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"Wise men" in thrall to "markets" have no answers

Amidst the roiling financial turmoil, the doyens of the Bretton Woods institutions and rich-country leaders are seemingly at a loss to provide any answers. This was evident at the recent annual IMF/World Bank meetings in Washington. Symptomatic of this malaise was the IMF's downplaying of the clout of hedge funds, a stance which no longer holds up to scrutiny in the wake of the near-collapse of the US hedge fund, Long-Term Capital Management, and its subsequent bailout by US and international banks.

by Chakravarthi Raghavan


GENEVA: Never in the history of these Fund/Bank and related meetings, not even during the Latin American debt crisis of 1982, have things been as tense as during this time, with key officials perhaps revising their views about the crisis, but not knowing what to do, one of the financial experts observing the Washington meetings of the Fund/Bank said in the first week of October.

The "markets" which they have promoted and pay homage to are now holding them to ransom, and the "wise men" at the Bretton Woods institutions and the leaders of the powerful countries are now afraid of saying anything that would frighten the markets further, and lead to a further flight of funds to "quality", the observer said.

And as reports in the financial pages of the media bring out daily, the "flight to quality" now means not merely flight of capital of all kinds from emerging markets to the United States, but "flight" within these markets - from "blue-chip" corporate stocks and bonds to US Treasury bonds, thus increasing the costs of enterprises and their operations.

Those who, a year ago at Hong Kong, were singing "globalization's" praises and calling for the removal of government regulations over the economy, capital convertibility and freedom to move capital without any restrictions, are now talking a different tune in Washington.

President Clinton has now spoken of the capital flows creating the havoc and impoverishing the once-flourishing middle class in these countries and is calling for global actions to spur recovery, but the Japanese and Europeans seem unwilling to accept his plan. And with the sex scandals and the spectre of impeachment hanging over him, the US President cannnot persuade the Congress to act, unless the crisis becomes a depression and even more radical steps and leadership are needed.

The last straw

A major reason for reticence is that everyone is worried about what could happen in Brazil or, in its wake, in China - and either of them could prove to be the straw that breaks the camel's back.

If Brazil becomes the next victim and goes down, that could be the end of the game for neo-liberal and globalized capital markets. At least for this reason, Washington and the IMF want to help Brazil and not allow it to go down, but it is not clear whether they can or whether they have the resources.

Bonds and other capital flows to Brazil now command a market premium of between 1,000 and 1,500 basis points or 10 to 15 percentage points above the US Treasury bond rate, and it is difficult to see how a country can use such "foreign capital" productively, and be able to service that debt or investment, and resume economic growth. The international financial establishment is now talking of long-term reforms like transparency and governance, but these have no relevance to the crisis, and provide no short-term answers to get out of it. And without short-term solutions, there will be no "long term" left.

The IMF and Washington want transparency of private operators, and international regulations, but are afraid of even talking about it. They repeat the mantra of financial liberalization, not shackling capital flows and freedom for capital as being in the interests of and beneficial to the poor countries - despite the lack of empirical evidence of this over the long term, and current anecdotal experience and historical evidence to the contrary.

"A surprising number of participants at the meetings (this year)," said a Wall Street Journal report, "are considering interventionist measures to deal with the issues ranging from hefty foreign debts to economies in crisis in volatile markets."

And the Deutsche Bank Research, in its October issue, said that what was a "regional crisis" last year at Hong Kong (Fund/Bank meetings) has now become a global crisis, and "the current lull is best described as the quiet in the eye of the storm."

For much of the past year, since the crisis began with the devaluation of the Thai baht in July 1997, it was all talk of "an Asian crisis", due to the inadequacies of the governments of the affected countries and crony capitalism.

But the WTO head recently called it a "world financial crisis" and now the IMF Managing Director sees it as "a system in crisis, a system not yet sufficiently adapted to the opportunities and risks of globalization."

Hedge funds

Only last year, after the attacks on Asian currencies and the outcry from the affected governments about the speculative activities of hedge funds, the IMF and the US government and its various institutions (including the Federal Reserve) came out in praise of hedge funds and their useful role, and pointed to the very small amount of hedge-fund capital, some $100 billion compared to the $20 trillion of institutional investors and banks, to argue against any restrictions on such funds.

And while the IMF staff papers absolved the hedge funds, and other experts praised the hedge funds and derivative markets and their ability to "connect" markets across the world, the daily unfolding saga of Long-Term Capital Management LP and its links with investors, lenders and financial and governmental figures and their "revolving door" movements show that "crony capitalism" (or relationship banking) is what turns the wheels of today's "free-market" and "financial capitalism".

According to the IMF's 1998 Annual Report, in the discussions on hedge funds at the IMF Executive Board (in March 1998 after the Asian crisis broke, with the staff producing a report virtually exonerating the funds and their role), the Directors noted the limited information available about the funds, the non-applicability to hedge funds, as private investment pools, of reporting and disclosure requirements called for from banks and mutual funds, and the difficulty of demarcating boundaries between the hedge-fund industry and other institutional investors. They also noted that it was difficult to generalize given the diversity of investment strategies of such funds. Excluding the "funds of funds" (funds made up of several smaller funds), the capital of hedge funds as reported by commercial services, the IMF Board was advised, was in the neighbourhood of $100 billion in the third quarter of 1997. Of this amount, some $25 billion was in the hands of macro funds that take large unhedged positions on changes in global economic conditions and leverage their capital through borrowing by a factor of 4 to 7.

The remainder, the IMF Board was advised, was managed by so- called relative funds, which bet on relative prices of closely related securities and are less exposed to economic fluctuations, and tend to be more heavily leveraged than macro funds.

And in the light of this information, the Directors discussed hedge fund operations and the public was advised (through IMF transparency of a sanitized version of the Board discussions, that does not disclose the Directors' identity or the countries represented by them) that Directors differed on the impact of hedge funds, with several highly leveraged funds taking large positions in the smaller emerging markets. They also noted the relative freedom and flexibility of hedge fund activities and their encouraging herd behaviour among investors. Others saw only limited evidence of hedge funds contributing significantly to herding and noted their potential role as contrarians or stabilizing speculators.

The IMF report goes on to say that in the discussions, several saw no clear evidence of the funds having a major part in the Asian crisis, while a few saw them as playing a more important role than as suggested by the staff paper.

Board members as a whole are also reported to have had different views on subjecting hedge funds to additional regulatory and disclosure requirements.

Perhaps if the staff paper had been written in the wake of the experience of and information about the US Long-Term Capital Management Fund, it might have been different, and even the views of the Directors might have changed. But then again, don't bet on it. Ideology and opinions are more sacred than facts in their economics.

Last year, and for much of this year, Asian countries were sternly lectured not to use public funds to rescue financial enterprises, but to allow them to go bankrupt, and their assets to be sold to foreign financial firms.

With a capital of about $5 billion, and with leveraged operations resulting in market exposure of $200 billion, LTCM's difficulties (known in the market since late August) and its possible collapse were viewed by the US Federal Reserve Chairman as a threat to the financial system, warranting New York Federal Reserve intervention to get the lenders into one room and "persuade" them to roll over their loans and convert them into equity to save the fund!

No public funds have been involved, the world has been advised by the Fed Chairman. It may be that public interest forced the intervention. But it is not so easy to remove public suspicions.

Mind-boggling

The stories coming out every day about those who ran the fund, invested in it, outside consultants who "advised" institutions to invest in the fund, and banks that lent monies without demanding to know the details of its operations, are indeed mind-boggling. Even more so is the story of the Italian Central Bank, which as a regulator is expected to oversee the operations of banks under its own jurisdiction, "investing" some $200 million of the country's reserves in LTCM, and justifying it as an "investment".

And the Union Bank of Switzerland, which lent monies to LTCM (and found out the entire range of its exposure only this August or so), gave "stock options" to its senior management and executives, not in UBS itself (a common tax-avoidance device, supposedly to ensure and reward better performance by senior management), but in LTCM, and hedged that by buying stocks of LTCM!

Look at the connections involved in the US, where there is a revolving door and traffic between Wall Street, the Treasury and the Federal Reserve:

John Meriwether, who headed LTCM, left Salomon Bros, the Wall Street firm, after the public scandal of the firm's staff rigging the US Treasury bond auctions; although the inquiry did not fault him personally, but those who worked under him in that department.

He presumably got his golden hand-shake for leaving the vice-chairmanship of Salomon Bros, and went on to set up the fund with its base in Greenwich, Connecticut, with former Wall Street colleagues putting their own and institutional monies into the fund. Meriwether also brought into his board David Mullins, a former vice-president of the New York Federal Reserve, who was responsible for the Fed's input into the government investigation of the Treasury bond market rigging involving Salomon Bros. And another former New York Federal Reserve vice-chairman is with a Wall Street firm that has invested in LTCM.

A number of Wall Street investment banking firms (and European banks) all have now been forced to pitch in to save LTCM - Merrill Lynch, PaineWebber, top commercial banks of the US and Europe, and several investment banks. Several of the executives of these have had investments in LTCM.

And while LTCM went on borrowing from banks to leverage its operations, none of the banks would appear to have demanded to know more details, such as the value of its assets and the collateral - details which they would request from any smaller enterprise or firm, in manufacturing or trading.

The partners of LTCM borrowed heavily to invest in the fund, and this has aligned their interests with those of the Wall Street firms and commercial banks which have now forked out money to keep the fund afloat.

And some UBS executives who have resigned in the wake of the scandal, have been given a "golden parachute", as a Swiss newspaper has described.

And while a recovery in the various bond markets could make LTCM solvent, the flight to quality within the United States itself could make its position worse too. (Third World Economics No. 195, 16-31 October 1998)

Chakravarthi Raghavan is the Chief Editor of the South-North Development Monitor (SUNS) from which the above article first appeared.

 


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