Playing with Fire

• Author: Randall Dodd
• Position: Senior Financial Sector Expert in the IMF’s Monetary and Capital Markets Department
• Pages: 40-42

Page 40

Firms across the spectrum of emerging markets entered into exotic derivative contracts that caused massive losses

THE NAMES sound as if they were toys or children’s stories—KIKO in Korea, TARN in Brazil and other countries. But they are part of a business model based on the use—or misuse—of exotic derivatives whose results are anything but imaginary. Transactions in these derivatives have resulted in massive losses that fueled currency market panics and helped transmit the financial crisis to emerging markets. The very real consequences led the head of Poland’s business roundtable to call them a “product from hell.”

The first reported losses were at private firms in the tradable goods sector. Most of the firms were exporters that appeared to be using the derivatives to hedge against ill effects if their domestic currency were to appreciate. But when the currencies depreciated instead and the losses were disclosed, foreign exchange markets reeled as the firms had to scramble and sell local currency for dollars to cover their losses. The direct losses have been deep and wide. An estimated 50,000 firms in the emerging market world have been affected. This includes 10 percent of Indonesia’s exporters and 571 of Korea’s small and medium-size exporters. Losses in Brazil are estimated at $28 billion, in Indonesia at $3 billion, and in Mexico and Poland at $5 billion each. Not all the losses are private. Sri Lanka’s publicly owned Ceylon Petroleum Company lost $600 million, and China’s Citic Pacific suffered $2.4 billion in losses.

The phenomenon appears to be widespread. Losses were also reported by exporters and other firms in Hong Kong SAR, India, and Malaysia. Firms in Brazil and Mexico also suffered large losses (see “A Hedge, Not a Bet,” in this issue).

A subject of debate

Policymakers in many countries have been engaged in often acrimonious debates over how to deal with benignly named KIKOs and TARNs—and other exotic derivatives (see box).

There are two fundamental questions at the core of the debate: Did the firms intend to hedge—that is, insulate themselves from currency movements—or speculate? And did banks, acting as derivatives dealers, merely meet the needs of their clients or did they engage in deceptive trading practices?

It is nearly impossible to establish the mindset of customers or dealers. So the debate has created more heat than light. This article seeks to describe these derivatives, analyze their appropriateness for hedging and speculation, and suggest some policy measures to help prevent their misuse.

The public interest concern surrounding these exotic financial products arose because their impact on the respective emerging market economies was greater than the direct impact on the firms involved. Once the local currency began to depreciate sufficiently to generate big losses for KIKO or TARN investors, the reports of those losses roiled the local currency markets and amplified selling pressures...