Corporate Performance in the East Asian Financial Crisis

The sharp decline in the once-stellar performance of East Asiancorporations following the 1997 financial crisis has sparkedan intense debate. Some observers argue that external shocks,including a drop in aggregate demand and a shortage of workingcapital, explain the corporate sector's poor performance. Othersassert that the difficulties were apparent well before the crisisand that the risky financial policies pursued by these firmsleft them vulnerable. A survey of the literature shows littlemicroeconomic evidence to support either view. This article compares the growth and financing patterns of EastAsian corporations in the years before the crisis with thosein other countries. It finds little microeconomic evidence thatcorporate growth was weakening but some support for the argumentthat many firms had a weak financial structure that left themvulnerable to an economic downturn. Based on a sample of morethan 850 publicly listed firms in the four crisis countries—Indonesia, Malaysia, the Republic of Korea, and Thailand and—andtwo comparators, Hong Kong (China) and Singapore, it appearsthat firm specific weaknesses already in existence before thecrisis were important factors in the deteriorating performanceof the corporate sector.      

INCOMPLETE MARKETS AND COMMODITY-LINKED FINANCE IN DEVELOPING COUNTRIES

This article provides a framework for appraising new financialinstruments and evaluating the extent to which they can helpalleviate problems of incomplete credit markets and contingentclaims markets in developing countries. Although the issuesinvolved apply to any new financial instrument, we give particularattention to commodity-linked securities because many developingcountries specialize in producing a handful of primary commoditiesand are therefore exposed to substantial commodity price risks.The article looks at the supply of, demand for, and pricingof commodity-linked securities and discusses some issues thataffect their use by developing countries: their special legalstatus as sovereign debt; their feasibility (since to becometruly effective they will require liquid secondary markets);and the construction of an optimal portfolio of external debtobligations. It also discusses the potential for new financialinstruments—particularly commodity-linked securities—asa tool for risk management in developing countries.      

REFORMING FINANCE IN TRANSITIONAL SOCIALIST ECONOMIES

Financial reforms initiated in most transitional socialist economiesdo not yet adequately provide many of the financial servicesassociated with market-oriented financial systems. Such services—mobilizingresources, selecting firms and allocating capital, monitoringfirm managers, and facilitating the management of transactionsand risk—are a necessary condition for economic reformto improve living standards. This article envisages four central strategies to guide reformof the financial sector: • Building an infrastructure based on clear and enforceableproperty rights, modern accounting and auditing standards, reliablepayments systems, sound prudential and enforcement regulations,and professionals trained in finance • Ending the shell game of trying to hide the losses ofstate-owned enterprises, and separating government decisionsto finance "priority" firms from the allocation decisions ofindependent financial institutions • Privatizing some financial institutions early—althoughnot necessarily precipitously—in concert with the privatizationof firms and supervisory capabilities, meanwhile cleaning upbank loans to maximize the chances that firms and banks willsucceed as private entities • Improving the tax system and stressing a prudent interestrate policy to reduce uncertainty, distortions, and excessiverepression of the financial sector.      

Crisis, Adjustment, and Reform in Thailand's Industrial Firms

New data on Thailand's industrial firms shed light on the originsof the East Asian financial crisis and on the response of themanufacturing sector to the structural adjust-ment program supportedby the international financial institutions. Before the crisis,Thai firms had declining profitability, but they neverthelessmaintained high levels of investment, often in domesticallyoriented areas (notably the auto sector). Thai firms financedthese investments with short-term borrowing from financial institutions,which in turn borrowed short term on foreign markets. That only40 percent of firms provided audited financial statements totheir banks meant that the financial sector had poor informationfor assessing the true riskiness of these investments. The financialstructure was thus vulnerable even to small shocks. How well did the adjustment program deal with the crisis? Thaifirms had difficulty increasing their exports quickly becauseof investment in the wrong sectors, a decline in regional demand,and bottlenecks that included red tape and poor customs administration.Because of the poor export response, the brunt of adjustmenthad to come through compression of demand and of imports. Inretrospect, the macroeconomic program— which assumed quickexport recovery— was too tight.      

Adjusting covariance matrix for risk management

The covariance matrix of asset returns can change drastically and generate huge losses in portfolio value under extreme conditions such as market interventions and financial crises. Estimation of the covariance matrix under a chaotic market is often a call to action in risk management. Nowadays, stress testing has become a standard procedure for many financial institutions to estimate the capital requirement for their portfolio holdings under various stress scenarios. A possible stress scenario is to adjust the covariance matrix to mimic the situation under an underlying stress event. It is reasonable that when some covariances are altered, other covariances should vary as well. Recently, Ng et al. proposed a unified approach to determine a proper correlation matrix which reflects the subjective views of correlations. However, this approach requires matrix vectorization and hence it is not computationally efficient for high dimensional matrices. Besides, it only adjusts correlations, but it is well known that high correlations often go together with high standard deviations during a crisis period. To address these limitations, we propose a Bayesian approach to covariance matrix adjustment by incorporating subjective views of covariances. Our approach is computationally efficient and can be applied to high dimensional matrices.     

Tight Money in a Post-Crisis Defense of the Exchange Rate: What Have We Learned?

Critics of the tight monetary policies pursued by some of thecountries hurt by the 1997 Asian financial crisis have questionedthe presumption that tight money can help sustain the valueof a currency. The issue is actually an empirical one becausetheory does not unambiguously predict the effect of tight moneyon the exchange rate under the circumstances faced by the crisiscountries. This article reviews the empirical research and showsthat the evidence does not yet support strong statements aboutpost-crisis links between monetary policy and the exchange rate.Proposed deviations from a sustainable medium-term monetarypolicy stance should thus be viewed with skepticism.      

Martingales and Portfolio Decisions: A User’s Guide

This article gives an overview and introduction to the Martingale approach to multi-period (dynamic) portfolio decisions. While Martingale pricing techniques have long been used with considerable success in the pricing of derivatives and financial assets in general, their potential to improve the practice of dynamic portfolio decisions is not sufficiently recognized yet. This article shows that the approach is, in principle, not difficult to implement for readers equipped with standard option replication techniques if markets are sufficiently “complete” in order to provide investors with the relevant information about the pricing of financial risks. The article provides a practical guide to implement the basic features of the approach in a binomial framework.     

Dynamic correlations and volatility linkages between stocks and sukuk: Evidence from international markets

An understanding of volatility and co-movements in financial markets is important for portfolio allocation and risk management practices. The current financial crisis caused a shrinkage in values of most assets, an increased volatility and a threat to the survival of several institutional investors. Managing risks and returns within the classic portfolio theory, when correlations across securities soar, is increasingly challenging. In this paper, we investigate the volatility behavior and the co-movements between sukuk and international stock indexes. Symmetric multivariate GARCH models with dynamic conditional correlations (DCC) were estimated under Student-t distribution. We provide evidence of high correlations between sukuk and US and EU stock markets, without finding the well-known flight to quality behavior affecting Islamic bonds. We also show that volatility linkages between sukuk and regional market indexes are higher during financial crisis. We argue that investors could obtain diversification benefits including sukuk in a well-diversified equity portfolio, given their lower volatility compared to equity. But higher volatility linkages and dynamic correlations during financial crises show that they are hybrid instruments between bonds and equity. Our findings are relevant for institutional investors and asset managers that include Islamic bonds in a diversified portfolio.     

FINANCIAL MARKETS, PUBLIC POLICY, AND THE EAST ASIAN MIRACLE

Many factors contributed to the rapid growth of the economiesof East Asia in the past quarter century. This article examinesone important aspect of that growth—commonly referredto as the "East Asian miracle"—public policies affectingthe financial markets. East Asian governments intervened extensivelyin financial markets at all stages of their development. Whatsets their actions apart from those of other developing countriesthat have not fared as well? We do not have the informationto answer conclusively what effect particular actions had (thatrequires a counterfactual test of what growth would have beenwithout the particular intervention). But we can identify themarket failures the East Asian governments addressed, assesssome of the theoretical reasons why each policy might be growthenhancing, and provide some data attesting to the impacts ofthe policy. Several characteristics of financial sector interventionsin East Asia stand out: they incorporated design features thatimproved the chances of success and reduced opportunities forabuse; interventions that did not work out were dropped unhesitatingly;and policies were adapted to reflect changing economic conditions.      

ALTERNATIVE FORMS OF EXTERNAL FINANCE: A SURVEY

For many developing countries, alternative forms of externalfinance—all forms of finance that are not guaranteed byor mediated through the public sector—have become increasinglyimportant as traditional financing to the public sector hasebbed. Yet a survey of the literature reveals few recent analyticalinsights about alternative financing, which includes foreigndirect investment, project lending, portfolio investment, closed-endequity funds, private nonguaranteed debt, licensing, joint ventures,quasi-equity contracts, and other forms of private, nonrecourselending to private borrowers. The literature offers little solidguidance for distinguishing between alternative and traditionalfinancing with respect to country risk, for establishing themost appropriate and efficient incentive structures and restrictionsin the host country, or for identifying the optimal financingmodes for international firms investing in developing countries.This gap in the analytical literature has important implicationsfor policy formulation. It is not always clear whether a countryis developing incentives and establishing safeguards (for ensuringadherence to project performance requirements) that are mosteffective in attracting alternative forms of finance.      

Contagion: Understanding How It Spreads

Much of the current debate on reforming the international financialarchitecture is aimed at reducing the risks of contagion—bestdefined as a significant increase in cross-market linkages aftera shock to an individual country (or group of countries). Thisdefinition highlights the importance of other links throughwhich shocks are normally transmitted, including trade and finance.During times of crisis, the ways in which shocks are transmitteddo seem to differ, and these differences appear to be important.Empirical work has helped to identify the types of links andother macroeconomic conditions that can make a country vulnerableto contagion during crisis periods, although less is known aboutthe importance of microeconomic considerations and institutionalfactors in propagating shocks. Empirical research has helpedto identify those countries that are at risk of contagion aswell as some, albeit quite general, policy interventions thatcan reduce risks.      

Asset Allocation and Selectivity of Asian Mutual Funds During Financial Crisis

This paper evaluates the ability of US-based Asian mutual fund managers in coping with the 1997 Asian financial crisis. We find that the actively managed mutual funds under-perform with respect to the market portfolio by 1.71% in average monthly return. Such poor performance is caused by fund managers' relative weakness in country selection as well as in stock picking. Fund managers are also found to be more skillful in picking the correct market when the market is going up than going down. Our results are consistent with the literature that asset allocation in Asian mutual funds is a dominating factor relative to selectivity in explaining fund returns during the financial crisis. In addition, there exists a negative relation between asset allocation ability and selectivity of fund managers.     

Taming animal spirits: risk management with behavioural factors

In several countries a major factor contributing to the current economic crisis was massive borrowing to fund investment projects on the basis of, in retrospect, grossly optimistic valuations. The purpose of this paper is to initiate an approach to project valuation and risk management in which ‘behavioural’ factors—Keynes’ ‘animal spirits’ or Greenspan’s ‘irrational exuberance’—can be explicitly included. An appropriate framework is risk-neutral valuation based on the use of the numéraire portfolio—the ‘benchmark’ approach advocated by Platen and Heath (A benchmark approach to quantitative finance. Springer, Berlin, 2006). In the paper, we start by discussing the ingredients of the problem: ‘animal spirits’, financial instability, market-consistent valuation, the numéraire portfolio and structural models of credit risk. We then study a project finance problem in which a bank lends money to an entrepreneur, collateralized by the value of the latter’s investment project. This contains all the components of our approach in a simple setting and illustrates what steps are required. In a final section, we briefly discuss the econometric problems that need to be solved next.     

Competition in the Financial Sector: Overview of Competition Policies

Competition in the financial sector, as in other sectors, mattersfor allocative, productive, and dynamic efficiency. Theory suggests,however, that unfettered competition is not necessarily bestgiven the special features of financial services. The authordiscusses these analytical complications before reviewing howto assess competition in the financial sector and its determinants.It is shown that competitiveness varies greatly across countries,in perhaps surprising ways, and that it is not driven by financialsystem concentration. Rather, systems with greater foreign entryand fewer entry and activity restrictions tend to be more competitive,confirming that contestability—the lack of barriers toentry and exit—determines effective competition. The authorthen analyzes how competition policy in the financial sectorhas generally been conducted and how changes in competitionin the financial services industries should affect competitionpolicy going forward. In part based on comparison with otherindustries, the author provides some suggestions on how competitionpolicy in the financial sector could be better approached aswell as what institutional arrangements best fit a modern viewof competition policy in the sector. The specific competitionchallenges for developing countries is also highlighted. Theauthor concludes that practices today fall far short of theneed for better competition policy in the financial sector. JEL codes: G10, G18, G28, L1, L5     

Equity portfolio diversification with high frequency data

Investors wishing to achieve a particular level of diversification may be misled on how many stocks to hold in a portfolio by assessing the portfolio risk at different data frequencies. High frequency intradaily data provide better estimates of volatility, which translate to more accurate assessment of portfolio risk. Using 5-min, daily and weekly data on S&P500 constituents for the period from 2003 to 2011, we find that for an average investor wishing to diversify away 85% (90%) of the risk, equally weighted portfolios of 7 (10) stocks will suffice, irrespective of the data frequency used or the time period considered. However, to assure investors of a desired level of diversification 90% of the time (in contrast to on average), using low frequency data results in an exaggerated number of stocks in a portfolio when compared with the recommendation based on 5-min data. This difference is magnified during periods when financial markets are in distress, as much as doubling during the 2007–2009 financial crisis.     

Dynamic Hedging Effectiveness in South Korean Index Futures and the Impact of the Asian Financial Crisis

This paper focuses on the impact of the 1997 Asian financial market crisis upon hedging effectiveness within the KOSPI 200 stock index and index futures markets. The paper utilizes the inter-temporal relationship between the two markets to examine the characteristics of several minimum variance hedge ratios. It also examines the performances of alternative hedging strategies for dynamic portfolio management in the presence of cointegrated time-varying risks. The results show a decline in the persistence of conditional volatility within market prices after the crisis. This decline leads to the relative performance of utilizing constant hedge ratios to increase, though not significantly so to guarantee a superior performance over more sophisticated time-varying hedge ratio strategies.     

Contagion in international financial markets: A recursive cointegration approach

This study utilizes the recursive cointegration technique to analyze the dynamic interdependence among ten major equity markets throughout North America, Europe, Latin America and Asia. Results indicate that the international equity markets are integrated and that the degree of integration among these markets has increased over time. A scrutiny of the various crisis periods reveals that a major financial crisis had an effect of increasing the level of convergence among these markets. Moreover, the recursive cointegration technique is able to pinpoint and capture the approximate timing of a major global crisis. In addition, the study finds that the U.S., Japan, India, China, U.K., and Germany lead the other markets with the U.S. contributing most heavily to the common trend. Overall, the results indicate that profitable opportunities from portfolio diversification are limited across major markets and that these benefits are further reduced during episodes that are marked by a global financial turmoil.     

Measuring systemic risk in the European banking sector: a copula CoVaR approach

We propose a new methodology based on copula functions to estimate CoVaR, the Value-at-Risk (VaR) of the financial system conditional on an institution being under financial distress. Our Copula CoVaR approach provides simple, closed-form expressions for various definitions of CoVaR for a broad range of copula families and allows the CoVaR of an institution to have time-varying exposure to its VaR. We extend this approach to estimate other ‘co-risk’ measures such as Conditional Expected Shortfall (CoES). We focus on a portfolio of large European banks and examine the existence of common market factors triggering systemic risk episodes. Further, we analyse the extent to which bank-specific characteristics such as size, leverage, and equity beta are associated with institutions' contribution to systemic risk and highlight the importance of liquidity risk at the outset of the financial crisis in summer 2007. Finally, we investigate the link between macroeconomy and systemic risk and find that changes in major macroeconomic variables can contribute significantly to systemic risk.     

<Emphasis Type="Italic">Shariah</Emphasis>-compliant equities: Empirical evaluation of performance in the European market during credit crunch

Islamic finance is based on the Islamic Jurisprudence as prescribed by the Shariah, and has witnessed significant growth and development in the recent decades. During the period of economic slowdown and following the financial crisis during FY 2007–2009, it was claimed that Islamic financial system seemed to be better in coping with economic slowdowns than conventional financial systems. The article analyses whether the same holds true for Shariah-compliant equities in the market, that is, whether Shariah-compliant equities perform better in the market as compared to the general market. Three portfolios are constructed based on the constituents of S&P Europe 350 to represent the overall market, the market without the financial firms and the market of Shariah-compliant equities. It is found that the portfolio of Shariah-compliant equities outperforms the other two portfolios in all aspects of analysis. However, it slightly underperforms the market portfolio when there is an upward growth trend in the economy. The findings of this article are very relevant for policymakers, investors and fund managers to determine policy matters, deciding on investment and marketing strategy for Islamic capital market products.     

Promoting Efficient Rural Financial Intermediation

Although governments have traditionally used subsidized creditprograms to promote agricultural growth, this approach has generallyfailed to improve incomes and alleviate poverty in rural areas.It has also led to the mistaken belief that rural credit programscannot be profitable. A new approach seeks to raise standardsof living in rural areas by casting the government in a veryd role—one of setting a favorable legal andpolicy environmentfor rural financial markets and addressing spec market failurescost effectively through well-designed and self-sustaining interventions.There is evidence that this approach can be highly successful.The Village Bank system of Bank Rakyat Indonesia has shown thatfinancial services can be extended to millions of low-incomerural clients without relying on subsidies. Indeed, the programhas generated enormous profits for the bank by using simple,innovative, and largely replicable techniques.