Behind the fears of recession

India's National Magazine From the publishers of THE HINDU

The dominance of finance in the global economy and the central role that cross-border flows of capital play in the process of globalisation are behind the current alarming features of the global economy.

PREDICTIONS of a deceleration in global economic growth and of the onset of a 1920s type depression are now routine fare in the financial media. Such expectations are driven by three tendencies in the contemporary global economy.

First, over the last year and a half, financial crises which initially surfaced in East Asia have spread across the globe. What is more, that spread has not been restricted to emerging markets such as Russia and Brazil in Latin America, but threaten the United States as well, as the LTCM episode indicates. (LTCM, or Long Term Capital Management, the prominent U.S. hedge fund company, was on the brink of collapse in September.)

Second, while these crises do destabilise the real economy and trigger recessions everywhere, stock market developments in the U.S. have been such that the consequences of a financial crisis are likely to be even more adverse. In 1997, household equity holdings were 143 per cent of the disposable income in the U.S., up from an average of around 50 per cent in the early 1980s. The corresponding ratio for Canada and Britain in 1997 was above 80 per cent and close to 75 per cent respectively, but it was less than 20 per cent in Germany. The high ratio in the U.S. meant that capital gains garnered by American households from the U.S. stock market boom amounted to 36 per cent of their disposable income. This affects consumption directly by affecting incomes and indirectly by influencing the propensity to save and accumulate for the future. Periods of rising financial asset prices trigger a real boom led by increased consumption, while a collapse in stock prices would result in a collapse in demand as well.

Lastly, despite the fact that a global recession or even a 1920s type depression is a real possibility, resulting in calls for a coordinated effort at global reflation, governments are exhibiting a kind of "policy paralysis", as the recent confabulations in and surrounding the annual meeting of the International Monetary Fund (IMF) and the World Bank indicate. While a crisis looms, no concerted response to stall it are forthcoming.

All these features are consequences of the rise to dominance of finance in the global economy and the central role that cross-border flows of capital play in the process of globalisation. The manner in which finance capital came to occupy this position of pre-eminence is of relevance.

INITIALLY, there were specific developments that increased international liquidity owing to developments outside the realm of finance itself, such as the surpluses generated by the oil shocks, which were largely deposited with the international banking system. Subsequently, financial liberalisation increased this overhang in three ways. First, by increasing the flexibility of banking and financial institutions when creating credit and making investments, as well as spawning institutions like hedge funds which, unlike banks, were not subject to regulation. A second way in which financial liberalisation increased the overhang is by providing the space for "financial innovation" or the creation of a range of new financial instruments or derivatives such as swaps, options and futures that were virtually autonomously created by the financial system. Thirdly, financial liberalisation increased competition and whetted the appetite of banks to earn higher returns.

The massive increase in international liquidity that followed these developments found banks and non-bank financial institutions desperately searching for means to keep their capital moving. At first, there was a consumer credit and housing finance boom in the developed industrial nations. But when those opportunities petered out, a number of developing countries were discovered as the "emerging markets" in the global financial order. Capital in the form of debt and equity investments began to flow into these countries, especially those that were quick to liberalise rules relating to cross-border capital flows and regulations governing the conversion of domestic currency into foreign currency. As a result of these developments, a host of new financial assets from the emerging markets entered the international financial system. These assests were characterised by higher interest rates, ostensibly because of the greater risks of investment in these areas.

THERE are a number of features characteristic of the global financial system which evolved in this manner. Principal among these is the growing importance of unregulated financial agents, such as the so-called hedge funds, in the system. Many years ago, the Group of 30 had cautioned governments that these funds were a source of concern because they were prone to "undercapitalisation, faulty systems, inadequate supervision and human error." Although hedge funds first originated immediately after the Second World War, they have grown in number and financial strength in recent times. Their number is placed at between 3,000 and 4,000 and they are estimated to be managing $300-400 billion of investors' money. These investors include major international banks, which are barred by rules and regulations from undertaking themselves risky transactions promising high returns. Consequently, they use hedge funds as a front to undertake such transactions.

The operations of the now infamous LTCM illustrates one of the roles these institutions play. Operating out of the U.S., as most hedge funds do, LTCM managed a part of the money of leading banks, including Travelers Group and UBS of Switzerland. The fund's principal trading activity was based on exploiting the differentials in interest rates between different securities. It was to the credit of LTCM, it was argued, that it indulged in such trade by investing primarily in sovereign debt in emerging markets which was more secure than others, and yet garnered returns as high as 40 per cent on capital. What was less creditworthy was the extent to which its operations were based on borrowed capital. On an equity base of a little less than $5 billion, LTCM had borrowed enough funds to undertake investments valued at $200 billion or more. This was possible because there was nothing in the regulatory mechanism which limited the exposure of these institutions relative to their capital base.

Such flows of credit to a few institutions are significant because in a world of globalised and liberalised finance, when countries are in different phases of the cycle and have differential interest rates, capital flows in the direction of high returns. Nothing illustrates this fact better than what the markets term the "yen-carry trades". The IMF's report for 1997 on capital markets stated: "Foreign purchases of U.S. Treasury and government agency bonds and notes reached $293.7 billion in 1996, and there was a further $78 billion of foreign purchases of U.S. corporate bonds. Similarly strong capital inflows to U.S. securities markets have been apparent in the first quarter of 1997: foreign purchases of government and corporate bonds during the first quarter of 1997 were slightly above the quarterly average during 1996... Particularly wide interest differentials between the United States and Japan, in conjunction with the belief that the Bank of Japan did not want the yen to strengthen in 1996-97, were viewed by some large global hedge funds as a potentially lucrative situation. These so-called yen-carry trades involved borrowing in yen, selling the yen for dollars, and investing the proceeds in relatively high-yielding U.S. fixed-income securities. In hindsight, these trades turned out to be considerably more profitable than simply the interest differential, for the yen depreciated continuously over the two years from May 1995 through May 1997, which reduced the yen liability relative to the dollar investment that it financed."

THE implications of these and other flows to the U.S. was that international liquidity "was intermediated in U.S. financial markets and invested abroad through purchases of foreign securities by U.S. investors ($108 billion) and by net lending abroad by U.S. banks ($98 billion)."

There are a number of points to note here. To start with, the current global financial system is obviously characterised by a high degree of centralisation. With U.S. financial institutions intermediating global capital flows, the investment decisions of a few individuals in a few institutions virtually determine the nature of the "exposure" of the global financial system. Unfortunately, unregulated entities making huge profits on highly speculative investments are at the core of that system.

Further, once you have institutions that are free of the now-diluted regulatory system, even those that are more regulated are entangled in risky operations. They are entangled, because they themselves have lent large sums in order to benefit from the large returns the risky investments undertaken on their behalf by these institutions seem to promise. They are entangled also because the securities on which these institutions bet in a speculative manner are also securities that these banks hold as "safe investments". If changes in the environment force these funds to dump some of their holdings to clear claims that are made on them, the prices of securities that the banks directly hold tend to fall, affecting their assets position adversely.

That is, there are two consequences of the new financial scenario: it is difficult to judge the actual volume and level of risk of the exposure of individual financial institutions; and within the financial world there is a complex web of entanglement with all the firms mutually exposed, but each individual firm exposed to differing degrees to any particular financial entity.

ENTANGLEMENT takes other forms as well. With financial firms betting on interest rate differentials and exchange rate changes at virtually the same time, debt, stock and currency markets are increasingly integrated. Crises, when they occur, do not remain in one of these markets but quickly spread to others, unless stalled by government intervention.

Finally, the rise of finance in the manner described above feeds on itself in complex ways. The explanation for the liberalisation wave in the developing countries is that this pyramidal growth of finance, which increased the fragility of the system, was seen as an opportunity. Enhanced flows to developing countries, initially in the form of debt and subsequently in the form of debt and portfolio investments, led to two consequences. First, the notion of external vulnerability which underlay the interventionist strategies of the 1950s and 1960s no longer seemed relevant - after all, any current account deficit could be financed, it appeared, with capital inflows so long as such inflows is ensured.

Second, growth was now easier to ensure without having to confront domestic vested interests, since international liquidity could be used not merely to finance current and capital expenditures but to ease any supply side constraints that may dampen or bring to a halt such growth. The financial press, the international financial institutions and large sections of the academic community argued that this created an opportunity to launch on an integrationist growth strategy in the developing countries, since in any case the sums required there were seen as a small fraction of the international liquidity being created by the financial system. For Western finance, emerging markets were a hedge, and for developing countries international finance was an opportunity. A cosy relationship was easily built, it was argued. What was needed was the liberalisation of finance and a monetary policy that ensured interest rates high enough to make capital inflows attractive after adjusting for risk.

It was not that finance did not see the dangers of fuelling an unsustainable boom based on capital inflows into developing countries. It was for this reason that the international financial institutions came down heavily on government fiscal deficits, partly because public profligacy was seen as the main danger, but more realistically because it was only such profligacy that could be curtailed without interfering with the functioning of markets.

What was swept under the carpet was the fact that as private flows to private investors rose, private profligacy could trigger an unsustainable spending boom. This we now know is what precisely happened in East Asia. This financial system fraught with danger remained in place essentially because it worked well for the world's leading capitalist nation, the U.S. So long as there are assets seen as worth investing in and finance rakes in high returns, a financial boom ensues in the U.S. Given the depth of U.S. financial markets, reflected in the unusually large investments made by households in the equity market, a real boom ensues, independent of whether the state there adopts Keynesian-style policies or not. The fact that the pursuit of such policies was difficult in a world of highly mobile finance, made clear by French President Francois Mitterrand's abortive bid at reflation years ago, did not pose any immediate problem.

THE point to note is that with growth in emerging markets dependent on capital flows, any curtailment of such flows and the adjustments made to respond to the balance of payments and currency crises results in deflation there. The first stage of what happened in East Asia is now history. As it became clear that a boom led by private profligacy financed with capital inflows could not be sustained, fundamentals that had prevailed for a relatively long period of time were now suddenly seen as being poor, resulting in capital flight.

Net private capital flows to 29 major emerging market economies are projected to fall to a little below $160 billion in 1998 from $240 billion in 1997 and a peak of over $300 billion in 1996. This fall reflects both the direct impact of the financial crises in Russia and Asia and consequential effects transmitted through financial markets. Such flight is inevitably a flight to safety. Since such flight to safety, in a world in which the dollar is a reserve currency, is to financial assets in the U.S., there is no immediate threat to the financial boom there. Thus even with the onset of severe deflation in East Asia the IMF was making a case for fiscal stringency, backed by the U.S. Government and the governments of other developed countries. However, as post-crisis developments push up interest rates to unprecedented levels in the emerging markets and pushes down interest rates, particularly of safe short term Treasury Bills, the expectations of relative interest rates and prices on the basis of which funds like LTCM placed their bets are belied. Demands for call margins rise, their asset base is eroded. However, if a few big funds like the LTCM are allowed to go bankrupt, they would have to unwind their positions at huge losses and meet some of their commitments. This would result in a further collapse in asset prices and affect other institutions entangled in the financial web. It would also result in a liquidity crunch as banks that are overexposed not merely refuse to lend more but refuse to roll over existing debt. The recession could then intensify. Above all, since many of their purchases have been financed through yen-borrowing, their closure would result in an increased demand for yen, which explains the appreciation of that currency vis-a-vis the dollar in recent weeks.

So what do we see? A revival of calls for intervention to prevent closure of financial institutions, a revival of calls for regulation, and above all a revival of calls for reflation, with the hope that real growth can restore confidence and restore normal interest rate and price differentials.

There are three problems here. The first is the problem of preventing closure when the web is characterised by differential exposures of individual firms in particular financial institutions.

Secondly, given the differential role of finance in securing growth in different countries, getting the G-7 countries to agree to a joint reflationary strategy is difficult - let Japan and the U.S. lead reflation, says Germany, for example. On October 16, the Federal Reserve Board, in a half-hearted attempt, cut interest rates by one quarter of a percentage point, but this move hardly seemed to have made any significant impact on the markets.

Third, since liberalised finance still rules and so much depends on expectations, nobody knows what attempts at reflation would entail. The world is on a traverse in which restoring growth is even more difficult. The current paralysis of policy is an inevitable outcome.