Global Trends by Martin Khor

Monday 12 March 2007

Behind the financial markets’ recent tremors

The recent tremors in world financial markets were caused by the huge trade involving speculative funds.  As long as they remain unregulated, more crises emerge.


Financial markets worldwide have experienced more than a ripple though less than an earthquake in the last fortnight, with a roller-coaster ride down and then up in a quick recovery.

Many reasons have been given for the sudden slide, ranging from rumours that China would raise its interest rate to the weakening state of the United States economy.

The most convincing explanation is that speculators that had borrowed Japanese yen cheaply (at very low interest rates) to invest in other countries whose currencies and assets fetch higher interest or returns were caught, when the Japanese yen appreciated sharply.

These speculators, many of them hedge funds and similarly “highly leveraged” funds, sought to get out of their yen commitments because they feared the yen would appreciate further, and it would be even more costly to repay their yen-denominated loans.

They had to sell shares and other assets they had invested in so that they could repay their yen loans.  Thus a shift out of one set of assets towards another set resulted in the sharp falls in stock markets in many countries.

Among the most incisive analyses of the fortnight’s events were the two articles by Malaysian financial analyst  J. Vong in The Star’s business section on 3 and 10 March.

Vong explained the workings of the “carry trade” in which highly leveraged equity funds borrow in one currency at low interest rates (Japan’s banks were lending at 0.5%) to invest in other currencies and assets where the return is higher.  Due to the high leverage (for example, the LTCM hedge fund could borrow 200 times more than its capital), these funds can make a lot of profits even if the difference between the rate in which they borrow and the rate of return on their investment is small.

With China coming under intense pressure from the US and rumours that it would raise its interest rate or impose curbs on capital flows, there was a sudden rush out of Chinese stocks to buy yen to clear the “carry trade” positions of these funds.

The resulting rise in the yen caused Japanese investors to worry that their industrial exports would become less competitive.  Thus there was a fall in both the Shanghai and the Japanese stock markets, which in turn had a downward effect on other markets in Asia, the US and Europe.

In the past week, the Japan’s central bank acted to stop (and to some extent reverse) the rise of the yen.  The hedge funds felt less need to repay their yen loans, and the financial markets recovered somewhat.

These recent events have highlighted the prevalence of speculative funds.  The “carry trade” alone is estimated to involve US$1 trillion outstanding in currency-to-equity and currency-to-currency swaps, according to Vong.

These funds are volatile and can switch from asset to asset, currency to currency and country to country in response to events and in anticipation of developments that may hit or help their positions and profits.  There is a “herd mentality” -- sudden shifts of perception by some market leaders can cause others to move in tandem, thus causing the capital movements to be sharp and large. 

The stampede for the exit triggered the Asian financial crisis in 1997, affecting first Thailand and then Indonesia, Korea, Malaysia and the Philippines.

Since the Asian crisis, the hedge fund industry has grown much larger. And it remains largely unregulated, despite occasional crises such as the collapse of the LTCM hedge fund which revealed the huge 200-to-one leverage.  With just over $3 billion capital, LTCM was able to raise US$200 billion in credit and take positions involving US1 trillion in various markets.

Some European leaders, particularly in Germany, have from time to time raised concerns about the power of hedge funds to destabilize the global market, and called for more transparency and regulation of their activities.

But there is resistance, especially from Wall Street and the US government, which do not want any regulation of their profitable financial trade.  This is supported by the US Treasury Secretary Hank Paulson, who previously headed the giant investment bank Goldman Sachs.

Kenneth Rogoff, former chief economist of the International Monetary Fund, is the latest high-profile analyst now advocating control of the hedge funds.  He recently warned that the funds’ Wild West mentality poses risks to the global financial system, where many firms make the same bet.

If they lose, a long string of bankruptcies may cut deeply into banking systems that profit by lending to the same hedge funds.  Rogoff criticizes the US no-regulation position as “telling investors to carry their own guns” because, as in the Wild West, there is no sheriff to help.   And he urges Germany as chair of the Group of 8 not to surrender on this issue, and to insist on regulation.

It is however unlikely that the Western countries will act on the hedge funds, even if only to require more transparency in their operations, until they are themselves hit by a major crisis caused by these funds.

During the Asian financial crisis, the Asean governments, led by Malaysia, asked the IMF to investigate the role of hedge funds in triggering the crisis.  The IMF initially reported that hedge funds played no role, a position so different from what its former Chief Economist now takes.

One reason given was that their capital was small compared to other institutions.  The IMF did not take into account the highly leveraged nature of these funds.

Malaysia then charged that the hedge funds had a leverage of 50 to one.  Even this alarming figure proved to be understated when the LTCM crisis revealed that this hedge fund had a 200 to one leverage.

It is still too early to conclude that the financial tremors of the past fortnight are over.  Even if they subside now, they can return, as the underlying system is now so unstable and volatile.  And like earthquakes, it is hard to predict where they may occur next, and with what degree of severity.