High-stake poker game moving on to G-7?

The trillion-dollar-a-day trade in foreign currency has now come to bear no relationship to the real economy. The origins of this trade as a means to hedge against the risk of currency movements has gained a life of its own and has become gambling on a global scale. Hedge fund investors stand to gain the most and the resulting transfer of wealth from Asia will be observed in a few years. Having already made their profits from emerging markets, the speculators are now likely to move their game to the G-7 countries themselves.

by Chandra Hardy

The global market in foreign exchange is like no other market. There are global markets in all sorts of commodities - coffee, tin, copper, and gold, to name a few. The factors determining the demand and the supply of these commodities are known. The traders in these commodities are registered and there are rules governing the operations of these markets.

This is not the case in the global market for foreign exchange. There is no identifiable, centrally located market, no rules of operation, no registration, no data, no supervision and no regulation. The operation of the market for foreign currency also does not follow expected rules of demand and supply.

Money, the text books say, has three uses.

It is a unit of exchange: the prices of all goods and services are expressed in money. It is a store of value: all assets, pensions, and stocks are expressed in money. It is a medium of exchange: that is how business is transacted. The purchase of imports, the sales of exports, and making investments, are all expressed in money.

The market in foreign currency could be expected to grow with the growth of world output, trade and investment. But the volume of foreign exchange trading bears no relationship to the real economy. The trading in foreign currencies exceeds the value of world trade, output and investments by multiples of ten or more.

The Bank for International Settlements (BIS) which gathers information on the banks in the industrial countries carried out a survey in 1992 which produced an estimate of foreign currency trading of $800 billion a day.

In 1995, the IMF estimated that the transactions in the foreign exchange markets had quadrupled in a decade, and amounted to US$ 1,000 billion a day.

But in fact, no one knows the actual size of the foreign currency market.

Despite the much heralded merits of the advances in information technology, there is no public record of an international transaction which takes place through a computer and a commercial bank. The computers in the firms undertaking these transactions record them automatically. But at the end of the day, there is no compilation of the data. There are no governmental reporting requirements for foreign currency trading, no review of the trades nor any exercise of supervision and controls.

Many stock exchanges have put in place trigger mechanisms which will cause a temporary halt in trading in case of rapid declines. These mechanisms were introduced after a 10% decline in the US market in one day in 1987. But the trillion-dollar-a-day market in foreign currency which could destroy economies in the fastest growing region of the world is unfettered.

Gambling on a global scale

The market in foreign exchange had its origins as a means of hedging risks. An importer, buying equipment from Germany, for example, would want to hedge against the risk that the German mark would strengthen against the dollar so that by the time he takes delivery of the equipment, he would have to spend more dollars. An investor in Japanese securities would in the same way like some protection against a fall in the value of the yen against the dollar.

But the trading in foreign exchange which began as a means of insuring against the risk of currency movements gained a life of its own - independent of international flows of goods, services and investment.

If the transactions in the foreign currency market are not related to the growth of world output, trade, investment, employment, or inflation, what is it doing?

The foreign currency market has become gambling on a global scale.

Hedging is a form of gambling. Fund managers use sophisticated mathematical models for assessing risks but these models have to be fed with data which can only be guessed. The decision to trade is not made by scientific reasoning but by a hunch, and these can turn out to be wrong. The losses of the Barings Bank ($1,000 million) and the Japanese copper trader, also a billion dollars, are examples of gambling that lost. But foreign currency traders have discovered a near foolproof way of winning.

Understanding the foreign exchange market

To understand how the foreign exchange market operates, one needs to understand how a high-stake poker game is played.

A certain number of people are allowed to play and each must begin with a fixed amount of money. The player could be playing with his/her own savings or with the savings of someone else which has been entrusted to the player.

The game is played through several rounds until in the end all the savings are transferred to the winner. The other players know that on another occasion they will have a chance to take back their savings. Vast sums of money change hands in this game but the exchange has no impact on the GDP growth of the US, UK, China or the world. There is an exchange of savings (wealth) among the players.

But in order for one player to be a consistent winner, someone must lose. So neophytes are invited to join the game. These are people with more money than good sense. People who believe that they can play as well as the other players. They become consistent losers and wealth is transferred permanently from these players to the winners.

When George Soros, and the Quantum Fund which he manages, bet against the pound in 1992, the operations of his fund and the Bank of England could best be described as a high-stake poker game. They played several rounds and at each round, Soros raised the stakes. The Bank of England called (paid the bet) and the game went on for a few days or weeks. Finally, the Bank of England could not spend any more money to protect the value of the pound. The Bank of England folded and Soros won.

In this case, the parties were playing with other people's money. The losers were the taxpayers and people of England on whose behalf the Bank of England was playing, and the winners were the investors in the Quantum Fund. According to reports, the Quantum Fund made US$1 billion betting against the pound. In plain English, there was a transfer of income or wealth totalling $1 billion from the British people to the wealthy investors in the Quantum Fund.

Much attention is given to George Soros because the Quantum Fund is one of the largest and most publicized hedge funds; but in fact, there are many more operators of large funds in the foreign exchange market.

No Central Bank has at its disposal as much money as all hedge fund managers. This is a fast growing and highly competitive business.

Imbalances in global balance of payments

The source of the funds for global gambling is the large amount of dollars and other hard currencies (yen, D-marks, and Swiss franc) which are unaccounted for in the world balance of payments (where credits and debits should match, and the balance should be zero, but isn't). The Errors and Omissions in the global balance of payments have been over $100 billion per annum for more than 20 years. This amounts to $2 trillion in global savings which is unaccounted for and outside the control or supervision of the Central Banks of the major industrial countries.

The IMF carried out two investigations of the imbalances in the global balance of payments in 1987 and in 1992. The two studies concluded that a substantial part of the discrepancy in the global current account balance was due to discrepancies in the data on investment income. The imbalances have been the largest on investment income transactions, and they have been steadily increasing. In 1994, the unrecorded flows of investment income reached $124 billion.

"As the developing countries accounted for only 10% of the gross income flows recorded in 1994, the large discrepancy on the income account is presumably related to recording difficulties in the industrial countries," says the IMF (World Economic Outlook, October 1996).

The IMF report further indicated that the accumulated surplus or excess of recorded financial inflows registered over the 1977-94 period totalled $1.5 trillion.

In other words, developing countries were reporting capital inflows of $1.5 trillion over this period (to match current account deficits) but there were no corresponding outflows from the industrial countries to match the inflows! The discrepancy in the global current account balance has risen to $124 billion in 1996 and $138 billion in 1997.

There are several sources of this unrecorded wealth.

In the 1960s, the unofficial exports of the former Soviet Union were a source of offshore holdings of foreign currencies, and it is believed that the market in Euro-dollars was started by London bankers to put these assets of the former Soviet Union to work. Other sources are the sales of military equipment which are not recorded in the trade statistics, the sales of illegal drugs, capital flight and a wide variety of unrecorded exports.

The upshot of all this unreported financial information is that there exists a stock of financial assets totalling $2 trillion or more which earns its owners some $150 billion a year, and the management of this stock of wealth does not fall under the control of the Central Banks of any country. The IMF investigation also concluded that the discrepancy on investment income and non-bank capital flows was attributable to the international transactions of the offshore banks.

Transactions of offshore banks

Offshore banks are banks owned by financial institutions in developed and developing countries and registered offshore in places like the Bahamas and Cayman Islands. Offshore banks do not fall under the regulation of their countries of registration or the home countries of their owners.

Offshore banks are not like other banks. They are not places which are open for business. They are store-front or name-plate operations - a name in the front of a building, an office with a computer and a skeleton staff. The countries of registration receive fees and the appearance of being a financial center but nothing much goes on in an offshore banking location.

The transactions of offshore banks take place in the major financial centres and are routed by fax, phone or computer through these offshore banks. The Quantum Fund is registered in the Cayman Islands, but its employees show up for work in an office on Eighth Avenue in New York City. But since the Quantum Fund is registered in the Cayman Islands, it is not required to make reports to the Federal Reserve or to pay taxes on its earnings.

The Quantum Fund does not trade in US securities and residents of the US cannot invest directly in the Quantum Fund. A US resident can however, invest in a money market fund, either in the US or abroad, and the manager of that fund can put part of his portfolio into a hedge fund such as Quantum Fund. As indicated earlier, a gambler can play with his/her own funds or with someone else's savings.

In a poker game, there is a technique known as "buying the pot". But where players are of equal wealth or equal ability, the technique of buying the pot is not frequently used. But it is highly effective when one player is not such a good player or not so rich.

At each round of the game, bets are placed. The person interested in buying the pot places a very large bet. The weaker player thinks his hand is good ( read, the country's macro-economic fundamentals are strong). The weaker player meets the bet. Another round is played, and the stronger player doubles or triples the bet. The weaker player again meets the bet, but finds that his pile of chips is getting smaller. In the next round, he cannot meet the bet. (His banks do not extend further short-term loans, but in fact, are asking for payment on earlier loans). The weaker player folds. He may be holding three Aces over two pairs but the other player was able to "buy the pot" and wins.

Does this sound familiar? It should because this is exactly what happened to Malaysia, Indonesia and South Korea. The gamblers also had a go at the currencies of Hong Kong, Singapore and Taiwan but they moved off to easier targets.

Two important points

It is important to note two things.

First, the people who are gambling on the global foreign exchange market are now a great deal richer than they were in July 1997. The Prime Minister of Malaysia says that the immediate cost to the region was $300 billion. This is probably an estimate of the loss of reserves and the sale of assets to try and protect the value of the currency of a few countries. The transfer of wealth from Asia to the hedge fund investors is probably much higher. And Asia will also lose a great deal more in the coming years - from the decline in output and investment and the need to pay higher debt service.

The evidence of this transfer of wealth will be made public in a few years when the statistics released on the distribution of income in the world will show that the G7 countries, which have been growing at half the rate of East Asian economies, have increased their share of world output.

The transfer of wealth and income will be also be observed in the increasing concentration of wealth within the G7 countries. The Swiss papers reported on 27/28 November this year, that 100 residents made profits last year totalling $44 billion, and that 2% of the population account for half of the income of the country.

The second point that is worth noting is that the gambler has to gamble. The money made available to hedge fund operators was not put in their trust to finance trade and investment. It was placed originally to hedge against risks of foreign currency changes but now these funds produce higher returns than other types of funds. And as long as they can show the kinds of rates of return that they are producing, they will receive higher levels of funding. But in order to show profits, hedge funds have to keep gambling and they have to find losers even if they have to manufacture them.

The game in the emerging markets is almost over.

Other candidates for an attack

The next candidates for an attack of their currency in the developing countries are in Latin America. And there is India, Turkey and Russia. But the gains here are likely to be small.

The hedge fund operators have moved to stronger countries. South Korea is a high income country and Korea did not think that it was a weak player. Officials in South Korea said that they were not Thailand, Malaysia, Philippines or Indonesia. They were the world's eleventh largest economy with high savings and investment rates and GDP growth of 8% per annum for three decades. But if the foreign banks do not roll over short-term debt, and a country does not want to or cannot sell more assets, the currency is allowed to depreciate against the dollar.

An attack is underway in Japan. This is quite extraordinary because Japan is the fourth largest economy in the world and Japan has a huge current account surplus. Japan is also not a weak player. But being rich is not enough. The question is will Japan blink? Will Japan fold because officials think that the risks are too great, or because they think gambling is bad (now is not the time to think this) or because they hate the gamblers, or whatever?

Japan may fold like the Bank of England did. In which case there will really be a massive transfer of wealth from Asia to Europe and the US. If Japan does not blink, assets will have to be sold to get the dollars to halt the attack on the currency and to protect the banks which are being deliberately weakened. The selling of assets, including Japan's holdings of US government securities would, as they say in the US, be the start of a whole new ball game.

The likelihood of a fall in asset prices in the US, and a switch by other savers from dollars to other currencies would make a significant dent in the savings of the gamblers. They may back off from Japan as they did with Hong Kong, Singapore and Taiwan and go off to search for other sources of gain.

The high-stake game of foreign currency gambling has moved to the G7 countries. (Third World Economics No.176, 1-15 january 1998)

(SUNS/TWN Special Feature)

(Chandra Hardy is a former, retired, senior economist at the World Bank. The above is part of her forthcoming larger study on Capital Flows to Developing Countries being prepared for the South Centre.)