IMF's lost chance to rein in hedge funds

by Martin Khor

PENANG: After the bailout of Long-Term Capital Management (LTCM), there are news and rumours that several other hedge funds could now be in trouble and that this may pose a risk to global financial stability.

More than a year ago, Malaysia had raised the alarm and requested the IMF to review the role of hedge funds in the Asian crisis.

Due to the agency's bias for a financial free market, however, the IMF chief defended speculation last December and the IMF secretariat in April 1998 produced a weak report largely exonerating hedge funds.

It was a wasted opportunity to limit the funds' powers. As a result of non-action, the hedge funds have been able to continue their operations without any tighter regulations, and they are now implicated not only in the original Asian crisis but also in speculation in Hong Kong, Russia and now in the recent volatile turnaround in dollar-yen rates.

Central realities

The LTCM debacle brought to light many central realities at the heart of the global financial crisis.

One of these realities is that some hedge funds are very influential in swaying financial markets, as they specialize in intense speculation in various markets (in equity, bonds, currencies).

Their awesome power is derived from their ability to command very high leverage by borrowing up to twenty or forty times more than the value of their equity. For example, with capital of less than US$5 billion, LTCM was able to borrow up to US$200 billion.

Their command over huge financial resources enables hedge funds to have a tremendous advantage and sway over the markets. For example, they can attack currencies and stocks and cause them to depreciate sharply, more sharply than can be justified by economic fundamentals.

Indeed, hedge funds have the power to trigger financial crises that cause recession and depression of whole economies in the developing world.

Another reality is that the crash of even one highly- leveraged hedge fund has the potential to cause a meltdown of a financial system as large as that of the United States.

Finally, since hedge funds are owned by very rich and powerful individuals and institutions, their activities are guarded and defended by governments in their home countries. After all, the profits of the hedge funds' adventures in emerging markets have benefitted the rich countries (or at least the top crust of their elites).

And when these funds themselves suffer huge losses, these governments will rush to the rescue by organizing massive bailouts. Even though the same governments preach to others that bailouts of a collapsed company must be avoided at all costs, as a cardinal market principle.

For some time already, attempts to highlight the damaging role of hedge funds had been made by a few developing countries that became victims of hedge funds and other speculative institutions.

Malaysia was first off the mark as early as August 1997, when its premier Dr Mahathir Mohamad bluntly attacked hedge funds (in particular those related to George Soros) for triggering the currency collapses in Asia.

A few months ago, the Hong Kong authorities joined in, blaming hedge funds for manipulating the local currency and stock markets, and intervened massively to beat the speculators off. Hong Kong has now joined Malaysia in campaigning to rein in and regulate the hedge funds.

But the shouts of the victim Asian countries had been ignored, even ridiculed and dismissed as figments of the imagination of leaders seeking to blame foreigners for their countries' plight and thus deflect blame from themselves.

Today, in the wake of the LTCM debacle and mounting losses in other funds, the laughter and derision have come back full circle to haunt the hedge funds, their investors and creditors, and most of all the financial authorities of the US and other rich nations.

"Shorting" currencies

Hedge funds are a leading component of financial institutions that have speculated on the currencies of many countries. One of their main methods is to "short" a currency. Using its high leverage, the fund borrows many billions of dollars' worth of a local currency and then sells this local currency continuously in a bid to get the currency to fall drastically.

The central bank concerned, trying desperately to maintain its currency's level, usually has far fewer resources than a single well-leveraged hedge fund. It buys up its own currency that is being flooded in the market by the speculators and sells off its limited supply of US dollars and other foreign currencies.

Soon enough, its foreign reserves dwindle to danger levels. When the central bank is no longer able to support the local currency, it devalues sharply. The hedge fund now needs far less US dollars to repay the local currency it had borrowed, and thus it pockets a large amount in profit.

The Northern financial authorities and the IMF have denied the power and manipulative practices of hedge funds and their role in the Asian crisis.

When Dr Mahathir blamed currency speculators and hedge funds for sparking the crisis, he was derided for not understanding how financial markets work.

Malaysia persisted, and called on the IMF to do a review of the role of hedge funds in the crisis.

The IMF thus had to undertake a study. It could have taken this opportunity to draw lessons from Asia's experience with hedge funds and to take initiatives to curb manipulation, for example by proposing measures to curb the funds' high leverage.

Unfortunately, the IMF was quite clearly biased from the start, choosing to defend the role of speculators and to blame local banking practices instead for the crisis.

This bias was clear in December 1997 during a seminar in Kuala Lumpur organized by the ASEAN Business Council on "Financial Initiatives for the 21st Century", held in conjunction with the ASEAN Finance Ministers meeting.

The IMF Managing Director Michel Camdessus gave a morning lecture on the Asian crisis, calling on Asian countries to be more transparent and market-friendly, and to further liberalize financially by making their capital accounts fully convertible.

At question time, a participant posed the question why the IMF seemed to be denying that the crisis was caused by Asian countries having liberalized their financial system and currency trade too rapidly (under the IMF's advice), which had allowed speculators to take advantage by making profit by forcing sharp devaluations onto the Asian currencies. The questioner commented that the IMF should change its policies that asked Asian countries to have unregulated financial markets, fully open to inflows and outflows of funds and thus to speculation.

In reply, Camdessus said that in finding a balance between regulation and freedom, it was important to have the right analysis.

"This is why I was happy to be asked to study the role of hedge funds. This study will say that you must be careful in using heavily loaded words like 'speculation' and 'speculators'. Speculation is often only good management and prudence in using our savings."

He warned that when a government undertakes the wrong policies, "it should not complain about speculators. What is needed is not to curb your market but to have policies that are not exposed to speculation."

Speculators, he added, are there to make money, and if a country had sound policies it would not be affected.

Largely absolved

From this response, it could be clearly anticipated that the IMF study would largely exonerate hedge funds from any major contribution to the Asian crisis.

True enough, the IMF study, released in April and entitled "Hedge Funds and Financial Market Dynamics", down-played the role of hedge funds, or the risks they posed.

A main conclusion was that while hedge funds are large in absolute terms, they are dwarfed by other institutional investors (banks, pension funds, mutual funds) that engage in many of the same activities.

"This points against the conclusion that hedge funds play a singular role in precipitating crises."

This is one of the report's main points, that the capital of hedge funds is "small relative to the resources at the command of other institutional investors" and thus implicitly that these hedge funds cannot have a major role in crises.

This conclusion of course downplays the most important point, that some hedge funds have extremely high leverage, as exposed by the LTCM episode, which gives them tremendous resources far beyond their capital.

The report says hedge funds did have large positions against the Thai baht in mid-1997, but so did other investors, and most hedge funds were late in taking those positions. There is also scant evidence that hedge funds had equally large positions against other Asian currencies.

As the report points out, it is true that other institutions (commercial banks, investment banks, domestic investors) also played a significant speculative role in the crisis.

However, the role and profits of hedge funds were also very significant. According to a Business Week report of August 1997, in the first half of 1997 the hedge funds performed poorly. But in July (the month when the Thai baht went into crisis and when other currencies began to come under attack), they "rebounded with a vengeance" and most types of funds posted "sharp gains".

The magazine says that a key contributing factor for the hedge funds' excellent July performance was "the funds' speculative plays on the Thai baht and other struggling Asian currencies, such as the Malaysian ringgit and the Philippine peso."

As a whole, the hedge funds made only 10.3% net profits (after fees) on average for the period January to June 1997. But their average profit rate jumped to 19.1% for January-July 1997. The IMF report also says regulation of investment funds can be justified on three grounds: consumer protection, systemic risk and market integrity. It says "few regulators see a need for stricter regulation on the first two grounds".

However, as hedge funds can manipulate particular markets, "limited measures to strengthen supervision, regulation and transparency might be considered." To do this, it suggests that the reporting mechanisms in the US can be replicated in other countries to make hedge funds more transparent.

In the light of the LTCM debacle, these conclusions can be criticized as inadequate and misleading.

The threatened fall of one hedge fund alone, LTCM, had the potential to disrupt the US and global financial system, thus necessitating a Fed-organized bailout. Contrary to the report's conclusion, there is thus a dire need for regulation because of the risk posed by hedge funds of a financial-system collapse.

As for the US regulations to ensure market integrity being adequate and worthy of replication, the LTCM debacle has also clarified that the existing US laws and practice are inadequate, and thus hedge-fund crises have developed. There are now more strident calls for tighter regulation of hedge funds.

This episode shows that international financial institutions and Western financial authorities have been in a "denial syndrome" over hedge funds and their power via leverage, their manipulative role, and their potential for causing systemic damage.

Countries that have become their victims, like Malaysia and Hong Kong, have called for dismantling the power of these funds and limiting their capacity for mischief.

Even as public disillusionment grows with regard to the once-revered hedge funds, it is still too early to tell whether the Western financial authorities will move to clip the wings of these funds, or whether they will still be allowed to operate in and plunder the resources of countries around the world. (Third World Economics No. 195, 16-31 October 1998)

Martin Khor is the Director of Third World Network.