Foreign capital must not be blocked
Wednesday, 17 October 2007
Mohamed El-Erian
AFTER this summer's turmoil, markets have entered a tentative healing phase helped by significant injection of central bank liquidity and a cut in US interest rates. The inter-bank market is normalising, credit costs are falling and share prices have resumed the march to record levels.
It is thus tempting to view the summer's disruptions as a "flesh wound" and to return to business as usual. But such a reaction would be inadvisable, as the uncertainty about the future relates to more than just economic and financial issues: it also has an important political dimension.
Unlike the majority of the systemic shocks experienced in the past 25 years, this one originated in the US, the country with the most sophisticated financial system. While collateral damage was felt around the globe, the classic bank run requiring emergency policy intervention occurred in another industrial country - the UK - and not in an emerging economy. Moreover, large intraday interest rate swings, approaching 100 basis points, were more evident in short-dated US Treasury bills than in emerging market bonds. It is therefore not surprising that the summer's turmoil has fed concerns about the outlook for income and employment in the US and about the robustness of economic growth in the rest of the world.
These concerns will play out in the coming months. I am inclined to believe that the US economy will slow substantially but not contract and that the rest of the world will continue gradually to decouple in a healthy manner. Indeed, it may well be that the uncertainty surrounding the economic outlook is less than that pertaining to political reactions triggered by recent events.
As market participants gradually unclog blockages in various segments of the financial system, politicians are likely to spend a lot of time debating the causes and consequences. The debates will go well beyond the debacle in subprime mortgage lending, increases in foreclosures and the adequacy of consumer protection. Questions will be asked about how complex financial activities ended up migrating to institutions outside the purview of sophisticated scrutiny and regulatory bodies.
There will be interest in how segments of the most sophisticated financial system in the world could not come up with market-based valuations, thereby inhibiting meaningful inter-actions between buyers and sellers. Inquiries will be directed to a banking system that somehow managed to lose sight of the size of its balance sheet commitments.
All these issues are relevant to how well the market system functions. As such, it is both understandable and desirable that the official sector - the executive and legislative branches, agencies and regulators - ask questions and look for solutions. But in doing so, it is important to remember the delicate line that separates repairs from distortions.
In past systemic crises, the official sector has welcomed injections of liquidity from other sources while repairs were being undertaken. After all, such liquidity serves to facilitate adjustments occasioned by market dislocations. But this welcome is less forthcoming today. Politicians in some industrial countries draw little comfort from the fact that a portion of the dry powder is in the form of newly acquired capital managed by sovereign wealth funds (SWFs) in emerging economies.
Rather than allow the deployment of this capital in a manner that allows the international system to sustain high growth and investment, they are considering harmful roadblocks citing ill-defined concerns about "national security" and the possibility that SWFs will make "non-commercial" decisions to allocate funds.
In encouraging transparency and disclosure for sovereign wealth funds, politicians in industrial countries are well advised to focus on issues of governance, process and risk management rather than take a broad approach that would inflict two distinct costs on the global economy.
First, by frustrating a natural and gradual process of portfolio diversification by SWFs, undue political interference would create distortions in other financial markets, limit the flow of capital to employment-creating activities in industrial countries and undermine the wellbeing of future generations in emerging economies.
Second, excessive limits on crossborder capital flows would fuel protectionist forces around the world and accentuate the impact of already slow moving efforts to liberalise trade. This is particularly so as it is estimated that SWFs manage only about 2.0 per cent of global financial assets, yet face the prospects of restrictions that go well beyond those envisaged for larger pools of capital (such as leveraged hedge funds).
In seeking to overcome recent turmoil and strengthen the financial system, the official sector is correct in providing breathing room through injections of liquidity and in taking steps to prevent fraudulent behaviour.
But politicians must avoid the temptation of going too far. If they knowingly or inadvertently frustrate the proper functioning of markets, they run the risk of derailing a comprehensive repair job - a job that can only be delivered by sustained actions on the part of market participants to retool the internal plumbing system, by improved risk management and by the free flow of capital across geographical and product boundaries.
The writer is president and chief executive of Harvard Management Company. In January he will join Pimco as co-chief executive and co-chief investment officer.
FT Syndication Service
AFTER this summer's turmoil, markets have entered a tentative healing phase helped by significant injection of central bank liquidity and a cut in US interest rates. The inter-bank market is normalising, credit costs are falling and share prices have resumed the march to record levels.
It is thus tempting to view the summer's disruptions as a "flesh wound" and to return to business as usual. But such a reaction would be inadvisable, as the uncertainty about the future relates to more than just economic and financial issues: it also has an important political dimension.
Unlike the majority of the systemic shocks experienced in the past 25 years, this one originated in the US, the country with the most sophisticated financial system. While collateral damage was felt around the globe, the classic bank run requiring emergency policy intervention occurred in another industrial country - the UK - and not in an emerging economy. Moreover, large intraday interest rate swings, approaching 100 basis points, were more evident in short-dated US Treasury bills than in emerging market bonds. It is therefore not surprising that the summer's turmoil has fed concerns about the outlook for income and employment in the US and about the robustness of economic growth in the rest of the world.
These concerns will play out in the coming months. I am inclined to believe that the US economy will slow substantially but not contract and that the rest of the world will continue gradually to decouple in a healthy manner. Indeed, it may well be that the uncertainty surrounding the economic outlook is less than that pertaining to political reactions triggered by recent events.
As market participants gradually unclog blockages in various segments of the financial system, politicians are likely to spend a lot of time debating the causes and consequences. The debates will go well beyond the debacle in subprime mortgage lending, increases in foreclosures and the adequacy of consumer protection. Questions will be asked about how complex financial activities ended up migrating to institutions outside the purview of sophisticated scrutiny and regulatory bodies.
There will be interest in how segments of the most sophisticated financial system in the world could not come up with market-based valuations, thereby inhibiting meaningful inter-actions between buyers and sellers. Inquiries will be directed to a banking system that somehow managed to lose sight of the size of its balance sheet commitments.
All these issues are relevant to how well the market system functions. As such, it is both understandable and desirable that the official sector - the executive and legislative branches, agencies and regulators - ask questions and look for solutions. But in doing so, it is important to remember the delicate line that separates repairs from distortions.
In past systemic crises, the official sector has welcomed injections of liquidity from other sources while repairs were being undertaken. After all, such liquidity serves to facilitate adjustments occasioned by market dislocations. But this welcome is less forthcoming today. Politicians in some industrial countries draw little comfort from the fact that a portion of the dry powder is in the form of newly acquired capital managed by sovereign wealth funds (SWFs) in emerging economies.
Rather than allow the deployment of this capital in a manner that allows the international system to sustain high growth and investment, they are considering harmful roadblocks citing ill-defined concerns about "national security" and the possibility that SWFs will make "non-commercial" decisions to allocate funds.
In encouraging transparency and disclosure for sovereign wealth funds, politicians in industrial countries are well advised to focus on issues of governance, process and risk management rather than take a broad approach that would inflict two distinct costs on the global economy.
First, by frustrating a natural and gradual process of portfolio diversification by SWFs, undue political interference would create distortions in other financial markets, limit the flow of capital to employment-creating activities in industrial countries and undermine the wellbeing of future generations in emerging economies.
Second, excessive limits on crossborder capital flows would fuel protectionist forces around the world and accentuate the impact of already slow moving efforts to liberalise trade. This is particularly so as it is estimated that SWFs manage only about 2.0 per cent of global financial assets, yet face the prospects of restrictions that go well beyond those envisaged for larger pools of capital (such as leveraged hedge funds).
In seeking to overcome recent turmoil and strengthen the financial system, the official sector is correct in providing breathing room through injections of liquidity and in taking steps to prevent fraudulent behaviour.
But politicians must avoid the temptation of going too far. If they knowingly or inadvertently frustrate the proper functioning of markets, they run the risk of derailing a comprehensive repair job - a job that can only be delivered by sustained actions on the part of market participants to retool the internal plumbing system, by improved risk management and by the free flow of capital across geographical and product boundaries.
The writer is president and chief executive of Harvard Management Company. In January he will join Pimco as co-chief executive and co-chief investment officer.
FT Syndication Service