Turbulence in World Financial Markets & China
London, UK - 28 February 2007, 22:23 GMT - Sharp
financial market sell-offs began in Shanghai at the start of Tuesday,
February 27. The sell-offs in China quickly spread in a wave moving across
markets throughout the world in the ensuing hours. News and media commentators
rang alarms virtually everywhere. Panic spread, among both big and small
investors in Asia, Europe and North America. By the time the wave hit
Wall Street, the Dow Jones average fell by more than 400 points, with
more selling stopped by the close of the market day. By Tuesday, calm
settled in as investors began to reconsider all their assumptions about
We are grateful to Dr Harald Malmgren based in Washington
DC for his submission to ATCA "Complex Turbulence in World Financial
Markets and The China Risk."
Dr Harald Malmgren is an internationally recognised expert on world
trade and investment flows who has worked for four US Presidents. His
extensive personal global network among governments, central banks,
financial institutions, and corporations provides a highly informed
basis for his assessments of global markets. At Yale University, he
was a Scholar of the House and Research Assistant to Nobel Laureate
Thomas Schelling, graduating BA summa cum laude in 1957. At Oxford University,
he studied under Nobel Laureate Sir John Hicks, and wrote several widely
referenced scholarly articles while earning a DPhil in Economics in
1961. His theoretical works on information theory and business organization
have continued to be cited by academics over the last 45 years. After
Oxford, he began his academic career in the Galen Stone Chair in Mathematical
Economics at Cornell University.
Dr Malmgren commenced his career in government service under President
John F Kennedy, working with the Pentagon in revamping the Defense Department's
military and procurement strategies. When President Lyndon B Johnson
took office, Dr Malmgren was asked to join the newly organised office
of the US Trade Representative in the President's staff, where he had
broad negotiating responsibility as the first Assistant US Trade Representative.
He left government service in 1969, to direct research at the Overseas
Development Council, and to act as trade adviser to the US Senate Finance
Committee. At that time, he authored International Economic Peacekeeping,
which many trade experts believe provided the blueprint for global trade
liberalisation in the Tokyo Round of the 1970s and the Uruguay Round
of the 1980s. In 1971-72 he also served as principal adviser to the
OECD Wise Men's Group on opening world markets, under the chairmanship
of Jean Rey, and he served as a senior adviser to President Richard
M Nixon on foreign economic policies. President Nixon then appointed
him to be the principal Deputy US Trade Representative, with the rank
of Ambassador. In this role he served Presidents Nixon and Ford as the
American government's chief trade negotiator in dealing with all nations.
While in USTR, he became known in Congress as the father of "fast
track" trade negotiating authority, which he first introduced into
the historically innovative Trade Act of 1974. He was the first official
of any government to call for global negotiations on liberalisation
of financial services, and he was the first US official to call for
the establishment of an Asian-Pacific Economic Cooperation arrangement,
known in more recent years as APEC.
In 1975 Dr Malmgren left government service, and was appointed Woodrow
Wilson Fellow at the Smithsonian Institution. From the late 1970s he
managed an international consulting business, providing advice to many
corporations, banks, investment banks, and asset management institutions,
as well as to Finance Ministers and Prime Ministers of many governments
on financial markets, trade, and currencies. He has also been an adviser
to subsequent US Presidents, as well as to a number of prominent American
politicians of both parties. Over the years, he has continued writing
many publications both in economic theory and in public policy and markets.
He is Chief Executive of Malmgren Global and also currently the Chairman
of the Cordell Hull Institute in Washington, a private, not-for-profit
"think tank" which he co-founded with Lawrence Eagleburger,
former Secretary of State. He writes:
Dear DK and Colleagues
Re: Complex Turbulence in World Financial Markets and The China Risk
Sharp financial market sell-offs began in Shanghai at the start of Tuesday,
February 27. The sell-offs in China quickly spread in a wave moving
across markets throughout the world in the ensuing hours. News and media
commentators rang alarms virtually everywhere. Panic spread, among both
big and small investors in Asia, Europe and North America. By the time
the wave hit Wall Street, the Dow Jones average fell by more than 400
points, with more selling stopped by the close of the market day. By
Tuesday, calm settled in as investors began to reconsider all their
assumptions about world markets.
What really happened on the 27th? Was this just an "anomaly,"
as a White House spokesman suggested, or does this portend a disaster
ahead? And for whom?
To put this event in perspective, if we exclude October 19, 1987, the
US stock market has experienced declines of more than 3.0 percent on
37 different occasions. Over the following month the indexes rebounded
by an average of 3 percent. In almost half of these occasions all of
the decline was erased within one month. So we should look not at the
lessons for this week, but rather for the lessons in the months and
In recent years the financial markets of every country have become fused
into a single global marketplace. This has been enabled by huge advances
in information technology, which allows investors anywhere to view what
is happening in real time in virtually every nook and cranny of world
markets. A surge in global economic growth has led to an even stronger
surge in the building of collective savings and wealth worldwide, generated
not only by savers in Japan, North America, Western Europe and Australia
but also by the OPEC countries, Russia, China and its Asian neighbourhood.
The world's rapidly accumulating financial wealth is increasingly managed
by professional money managers working in financial institutions, hedge
funds, and a variety of other asset management businesses. The stock
and bond markets in virtually every country are now dominated by these
financial enterprises. Hedge funds alone are estimated to account for
over half of the daily trading in US stocks. Institutional investors,
including investment banks, hedge funds, mutual funds, insurance companies,
public and private pension funds, trusts, foundations, and endowments
have a predominant influence on what takes place in markets. The retail
market of individual investors is no longer a driver in most markets.
Institutional investors and hedge funds do try to manage their risk
exposure, and they increasingly do this by diversifying their investments.
Diversification is undertaken geographically; it is accomplished by
spreading investments among many classes of assets, including stocks,
bonds and various other forms of public and private debt, derivatives
based upon measures of various slices or degrees of risk, currencies,
real estate, energy and raw materials, and unregistered securities like
venture capital and private equity enterprises. Investments are not
only made in current assets, they are also made in the form of expectations,
through the futures markets.
This growing diversity and complexity of financial markets has spread
the risks of market accidents far more widely than ever before in history.
For example, most mortgage bankers in America no longer hold on to the
mortgage loans they provide for home buyers. Instead, many mortgages
are bundled as single securities and sold off to other investors such
as pension funds, which are attracted to the relatively higher yields
of mortgage debt compared with government bonds. Companies that want
to borrow large sums of capital no longer need to rely on bank loans.
They can issue complex financial obligations directly to investors,
and these debt obligations are then sold and resold to an ever widening
array of institutional investors. The ever-widening diversification
of risk leaves big banks and investment banks with little direct exposure
to business failures or economic downturns. This global diversification
also suggests to institutional investors that although there may be
some risks within their portfolios, the probability of meaningful damage
under most plausible scenarios is minimal.
Many of the hedge funds and proprietary desks of big financial institutions
use financial leverage to achieve returns for their investors which
beat market averages. In recent years, growing savings accumulated in
many countries have spilled into world markets generating rivers of
what professional investors call financial liquidity. This river of
liquidity is surging through all markets. Much of it managed by professionals
in London and New York who, using leverage, spread the continuing flow
of new investment capital throughout world markets -- a large portion
of it going to the most liquid markets, of which the US financial market
is still the biggest.
Some countries, most notably Japan, continue to maintain low domestic
interest rates because of underlying domestic economic weaknesses. Japanese
and foreign investors alike have seen the opportunity of borrowing in
Japanese Yen, selling the Yen, and investing in higher-yielding assets
and currencies in far away places like New Zealand, Australia and the
US. This practice is called carry trade. Inside Japan, households account
for a huge share of the Yen carry trade, as they seek to get better
returns on their savings than can be found in miniscule yields on Japanese
time deposits or government bonds. Investors in Europe and the US also
use Yen borrowing to finance highly leveraged investments in other markets
throughout the world.
The flow of liquidity is now so large that central banks have difficulty
guiding their own national capital markets. The Federal Reserve can
set short term interest rates at a specific level, but global capital
flows overwhelm what the Fed tries to do by pouring into longer-term
American bonds. In recent months, the inflow of domestic and international
capital to the US bond market pushed prices of US bonds up and yields
on those bonds down, well below the Federal Reserve's target rate of
interest. What happened is that long-term rates have become much lower
than short-term rates in the US. In the past, this phenomenon usually
signalled a recession to come, but right now it simply signals that
global investors believe one of the safest places to hold capital is
in the US debt market.
The flow of liquidity and the widespread diversification of risk have
lulled most investors into an eerie calmness about what might go wrong.
The competitive scramble for enhancing investment performance by every
financial manager has led to rapidly increasing use of leverage in investment.
Risky investments with higher yields are sought after, driving up their
value and down their yields, until the difference between risky and
less risky assets has all but disappeared. For months, the "spreads"
between risky and non-risky assets have become paper thin, and volatility
in financial markets has disappeared. It is as if everyone expects the
next days and months will continue to be characterized by mirror-like
flat seas and gentle winds into which to sail. Central bankers often
worry about this tendency of the markets to "price everything to
perfection." Their fear is that small surprises could generate
big shocks, particularly because most of the big players in the market
are highly leveraged.
However, risks are never eliminated. There are always unanticipated
problems that generate shocks. 9-11 brought to financial managers a
personal recognition of the challenges posed by terrorism. Continuing
terrorism affects diversification strategies. Political volatility in
the Middle East keeps energy traders on edge. Climate chaos, as pointed
out by ATCA, including weather swings are now a major element in evaluating
the outlook for everything from agricultural crops to energy use, and
even to energy production in offshore oil rigs and refineries located
China has shown such an extraordinary rise in economic strength over
recent years that it has become commonplace to project continued straight-line
growth to the point that China is expected by many analysts to become
the next global superpower. Because China's economy functions under
Communist leadership, it is widely assumed that somehow the government
will be able to steer the economy away from severe disruptions or collapse.
The Chinese Communist Party leadership understands that its economy
is characterized by distorted or misplaced investments, corruption,
and excessive speculation. The leadership has tried a number of different
tactics to rein in what seems to be a runaway economy, with only limited
success. Politically, a new danger has emerged as millions upon millions
of Chinese households have stepped up borrowing to speculate in stocks
and real estate, generating what Westerners would call a big bubble
-- ready to burst.
Chinese authorities have been publicly warning for many days now that
there is a stock market and real estate market bubble. These public
warnings should have awakened foreign investors to growing risks in
China -- not only from market forces but from implied government action.
The February 27 "correction" in Shanghai was encouraged, perhaps
even engineered by Chinese authorities. There will have to be more "corrections"
ahead in the Chinese financial market. Many foreign investors in China
and its surrounding Asian neighbourhood should not have been surprised
on February 27, and they should not be surprised when more such events
come in the near future.
In our view, China will experience a number of economic and environmental
accidents in the next two or three years. These accidents will stimulate
political unrest and heightened strains within the political structure
of China, at the national level, and between the national and local
levels. Troubles in China will affect China's neighbourhood, the economies
of which are inextricably interactive with China. Moreover, for those
analysts who confidently state that China's economy is now the "other
engine of global growth" besides the US economy, prudence would
suggest making the caution that "China will function as the other
engine of global growth if the political framework of China can successfully
avoid a hard landing, and can sustain itself in a position of national
power over a highly decentralised nation." These are big unknowns
What happened on February 27 was that highly leveraged investors throughout
the world experienced a big, unanticipated event in China, and out of
fear of what else might go wrong rushed to protect themselves by trimming
leverage in many other markets. When many investors reduce leverage
at the same time, the need for immediate cash puts stress on the global
financial system. The easiest, most liquid assets to sell quickly are
the blue chip stocks, which resulted in a abrupt, sharp reductions in
valuations in Europe and the US in subsequent hours. Yet another unanticipated
shock materialized in New York, when the computerized trading systems
of Wall Street temporarily froze. Orders were not recorded correctly,
and the market appeared to drop another 200 points all at once at 3:00pm.
The stock market managers explained this away by saying there were computer
"glitches," but this unanticipated event must now be added
to the list of possible future risks: If everyone is rushing to the
exit doors at the same time, will the doors open? Will the markets actually
function? If not, who will end up holding the risk? Investors ask this
another way: "Where is the counterparty risk?"
Regulators in London, New York, and elsewhere are now trying to rein
in the exponentially growing trading activities which appear to be based
on increasing leverage combined with an assumption of endless flows
of liquidity. Their task is difficult and challenging, because if they
step on the brakes too firmly with tougher rules on leveraging, many
investment groups will seize up and crash through the windscreen. If
they issue stricter "guidance" and greater direct oversight
of what is going on they will need more transparency in the functioning
of hedge funds and institutional traders. But these latter groups of
investors thrive on secrecy, believing the way they win competitively
is by taking positions before other investors know what those positions
Thus we expect yet another risk to investors in coming months generated
by the growing pressure of regulators to reduce leverage and increase
transparency. Many institutions now rely on leverage to increase their
performance at a time of gradual economic slowdown, slowing growth of
corporate earnings, and thinness of spreads between risky and non-risky
assets. Reducing their leverage will weaken their investment performance.
One wonders whether central bankers and other regulators, most of whom
are officials without direct market experience, can engineer a gentle
"adjustment" in the frenetic pursuit of performance by the
institutional investors which now dominate world financial markets.
In other words, we should add "regulatory risk" as yet another
risk to the list of things about which to be concerned.
As for those who once could count upon the central banks as lenders
of last resort, we can only say their ability to stabilize markets now
is less than it was only a decade or two ago when market capitalization
was smaller and financial complexity much simpler. And for those who
argue that central banks will not themselves be caught up in the globalization
of markets, we must caution that even their role is changing -- just
consider what China is thinking to do with a significant part of its
vast foreign currency reserves, by diversifying some of its holdings
away from official bonds to market-based assets throughout the world.
If China goes ahead with this kind of diversification, the government
of China will become a major player in all segments of world financial
In conclusion, it is important to keep in mind terrorism, the Middle
East, climate chaos including weather changes and other such risks,
but it is also imperative to keep in mind the ability, or lack of ability
of governments and central banks to keep order.
Right now, markets are not adequately pricing risk. When trouble comes,
the weakest markets and economies will suffer most-- most especially
the emerging market economies. And when trouble comes to global markets,
capital will tend to flee from risk to "quality." Most likely,
the primary beneficiary will be the US economy and the US Dollar, however
much many non-US ATCA members may say that would be an unfair or undeserved
We look forward to your further thoughts, observations and views.
For and on behalf of DK Matai, Chairman, Asymmetric Threats Contingency
ATCA: The Asymmetric Threats Contingency
Alliance is a philanthropic expert initiative founded in 2001
to resolve complex global challenges through collective Socratic
dialogue and joint executive action to build a wisdom based global
economy. Adhering to the doctrine of non-violence, ATCA addresses
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poverty, organised crime & extremism, advanced technologies
-- bio, info, nano, robo & AI, demographic skews, pandemics
and financial systems. Present membership of ATCA is by invitation
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officials and over 1,500 CEOs from financial institutions, scientific
corporates and voluntary organisations as well as over 750 Professors
from academic centres of excellence worldwide.
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