The Day After Russia Attacks
What War in Ukraine Would Look Like—and How America Should Respond
All these countries have spent 40 years trying to build up their economies and a moron like Soros comes along with a lot of money to speculate and ruins things.
- Mahathir Mohamad, prime minister of Malaysia, January 1998
TOO DARN HOT
Mahathir's flamboyant rhetoric may be his alone, but his views have gained respectability in the wake of the recent financial crises in Russia and Asia. Famous for moving large sums of money in and out of countries quickly, hedge funds are frequently blamed for destabilizing economies and impoverishing the innocent. As their detractors see it, these funds routinely gamble vast sums of money in shadowy, overleveraged investments, unimpeded by government supervision. And this high-stakes financial poker, critics argue, sparked the volatile "hot-money" flows that undermined emerging markets in 1997 and 1998.
But skeptics thinking about imposing capital controls or otherwise curtailing the activities of hedge funds and other portfolio investors should pause. Those investments were not the prime cause of the volatility of global capital flows. In fact, the hot money in the recent crises came mostly from bank lending, not from hedge funds or other nonbank investments such as pension and mutual funds. International bank lending to emerging markets has often been more volatile than portfolio investments in equities and bonds -- because the vast majority of bank lending has taken the form of short-term loans between banks, not long-term project financing. As capital markets continue to grow, eventually replacing traditional bank lending as the primary source of international financing, capital flows are likely to become less volatile. Moreover, despite all the focus on hedge funds, they remain small when compared to other market players.
These facts reshape the entire global financial debate, which should instead center on how to help countries shift from bank financing to capital markets where the transition has just begun -- while ensuring that their governments and global financial institutions adequately protect investors.
FOLLOW THE MONEY
Thailand's financial crisis is a good example of the impact of irresponsible bank lending. Foreign capital flows to that country grew rapidly throughout the 1990s, reaching a peak of $25.5 billion in 1995. Nearly 75 percent of this took the form of bank loans; the remainder was equity and bond investments (including those made by hedge funds) and direct investment by companies. By early 1997, many of these investments were clearly becoming unprofitable, while the Thai banking system was struggling with a growing number of loans that were in default. Foreign banks got out quickly, turning a $1.9 billion inflow in the first quarter of 1997 into a $6.2 billion outflow in the second quarter -- a plunge of more than $8 billion within three months. (This figure may even understate the amount withdrawn, since it does not include unused lines of credit that may have been cut.) These outflows put enormous pressure on the baht, which was devalued the following July. Foreign banks continued to pull money out of Thailand rapidly through the rest of 1997 and 1998, triggering a massive liquidity crisis that ultimately spawned a severe economic recession. In addition, $2.5 billion of Thai capital fled the country.
What role did foreign portfolio investors play in all this? In contrast to many banks, they remained calm throughout the initial crisis, continuing to put money into the country even after the baht's devaluation. Portfolio inflows increased by more than 70 percent between the second and third quarters of 1997 and remained positive, albeit much smaller, through the rest of the year and the first half of 1998. Not until late 1998, when it became clear that the economic recession caused by the banking crisis would dampen growth prospects for several years to come, did foreign investors begin to withdraw money from Thailand.
Foreign bank lending proved fickle in the rest of Asia and Russia as well. The five Asian crisis countries (Thailand, Malaysia, South Korea, Indonesia, and the Philippines) received $47.8 billion in foreign bank loans in 1996. This capital inflow turned into a $29.9 billion outflow in 1997 -- a turnaround of almost $80 billion. Portfolio inflows, in contrast, fell by half but remained positive. The same pattern held for most individual countries, such as South Korea and Malaysia; Indonesia experienced a large outflow of portfolio investments in the fourth quarter of 1997 that became positive again by mid-1998. In most cases, it was money from foreign banks that dried up and fled the country, not money from portfolio investors. (Only in the Philippines, the country least affected by the crisis, did portfolio investors bail out more quickly than foreign banks.) A year later in Russia, foreign bank lenders again were the first to flee.
This pattern is not limited to recent crises. Across the world, foreign bank lending is generally more volatile than portfolio investments. During the 1990s, quarterly swings in the total amount of foreign bank lending were far larger than the ebbs and flows of either portfolio bonds or equities. The volatility of bank-loan flows over this period -- the standard deviation of flows divided by the average size of capital flows for the entire world -- was 82 percent, as against 50 percent for portfolio flows. The same pattern holds for many individual countries. Between 1992 and 1997, for example, the average volatility in annual foreign bank lending to an individual country was 239 percent. During the same period, average annual volatility in bond flows was only 176 percent and in equity flows 150 percent -- still turbulent, but much less so than foreign bank loans.
This instability reflects the nature of international banking today. Many people assume the loans that global banks make are a form of long-term project financing that cannot be withdrawn abruptly. But today's international bank lending often takes the form of short-term interbank loans. At the end of 1997, after the Asian crisis had begun, more than 55 percent of foreign bank loans worldwide were short term, with maturities of less than one year. More than one-third of these were interbank loans that were then applied to many purposes, including the financing of long-term domestic lending. These proportions are even higher in many emerging markets. In Thailand, two-thirds of foreign loans had maturities of less than one year. The vast majority of these went to Thai banks and finance companies, which then used them to support loans of longer duration.
In better days, foreign banks would roll over (that is, extend) most short-term loans as soon as they officially expired, often indefinitely. This became so routine that many emerging-market banks and finance companies imprudently began to rely on this money to fund new, longer-term loans -- i.e., borrowing short to lend long. But when trouble appeared on the horizon, foreign banks stopped rolling over these loans as they expired and demanded repayment, thereby precipitating the crisis and forcing capital to flee.
A COMMITMENT PROBLEM
What makes international bank lending so volatile? It is not that banks are irrational or foolhardy about the risks involved. The problem lies in the incentives at work in today's fiercely competitive environment. During the 1990s, profit margins on traditional bank lending shrank. As a result, many banks came under pressure from shareholders to bolster their returns by lending to emerging markets, which offered higher interest rates and robust economic growth. The capital requirements of the Bank for International Settlements inadvertently encouraged this trend by making it cheaper for foreign banks to lend to many emerging-market banks than to the largest, most stable corporations. But once they entered these markets, banks tended to pull loans quickly in times of trouble. The unique combination of pressures and incentives thus caused banking institutions to drive the hot money in global financial markets. The fact that all banks share the same incentives and tend to act in unison amplifies market volatility.
The root of volatile bank lending also lies in the nature of the loan contract. Bank loans are mostly illiquid, fixed-price assets -- they cannot be quickly converted into cash, and once priced, their interest rate does not go up and down to reflect new information about a borrower (except in the case of a breach of contract or a default). Because the "price" of a loan -- the interest rate -- does not automatically adjust to changing market conditions, banks adjust the quantity of lending instead. A bank can avoid a default by simply declining to roll over its loans if it sees a borrower in trouble. The short maturities that are common today give banks this flexibility. Bonds and equities, in contrast, adjust to changing market conditions through price rather than quantity. These securities continually reprice to reflect new information as it becomes available. Because prices fall immediately, an investor has no time to sell without incurring a loss. Rather, equity and bond investors have an incentive to hold on to their investment and wait for prices to rise once the market's downward correction has ended.
Paradoxically, advances in bank risk-management techniques exacerbate the volatility of foreign bank lending. With bank loans, the bank itself and its shareholders bear the full risk of a loss. As the 1980s debt crisis illustrated, the loss from foreign lending incurred by a single bank can be tremendous. Citibank, for example, wrote off $3.5 billion in loan losses on Latin American debt in the 1980s. To avoid such debacles, banks have developed sophisticated risk-management models, such as the value-at-risk model. When market risk or credit risk in a particular country increases more than expected, these models indicate that banks must either put up extra capital to cover the risk or reduce their exposure to that market. If banks choose the latter, they can either shed that country's securities or cut lending. But because a selloff of assets typically entails losses, banks are more likely to cut lending.
Many banks had already adopted similar risk-management models before the 1997 financial crisis struck. Not surprisingly, when the credit risk of Asian banks began to rise and banks had to either shed Asian securities or cut lending, they did the latter. The widespread adoption of such risk-management practices in the years leading up to the crisis ultimately magnified the impact of the banks' actions when they raced to cut their exposure in emerging markets in 1997.
The largest portfolio investors generally use different risk-management techniques, in part because the capital of a numerous and diverse group of shareholders is at risk, not that of the funds. Most fund managers would not rapidly pull out of a market unless withdrawals by lots of investors forced them to do so. But the investment strategies of individual investors have been remarkably stable -- largely because emerging markets typically make up only a very small percentage of their overall portfolios. (Indeed, customer withdrawals from emerging-market mutual funds did not increase notably during the Asian crisis.) Hence, portfolio investment managers enjoy more flexibility in reacting to risk and have less incentive than banks to withdraw funds when market conditions change.
In the years leading up to the crisis, the sluggish profitability of domestic lending in developed markets made emerging markets an attractive alternative. Emerging markets everywhere offered high returns on investment, especially after the lower capital requirements of some of this lending are factored in. Banks carefully minimized the risk to themselves by concentrating on loans with short maturities, which gave them the flexibility to pull out if economic conditions changed. Moreover, they denominated the vast majority of loans to emerging markets in U.S. dollars, thereby eliminating currency risk. In Thailand, for example, 75 percent of foreign loans were in U.S. dollars, even though most of these came from Japanese and European banks. These precautions paid off for banks but increased the risk for borrowers. Hence, most losses in Asia -- at least for U.S. banks -- came from losses in bond and equity trading and a decline in other Asian business (like securities underwriting), not from loan defaults.
Ironically, the most troubled banks had the greatest incentive to lend to emerging markets. Faced with a mountain of bad debt at home and paltry returns on investment overall, Japanese banks had become the largest lenders to Thailand and Southeast Asia before the crisis. By June 1997, they had extended $97.2 billion in loans to the region, whereas U.S. banks had extended only $23.8 billion. Large French and German banks, prompted by stagnant domestic markets and pressure from competitors, also became prominent lenders to the region. For a time, this lending was highly profitable. Japanese banks could pay one percent interest on deposits and then lend to Thai or South Korean banks at four or five percent interest. But their difficulties at home made them highly sensitive to potential losses, prompting the massive withdrawal of credit to the region at the start of the crisis. Of the $17.5 billion decline in lending to Southeast Asia between June and December 1997, $10.5 billion came from Japanese banks. They simply did not have the financial strength to renew credit to Southeast Asian borrowers in difficult times.
In short, it should not be surprising that foreign bank lending can be highly volatile. Changes in the types of lending activities, the nature of the loan contract, risk-management techniques, and competitive pressures all prompted banks to engage in high-risk lending to emerging markets in a way that minimized the risk to themselves. But how do hedge funds fit in to all this?
THE USUAL SUSPECTS
At first glance, hedge funds would seem to be the prime suspects behind global market volatility. They are largely unregulated investment funds with few disclosure requirements and a penchant for secrecy. Rather than clustering in global financial centers with large banks and brokers, hedge funds often locate themselves offshore or in outlying areas. They generally use highly dynamic, aggressive trading strategies, darting in and out of markets to arbitrage price differences. They have few investment restrictions and can build highly concentrated portfolios or invest in exotic financial instruments like futures and forward contracts.1 As the near bankruptcy of Long-Term Capital Management (LTCM) revealed in 1998, hedge funds also can use disproportionately large amounts of borrowed money. Critics allege that this enables them to manipulate markets and even cause financial crashes.
But the impact of hedge funds on international markets is greatly exaggerated. First, hedge funds do not fundamentally differ from other market players, like proprietary traders at commercial and investment banks, who have been using the same types of trading strategies for years. In fact, many hedge funds were started by traders from the major banks. The major difference is that the proprietary trading operations of banks as a group control about twice the amount of assets as do hedge funds.
Compared to other portfolio investors, hedge funds are even smaller. Whereas pension funds, mutual funds, and insurance companies together hold nearly $25 trillion in assets worldwide, hedge funds control only around four percent of that -- an estimated $800 billion to $1 trillion. Furthermore, the overleveraged risk-taking of LTCM -- which infamously invested sums that were 20 times or more the size of its capital base -- is not typical. Van Hedge Fund Advisors reports that roughly a third of hedge funds use no leverage at all, while the average leverage ratio for all hedge funds lies between 4:1 and 7:1. So even counting leveraged assets, hedge funds pale when compared with institutional investors. And although risk-hungry hedge funds put more of their investments into foreign markets than do institutional asset managers, they are marginal players there as well. The relatively small size of hedge funds thus suggests that they alone are unlikely to have caused excessive volatility in most markets.
Instead, it was the herdlike behavior of other market players that rocked the markets in recent years. Again, consider Thailand. In July 1997, the Thai government abandoned its exchange-rate peg and allowed the baht to float, spurring a depreciation that wiped out 56 percent of the currency's value by January 1998. At the time that the peg was dropped, the Bank of Thailand estimated that hedge funds held at most 25 percent of the $28 billion in forward contract sales of the baht. Most of the pressure on the baht actually came from short sales by other market players, the massive outflow of foreign bank loans, the liquidation by domestic companies and banks of their securities positions, and last-minute attempts by corporations and banks to hedge previously unhedged foreign loans. Hedge funds took their positions on the baht after significant pressure had already built up, and they exited the market early. In fact, many hedge funds started taking long positions on the baht and other Asian currencies again in August and September 1997 and lost money doing so. Certainly, a few of the large hedge funds profited handsomely from the initial devaluation of the baht, but they did not precipitate the collapse. Instead, it was caused by the overwhelming pressure exerted by the collective actions of all market participants. As one trader in Thailand noted, "Who wasn't betting against the baht?"
Indeed, hedge funds often play a critical role in curbing market volatility by providing liquidity. Within the hedge fund universe, a great diversity of investment strategies abounds. Relative-value funds, for example, arbitrage price differences between securities; macro funds bet on the direction of the market; and global funds assess the prospects of individual companies. Different hedge funds often end up taking opposite positions in the same market. They are also likely to bet against the market, helping correct an imbalance between buyers and sellers. Hedge funds behave this way because their managers are rewarded for finding overlooked opportunities that produce extraordinary returns rather than for matching an industry benchmark. In short, their enormous flexibility in choosing investment strategies and their restrictions on customer deposits and withdrawals give them the freedom to be contrarian.
In addition, hedge funds can play an important role in promoting price efficiency. Relative-value hedge funds, which profit by correcting anomalies in the relative prices of assets, help to ensure that risk is priced more uniformly and accurately throughout the world. Macro hedge funds help correct the price level within a market when it is out of equilibrium. In developed capital markets, the activities of hedge funds (and the nearly identical activities of proprietary traders at banks) have greatly increased the efficiency of pricing, as seen by the decline in arbitrage opportunities. Thus hedge funds and proprietary traders generally play a positive role in well-functioning capital markets by ensuring that prices accurately reflect market fundamentals and that risks are priced uniformly.
A CAPITAL IDEA
Rather than trying to limit hedge-fund activities, policymakers should focus on the quality of the information that investors use to make decisions. They can accomplish this by improving disclosure, financial transparency, and investor protection. But this goes only so far. They must also recognize that capital markets are replacing banks around the world as the primary source of financing. Today, countries with deep capital markets -- such as the United States, the United Kingdom, and Switzerland -- are furthest along in this transition. Other countries lag behind due to their lack of economic development (the emerging markets) or the necessary financial and regulatory infrastructure (Japan and much of Europe). Nevertheless, many markets are making the transition, no matter how slowly.
This shift to capital markets will help both individual countries and the world. As explained above, markets will stabilize as more financial instruments begin to adjust through price rather than quantity. Risk will be increasingly diluted as it is spread across a larger investor base, ultimately resulting in lower interest rates for issuers. Competition among intermediaries will increase and improve market efficiency.
To facilitate the transition, developing countries should focus on strengthening the "intangible" structure of modern markets. This would involve adopting global standards for accounting and reporting by both private firms and government institutions, such as national treasuries. (In the case of the latter, this would include reporting on the real level of usable reserves.) Adoption of such standards would also entail more rigorous market supervision and regulation as well as protection of creditors -- and all shareholders -- even in the event of a borrower's insolvency. For its part, international banking has a role to play during the transition in enforcing rigorous credit-assessment and loan-monitoring practices to emerging markets, where poor skills and low standards are still the norm. Long-term foreign direct investment in emerging-market companies would further improve supervision of management. All these reforms would ultimately lessen volatility.
Although the G-7 group of highly industrialized nations has promoted more open and transparent markets and stronger national financial systems, some governments and economists now talk of slowing down, rather than speeding up, the transition. Discussion of capital controls and the curtailment of hedge-fund activities abounds. Meanwhile, crisis countries are busy bailing out (and in some cases restructuring) weak domestic banking institutions. Such actions -- although needed and appropriate -- do not constitute a comprehensive solution to the problem.
To counter a retreat by traumatized emerging economies, policymakers must promote domestic capital market development and encourage the transition from banks to capital markets. Although many countries opened their fledgling markets to foreign investors in the 1990s, the crises underscored how woefully underdeveloped the infrastructure of these economies really was. Rather than hiding behind the false security of financial isolation and capital controls, such countries need to equip themselves to become full-fledged participants in the global market. But for that to happen, they and the policymakers who assist them must realize who is actually driving the hot money in international finance.
1 In a forward contract, a party agrees to sell a given currency at some point in the future at a given price. Parties enter into such contracts for the purpose of shortselling a currency-that is, borrowing in that currency with the expectation it will depreciate. If it does fall, they pocket the difference between the value of the amount borrowed and the amount repaid.