The Hindu Business Line : Problems in the capitalist market

AFTER conducting a year-long research on financial markets across 100 countries since 1980, the Mckinsey Global Institute (MGI) has said in its report Mapping the Global Capital Market that, with growing cross-border capital flows, the world's capital markets now enjoy unprecedented breadth and strength.

According to MGI, financial institutions routinely move assets worth trillions of dollars — stocks, bonds, and other instruments — around the globe. Cross-border capital flows and foreign holdings of financial assets continue to grow rapidly, linking individual financial markets to form an increasingly integrated global one.

Executives who seek to raise money, institutions hoping to shape the global capital market, and policy makers who regulate it must all understand its evolution.

This research, says MGI, yields several notable observations. "One of them is simply that global capital markets are huge: We calculate that the world's financial assets now total more than $118 trillion and will exceed $200 trillion by 2010 if current trends persist. The stock of global financial assets has grown faster than the world's GDP, indicating that financial markets are becoming deeper and more liquid. With a few qualifications, this trend bodes well for the world's economies, since deeper markets provide better access to capital and improve the allocation of risk.

"Much of the growth in global financial assets comes from a rapid expansion of corporate and government debt, with all of the attendant benefits and risks.

"Last, the roles that major countries and regions play in capital markets are changing. The United States has the largest of them, which attracts foreign issuers and investors alike. European markets are becoming more integrated, however, and gaining in market share and depth. Meanwhile, Japan's role in global capital markets is diminishing and China has become a new force."

As McKinsey & Co has pointed out, three global themes emerge from MGI's analysis of the global financial stock which is, quite simply, the total financial capital available for intermediation.

First, the development and expansion of financial institutions such as banks and stock markets far outpaces the growth in underlying GDP, resulting in financial deepening. While the global financial stock was similar in size to the world's GDP in 1980, today it is more than three times larger.

Financial deepening, according to McKinsey & Co, is usually beneficial, giving households and businesses more choices for investing their savings and raising capital as well as promoting a more efficient allocation of capital and risk.

Second, debt securities are today the most important asset class in the global financial stock. They hold the largest share of GFS and have been steadily expanding over time. The relative role of private and government securities varies across geographies; for example, government debt is a relatively small share of the US's and the UK's financial stock, but dominates Japan's.

Third, the roles of the different regions in the GCM are shifting, reflecting the profound contrasts in size, composition, growth, and degree of integration. The US maintains a unique role as the hub for GCM, which bolsters its dominance in private debt and equity securities. Europe is integrating quickly and is gaining global share across all asset classes. Japan's global role is diminishing in all assets but government debt, which has driven most of Japan's growth in financial stock. And China, while still relatively small in the GCM, controls a meaningful share of global bank deposits.

All this would have been most reassuring if it had not been for the ambivalence which runs through the International Monetary Fund's recently released semi-annual assessment on the state of global financial markets.

The document gets off to a rousing start with claims of an enhanced "resilience of the global financial system in the last six months" because of "continued improvement" in the corporate, financial and household sectors in many countries. It then goes on to deal extensively with the dangers arising from the ever-increasing complexity of the structure of the global financial system!

According to the Global Financial Stability report, the global financial market, in past decade and a half, has been witness to the rapid growth of complex financial instruments designed to spread risk and increase stability.

However, the report then segues into a concession that, in a time of intense market fluctuations, this process could itself become a source of greater instability as these instruments primarily rely on quantitative mathematical models for value, assessments and pricing. "Therefore, there is a risk that models that are overly similar in their construction could cause investors to rush to exit at the same time, leading to market liquidity shortages."

This observation is sufficient to send chills running up the collective spine of the global financial community which remembers all too well the crisis which overtook the hedge fund, Long Term Capital Management (LTCM), in September, 1998, culminating in a $3-billion bailout carried out through the New York Federal Reserve. LTCM's investments were based on complex mathematical models which were almost indistinguishable from those of other funds. Thus, if LTCM had gone down, the other funds would have sunk like so many stones too...

The report makes a very valid point that while risk management may have been strengthened in recent times, the system continues to depend almost solely on financial institutions having ready access to liquidity in times of "market stresses".

And then again, most risk management models dealing with the recently devised complex instruments such as derivatives "have not been subjected to a live test" as a result of which no one really knows for certain whether "the anticipated counter-parties will stand ready to absorb the additional market and credit risks from those who would like to shed it."

Shorn of jargon, what the report points out is that one of the most critical problems of the capitalist market — the difficulty faced by sellers in finding buyers in times of trouble — persists, however complex and sophisticated the instruments currently under use may be.

At a macro level, the report identifies the weakness of the US dollar and the mounting US payments deficit as potential sources of instability.

These are, of course, fears that are shared by many.

For instance, the former US Federal Reserve Board Chairman, Mr Paul Volcker, in an article published recently in the Washington Post, began by pointing out that, under the apparent placid surface of the world economy "there are disturbing trends: huge imbalances, disequilibria risks — call them what you will."

"Altogether the circumstances seem to me as dangerous and intractable as any as I can remember, and I can remember quite a lot. What really concerns me is that there seems to be so little willingness or capacity to do much about it."

Touching upon the fact that the US economy is being held together by a massive inflow of capital — adding up to more than $2 billion every working day — Mr Volcker wrote: "The difficulty is that this seemingly comfortable pattern can't go on indefinitely. I don't know of any country that has managed to consume and invest six per cent more than it produces. The United States is absorbing about 80 per cent of the net flow of international capital. And at some point, both central banks and private institutions will have their fill of dollars."

While Mr Volcker denied any prescient insight into whether the situation would end with a bang or a whimper, he made it plain that, in his opinion, financial crises — as against policy foresight — would drive changes in the global financial system.

Article E-Mail :: Comment :: Syndication :: Printer Friendly Page

Stories in this Section
Not wholly creditable

A bad show

Afghanistan: Challenges abound

Business defines Sino-Indian relations

How AIDS saps the economy

Giving people a right to information

What is the optimum rate of tax?

Problems in the capitalist market

EPF rate issues

Lalu's lore