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«THE (IN)SECURITY OF INTERNATIONAL FINANCE Valpy FitzGerald [Originally delivered as the first of the Wolfson College Lectures 1999 series on the ...»

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THE (IN)SECURITY OF INTERNATIONAL FINANCE

Valpy FitzGerald

[Originally delivered as the first of the Wolfson College Lectures 1999 series on the theme

Globalization and Insecurity. Revised version presented as the keynote speech at the VII

Jornadas de Economía Crítica, Albacete, February 2000]

Finance and Trade Policy Research Centre,

Queen Elizabeth House,

University of Oxford OX1 3LA

THE (IN)SECURITY OF INTERNATIONAL FINANCE. -Abstract By Valpy FitzGerald Finance and Trade Policy Research Centre, Queen Elizabeth House, University of Oxford OX1 3LA Daily news headlines tell us of yet another financial crisis in some far corner of the globe;

while world leaders gathered in Davos regard currency instability as the critical threat to western civilization at the close of the twentieth century - in sharp contrast to the threat of socialist revolution with which it opened. A significant and even symbolic characteristic of current global financial insecurity is the uneasy combination of the speed and sophistication of computerized trading systems with the faltering economies of ‘emerging markets’. Sudden exchange rate collapses lead not only to steep income declines for millions of poor people but also to major bank and stock market losses in advanced industrial countries. For the first time, economic events in the developing world are affecting the financial security of developed countries. Discussions on ‘global financial architecture’ thus necessarily involve the two-fifths of the world population living in countries who until recently were seen only as clients for development assistance.

The debate on the security of the international financial system thus extends beyond technical economic issues to encounter problems derived from the problematic nature of globalization itself. In the first part of my lecture I shall try to explain the origins of inherent instability in international capital flows, and why this requires public institutions to maintain an orderly market. In the second part, I shall argue that despite widespread recognition of this problem, the necessary institutions do not exist due to the mismatch between intergovernmental power and the requirements of a global market. In the third and last part of the lecture I shall sketch some of the implications of this dilemma for belief in the efficiency of markets, the establishment of international property rights, and ultimately for global citizenship itself.

My three main conclusions are: first, financial markets are inherently unstable because they deal in expectations; they require strong regulation to underpin contracts and prevent systemic collapse; so that global financial markets require global regulation - not as a means of protecting consumers or small investors, but just so that they can function at all;

the consequences of this instability - particularly for the three-quarters of the world population outside the OECD; second, it has taken repeated international crises to convince global policymakers that the Bretton Woods Institutions are wholly inadequate to provide the required international security; but the implementation of the required regulatory framework faces the opposition of both the major global economic power and private financial intermediaries; resolution of this impasse may only come about through the geopolitical balance between new currency areas; third, the process by which a new inter-governmental financial architecture is established will be slow and driven by successive crises; but it will entail a more critical approach to markets ‘rationality’ as a substitute for political process, to the nature of international property rights, and possibly ultimately towards the concept of global citizenship itself.

My argument is thus not against global financial integration - which in any event is an inevitable trend - but rather a case for the construction of an appropriate international framework which an orderly market requires. The construction of that framework will be slow and driven by national interest, but I believe that it just might contain an opportunity for global emancipation.

–  –  –

1. INTRODUCTION1 Half a century after Keynes’ dictum, the security of international finance - the topic of this lecture has clearly become a cause for acute concern far beyond Wall Street and Canary Wharf. 2 ‘Steady business’ - and thus the livelihoods of almost all the world’s population ranging from British pensioners to Indian peasants - is apparently threatened by the volatility of paper assets, the very existence of which they are unaware. Daily news headlines tell us of yet another financial crisis in some far-flung corner of the globe; while world leaders gathered in Davos or Hong Kong seem to regard currency instability as the critical threat to western civilization at the close of the twentieth century - in sharp contrast to the threat of socialist revolution with which it opened.

A significant and even symbolic characteristic of current global financial insecurity is the uneasy combination of the speed and sophistication of computerized trading systems with the faltering economies of ‘emerging markets’. Sudden exchange rate collapses lead not only to steep income declines for millions of poor people but also to major bank and stock market losses in advanced industrial countries. For the first time, economic events in the developing world are affecting the financial security of developed countries.3 The G7 has mobilized some US$ 300 billions as lender of last resort to major economies such as Mexico, Korea, Indonesia, Russia and Brazil because of the threat to the international market system.4 This concern reflects in turn the fact that although 28 advanced industrial countries still dominate the international financial and trading system; 48 percent of global production and 55 percent of world investment now takes place outside this group of rich countries.5 Discussions on ‘global financial architecture’ thus necessarily involve the two-fifths of the world population living in countries who until recently were seen only as clients for development assistance. The debate on the security of the international financial system thus extends beyond technical economic issues to encounter problems derived from the problematic nature of globalization itself.





In the first part of my lecture I shall try to explain the origins of inherent instability in international capital flows, and why this requires public institutions to maintain an orderly market. In the second part, I shall argue that despite widespread recognition of this problem, the necessary institutions do not exist due to the mismatch between intergovernmental power and the requirements of a global market. In the third and last part of the lecture I shall sketch some of the implications of this dilemma for belief in the efficiency of markets, the establishment of international property rights, and ultimately for global citizenship itself.

2. THE INHERENT INSTABILITY OF INTERNATIONAL FINANCIAL MARKETS

Sources of Systemic Volatility Global capital markets are characterized by asymmetric and incomplete information derived from the fact that all financial assets are promises to pay in an uncertain future. The increasing international exposure of bank balance sheets and equity funds in industrial countries to the financial systems in emerging market economies has not been accompanied by a corresponding depth of information about the true value of the assets and liabilities. The speed and scale of shock transmission between markets has increased enormously due to technological advances in trading and settlement, which forces traders to act without knowledge of wider price movements, exacerbating random fluctuations into serious instability.

There are also substantial agency problems for bank lenders and portfolio investors. Unlike multinational corporations involved in direct foreign investment, they can exercise little direct control over the asset acquired and thus cannot protect its market value. To the extent that banks and funds cannot count upon their own governments or the international financial institutions to ensure payment of their loans or maintenance of asset value, their logical response is to avoid assets which cannot be rapidly sold if things go wrong.

These information and agency problems explain the two main characteristics of so-called ‘portfolio’ investment in emerging markets. First, international portfolio investors and bank lenders seek liquidity and use rapid exit as a means of containing downside risk by buying quoted securities or rolling over short loans. In consequence, indicators such as the ‘quick ratio’ of a country’s shortterm foreign liabilities to central bank reserves become critical to market stability, and can easily trigger self-fulfilling runs on a currency. Second, fund managers control risk not by seeking more information or control, but by portfolio diversification based on an assumed lack of covariance between emerging market indices. The competition between funds for clients6 drives them towards high-yield, high-risk assets; and by the same token obliges them to make frequent marginal adjustments to their portfolios in response not only to changes within these emerging markets but also in anticipation of what all other fund managers are likely to do next.7 The effect of these behavioural characteristics is exacerbated by the way in which financial markets clear. It is now well established in theory and practice that financial markets are in permanent disequilibrium in the sense that demand for funds always exceeds supply at the equilibrium interest rate.8 In consequence, asset prices and interest prices do not fully reflect risk: lenders use portfolio allocation rules - and thus rationing - to reduce uncertainty. Domestic banks and securities firms are closely regulated to make sure they do this prudently and always have sufficient collateral and adequate reserves. In this way an ‘orderly market’ is established.

In contrast, international investment flows - which often enjoy neither legal collateral nor prudential regulation - react sharply to changing perceptions of country solvency rather than to variations in underlying asset value. Even if information on the return (or risk) on a particular asset can be acquired at a cost, the value of this knowledge declines as the opportunities for diversification increase, so investors have no incentive to search for information. Herding behaviour becomes endemic as the observed asset prices, exchange rates and reserve levels send the same signal to all participants but they all attempt to anticipate the same trend in order to make a capital gain.

Emerging market assets form a relatively small part of savers’ portfolios in developed countries, but a large part of firms’ and banks’ liabilities in developing countries. Because of this asymmetry between borrowers and lenders, marginal shifts in lenders’ positions tend to destabilize borrowers.9 These surges are then worsened by herding behaviour because as opportunities for diversification increase the impact of news on the allocation of funds in a single country relative to initial allocations grows without bounds, resulting in a massive flows further threatening financial stability.10 Why the security of international finance matters The international financial system is vulnerable to emerging market volatility; rather like banking in the US and the UK in the nineteenth century, when huge fluctuations in the real economy were associated with banking booms and busts.11. There is often a high degree of leverage in short term flows; banks making loans to hedge funds and similar intermediaries based in largely unregulated offshore international banking markets. In other cases they are on-selling risky securities to their clients; or extending short-term loans which are renewed every six months. Banks and other financial intermediaries have financial assets far larger than their own capital, so that the loss of only a small part of their loans threatens their survival. This is why they are restricted in the loans they can make by regulators. In consequence, when such losses do occur, they must sell other assets in order to recover the liquidity necessary to maintain their own capital. This exacerbates market fluctuations, leading to collapses more rapid and more deep than the preceding boom, for two reasons.

The first is a process known as ‘rolling margin calls’ where other assets (many of which are not owned, but rather obligations or options to buy or sell at some future date) have to be quickly sold, depressing their price and forcing other investors to sell further assets and so on. Thus the selling wave moves through the market far more rapidly than the original buying surge. When this results in a reduction of credit to firms in the ‘real’ economy, firms which have relied on the renewal of bank credit to finance operations are forced into bankruptcy.

The second reason is the effect that losses have upon the reputation of banks and funds, in a process known as ‘contagion’. In the absence of reliable information as to the value of the assets held by a particular bank or fund, depositors withdraw their funds rapidly from this and related institutions thus bringing about the very situation they fear and panic spreads - affecting firms in the same sector or country indiscriminately independently of their solvency. It this situation which usually obliges central banks to intervene by supplying sufficient liquidity for banks to meet their short-term obligations without becoming bankrupt.

Financial markets are thus inherently unstable, which is why at a domestic level they are so closely regulated. At the international level, it is precisely at the interstices between regulatory authorities that the largest short-term profits are to be made and the greatest risks of systemic collapse are to be found.12 Emerging markets are particularly vulnerable13 to this instability, not only because they have weak and inexperienced financial regulators.



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