond market, decline 358,
Taiwan 241-2, 245 362
correlation 132,154
Valdes-Prieto and Soto 205
cumulative returns (1977-93) 239
valuation ratios 160
filter probabilities 249-52, 251
VAR decomposition 231,231
kurtosis 132, 146
Velasco, Andres 23-48
Markov switching models 237-57
Venezuela
returns 114, 120
skewness 132, 138
kurtosis 132, 147
volatility 114, 128
returns 114,121
tax, Chilean capital inflows 38-9
skewness 132, 139
taxpayers, servicing debt burdens 69
volatility 114, 129
Taylor series expansion, Brady bonds 313,
Viskanta, Tadas E. 107-73
314, 316
volatility 112-14,113,169-70
Telljohan, K. 307
arithmetic returns 157, 157
tequila effect, duration 199, 200
BMV traded stocks 180,181,186-7,
term structure, risk premia 326-8, 327-8
187,207-10
tesobonos 4, 9-11, 9-11
Brady bonds 316-17
Cole and Kehoe model 20
change estimates 183-4
debt outstanding (1988-95) 330-31,331
country fund effects 269-70, 270
financial fragility 38
economic growth 103
risk premia 320-34, 321n2, 323, 325-7
emerging markets 97,114,123-30, 131
382-3 '
Eurobond returns 339-40, 340
sterilization 36
investor base relationship 358
Thailand 241-2,245
Mexican financial crisis 107
correlation 132,154,211,212
return premia 354-60,355-7
cumulative returns (1977-93) 238
sovereign credit spreads 355, 355
filter probabilities 249-52, 250
stripped spreads 350
fiscal policy 56
votes, RR holders 404,412-14, 413n17
kurtosis 132, 146
Markov switching models 237-57 wages
returns 114,120 Chilean/Mexican comparison 26-7, 27
skewness 132, 138 Mexican crisis 6
volatility 114, 128 Wall Street boom 53
Tobin tax 46 Walter,lngo 85-105,199-205,211-15
tort claims, bankruptcy procedures 439-40 'Washington consensus' 88, 88n5, 90
tradable securities, domination 294-5 295 capital controls 99-100
trading portfolio costs 167-8 167 ' disillusionment 100-5
trading volume 180, 181,338' Whitelaw, Robert F. 307-17,375-9
Treasury curves 364 Wigmore, B. 41n12
Treynor ratio 360 Williamson, John 88n5, 232
Truman, Ted 72, 77 willingness to pay, credit risk analysis 352
Trust Indenture Act 1939 68n14, 69,434, Wolf, Holger C. 219-35
438 Working Group on Sovereign Liquidity
trustees, bondholder representations 69 Crises (Rey Committee) 67-73
Turkey World Bank, project lending 372
kurtosis 132, 146 yields 346-8, 358, 362
474 Index
Z-score model, Altman 391-93,398 kurtosis 132, 147

Zervos, Sara 227 returns 114,121
Zimbabwe skewness 132, 139
correlation 132, 155 volatility 114, 129
The New York University Salomon Center Series
on Financial Markets and Institutions
1. I.T. Vanderhoof and E. Altman (eds.): The Fair Value ofInsurance Liabilities. 1997
ISBN 0-7923-9941-2
2. R. Levich (ed.): Emerging Market Capital Flows. 1997 ISBN 0-7923-9976-5
3. Y. Amihud and G. Miller (eds.): Bank Mergers & Aquisitions. An Introduction and an
Overview. 1997 ISBN 0-7923-9975-7
KLUWER ACADEMIC PUBLISHERS - DORDRECHT I BOSTON I LONDON

(the New York University Salomon Center Series on Financial Markets and Institutions 2) Timothy J. Kehoe (Auth.), Richard M. Levich (Eds.)-Emerging Market Capital Flows_ Proceedings of a Conference He

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EMERGING MARKET CAPITAL FLOWS

The New York University Salomon Center Series

Stern School of Business

Springer Science+Business Media, B.V.

ISBN 978-1-4613-7841-9 ISBN 978-1-4615-6197-2 (eBook)

Printed on acid-free paper

All Rights Reserved

Part I The history of emerging markets: what have we learned? 1

Part II. Returns on emerging market equities 83

Part III. Integration of emerging markets and international equity

8. A Markov switching model of market integration

Part IV. Lending on 'fixed' terms in emerging markets: bank lending

Part V. Topics in corporate debt and emerging markets. 389

P. AERNI c.B. ERB

R.M. LEVICH R.C. SMITH

How should we determine the pricing of emerging-market bank loans and

The history of emerging markets:

1. Can debt crises be prevented?*

Table 1. Debt/GDP percentages for selected countries

1990 1991 1992 1993 1994

Mexico 55.2 45.8 35.1 35.0 37.4

OVERVIEW OF THE MEXICAN FINANCIAL CRISIS

What went wrong in Mexico in 1994 was a combination of an unprecedented

Figure 1. Foreign investment in Mexico.

MONETARY POLICY AND THE LOSS OF RESERVES

Figure 2. Mexican international reserves. December 1993-December 1994" .

significant interventions in the peso/dollar markets only during six, relatively

MONEY SUPPlY (M1)

enterprises; Banco Nacional de Comercio Exterior (BANCOMEXT), which

DEBT MANAGEMENT AND THE DEBT CRISIS

Table 2. Outstanding domestic government debt in Mexico 1994 (billion $US)*

Month Cetes Tesobonos Bondes Ajustabonos Total

January 24.07 2.43 5.22 10.82 42.54

dollars at 9:30 am on Tuesdays. An 11:00 am fix of the peso--dollar exchange

I.4EXICAN 91 CAY TESOSONC>S / ..... - - - / -

Figure 5. Interest rates Mexican-US Government bonds. December 1993-December 1994.

Table 3. Average maturity of domestic government debt in Mexico 1994 (days)

Month Cetes Tesobonos Bondes Ajustabonos Average*

January 161.1 72.5 317.6 740.8 322.7

Source: Secretaria de Hacienda y Credito Publico.

MODELING SELF-FULFILLING DEBT CRISES

Figure 6. Average maturity of the debt and the crisis zone.

AN INTERNATIONAL LENDER OF LAST RESORT?

Ct + kt+ 1 - k t :$; (1 - (J}(IX,f(k t ) - (jk t )

differentiable, concave, and monotonically increasing production function. Each

price of this debt is ql = O. This unwillingness to buy government debt creates

new debt, it chooses to default. If 'I

Concept of equilibria and central results

Cr = c(sr' k t , B 1 + 1 , gr, Zt)

kr+ 1 = k'(sr, kr' Br+ I, gr, Zt}

The .consumer's investment policy determines the evolution of the aggregate

K t +1 = k'(st, K t , B t +1,gt, Zt),

q(St, Bt+ d = PEz(St+ 1, B'(St+d, q(St+ 1, B'(St+1))),

(1 - lJ)(rxf'(kd) - <5) = liP - 1

[en + v(9(f(kn) - Jkn) - (1 - P)B)]/( 1 - p)

~ ed(kn) + v(9(rxf(kn) - Jkn) + PB)

en + v(9(f(kn) - bkn) - B) + PEen + v(9(f(k n) - bk"))]/( 1 - P)

(1- 9)[( 1 -1t + 1trx)f'(k") - b] = liP - 1

e" = (1 - 9)(f(k") - Jk").

Optimal government behavior is not necessarily stationary, however. In particu-

A calibrated model and a lender of last resort

Cole and Kehoe (1996b) present a model designed to capture, in a stylized

(Banco de Mexico 1995, p.206, reports a ratio of 0.22 in Mexico in 1994).

8(f(kn) - bkn) - (1- P) = 8(f(kn) - bkn) - B + D