Campbell R. Harvey Duke University and NBER Andrew H. Roper Duke University

Campbell R. Harvey

Duke University and NBER

Andrew H. Roper

Duke University

"The Asian Bet" by Campbell R. Harvey and Andrew H. Roper

Emerging markets can provide substantial returns to foreign investors. However, emerging markets also introduce investors to new sources of economy/region wide risks not present in more developed markets.

•Latin Debt Crisis (1980)•Mexican Peso Crisis (1994)

•Asian Crisis (1997)

•Russian Ruble Crisis (1998)•Brazilian Real Crisis (1999)

Crisis, Emerging Markets, and Risk



In order to understand the risk of investing in emerging markets, we must understand these crises.

•What were the causes (indicators) of the crisis?

•What were the remedies (resolutions) of the crisis?

Both involve risks!

We will focus on the first.



Crises are “worst case” scenarios for foreign investors.

•Increased political risk

•Increased currency risk

•Increased financial risk

Crises tend to follow periods of political change and the resolution of crisis usually involves dramatic changes from the status quo policy. Capital controls, government appropriation of private corporates, and government led corporate restructuring are common place during the resolution of crises.

Crises are often accompanied or triggered by dramatic changes in exchange rates. Government’s often impose capital controls and/or strict guidelines on foreign exchange rate transactions during crises.

Crises lead to liquidity shortages as domestic financial institutions face large amounts of non-performing loans and foreign lenders reconsider the risk/return relationships in the region.


The Signs on the WallEarly “Indications” of the Crisis to

ComeHanbo Steel collapsed under large debt service obligations in Jan-97. The following month, Somprasong failed to meet its foreign debt obligations. “I don’t see any reason for the crisis to

develop further.” Managing Director of the IMF

(Jan-97)In May-97, the Thai government suspended operations of Finance One.

“We will never devalue the baht.”

Prime Minister of Thailand

(May-97) In June-97 Thailand suspended 16 cash strapped finance companies.

“We will never devalue the baht.”

Prime Minister of Thailand

(June-97)


Learning from the Past

Prescribing the causes of the crisis ex-post can be detrimental and uninformative. In order to not be trapped into a sense of false sense of security, we should seek instead to uncover characteristics which helped to promulgate the crisis.First, we look at the usual suspects.

•Macroeconomic imbalances

•Foreign speculators

•Asset price bubble

•Micro (firm level) analysis


Stock Market Return Performance

Setting the Record Straight

The return performance of East Asian stock markets varied across countries. However, during the 1990s the return performance throughout East Asia lagged behind the US market.

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n-90

Sep-

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Sep-

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May

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-95

Jan-

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-97

Jan-

98

Sep-

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Por

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io V

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( Ini

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)

Taiwan

Indonesia

Korea

Malaysia

Philippines

Thailand

USA

Thai BahtDevaluation


Jan-

95M

ar-9

5M

ay-9

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Jul-9

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Sep-

95N

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Jan-

96M

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Jul-9

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Sep-

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Jan-

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Jul-9

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Sep-

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ov-9

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Jan-

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ar-9

8M

ay-9

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Jul-9

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Sep-

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East Asia (Ex-Taiwan)

East Asia

-400

-200

0

200

400

600

800

1000

Net

US

Equ

ity

Inve

stm

ent

East Asia (Ex-Taiwan) East Asia

Foreign Equity InvestmentNet Purchases of Foreign Equity by US

Investors

Taiwan experiences $283 million capital outflow.


Micro Level Stylized Facts

As the 1990s progressed . . .

•Asian corporations experienced a decline in performance.

•Asian corporate managers borrowed substantially from international capital markets in foreign currencies (US Dollars).

•Asian corporate managers increased the leverage of their firms.


Trends in Corporate Profitability

Country Comparisons

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Ind

ones

ia

Kor

ea

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aysi

a

Phi

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Tai

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Tha

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d

Median ROIC Across Countries

19921996


Trends in Corporate Leverage RatiosCountry Comparisons

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Ind

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Kor

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Tai

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Median Leverage Across Countries

1992

1996

Rating Ratio

AAA 13.4

AA 21.9

A 32.7

BBB 43.4

BB 53.9

B 65.9


Trends in Corporate Coverage RatiosCountry Comparisons

0

12

3

4

56

7

89

10

Ind

ones

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Kor

ea

Mal

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a

Phi

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Tai

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Tha

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d

Median EBITDA by Interest Payable

1992

1996

Rating Ratio

AAA 20.3

AA 14.94

A 8.51

BBB 6.03

BB 3.63

B 2.27


Financial Risk of Foreign Debt

A firm’s leverage ratio encompasses all forms of debt, including foreign debt. When we think about the financial risk of debt, we need to consider both the maturity of the debt and the denomination of the debt.In general, Asian corporate borrowed short term and often times in dollar denominated issues.


Trends in External FinancingInternational Bond Offerings from East Asia

$0

$5,000

$10,000

$15,000

$20,000

$25,000

$30,000

$35,000

1990

1991

1992

1993

1994

1995

1996

1997

Dollar

Total


The Next Logical Step is Value at Risk

The substantial foreign exchange exposure of Asian corporation is difficult to quantify with standard methods. •For example, standard risk analysis would regress stock returns on the foreign exchange rate change. This statistical measure would suggest no significant exchange rate exposure.

However, a Value at Risk analysis could have uncovered potential weaknesses throughout the region prior to the crisis.


Value at Risk: The Next Logical Step

Harvey and Roper (1999) suggested this analysis. Their proposed exercise was simple.

Using detailed data on firm’s debt liabilities, we can stress test a firm’s coverage ratio under various interest rate and exchange rate scenarios.


Value at Risk: Illiquid Firms

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Sensitivity Analysis of Coverage Ratio

Both FX Shock Interest Rate Shock


Value at Risk: Insolvent Firms

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Tha

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Sensitivity Analysis of Coverage Ratio

Both FX Shock Interest Rate Shock


The Asian Bet

Asian corporate managers “bet” their firms when they increased leverage in the face of declining profitability. They raised the stakes by issuing foreign currency denominated debt.

We conclude . . .

Documents

Campbell R. Harvey Duke University and NBER Andrew H. Roper Duke University