What Does Credit Crisis Mean?
A crisis that occurs when several financial institutions issue or are sold high-risk loans that start to default. As borrowers default on their loans, the financial institutions that issued the loans stop receiving payments. This is followed by a period in which financial institutions redefine the riskiness of borrowers, making it difficult for debtors to find creditors.
Investopedia explains Credit Crisis
In the case of a credit crisis, banks either do not charge enough interest on loans or pay too much for the securitized loan, or the rating system does not rate the risk of the loans correctly. A crisis occurs when several factors combine in the marketplace, affecting a large number of investors.
For example, banks will charge teaser rates on loans, but when the initial low payments change, they become too high for borrowers to pay. The borrowers default on the loans, and the loan’s collateral value simultaneously drops. If enough lending institutions reduce the number of new loans issued, the economy will slow down, making it even harder for other borrowers to pay their loans.
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Nov. 27, 2009, 1:41 p.m. EST
Emerging markets become more costly
Governments impose investment regulations to thwart speculation
By Carla Mozee, MarketWatch
LOS ANGELES (MarketWatch) — Emerging-markets stocks and bonds have posted stunning returns this year, but foreign investors’ access may be limited and more expensive as some governments impose taxes, restrictions and even outright bans on transactions to curb speculative activity.
The surging value of emerging-market currencies is the root of the problem. Government controls are designed to regulate, discourage or halt capital flows in an effort to counteract investments that can undermine a country’s exchange rate or foreign-exchange reserves.
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Brazil, China and Taiwan, for instance, have already put capital controls in place while officials in several other countries have hinted at similar moves.
Investors in countries with capital controls are finding it more costly to own shares. For example, in response to one of the two taxes Brazil recently levied on trading activity, Vanguard Group Inc. doubled the purchase fee for its emerging-markets mutual funds, including Emerging Markets Stock Index Fund (FUND:VEIEX) , to 0.50% from 0.25%.
“As long as emerging markets rally, the more countries will succumb” to imposing limits, said Win Thin, senior currency strategist at Brown Brothers Harriman.
Investor interest in emerging markets remains strong, he added. “But if they start really punishing foreign investors, [investors] are going to think twice. It’s very easy to lose market confidence and very difficult to get it back.”
Commands and controls
Citigroup this week downgraded Colombia’s equity market to neutral from overweight, saying that after meeting with the country’s central bank, it has the “impression that capital controls could once again be imposed” to curb the appreciation of the Colombian peso. The peso is up about 14% against the U.S. dollar so far this year.
In China, the foreign exchange regulator tightened rules on cross-border money transfers by individuals, bolstering efforts to quell inflows of funds on speculation the yuan is undervalued. Read about China’s new rule on money transfers.
Brazil, whose currency has jumped 35% so far this year, recently slapped a 2% tax on foreign purchases of Brazilian stocks and bonds. It also levied a 1.5% tax on purchases of U.S.-listed shares of Brazilian companies, which include heavyweights Petroleo Brasileiro (NYSE:PBR) and mining giant Vale (NYSE:VALE) .
There are also “rumblings” from Russia, Thin said. The ruble is up about 28% as its economy remains in recession but is flashing signs of recovery.
The appreciation in the currencies and securities markets have been fueled by bets that emerging markets, particularly commodity-rich countries, will pace global economic recovery.
“It’s cheap to fund in dollars right now and investors are looking for opportunities to put that money to work,” said Norberto Zaeit, head of treasuries and trading at Espirito Santo Investments in New York. “They see emerging markets, especially those that have done a good job lately on monetary policy, on fiscal discipline, and curbing inflation,” as good places to invest, he said.
But as values climb, governments become concerned that such activity will eventually hurt their economies, in large part by making their exports more expensive.
Also, “there’s concern that sudden [currency] appreciation might increase imports, which damages current accounts,” Zaeit said.
Even countries whose currencies haven’t posted double-digit gains are taking action. Taiwanese officials earlier this month banned foreign investors from putting money in a certain type of deposit account. The New Taiwan Dollar is up about 8% since hitting a five-year low in February, but is just up 2% for the year. Read more about Taiwan’s restriction.
Kazakhstan, whose currency has declined 19% against the greenback, has said it may impose a tax on short-term foreign investments.
Investors in emerging-market stock and bond funds will be the most affected by capital controls, particularly if they take the form of Brazil’s 2% tax, said Bradley Kay, an analyst covering exchange-traded funds at investment researcher Morningstar Inc.
“That’s generally going to cause larger bid/ask spreads, especially if you’re talking about creation in new shares. That’s something which you’re going to need a bigger incentive to overcome the tax to buy in,” said Kay.
The implementation of capital controls won’t particularly affect fees for ETFs because there’s no entry fee, Kay said. Investors pay a commission and trading firms, major investment banks and brokerages take those out of the premiums when they are creating new shares.
For example, iShares MSCI Brazil Index (NYSE:EWZ) is trading at “a very slight” premium of 1.2%. “So [investors] are not paying up the full cost of the 2% entry, but they are paying as part of it. There does seem to be a net inflow right now,” Kay said.
Brazil funds during the week of Nov. 6 saw their first outflows in eight weeks, but then booked inflows the following week, according to EPFR Global, a provider of international fund flow data. Brazil funds had absorbed $3.39 billion this year through October.
Brazil’s Bovespa equity index has shot up 79% in local currency terms and almost doubled in U.S. dollar terms since the end of last year.
Investors seeking an ETF alternative to Vanguard’s Emerging Markets Stocks Index Fund can buy its Emerging Markets Stock ETF (NYSE:VWO) .
Meanwhile, Colombia’s IGBC General equity index has nearly doubled this year. Capital controls, if imposed, would hurt the market “as it effectively raises the required rate of return, or hurdle rate, for most foreign investors,” wrote Geoffrey Dennis, global emerging markets strategist at Citigroup, in a note to clients following a research trip to Colombia, Chile and Peru.
Impact on investors
In his report, Dennis reminded investors that it wouldn’t be the first time that Colombia has imposed capital controls. All foreign inflows between May 2007 and September 2008 were subjected to a 0% interest, six-month deposit requirement at the central bank.
Brazil, in March of last year, issued a 1.5% tax on fixed-income inflows to cool the real’s surge. That tax was later dropped as the global financial crisis deepened.
Levying taxes is just one of many tools to implement capital controls, said Alfredo Coutino, director of Latin American research at Moody’s Economy.com. Governments can also establish savings funds of sovereign wealth funds to keep companies from bringing back U.S. dollars, for example, into their respective countries.
The worst capital controls that foreign investors can face, Coutino said, “is tax on capital, because that represents a punishment of foreign investors by the government.”
In contrast, he added, “The most acceptable measure is that the central bank accumulates more reserves. You can go to the country, you can put your dollars in the country.”
Espirito Santo’s Zaeit said periods of negative investor reaction will likely occur in the short-run in the wake of Brazil’s taxation efforts. But from the standpoint of a medium- to long-term investor, “the 2% tax is not going to hurt as much,” considering the growth prospects for Latin America’s largest economy.
Investors should keep tabs on emerging markets that impose capital controls, paying close attention to the rules imposed and how long the restrictions might last, said Bill Rocco, a senior fund analyst at Morningstar. He added: “The devil is in the details.”