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 years ahead.

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 by seaports.

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 right now.

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 are.

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 markets.

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 outcome.

Best wishes


Harald Malmgren

[ENDS]

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