Institutional investors appear to have grown weary of emerging markets. While they understand the dramatic upside to these investments, they more likely appreciate the significant downside from their recent exposure during the crises of the 1990s. Investing in emerging markets tends to bring to mind these historic losses. If institutional investors are to feel more comfortable about emerging markets, they must better understand the crises.

The financial crisis in East Asia (1997-1998) serves as an excellent learning example. First, the crisis greatly changed institutional investors' perception of the region. As the wealth and relative incomes of these economies diminished, many investors reduced their holdings after the crisis and viewed future investment opportunities with extreme conservatism. Second, recent research by Harvey and Roper (1999) suggests that the risks could have been anticipated using simple techniques.

Our micro-level analysis of Asian financial markets reveals that Asian corporate managers increasingly leveraged their companies, despite their declining profitability. We refer to the higher leverage at a time of declining profitability as a "bet." Asian corporate managers raised the stakes of this bet, tapping into foreign debt markets to fund their investment projects. Adding U.S. dollar denominated debt to their liabilities not only increased the nominal leverage on their books, but also greatly increased the real leverage equity holders faced by introducing currency risk into the equation. History proves that Asian corporates lost both of these bets.

In support of our argument, our study shows that several firm level performance indicators deteriorated throughout the 1990s. For example, the median rate of return on equity (ROE) for Asian non-financial corporates fell steadily from 15% in 1992 to 12.5% in 1996. In the hardest hit economies, the deterioration was more pronounced. In 1992, the median ROE for Thailand corporates was 19.4%. By 1996, the median had fallen to 7.7%.

As firm performance declined, corporate managers continued investing at rates exceeding most other corporates in the world. This investment required capital, and Asian managers turned to local and international debt markets for funds. The change in leverage was most noticeable in Thailand. In 1992 the median leverage ratio across Thai firms was 68.6%. By 1996 the median firm's leverage ratio had almost doubled to 114%. This pattern was consistent throughout the region.

Assessing Risk
Increasing leverage and decreasing profits are key determinants of default risk. Moreover, much of the debt was denominated in U.S. dollars. This substantial foreign exchange exposure would have been difficult to quantify with standard methods. Attempts to estimate currency based betas would have misled investors, due to the stable exchange rate regimes leading up to the crisis. Moreover, risk should be measured with an eye towards the future. Clearly, any exchange rate realignment would have serious implications for default risk through the region.

We suggest a simple, yet effective tool to assess this risk. VaR analysis could have revealed the potential weaknesses of corporate balance sheets prior to the crisis. Stress testing interest coverage ratios under various exchange rate changes could have uncovered the significant amount of currency risk embedded in Asian corporate liabilities.

Where does this leave institutional investors? While our analysis is simple and computationally tractable, we understand that many institutional investors do not have the time or resources to conduct such studies. The most valuable lesson provided by our study is its fundamental concern with risk. Institutional investors should concern themselves with risk at every stage of the investment decision. In their dealings with the sales side, they should ask questions regarding the assumptions that led to the recommendations they receive. After all, anyone can provide a price target that suggests a buy recommendation. Institutional investors should routinely question the assumptions and introduce new questions as they seek investment advice.

Andrew Roper is a Doctoral student at the Fuqua School of Business at Duke University in North Carolina.