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| A V Rajwade: The dominant minority-III | | Many financial industry high flyers made fortunes through activities that were destructive from a social point of view |
| A V Rajwade / New Delhi Aug 10, 2009, 00:33 IST |
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In the context of huge volatility in the price of crude oil, last week, I quoted Prime Minister Gordon Brown and President Nicolas Sarkozy calling on regulators “to consider improving transparency and supervision of futures markets to reduce damaging speculation….This would serve the interests of orderly and adequate investment in future supplies. Volatility and opacity are the enemies of growth”. Whether the regulator acts or not, the speculators have surely made tens, if not hundreds, of billions of dollars in profit — to my mind, at the cost of the rest of the world. And, apart from oil, such volatility in prices has also been manifested by other commodities like steel, copper, etc — prices critical to global inflation.
Consider another kind of commodity — namely foreign currencies. In the floating rate era, currencies, in terms of their exchange rates, have assumed the characteristics of commodities — with their prices fluctuating every minute. Since its birth a decade ago, the euro has moved between $ 0.8270 (October 25, 2000) and $ 1.6027 (July 7, 2008). In less than 3 ½ years, the yen had gyrated between JPY 80.22 (April 19, 1995) and JPY 147.14 (August 11, 1998)!
During the period, there has been little change in the fundamentals of the three economies in terms of inflation rates, current account etc — in any case, nowhere close enough to justifying the changes. Market-determined exchange rates are supposed to be rational outcome of efficient markets, reflecting all known economic data, relevant to the price: Empirical evidence, does not support the hypothesis. (It does, however, support the corollary, that future price moments are unpredictable).
The reasons why, too often, market outcomes are less than rational are several:
It is speculative (not end-user) demand/supply that determines prices, whether of currencies or commodities;
The speculation is on a gigantic scale: Currency markets trade more than $ 3 trillion every day; the average daily cross-border trade in goods and services is just 3 per cent of that; an average barrel of oil was changing hands more than 25 times between the producer and the end-user, at the height of the oil price boom;
The expectation that rational arbitragers would step in if prices deviated too far from fundamental values, and correct them, has proved unrealistic. In fact, the mechanics of trading — stop-loss reversals by bank’s proprietary trading desks; delta hedging; leveraged bets by hedge funds; the ever present herd instinct etc — are such that they all act cyclically in either direction. The rule of the game is that ‘you keep dancing until the music stops’, as Chuck Prince, the Chief Executive of Citibank, said just before he was sacked after huge losses in mortgage securities.
The end result: Huge volatility in prices of currencies and commodities.
The rupee-dollar exchange rate has been as volatile in the last couple of years (2007-08 and 2008-09), with a rupee high of Rs 39.25 per dollar and a rupee low of Rs 51.98 per dollar, a difference of 32.43 per cent. Over the period, the stock market, too, has been equally volatile.
Increasingly, the accepted wisdom seems to be that the real economy must adjust to the prices produced by the financial economy. By no means is this just a theoretical or academic issue. As a believer in the benefits of globalisation, I suspect that volatility of prices of currencies and commodities in particular, have increased the risks in cross-border trade and, indeed, even in badly needed investments. Consider, for example, an entrepreneur wanting to invest in alternate energy sources. What price of oil should he consider for judging the feasibility and viability of such an investment? What exchange rates? One concrete evidence of the benefits of low exchange risks to cross-border trade is the much faster trade growth within the Eurozone as compared to the rest of the world. What Gordon Brown and Nicolas Sarkozy said about oil prices and the need to curb excessive speculation applies equally to exchange rates.
Hence the argument that speculative capital, whether in the form of proprietary trading desks in banks or hedge funds (there is very little difference between the two in practice), has become the dominant minority in today’s global economy, taking out far more than contributing to it in the form of higher market liquidity. (In fact, too often, they have become users, not providers of liquidity!) As Nobel Laureate Paul Krugman argued in a recent column in the New York Times, “many financial industry high flyers made fortunes through activities that were worthless, if not destructive, from a social point of view”. There was some hope that bank’s proprietary trading may be curbed after the recent crisis. But apart from Goldman Sach’s jump in trading profits, which I commented on a couple of weeks ago, recently both Barclays and HSBC have reported a doubling of trading income in H1 of 2009, even as profits in traditional banking slumped. If this continues, we should see even more volatility in prices of currencies, commodities and equities.
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