Taming Risky Financial Markets.
Book Excerpt Review
Taming Global Financial Flows: A Citizen’s Guide
By Kavaljit Singh
This is a review of three excerpts from Singh’s book which focuses on global finance capital or ‘hot money’ as he calls it. The increasing speed in which capital moves around the world and its extremely speculative nature -have created possible dangers Singh argues. These dangers could create massive global financial instability that would cause significant harm to the everyday normal citizen. The three excerpts being reviewed deal with foreign exchange trading, derivatives trading and a concept called financial liberalization.
Foreign Exchange Trading
Singh’s argument in the small section on foreign exchange trading is that a large majority of FX trading is done purely for speculative reason by large international banks and serves no real economic purpose. These trades involve billions and billions of dollars on a daily basis. This speculation is risky and could possibly cause a meltdown or chain reaction if one of the main participants were to default.
The foreign exchange market is the world’s largest market (the largest FX trading market is in London), with daily transactions worth $1.5 trillion US a day (2001 figure). Singh argues that a large percentage of that figure serves no real economic purpose. In 1977 daily transactions were only worth $18 billion a day. Foreign exchange trading was originally designed to do two main things: facilitate cross-border investment and trade, and to allow companies to hedge against foreign exchange risk. The paradox here is that the world’s total exports only equal $6.6 trillion (1997 figure), or about four days worth of annual FX trading. Singh takes his argument even further by comparing the FX daily trading value to the world GDP of $29.2 trillion annually (1998 figure).
The question remains as to who would be trading these large amounts of foreign exchange and for what reason? Singh states that large international banks are the main culprit in the excessive amount of FX trading. Banks such as Citibank, Deutsche Bank, Chase Manhattan, Goldman Sachs, HSBC, JP Morgan, Industrial Bank of Japan and others are the big players in FX trading, accounting for up to two-thirds of the volume. Singh states that these banks are playing the high-risk speculative game for their own benefit and are not helping to facilitate international trade -or help companies reduce risk. Because of the high volatility and risk of FX trading it could be very easy for one of these banks to get caught holding a large position they cannot handle, and in a worst-case scenario they would be forced to default on their positions. This would cause shockwaves throughout the global financial system. One could say that foreign exchange trading is a ticking time-bomb!
Derivatives trading is another market that has witnessed rapid growth in the past 10 to 15 years similar to the growth of FX markets. Singh makes a note that since most derivatives trade OTC (over-the-counter) statistics are not easily available.
Derivatives are intended to reduce risk, but instead have become a major source of volatility and instability, much the same as FX trading. Derivatives are high-risk because they are highly-leveraged, meaning that a small change in interest rates, stock prices or commodities can mean a large gain or loss on a derivative (i.e. a long call option on the price of oil).
Another problem that Singh identifies with derivatives is that a large percentage is traded on OTC markets. These types of markets are unregulated and not ‘policed’, meaning that there is increased risk of an entity taking a derivatives position that they cannot handle or is unsuitable for them to hold. This increases the risk of default, and given the large amount of capital involved in derivatives trading, it could cause shocks throughout the whole financial system.
Singh ends the section by giving some examples of recent derivative stories gone wrong:
- In 1992, a subsidiary of Royal Dutch Shell lost $1.1 billion US in a $6.4 trillion derivatives position that was betting on the strength of the US dollar against the Yen, instead the opposite happened and a huge lose ensued.
- In 1995, a Singapore based ‘rogue’ derivatives trader named Nick Leeson working for Britain’s Barings Bank built up a large Futures position betting that the Nikkei 225 would increase. By the time Barings Bank had found out about Leeson’s hidden positions he had losses totaling $1.4 billion, this eventually led to the demise of the once prestigious Barings Bank.
These examples (and there are many more like "Long Term Capital Management" which despite their name speculated in the short term, loosing about 4 Bill US $ and getting bailed out the US Fed itself) demonstrate the high risk nature of modern derivatives trading. Singh believes that even larger shocks could happen in the future due to the large size and little regulation in the industry.
Singh defines financial liberalization as "a process in which allocation of resources is determined by market forces rather than the state. It minimizes the role of the state in the financial sector by encouraging market forces to decide who gets and gives credit and at what price".
Singh lists six key components of financial liberalization:
- Deregulation of interest rates
- Removal of credit controls
- Privatization of government owned banks and financial institutions
- Liberalization of private sector entities and/or foreign entities into the domestic financial market
- Introduction of market-based instruments of monetary control
- Liberalization of capital accounts
Most developed countries had no problem liberalizing their financial markets in the 1970’s and 1980’s, with the exception of the U.K. in the late 1980’s where the liberalization took several years to be implemented. Singh makes an important point that financial liberalization in developing countries took place not because local government supported these reforms, but because of pressure from the Washington Consensus (which is defined as institutions based in Washington D.C. like the IMF, World Bank, US treasury, US Federal Reserve and other powerful lobby groups).
In the next section Singh does a good job at examining the shortfalls and dangers to financial liberalization. He discusses the financial markets of South Korea and Japan where both countries operate under the ideology of "financial repression" (the opposite of financial liberalization). Both countries (as of 2001) had enjoyed strong growth and stability under this type of regime. Financial repression also helped each country to avoid the full effects of the Southeast Asian financial crisis. Some other shortfalls include less tax revenue, no longer benefiting from the setting of interest rates, opening up financial markets to increased speculation (i.e. FX and derivatives trading), and less control in monetary policy decision making. Overall, the risk level is clearly raised with financial liberalization due to several factors:
- When interest rates rise, riskier projects are favored because of potentially higher returns
- In newly liberalized countries regulatory bodies are usually weak and untested.
- Increased competition within financial markets creates situations where defaults could occur (for example a bank defaulting because of the speculative projects it was forced to accept in order to survive).
- Systemic risk appears in countries that have just opened their financial systems to the world. A large bank default in Germany could shock a bank in India due to some relationship that exists between the two (i.e. they are involved in a FX trade), as a result the other banks in India also receive the shock.
Singh goes on to discuss how fragile free financial markets truly are and how the risk of a financial crisis exists. This is especially evident in the case of developing nations. The arguments of asymmetric information, herd behavior and self-fulfilling panics are all used here to support Singh’s opinion. Financial liberalization implementation has preceded several recent financial crises. For example, the Chilean crisis in the early 1980’s; the ERM (Exchange Rate Mechanism) crisis in 1992-93 which effected the U.K., Italy and France; the Mexican crisis in 1994 and the Southeast Asian crisis in 1997. Singh states that this is a confirmation that financial liberalization is one of the elements that causes financial crises. There have not been many notable financial liberalization success stories among developing countries. Singh discusses the disaster that resulted in Chile as a result of the Pinochet government liberalizing the financial markets in the late 1970’s. The result was heavy external indebtedness, an onslaught of bankruptcies and rampant inflation. Similar results were seen in Uruguay, Argentina, Nigeria, Turkey and Bolivia.
In the next section Singh goes on to cite some recent empirical studies that prove the negative effects that financial liberalization has on developing countries. At this point in the chapter it is abundantly clear that financial liberalization has a negative effect on developing countries and is a root cause of past financial crises. Singh maybe does a bit of overkill in proving his point. But he does prove beyond a reasonable doubt that the Washington Consensus was remarkably blind-sighted in thinking that if financial liberalization was successful in the U.S., then it would also be successful in developing nations across the world.
Singh presents an interesting argument that financial liberalized markets are not necessarily the blessing the Western world has made them out to be. Possibly, the worst is yet to come as FX and derivative markets grow ever complex and large, the opportunity for a world-wide financial crisis looms. Financial liberalization has already failed in developing nations, and in light of all of the recent accounting and fraud scandals in the U.S., perhaps the cracks are starting to show in the systems of developed nations.
Singh goes on to talk about many other interesting subjects in the book including offshore financial centers, hedge funds, capital controls and other current topics. For anyone looking for an alternative view of the current global financial state, a view that is not often reported on in the mainstream media, this book is recommended.
Taming Global Financial Flows is available for purchase at Amazon.com - click here -
Best Regards to all Members,
Paul A. Renaud.