A financial crisis that occurs far away may give senior managers a false sense of security; after all, the crisis happened in another country. Yet, one of the stark realities of a rapidly globalizing world is that you can run, but you cannot hide. When a financial crisis hits one country, it can complicate busi- ness strategy, operations, and financial results for companies around the world—even those without operations in the crisis country.
Consider the aftermath of the Russian crisis. In August 1998, the Russian government unilaterally restructured payments on its Gosudarstvennye
Kaznacheyskie Obiazatelstva (GKO) bonds, essentially going into default.
This move spread panic in bond markets throughout the world, as investors who faced big losses in Russia sought to dump other risky investments.
Interest rates in all types of bonds—emerging market bonds, corporate bonds, government bonds—jumped in response (Figure 2.8). Rates on emerging market index bonds jumped by more than 500 basis points. Prior to the Russian default, Brazil for example paid roughly 6 percent on its gov- ernment bonds. Just after the crisis, however, that yield soared to more than 18 percent. Even some issues of the venerable U.S. Treasury bond—which is widely considered the safest bond in the world—saw demand dry up.
Price volatility after the Russian default spilled over into corporate bond markets as well. Companies with lower credit ratings saw their inter- est rates soar by 500 basis points or more. For many borrowers, credit was unavailable at any price. New emerging market bond issues fell from $17 billion for the month of April 1998, four months before the crisis, to less than $0.5 billion in August 1998, the month of the Russian default.12U.S.
corporate high-yield bond issues fell by more than half, from $54.3 billion to $17.6 billion. Companies and borrowers of all stripes—whether or not they had anything to do with Russia itself—saw their cost of debt skyrocket.
Stock markets were affected too, as investors shied away from risk.
Although earlier financial crises caused some repricing of risk outside the crisis country, the size and breadth of the market response to the Russian crisis are new phenomena. The Mexican crisis in 1994–1995, for example,
default default Percentage points
Emerging Market Index Argentina
Russia Brazil
Philippines Thailand Korea 1%
4%
7%
10%
13%
16%
19%
M A M J J A S O N D J F
RISK SPREADS INCREASE GLOBALLY AFTER RUSSIAN DEFAULT spread over 10- year U.S. Treasury Index
Russian Russian
1998 1999
Government bond
Source: IMF; Bloomberg; McKinsey analysis
FIGURE 2.8 Risk spreads increase globally after Russian default.
caused a repricing of risk only within Latin America. Other emerging mar- kets, such as those in Asia, were not affected. The Asian crisis of 1997 caused more widespread repricing of risk, but its effect was still limited to emerging market borrowers. Neither developed country government debt nor corporate debt was affected.
What was different about the Russian crisis that caused such widespread ripple effects? The answer has little to do with Russia, and everything to do with how international financial markets operate. In extremely risky invest- ments like Russian GKOs, there were relatively few investors interested.
Pension funds, for instance, are typically restricted from holding much in noninvestment-grade assets. When there are only a few large investors, their actions can more easily reinforce one another and have repercussions in markets around the world. What happened in the aftermath of the Russian crisis was not an anomaly and could well happen again.
Consider a hedge fund that had bought Russian bonds and used them as collateral to borrow funds to invest in mortgage-backed securities. After the Russian default, the value of its collateral fell and its bank would have called for more cash to be put into its margin account. The hedge fund might have unwound some of the mortgage-backed securities trades, depressing prices in that market. That act alone may not have been enough. So it would have unloaded other securities it was holding, lowering prices in those markets as well. This is exactly what would have happened, until investors with no connection to Russia suddenly discovered that the price of their investments was plunging.
Clearly, the opportunity cost of lost growth from a financial crisis is higher in a world in which distant markets can be affected.
Companies can also be exposed increasingly to crisis risk through the impact on their operations abroad. A financial crisis that puts one player out of business can have serious repercussions across the value chain to suppli- ers and customers around the world. Daewoo, for example, was a major car producer in Poland. When Daewoo went bankrupt after the Korean crisis began, it hit Polish workers and managers hard—so hard, in fact, that one of Daewoo’s Polish subsidiaries, DMP, filed for bankruptcy in September 2001, and the other, FSO, is still facing financial difficulties in 2002.
Daewoo’s bankruptcy illustrates another hard truth about globaliza- tion: Bankruptcy workouts—and resolution of financial crises—become far more complex. Daewoo had over 240 banks and major creditors from over ten different countries involved in the workout negotiations—and many had different sets of bankruptcy law. Sorting out the repayment of Argentina’s massive $150 billion default, on the other hand, will entail potentially even more creditors, although most of its bonds were written under New York law, which will simplify matters. In past crises, such as the U.S. S&L crisis or the Swedish crisis, most of the participants in workouts were from the
affected country and just one set of laws applied. In the patchwork global capital market of today, no such set of uniform standards exists. We believe this is a critical issue, which we address in Chapters 8 and 9.
Consider the fallout from the latest financial crisis in Turkey. Beginning in November 2000, there has been a growing crisis of confidence in the Turkish financial system after the failure of Demirbank—the ninth largest private bank in Turkey—sparked fears of a more widespread, and unde- clared, nonperforming loan problem. As the Economist Intelligence Unit reported in 2000: “As in the Japanese banking sector, there is a great fear of revealing the true extent of the rot. There are rumors of up to twenty more banks in serious trouble.”13 Over the next year, bank failures continued, the lira plunged to a new low against the dollar, while inflation climbed to three-digit levels. Yet, companies halfway around the globe were affected.
Procter & Gamble in Cincinnati, Ohio, was forced to issue a profit warn- ing and watch its stock price fall 5.2 percent in one day (Turkey was P&G’s twelfth largest market). Akso Nobel, the large Dutch pharmaceutical and chemical company, watched its first quarter 2001 earnings drop by 11 percent.
In a globalizing world, no one is immune to financial crises, and events in one corner of the world have far-reaching effects. Thus, strong ripples in the private sector are transmitted throughout the entire global economy. As we write this book, most financial observers and many managers on the front lines are worried about events not only in diverse countries such as Turkey and Japan, but also China, which agreed in 2001 to liberalize its financial system and economy as a condition of its World Trade Organization (WTO) membership. Moreover, you do not have to be in the front lines to be at risk;
even a company’s retirement plans (e.g., 401(k) retirement plans in the United States) are likely to be affected by financial crises overseas.