Monday, March 10, 2003

My comments on World Bank's "Global Development Finance 2003"

Chapter 3. Coping with Weak Private Debt Flows. 

Argentina’s External Debt furnace was stoked over a long period of time by high ratings issued by the credit rating agencies who, when they awoke surprised by the resulting mountains of debt, speedily reversed themselves 180 degrees, putting new pressure on interest rates and reinforcing the tragedy of a self-fulfilling prophecies. 

Venezuela, even though during the last couple of years has had a very low public external debt, less than 30% of GDP, which it has been servicing, has in a continuum been brought down to a highly speculative CCC rating, and has probably no alternative except that of waiting for a de-rating, the day the credit agencies happen to discover that it no longer has any outstanding debt. 

We make these somewhat exaggerated examples so as to remark the fact that, in this otherwise very complete Global Development Finance 2003, there is no mention about the issue of the growing role of the Independent Credit Rating Agencies, and the systemic risks that might so be induced, when they are called to intervene and direct more and more the world’s capital flows

It is not a small issue. Today many insurance companies and pension funds are already limited by the credit ratings for their investments and, for banks, we are only told things will get worse. 

For instance, Basel II, page 47, states “risk weights would be set for a bank’s exposure to sovereigns, corporations, and other banks based on ratings from major credit-rating agencies… the new methods of assessing the minimum-capital requirement is expected to have important implications for emerging-market economies, principally because capital charges for credit risks will be explicitly linked to indicators of credit quality… the regulatory capital requirements would be significantly higher in the case of non-investment grade emerging borrowers than under Basel I", plus finally “The current proposal places project loans in a higher risk category than corporate loans”. 

The sole fact that emerging countries, when affected by lower credit ratings, face additional difficulties to access investors with availability of long term financing, forces them into more short term arrangements which, compounded by the much higher rates charged, almost guarantee a crisis, once the snowball starts rolling. 

Chapter 3 dedicates six full pages to the interesting issue of the search for better crisis management, especially the problems surrounding sovereign debt restructuring. We commend this discussion as we agree with the statement that “Debt crisis have severe implications for the poor, who had no role in making decisions on borrowing” but, this only highlights the importance of carefully identifying, reviewing and correcting the factors that might lead to a crisis. 

We would also like to make a comment with respect to “Bank retrenchment in context”, page 45. It is said that “The significant presence of BIS-area deposit taking institutions is one of the most important ways in which the poorest developing countries” and that their presence “should improve the efficiency of the local financial intermediation system” but then, on page 47, Basle II, we read that “If, as expected, most domestically owned banks in emerging market economies adopt the standardized approach to credit risk, they will be at a comparative disadvantage vis-à-vis cross border lending by international banks when attempting to lend to high quality domestic borrowers”. There is a clear conflict between those two statements inasmuch the “comparative disadvantage” might justly be interpreted only as a disadvantage unfairly decreed by Basle, something which relates poorly to improving the efficiency of the local market. 

With respect to Basle, we would also like to point out that the document does not analyze at all a very fundamental risk for the whole issue of Development Finance, being it that the whole regulatory framework coming out of the BCBS might possibly put a lid on development finance, as a result of being more biased in favor of safety of deposits as compared to the need for growth. Even though, in theory, we could agree that there should be no conflict between safety and growth, in practice there might very well be, most specially when the approach taken is by substituting the market with a few fallible credit rating agencies. 

We would also like to comment with respect to credit derivatives. This market for credit risk transfer, that between 1997 and 2002 has “expanded more than ten-fold… reaching $ 2 trillion in outstanding notional value, expected to increase to US$ 4.8 trillion by end of 2004” and “yet the use of credit derivatives to manage risk is still only about 2 percent of their use in managing interest rate and currency risk” carries its own very clear and present danger of blindfolding the market as to where the real risks are truly allocated. Recently, and in relation to the losses from energy trading and their related derivatives, there have been reports that markets are still unsure on where the losses are finally going to surface… and be paid for. 

As the financial sector grows ever more sophisticated, making it less and less transparent and more difficult to understand for ordinary human beings, like EDs, it is of extreme importance that the World Bank remains prudently skeptical and vigilant, and not be carried away by the glamour of sophistication. In this particular sense, we truly believe that the World Bank has a role to play that is much more important than providing knowledge per-se and that is the role of looking on how to supply the wisdom-of-last-resort.