Wednesday, August 13, 2008

Financial markets held hostage by fear

Business Times - 14 Oct 1998

By Ong Yong Hwee

An interesting phenomenon became evident early last month. Stock prices traded on Clob and on KLSE in the wake of Malaysia's capital control measures showed large differences.

In a market where fear was the predominant sentiment, a difference of as much as 78 per cent was possible on the same stock on the same day. Some banks even classified Clob shares held by margin investors as worthless.

It goes to show how fear alone can significantly drive down any financial market, disregarding any fundamental factor of the economy. Many analysts think that crony capitalism was the main reason for the fall of the Asian financial markets. However, the severity of the plunge in both the stock and currency suggest a systemic error or faultline in global capitalism.

For a good five years before July 1997, huge amounts foreign capital came pouring into Asia driven by expectations of good returns from the lands of rising tigers and dragons. Western funds willingly found their way into the pockets of powerful individuals and corporations with "good" projects and connections.

Lenders later came to realise that much of their funds had been unwisely used or squandered and that many of the borrowers were cronies with connections but perhaps not the financial wisdom for sound investment decisions. This, according to some economists, triggered the reversal of foreign capital flow.

However, I believe crony capitalism has little impact on a country's economic system, as long as the money is circulated within the economy.

Crony capitalism may have an impact from the standpoint of efficient allocation of resources, but is not likely to have been the key factor leading to the rise and sudden fall of the Asian economies.

The real reason for the crisis is the intense fear initiated by financier George Soros' attack on the Thai baht that started the downfall of one Asian currency after another. The speculative attack (the greed factor) on the baht and other Asian currencies created fear in overseas lenders. Short-term lenders left in droves.

The present sorry state in Asia is the result of a lack of resolve by the Group of Seven industrialised nations, which have it within their power to tame financial speculators like Mr Soros and calm the markets.
The free-enterprise system, like the law of the jungle, encourages the survival of the fittest. But when the fittest become too greedy, the weak will build walls to protect themselves to ensure survival.

Like ostriches, the world's economic powers prefer to bury their heads and leave everything to the the market. But if the atmosphere of fear is not calmed, the world's hope of more openness and democracy will be undermined. The world trading system will go backwards. More walls will be built. What Malaysia is doing now in the area of capital control will be imitated by others, in one form or another.

The world's financial system must be reformed and a proper framework instituted to ensure that the greedy cannot plunder and destabilise the system.

The recent debacle involving a US hedge fund, Long Term Capital Management (LTCM), should be an eye-opener. LTCM was reportedly able to borrow more that US$100 billion (S$164 billion) from banks to buy securities, based on the fund's relatively small capital of US$2.5 billion.

The borrowed money was then used as collateral to take positions on various derivatives and forward contracts with an underlying value of more than US$1 trillion.

Imagine the amount of leverage these combined global hedge funds can exert to destabilise financial markets. Speculators are allowed to sell and profit on what they don't have.

On the other hand, the margin investors are coerced into force-selling their declining assets at below the net asset value of their shares.

So, without proper controls and regulations, fear can overwhelm market fundamentals.

The problem today is that the key world leader, US President Bill Clinton, is preoccupied with his own problems. But until another powerful leader -- or a world organisation -- is prepared to trigger the process of cleaning up the system, confidence will not return to our markets.

The writer is a mechanical engineer by training and a business consultant by profession

No comments: