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

1. The Asian Bet Campbell R. Harvey Duke University and NBER Andrew H. Roper Duke University

2. Crisis, Emerging Markets, and Risk 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) "The Asian Bet" by Campbell R. Harvey and Andrew H. Roper

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

4. Crisis, Emerging Markets, and Risk Crises are “worst case” scenarios for foreign investors. • Increased political 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. • Increased currency risk 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. • Increased financial risk 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 Asian Bet" by Campbell R. Harvey and Andrew H. Roper

5. The Signs on the WallEarly “Indications” of the Crisis to Come Hanbo 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) "The Asian Bet" by Campbell R. Harvey and Andrew H. Roper

6. 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 • Asset price bubble • Foreign speculators • Micro (firm level) analysis "The Asian Bet" by Campbell R. Harvey and Andrew H. Roper

7. Stock Market Return PerformanceSetting 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. "The Asian Bet" by Campbell R. Harvey and Andrew H. Roper

8. Foreign Equity InvestmentNet Purchases of Foreign Equity by US Investors Taiwan experiences $283 million capital outflow. "The Asian Bet" by Campbell R. Harvey and Andrew H. Roper

9. Micro Level Stylized Facts As the 1990s progressed . . . • Asian corporations experienced a decline in performance. • Asian corporate managers increased the leverage of their firms. • Asian corporate managers borrowed substantially from international capital markets in foreign currencies (US Dollars). "The Asian Bet" by Campbell R. Harvey and Andrew H. Roper

10. Trends in Corporate ProfitabilityCountry Comparisons "The Asian Bet" by Campbell R. Harvey and Andrew H. Roper

11. Trends in Corporate Leverage RatiosCountry Comparisons Rating Ratio AAA 13.4 AA 21.9 A 32.7 BBB 43.4 BB 53.9 B 65.9 "The Asian Bet" by Campbell R. Harvey and Andrew H. Roper

12. Trends in Corporate Coverage RatiosCountry Comparisons Rating Ratio AAA 20.3 AA 14.94 A 8.51 BBB 6.03 BB 3.63 B 2.27 "The Asian Bet" by Campbell R. Harvey and Andrew H. Roper

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

14. Trends in External FinancingInternational Bond Offerings from East Asia "The Asian Bet" by Campbell R. Harvey and Andrew H. Roper

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

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

17. Value at Risk: Illiquid Firms "The Asian Bet" by Campbell R. Harvey and Andrew H. Roper

18. Value at Risk: Insolvent Firms "The Asian Bet" by Campbell R. Harvey and Andrew H. Roper

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