The recent weakness and volatility of financial markets here and abroad have been perplexing. Since the US economy has been growing fairly steadily, the markets, which had fallen in value by as much as 10 percent since February, evidently do not reflect the state of the economy. The recent increases in interest rates imposed by the Federal Reserve to prevent inflation have been criticized for threatening the economic recovery, especially since inflation has barely increased. In any case while the costs of some loans, particularly mortgages,have risen, they cannot possibly just by themselves have a large economic effect, even though sharp turns in the market are attributed to them. 1 The explanation for the shaky condition of the financial markets has to be found elsewhere.
Some clues to the recent weakness of the markets can be found in the international controversies of the last seven years or so. In October 1987, the US government publicly criticized Germany for maintaining what the US considered artificially high interest rates. Some investors feared that the longstanding German-American relationship was about to come apart and that this would have unfortunate consequences for financial stability generally. Two days later the Dow-Jones Industrial averages fell by over 500 points and the financial system itself seemed in danger. While other factors were undoubtedly involved in this collapse, the quarrel between the US and Germany appears to have been critical. What also soon became clear as well is that technical innovations such as “computerized program trading” and “portfolio insurance” could result in sudden sales of enormous numbers of shares and turn downward market pressures into panic.
In February 1994, the talks between the US and Japan, which were intended to resolve differences on trade issues, broke down acrimoniously. The international managers of the “hedge funds” that control the investment of hundreds of billions of dollars evidently feared that the US, in carrying out a policy of retaliation against Japan, might depress the value of the dollar to make US exports more attractive. The result was that speculative holdings of investments in foreign bonds and foreign currencies-particularly investments of traders who had bet against the yen-were sold, disrupting financial markets throughout the world. The abrupt decline in the bond markets caused a general rise in interest rates. While US markets were relatively unscathed, markets in East Asia and Latin America were harshly affected, and European bond markets were so weakened that some dealings in French government bonds were temporarily suspended. In Spain, Italy, and Scandinavia, sellers were unable to find buyers for relatively routine bond transactions for a few days. As in October 1987, there were more factors in play than just the breakdown of the US-Japanese talks-the recent tightening of interest rates by the Federal Reserve being perhaps the most important among them. But there seems to me no doubt that the event that set off tremors in financial markets was the quarrel between Japan and the US.
It is worth remembering these events as we assess President Clinton’s recent decision (which Isupport)to continue China’s most favored nation status. Political developments which were traditionally a matter of foreign policy have combined with the instability caused by speculation to pose enormous financial risks. Denying MFNstatus to China would undoubtedly have shaken financial markets that were already fragile. A further recent example was the reaction to the assassination in Mexico of presidential candidate LuisDonaldo Colosio. Only the immediate closing of the Mexican securities markets, combined with a much publicized grant of $6 billion credit to Mexico from the US Treasury, kept world markets from being seriously disrupted. Still, US securities markets moved sharply downward in reaction to the killing.
The “New World Order” that was once thought to follow the collapse of communism has turned out to be anything but orderly. The Europe envisaged in the Maastricht Treaty is still far in the future; the transition of the former Soviet countries to market economies and democracy may be even further off; North Korea flirts with nuclear weapons, the former Yugoslavia slides back into the Dark Ages, and the Middle East remains full of dangers. However, despite the threats and conflicts within different regions, one development has gone ahead relentlessly throughout the world: the growth of global capital markets. A genuine worldwide market in stocks, bonds, currencies, and other financial instruments has emerged, tied together by modern data-processing and communications technology, and operating twenty-four hours a day, seven days a week. The continued growth and stability of this market is vital for the growth of the developing world as well as for the Western countries. For the last fifty years, the Bretton Woods institutions, the World Bank and the IMF, have been directly involved in financing economic development in the emerging economies. This role will, more and more, be taken over by the global capital markets. The cold-blooded selection process by which world capital is invested will determine the economic progress of many developing countries.
Without rapid growth in the developing world, the West itself will be in great difficulty. The need for such growth has been little noticed, but it becomes clear when one considers how much demand for US exports depends on countries outside Europe, and other than Canada and Japan. During the past three years, exports to the other countries that make up the G-7-Japan, Germany, Canada, the UK, France, and Italy-have grown at an annual rate of only 0.6 percent. By contrast, shipments of US goods to the rest of the world have risen at a rate of 7.6 percent. 2 Although Europe and Japan are likely to recover eventually, the differences in the rate of growth are likely to continue.
The economist Henry S. Rowen recently published an article in The Wall Street Journal estimating growth rates between 1990 and 2020 in what he called “Rich Countries”-the G-7 and countries like Switzerland with comparable income levels-and the “Non-Rich Countries,” including, for example, India, China, Indonesia, and Russia. Rowen estimated that the output of the rich countries would grow from $13 to $24 trillion during the period for an average annual growth rate of less than 2 percent per year. The output of the “non-rich” countries is expected to grow from $9 trillion to $34 trillion over the same period; that is, at about 4.5 percent per year.
These estimated growth rates are hardly exact, but when considered along with other relevant data, such as the sources of demand for US exports, they clearly show that strong growth in the poorer parts of the world will be needed to sustain enough growth in the West to maintain adequate levels of employment and to enable Western governments to deal with their pressing social problems. It is also obvious that if added output of over $25 trillion is to be produced in the “non-rich” part of the world, huge amounts of capital will be required.
The projections of Rowen and others implicitly assume that the capital necessary to make them a reality will be available, but this is a large and arguable assumption. Investment in all developing countries, whether from domestic or foreign sources, averaged 25 percent of their GDP in 1992 and it is forecast to rise to 27 percent by 1998.3 But the public and private needs of a modernizing economy-particularly for infrastructure such as transportation and communications-are more and more dependent on the supply of capital, and the ratio of investment to GDP is therefore likely to rise. If we were to assume that the equivalent of 35 percent of the GDP of the “non-rich” nations would be invested between 1990 and 2020, then approximately $300 billion per year (or an aggregate of about $10 trillion) above the present levels would have to be invested in them to produce the expected growth in output.
This amount will have to come from a combination of foreign capital investment and domestic savings. According to OECD estimates, total private capital flows-including both investments and bank lending-to developing countries rose gradually from $45 billion in 1989 to $62 billion in 1991 before surging to $100 billion in 1992. This investment consists of purchases of stocks and bonds of local businesses (i.e., “portfolio investments”) as well as bank loans and other forms of direct investments in businesses and government agencies. The total is far below the $300 billion per year of additional investment which seems likely to be required and which would represent almost half the total annual savings by the US economy in 1993-about $700 billion.
Secretary Lloyd Bentsen’s recent estimate that, Japan apart, East Asian countries plan to spend $1 trillion on transport, communications, and other infrastructure alone during the next decade underlines the need for huge amounts of development capital. Obviously, if the capital is not available in appropriate amounts and at reasonable rates, these expectations for local investment will have to be cut back and, along with them, the related exports from Western countries.
When we consider the prospects of finding capital for foreign investment, it is worth remembering that the original Marshall Plan consisted of $16 billion, which was to be disbursed over a four year period; this is about $100 billion in today’s dollars or $25 billion per year. In view of the slow growth and budgetary constraints of Western countries, no combination of Western public and private investment can provide more than a fraction of the required amounts. However, if political conditions are sufficiently stable, liberal Western trade and investment policies could help China, India, and the other large developing countries to generate much of the needed capital from within their own economies. Thanks to recent developments in computer software and in manufacturing methods, it is now more possible than ever before for advanced countries to transfer technology to countries that have labor forces and management that can make use of it.
Therefore creating adequate domestic capital markets is an absolute necessity for developing countries, whether they take the form of local stock and bond markets, or local banks that can lend and invest, or other channels by which foreigners can confidently put money into enterprises and basic facilities such as telephone systems and utilities. Most of these countries have already set up such markets, or plan to do so, but on the whole they still are not reliable enough, or safe enough, to attract the amounts of long-term investment that are likely to be needed. If they can become more efficient and secure they will make it possible for the developing countries to tap much deeper into the global savings pool that is represented by the rest of the world’s capital markets. We have to hope that a global competition for capital will encourage the countries urgently in need of capital to make economic and political reforms, which in turn will mobilize domestic and foreign savings.
If they are to rely largely on investment of private capital, as they must, developing countries must meet three basic requirements: a growing economy, a stable currency, and receptive social and political institutions. Runaway inflation brought about economic collapse and Nazism in Germany after World War I. Spiraling inflation is still the biggest enemy of investments and stability today, as the events in Russia and Ukraine show. It has becomeincreasingly clear, moreover, that short-term “shock therapy,” as applied in Russia, can hamper the efforts of former command economies to control inflation and establish a market economy. (The recent return of former Communists to power in Poland and Hungary suggests the possible consequences of deficient economic theories.) We should recall that at the end of World War IIit took most of Europe ten to twenty years to achieve fully convertible currencies and reasonably stable political conditions. It took that long, moreover, notwithstanding (a) the large amounts of aid that were sent to Europe through the Marshall Plan; (b) the extensive European experience with market economies; and (c) the German “economic miracle” beginning in 1949. Yet the task of rescuing Western Europe from the catastrophe of World War II was much easier, politically and economically, than the tasks facing the former Soviet republics and China today.
Both in government and on Wall Street a preoccupation with bilateral trade deficits, especially our deficits with Japan and China, has taken precedence over the continued need to increase and protect the flows of capital for investment throughout the globe. This is short-sighted. Our trade deficit with Japan has to be dealt with gradually and with close attention to its often favorable consequences for the rest of Asia. Japan’s $130 billion current account surplus, a direct result of its trade surplus, is helping to keep interest rates down in Asia and is helping to provide cash and credit-“liquidity”-to Southeast Asian countries.
The total investment in the financial markets in the developing countries-including for example Mexico, India, and China-is now $180 billion, up from $2.4 billion seven years earlier. No wonder some of these markets went into a tailspin when the US and Japan appeared headed for a confrontation. If, in order to quickly eliminate the Japanese trade surplus, high tariffs were to be imposed, or if the dollar were deliberately made to collapse in relation to the yen, the results would be a serious loss of liquidity in some of the emerging markets.
In formulating US economic policies, direct investment in foreign countries-now of relatively small official concern-should be at least as important as trade balances. In 1992 worldwide investment in all markets, from New York to New Delhi, amounted to over $5 trillion as opposed to $4 trillion of international trade. Investment by Americans in countries such as China, India, and Mexico has the effect of increasing both trade with the US and employment within the US; as foreign subsidiaries set up by American companies obtain components and materials from the parent companies in the US, trade with the US also increases. Particularly in the case of our trade dispute with Japan, we should also be insisting on the freedom to invest in Japan.
In fact, increasing foreign investment in Japan is as difficult as breaking down its trade barriers, but the difficulties of investing have been too much ignored. Thanks to the combined resistance of Japanese ministries, banks, and large corporations, and to the labyrinth of regulations and other obstacles the Japanese present to outside investors, Japan has the lowest rate of foreign investment of any G-7 country. We should put as much pressure on Japan to open up to foreign investors as we have to improve its trade balance with the US. Although some recovery has recently taken place, the NIKKEI market average is still down about 40 percent from its 1989 high; Japanese banks, insurance companies, and other portfolio owners are in serious financial difficulties. This would be the time for US corporations to acquire stakes in Japanese companies. Such ownership would not only improve trade flows, but would create the kind of political influence that comes only from having an actual presence in a market.
If the US is to have an effective policy favoring investment in Japan (and US foreign investment in general), the US government should also favor a reasonably “strong” dollar instead of the deliberate “weak” dollar policy it had originally appeared to support. The recent statement by Secretary Bentsen disavowing such a “weak dollar” policy and the recent international interventions to support the dollar led by the Federal Reserve, appear to be a welcome reversal of US policy. The historical record shows that strong money virtually always wins out over weak money, and a weak dollar, which some experts thought would increase foreign purchases of US goods, has done nothing to improve our trade balance with Japan. It is also an underlying factor in the fears of inflation that have been creating uncertainty in the American financial markets.4
The principle of open investment, both domestic and foreign-with no limitations other than those connected with national security-is one that the US should be urging on other countries. That the US is more open to foreign investment than other countries has worked to its benefit. In Europe, the UK is almost as receptive to foreign investment as the US. While its productivity remains relatively low, its willingness to accept foreign investment has been an important source of stimulus to its economy. Germany, while legally open to investment, nevertheless has a system of interlocking relationships among its big banks, insurance companies, and industries which is somewhat reminiscent of Japan. Germany has been slow to realize that it could help its own competitive position as well as the international financial system by allowing more scope to foreign investors. France and Italy, while more open to investment than in the past, nonetheless insist on maintaining state ownership of major industrial and financial enterprises; and they make heavy use of devices such as “core shareholders” and “golden shares” as a way of maintaining domestic and even government control. The use of such practices will have to diminish if they are to attract the international investment their slowly growing economies need.
The capital requirements of Eastern European countries and especially the former Soviet countries will also be enormous. Germany is providing $100 billion annually to the former East Germany, with its population of 17 million people. Only part of this huge investment is for physical reconstruction, capital investment, and cleaning up the environment; a large proportion goes for transfer payments to maintain unemployment and other benefits for workers who lost their jobs when their obsolete facilities were closed down.
A similar approach will have to be followed with Russia, Ukraine, Belarus, and other former Soviet republics if their obsolete and hopelessly inefficient industries are to be phased out without disastrous social and political consequences. However, the kinds of legal and financial organizations required by a modern economy, including capital markets, are almost wholly lacking in the former Soviet Union. At the same time, foreign capital is still absolutely necessary if their economies are not to collapse. Special measures will have to be devised to protect such capital, such as large scale guarantees from Western governments, which will have to be combined with significant amounts of assistance from international institutions such as the World Bank and the IMF.
Without such outside support, the transition of the former Soviet Union to a market economy and working democracy is unlikely to take place. If the former Soviet Union were to receive investments comparable to those being made in East Germany it would require more than $1 trillion annually-a sum that will clearly be impossible to raise for a long time. Current foreign investment in the former Soviet Union is almost impossible to estimate accurately. Both the G7 nations and private consortiums have made large commitments of money and credit which they have failed to fulfil. Billions of dollars of German economic assistance and proceeds from former Soviet enterprises have been surreptitiously sent to Switzerland and other shelters, depriving Russia andthe other former Soviet republics of desperately needed resources. It is likely that the actual amount of foreign investment during the last two or three years has been a small fraction of what is required.
Four conclusions can be drawn from the situation I have been describing:
1) If the mature Western economies themselves are to maintain reasonable rates of growth, consistently strong growth must also take place in the developing world.
2) The requirements for capital to finance that growth are beyond the capacities of the West, either from private or public sources.
3) Global growth, therefore, requires not only direct investment by private and public foreign capital in the developing countries but also large-scale domestic investment by those countries themselves. This will only take place if savings within those countries increase along with their GDP and are directed toward domestic investment and if efficient capital markets can be created in each country, whether they take the form of stock markets, bank-managed investments, trading companies, or joint ventures with foreign investors.
4) These local capital markets will gradually have to be connected organically to the global financial marketplace.
The global interconnection of capital markets as a result of new communications and new data-processing technology underlines the limitations of the markets that now exist. It is pointless and even dangerous to connect systems that appear to be similar on the surface, but are really disconnected in reality-it is rather like trying to connect two railroad systems with different track widths. The procedures of capital markets of the developing world are, in many cases, far below the standards of those in the Western world and ways must be found to improve them.
America’s myriad problems with stagnant incomes, drugs, crime, and urban breakdown make us forget that its capital market has, after all, evolved from the boom-and-bust frontier-type capitalism of the 1910s and 1920s into the world’s most broad-based and sophisticated system for investing money, one supported by effective legal and financial institutions and by advanced communications and data-processing technology. The New Deal legislation of the Depression gave the modern system its legal underpinnings, including disclosure requirements and protection against market manipulation that are aimed at preventing the speculative abuses that led up to the crash of 1929. The independence of the Federal Reserve reinforces the soundness of the currency and banking system, while Federal Deposit Insurance assures depositors of the safety of their assets; the modern pension system has encouraged an increased volume of savings by allowing accumulation in pension funds of profits that are deductible to the employer. During the last fifty years this system has created a savings and investment pool in private and public pension funds of almost $3 trillion.
Furthermore, electronic and communications technology has made possible a nearly paperless network which easily handles 300 million shares per day in the New York Stock Exchange plus huge turnover on the American Stock Exchange and NASDAQ. It was only in the late 1960s and early 1970s that turnover of as much as ten million shares a day created an overflow of paperwork in the back offices of Wall Street that almost brought down the New York Stock Exchange.
The American political system may not be an appropriate model for every developing country to adopt; however, many of the features of American capital markets should serve as the model for the world’s new economies to strive for. The legal protections; the requirements of disclosure; the variety of financial instruments available to investors including stocks, bonds, mutual funds, options, and futures; the technical capacities of the system-all suggest standards that are far from being met in most of the developing countries but will be necessary for the capital markets of the future.
In the developing world, there will be fierce competition for the capital necessary for economic growth; and capital investors will become more and more choosy and will insist on modern legal and credit systems, political stability, and independent central banks to manage currency. Capital is both nervous and greedy. India attracts investors because of its relative stability and its affinities with Western political and economic institutions. Its stock markets have been booming. However, the huge speculative increases in the market values of Indian securities do not mean there will be comparable increases in direct investment necessary to sustain economic growth. India will have to accelerate the liberalization of its foreign trade and investment policies and crack down on the pervasive corruption which has plagued its economy. It must do so if it is to attract sufficient capital to finance the 15 percent annual growth of its manufacturing sector that the government now projects and if it is to build up purchasing power of its growing middle class of some 200 million people.
Its main competitor will be China, which will have to reform its political system and its human rights policies if it is to deal with the economic and environmental consequences of Deng’s reforms. China’s potential attraction is high growth, although large parts of the country have not benefited from the kind of development that is now visible in the southern part of the country. It seems possible that increasing unrest and instability in the poorer regions of China may spread and create a different picture of China’s future than the rosy prospect currently accepted by the financial markets. Still, both China and India are potentially huge markets. The competition for capital between the two countries will be fierce and seems likely to push both of them toward further reform, China politically, and India economically.
The Western countries themselves still have some problems with their own capital markets. Britain’s success in privatizing such industries as telephones is in large part owing to the sophistication of its capital markets. The French capital markets had to reform and modernize in order to permit a successful series of large scale privatizations during the 1980s and they are still not up to US standards in matters such as disclosure. Italy is carrying out the ambitious privatization program planned in 1993, but Italian capital markets require significant changes both in the basic Italian law governing them and in enlarging their technical capacities. Italy still has to prove that its privatization program will actually put public corporations onto the market and that a few private groups will not simply replace the government in controlling industry and finance.
In considering what can be done to improve global capital markets, we need also to distinguish between speculation and investment, since today much of the world’s capital movements are speculative in nature and not investments for the long term. They can be highly destabilizing and potentially quite dangerous. Excessive borrowing, far from disappearing in the late 1980s, simply came to take different forms. It is ironic that US government bonds, basically the safest of all investments, have become among the main vehicles for speculation because of their liquidity and their attractiveness as collateral for borrowing.
The most obvious example of borrowing and speculation being combined is to be found in the activities of so-called “hedge funds”-a misnomer since “hedging” usually refers to investments to offset risk, while the hedge funds are purely speculative pools of money, which are “leveraged”;that is they invest large amounts of borrowed funds. Their estimated capital is $50-75 billion while the assets under their control, because of their borrowing capacity, could be as much as $500 billion at any one time. They are distinct from traditional mutual funds, pension funds, or insurance companies not only because their investments consist largely of borrowed moneybut because they can be “short” as well as “long.”-i.e., they can bet on the fall in value of a security, a currency, or a commodity by borrowing and selling assets they do not own, as well as betting on their increase in value by borrowing and actually buying the assets and holding them for their appreciation. They are designed for very rich private investors and for aggressive institutional investors who look for sophisticated management and very high returns on their investment. Comparable investments also are made on a large scale by American, European, and Japanese banks as well as by big securities firms trading for their own account.
The financial power of hedge funds was made clear last year when, by speculating heavily against the British pound, hedge-fund managers largely caused the pound to be devalued. Their influence over markets was demonstrated again after the US-Japanese trade talks collapsed in March and the yen rose 8 percent against the dollar in one day, as mentioned earlier. In many cases hedge funds, and speculative activity in general, may now be more responsible for foreign exchange and interest-rate movements than interventions by the central banks. The sensitivity of the market to their activity was shown when the forced liquidation of the Granite Funds at the end of March, a relatively modest $2 billion pool of capital, created enough turmoil by itself to push down bond prices in the US market.
Meanwhile, traditional institutions such as mutual funds and pension funds have been rushing into Asian and other foreign markets, some of which are not as capable of handling a large volume of transactions as the developed Western markets. This can create serious problems when the markets turn sharply downward and investors suddenly realize that it is much easier to get in than to get out. The relatively low US interest rates and the inflation in financial asset values in the US stock market have created a frantic search by money managers for higher returns. These were achieved in the last year or two by the spectacular performance of emerging country markets. Poland, the Philippines, Indonesia, Thailand, Malaysia, and many others brought high profits to investors. US investment houses now compete with each other to enter these markets and are setting up offices in Beijing, Singapore, and Djakarta, among other capitals.
The movement of foreign capital to China and other developing countries is critically important for the world economy, but care must be taken to protect investors from the risks of current speculative fever. In the weak protection they give investors, many investment markets are closer to the American securities markets of the 1920s than to that of the 1990s. Sharp increases in market values because of relatively large foreign purchases of securities in a local market do not necessarily reflect underlying economic health; nor do they necessarily reflect the amount of direct investment that actually takes place. If speculative excesses were to destroy the confidence in emerging markets, political reform and economic growth in the developing world will be badly hampered, with significant losses in the West as well as in the developing world. US pension funds and similar institutions now own equities in other countries worth about $170 billion, and they plan to raise this to $400-450 billion over the next few years. A loss of confidence caused by excessive speculation or corruption-as has been revealed recently in the breakdown of the Venezuelan banking system and in recent reports of official corruption in Spain-would slow down this flow of funds and could have very negative global consequences.
The explosion over the past ten years in the use of “derivatives” is a further potential risk to the stability of the financial system, even though these instruments are intended to do just the opposite. Derivatives are highly complex transactions which are based not on direct purchase of stocks, bonds, or other standard financial instruments but on investments in options and in futures markets in securities, interest rates, foreign exchange, and commodities. They “derive” their values (hence the name) from changes in the value of the underlying assets. They often make use of calculations of potential market movements so as to transfer or limit risks among large investors; but they can also be used for speculation that is highly leveraged. For financial institutions they are “off-the-balance-sheet” items, meaning that the risks involved are not carried as specific liabilities in their accounts.
The total volume of these derivatives now amounts to over twelve trillion dollars. Only a part of this amount is actually at risk, of course, but the risk is still considerable.5 Derivatives also create a chain of risks linking financial institutions and corporations throughout the world; any weakness or break in that chain (such as the failure of a large institution heavily invested in derivatives) could create a problem of serious proportions for the international financial system. An illuminating example occurred a few years ago when the medium-sized Bank of New England required a federal bailout as a result of bad loans mainly in New England real estate. The Bank of New England had a balance sheet of about $33 billion in total assets; however, it had “off-balance-sheet” commitments of $36 billion consisting of various types of futures contracts and other derivative contracts with US and foreign institutions. It took many weeks for monetary authorities in the US and abroad to arrange in an orderly way for other investors to take over the contracts and to avoid significant losses to creditors. If the demise of a relatively modest sized regional US bank can cause such difficulty, it is easy to see that major losses among a few large financial institutions could unleash a serious crisis as a result of these potential liabilities, which now exist on a vast scale throughout the world.
While derivatives were originally designed to be part of sophisticated risk-management techniques for large, professional investors, they have, in many cases, produced just the opposite result. Either because they are used carelessly or for inappropriate purposes or because of unexpected changes in historical patterns, very large losses have been incurred by a variety of investors in derivatives in widely different parts of the world. Local municipalities in the UK lost almost $900 million during the 1980s through investments in various types of interest-rate swaps; Pechiney, the French government-owned aluminum company, lost $150 million in derivative investments on the Chicago commodities exchange; Procter and Gamble, one of the most conservative US companies, lost $150 million on interest-rate swaps; Metallgesellschaft, one of Germany’s largest trading companies, lost over $1 billion in the oil futures market, and almost went bankrupt. Derivatives, if carefully regulated, are a useful tool in financial risk management just as the Chicago futures market in grain and other commodities strongly helped agricultural development in the US. However, the huge amounts now involved, together with the dynamics of instantaneous information and reaction, may create unforeseeable stampedes to sell, with possibly very dangerous results.
The sophistication and volume of new financial instruments require that we consider what can be done to regulate banks and securities firms on a global basis; but there is so far no agreement on the lines that new regulation should follow.6
Congressional committees have called for new laws to curb the activities of dealers in derivatives while administration officials have, quite reasonably, warned against actions that would simply push much of this investment activity to foreign markets to the benefit of foreign banks and financial institutions, without in any way diminishing risk. The General Accounting Office has recently issued a report calling for stringent new regulations for all US dealers in derivatives, while Alan Greenspan, Chairman of the FED, has suggested that a “whole new kind of regulation” should concentrate on the way particular firms handle the risks of derivatives and should ensure that a firm’s “risk management systems work for that firm.” The following points seem worth emphasizing:
1) The sense of confidence in the soundness of the financial system is increasingly being shaken by volatile markets, by high levels of speculation by professionals and by new financial instruments including derivatives that rely heavily on complex computerized models. The lethal potential of the combination of new financial instruments, high-tech trading procedures, and intensely motivated young MBAs can be seen in the current problems of Kidder-Peabody. The sudden discovery that this firm-with almost $90 billion in assets and tens of billions in liabilities-had $350 million of fictitious profits might conceivably have put its business in jeopardy if it did not have the backing of GE, its parent company. The impact on both the securities market and the credit markets could have been very severe.
2) New approaches to investment, put forward with great conviction by leaders of the financial industry, have too often turned into disasters when circumstances changed. Recycling petrodollars in the 1970s led to banks losing tens of billions in third world debt; the vogue for junk bonds in the 1980s led to similar losses domestically; portfolio insurance and computerized trading helped turn a severe break in the market into a near meltdown in October 1987. It is not impossible that the rapid increase of the new financial instruments I have been discussing could help cause a destructive chain reaction when speculative positions in the tens of billions are routine and when a sudden loss of confidence can turn heavy selling into panic.
3) Derivatives, hedge funds, and other types of highly leveraged trading activity by financial institutions grew spectacularly at a time when interest rates were falling and the stock and bond markets were flourishing in the late 1980s. They have not been tested during prolonged periods of rising rates and falling markets; yet they are bought and sold in ever increasing amounts and complexity not only by securities firms but by banks, insurance companies, and other financial institutions, whether in New York, London, and Tokyo, or in many other markets.
Two broadly different approaches to regulation are possible. The GAO would want government regulators (1) to require full disclosure by the issuers of highly leveraged investments; (2) to analyze how much overall risk is being taken; and (3) to set general standards for the amounts of capital that institutions should have to back up their operations, including the capital put at risk in sales of derivatives. As has been said, a different approach is suggested by Alan Greenspan, who wants to concentrate on the abilities of each firm to manage its potential risks; but he has yet to suggest just how this is to be done. An obviously complicating factor is that different regulators now oversee institutions dealing in these instruments and set different standards, including the Federal Reserve and State Banking commissions for banks; the SEC for securities firms; and state insurance commissions for insurance companies. Before rushing into new legislation and regulation which might make things worse instead of better, the US should take the lead in trying to establish a common understanding of the facts.
The beginning of any new process of regulation has to be adequate disclosure. Balance sheets become meaningless, especially for banks and other financial institutions, when more assets and liabilities are carried in footnotes to the financial statements than on the balance sheet itself. Accounting standards should be tightened so that creditors and stockholders have a clearer understanding of the levels of risk, the reserves set against such risk, and the adequacy of the capital supporting it. These standards should apply equally to all financial institutions, not only banks and securities firms but corporations that, in some cases, have turned their treasury departments into speculative profit centers by using derivatives as a way to increase their earnings. Their shareholders should be able to evaluate the risk and to judge the quality of the earnings. Whether or not more capital is required to support any or all of the current speculative activities will become evident when stricter standards of disclosure are set and the financial markets react to the risks disclosed. Since these activities are global, any such plans to survey and protect against risks must include overseas regulators, mainly in Western Europe and Japan. There must also be tighter oversight and accountability with respect to practices used to sell these instruments.
At the same time, global capital markets require that much greater efforts be made to guarantee international investors the kinds of protection now afforded by American securities legislation. The recent attempts of the European Union to encourage regulations of this kind have some distance to go, since Germany has only now introduced legislation requiring higher disclosure standards, more adequate protection for minority shareholders, and severe penalties for insider trading. Daimler-Benz recently was the first, and so far the only, major German company to adopt the accounting standards that have for years been required by American securities laws in order to obtain a listing on the New York Stock Exchange.
If the countries of the developing world are to have access to increasingly large amounts of foreign capital, while also encouraging their citizens to invest their savings, worldwide investment standards will, in my view, have to be adopted. There should be a separate and comprehensive organization comparable to GATT for investment just as there was a GATT for trade, even though some aspects of investment are now covered under GATT. Only through such new arrangements will Western investors-including pension funds, insurance funds, mutual funds, and others with fiduciary responsibilities-get the kind of protection they will require if they are to make large amounts of capital available. As the world’s largest capital market, the US is also in a position to propose that international procedures to protect investors be phased in over a definite period, say by the year 2000. And the US government should make such phased-in protection a condition for investment abroad by US fiduciaries.
Finally, there should be some type of contingency plan, undoubtedly private, among the major central banks for dealing with a systemic crisis of the financial markets, should it occur. It is all very well for the Federal Reserve, the Bank of England, and others to minimize the risk of such a crisis being set off by the increasing volume of derivatives and other highly leveraged activities. But the Federal Reserve and the Bank of England could be wrong. Derivatives have grown dramatically during the last decade to over $12 trillion; five years from now they may very well amount to $18 trillion or more. During the 1987 stock market crisis, the Bank of England stepped in as the underwriter of last resort to rescue a huge British Petroleum share issue whose failure could have crippled major securities firms throughout the world; the Federal Reserve, for its part, saw to it that the banking system provided ample liquidity to large securities firms with unsalable inventories. A financial crisis in the 1990s, in light of the greater potential for instability as well as the greater interconnection of the global financial system, could be much more serious. The central banks should not have to depend on ad hoc measures if such a crisis were to occur.
The recent volatility of securities markets here and abroad is a warning that while huge amounts of capital, some of it highly speculative, are overpowering the world financial system, our arrangements for protecting that capital are inadequate. So are arrangements for raising the capital that the developing countries will urgently need. We are now nearing the fiftieth anniversary of the institutions created by the Bretton Woods Agreements-the World Bank and the IMF. It is time to review the structure of the world’s financial system not only to increase its potential for raising living standards but to reduce the risk of enormous damage from a breakdown that could not be locally contained.
July 14, 1994
In any case the effects of the Federal Reserve actions have been variable: the markets declined sharply with the first two boosts in interest rates by the Federal Reserve, but they rose after one on May 17. ↩
Business Week, April 4, 1994. ↩
International Monetary Fund, World Economic Outlook, October 1993. ↩
Lower budget deficits may be required to strengthen the dollar without raising interest rates-and this may be a price worth paying. ↩
If we base an estimate of credit risk on the disclosures made in various annual reports of banks, about 2 percent of the total amount of derivatives would appear to be at risk, or over $200 billion. The net capital of America’s twenty largest banks is about $115 billion. ↩
Both in the US and abroad, the activities of banks and securities firms are more and more similar. The separation between banking and investing called for by the Glass-Steagall Act of 1936 has all but disappeared and there are only limited international standards covering the behavior of banks. It is true that the Basel Convention of 1987, under the sponsorship of the Bank for International Settlements, set out minimum capital requirements for international banking institutions, including their derivative activities. But these have not yet been universally observed. Japanese banks, for instance, have failed to recognize the seriousness of their vast portfolios of bad loans to the extent that American banks do. ↩