ROLE OF FUTURES & DERIVATIVES IN AN EMERGING ECONOMY
at the Financial Seminar
São Paulo, Brazil
October 14, 1997
1985 motion picture, Brazil, directed by Terry Gilliam,
was a wonderful Orwellian satire that depicted the world of the
future as dark and evil, existing within a senseless bureaucratic
structure. But there was one imaginary exception: it was Brazil,
the world's remaining Camelot.
a frequent visitor to this wonderful country, I can readily understand
why Gilliam chose Brazil as his imaginary paradise. Indeed, Brazil's
vibrant people, rich natural resources, and abundant sunshine
are sufficient to qualify it as for this role. But in choosing
Brazil, Gilliam made one fatal error. You see Gilliam is a movie
maker and as such, it seems, had little knowledge of economics.
What he did not know was that for a country to qualify as a candidate
for paradise required one additional component: free and
efficient capital markets. Alas, this condition in Brazil
of 1985 was but a dream.
perhaps Gilliam was a greater visionary than we gave him credit.
Here we are, a scant twelve years later and Brazil is well on
the road to achieve its own economic Camelot.
Need for Efficient Capital Markets
is no longer any guesswork on the subject. The largest difference
between rich and poor countries— between economic hope and economic
despair for its people—is the freedom and efficiency with which
they can utilize their resources. Free and efficient capital
markets ensure that resources are allocated wisely. They foster
the movement of savings into productive investments. The more
efficient the system, the better the allocation of these resources.
The more productive the investment, the higher the rate of growth.
it is axiomatic! Efficient markets lead to tighter bid-ask spreads,
higher volumes of trading, and greater market liquidity. In an
efficient market, all information relevant for determining the
value of a product is reflected in the current market price.
A liquid market reflects truer price values and gives investors
confidence in the marketplace. Liquidity in the marketplace encourages
participants to readily convert securities into cash, or vice
versa, at reasonable costs and speeds. As a consequence, the
cost of capital is reduced and the social order is greatly benefited.
how can a society strive to achieve efficient and free markets?
It's not easy. It takes time and determination and there are
many pitfalls along the way. The history of Latin America is
replete with proof of the difficulty in attaining this precious
goal. So are the recent events in Southeast Asia (more about
that later). If there is one single mandatory requirement, it
is the one Milton Friedman proclaims. He will tell you that economic
freedom cannot be achieved without the coincidence of political
freedom. We need only review the recent history of the Soviet
Union to recognize the wisdom of this ideal. Political freedom
is indeed a fundamental prerequisite in the journey toward efficient
markets. So are financial derivatives.
derivatives represent some of the basic tools necessary in the
mechanics of efficient capital markets. Derivatives have become
an integral part of the financial system in the world's leading
economies. Allow me to quote no less an authority than Alan Greenspan,
Chairman of the U.S. Federal Reserve Board:
array of derivative products that has been developed in recent
years has enhanced economic efficiency. The economic function
of these contracts is to allow risks that formerly had been
combined to be unbundled and transferred to those most willing
to assume and manage each risk component.(1)
Function of Derivatives
driving force behind the recent growth of derivatives was radical
technological advancements in computer science. This technological
revolution was global and unleashed profound transformations
in every component of civilization—from science to finance. Computer
technology enabled the world to move from the big to the little,
from the vast to the infinitesimal. In physics, we moved from
General Relativity to quantum mechanics. In biology, from individual
cells to gene engineering. And similarly in markets, from macro
to micro. State-of-the-art computerized systems offered financial
engineers the ability to divide financial risk into its basic
provide three important economic functions: (1) risk management,
(2) price discovery, and (3) transactional efficiency.
The primary purpose of risk management is to protect existing profits,
not to create new profits. It is imperative to understand
this purpose and function. Risk management involves the structuring
of financial contracts to produce gains (or losses) that counterbalance
the losses (or gains) arising from movements in financial prices.
by virtue of derivatives application, risks are reduced and profit
is increased over a wide sphere of financial enterprise and in
various ways—from businesses whose efficiency is enhanced, to
banks whose depositors and borrowers are benefited; from investment
managers who increase their performance for clients, to farmers
who protect their crops; from commercial users of energy, to
retail users of mortgages.
price discovery. This represents the ability to achieve and disseminate
price information. Without price information, investors, consumers,
and producers cannot make informed decisions. They are then inhibited
and deterred from directing their capital to efficient uses.
Derivatives are exceptionally well suited for the role of providing
price information. They are the tools that assist everyone in
the marketplace determine value. The wider the use of derivatives,
the wider the distribution of price information. In this respect,
I must underscore that futures exchanges are particularly adept
at price discovery and dissemination of price information.
transactional efficiency. Transactional efficiency is the product
of liquidity. Inadequate liquidity results in high transaction
costs. This impedes investments and deters the accumulation of
capital. Derivatives facilitate the opposite result. They significantly
increase market liquidity. As a result, transactional costs are
lowered, the efficiency in doing business is increased, the cost
of raising capital is lowered, and the amount of capital available
for productive investment is expanded.
derivatives are used for speculative purposes—as they often are—they
are not being applied toward risk management. Such uses have
given rise to the impression that derivatives create risk. That
is an uninformed judgment and generally untrue. As every academic
study undertaken has shown, when derivatives are used to manage
risk, they deal with risks that already exist. These represent
the four basic types of financial risk in the marketplace: equity
risk, foreign exchange risk, interest rate risk, and commodity
price risk. These are not risks created by derivatives;
they are risks inherent in business. Interest rates go up and
down, the value of the dollar and the real fluctuate, prices
of equity markets change, crop yields rise and fall depending
on the weather and a host of other variables. Risk management
through derivatives helps protect these price exposures. The
risks resulting from non-speculative derivatives application
are therefore transferred risks and are not new.
Unruly Road Toward Market Efficiency
one cannot speak about efficiency of markets without mentioning
the role of the speculator. All modern analysis leads to the
conclusion that competitive speculation serves an all-important
role in improving price efficiency. Speculation enhances market
liquidity by creating higher levels of trading and a tighter
bid-ask spread. The more trading and smaller the spread, the
more market prices will migrate toward their true values. The
more investors are confident that market prices reflect a high
level of accurate information, the more willing they are to commit
capital with a smaller premium for uncertainty. Thus, where speculation
is high, the cost of capital will be lower, and the efficient
allocation of capital among competing investments more likely.
In other words, just as Adam Smith suggested a long time ago,
by performing his greedy speculative function, the speculator
serves the overall economy.
leads us directly to the recent problems and controversies in
Southeast Asia. Last August, an Indonesian newspaper close to
the government ran an advertisement with a picture of a currency
trader wearing a terrorist mask made of American $100 bills. "Defend
the Rupiah," the ad urged, "Defend Indonesia." Indeed, recent
financial troubles in Southeast Asia have resulted in some of
its leaders accusing currency speculation as the main culprit
of their problems. Nothing new about that. Currency speculators
have been a convenient scapegoat throughout the centuries whenever
government policies fail and a country's currency begins to devalue.
main villain in the current attack has been George Soros, the
billionaire financier who is clearly the most colorful and notorious
of the speculator lot. Soros was called a "moron" and a "rogue" by
Malaysian Prime Minister Mahathir Mohamad at the recent IMF World
Bank Conference in Hong Kong. He declared that "currency trading
is unnecessary, unproductive, and immoral... and should be made
illegal." He accused the "great powers" of pressing Asian countries
to open their markets and then manipulating their currencies
to knock them off as competitors.
accusations. Unfortunately, they rang a bit hollow. They came
from a man who loudly applauded his government's string of economic
successes of recent years—built on foreign capital—and who pronounced
grandiose plans to build airports, dams, and a Southeast Asian
Silicon Valley. The same leader who gladly used foreign investments
to build the world's tallest building, Southeast Asia's largest
airport, and harbored visions of a glittering new capital.
he sings a different tune. Now he proclaims his theory of Western
desires to suppress Asian competitors. The reason for his change
in opinion is obvious. After a decade of advances in this region's
journey toward open and efficient markets, serious problems have
erupted. Indeed, Southeast Asia was and still is in a financial
crisis. It began in Thailand, one of the most successful of the "tiger" economies
which attracted billions of dollars in foreign investment, more
than it could wisely invest. Thailand's currency, the ringgit,
has plunged 30 percent against the dollar, its banking system
began to creak, and the Malaysian stock market crashed. Foreign
investors fled and the crisis quickly spread to Indonesia and
Malaysia. It is instructive to examine why this happened, what
mistakes were made, and how to avoid them.
there have been financial crises before—Latin America in the
early 1980s and Mexico in 1995—the feel of what has happened
in Southeast Asia is in some ways quite different. From afar,
it is easy to think of Asia as a seamless whole. But in fact,
it is made up of distinct regional economies that these days
find themselves competing against one another. The explosive
boom in exports to the developed world from low wage China, for
instance, is a large part the underlying cause of Southeast Asia's
slump. A few years ago, the VCRs, televisions, and toys that
lined the shelves of American stores most likely had a Made
in Thailand or Made in Malaysia label. Today they
say Made in China.
Southeastern emerging markets unfortunately came to regard the
private foreign investors as a virtually unlimited source of
funds. Only seven years ago, private investment in developing
nations around the world was a mere $30 billion, compared with
official development aid of nearly $65 billion. Now the proportions
are starkly different. Official aid has declined to $45 billion
last year, and private investment ballooned to roughly $245 billion.
When the money was flowing in, Asian leaders had no complaints.
They were being rewarded, they said, for hard work, rising productivity,
and emergence of an educated middle-class that saved at rates
that put Americans to shame. Now that the money has begun to
flow the other way, leaving many countries with huge debts denominated
in dollars that must be paid back with devalued local currencies,
their attitudes have begun to change. Quickly the argument has
become a debate over "Asian values" versus "western values." Never
mind the facts. Never mind that the market always reacts to perceived
realities. Never mind that the credit rating of Malaysian paper
was lowered by Standard &Poor's from stable to negative
because of Malaysian reluctance to curb rapid credit growth when
inflation was building in the economy.
is always easier to blame currency problems on speculators than
to admit to excessive government spending or lax monetary policy.
And the perfect whipping boy in all this is the United States,
the champion of financial liberalization. Thus it was left for
U.S. Treasury Secretary, Robert Rubin, to lead the defense on
behalf of free markets during the Hong Kong conference. He remained
the standard-bearer of Western view that markets impose discipline
on nations, economies, and most of all, politicians. His 26 years
in investment banking at Goldman Sachs & Company steeped
him in the belief that markets go to extremes but that in the
long run, they reward countries that keep their houses in order
and punish those that do not. He countered Mr. Mahathir by saying
that currency speculation is "part of the total activity in secondary
markets" which "increases liquidity and lowers costs."
real problem in Southeast Asia is not George Soros. It's the
lack of sound economic policies, sober banking practices, and
open markets. Put simply, Southeast Asian nations were living
beyond their means. It began with several years of excessive
money and credit growth. The problem was accentuated when huge
amounts of foreign capital in the form of loans and direct investments
poured into the region. All this encouraged the local population
to spend freely and splurge on imported goods. The predictable
result was that the countries' trade deficits ballooned and their
currencies came under severe pressure. The gravest deficiency
was inadequate government supervision, particularly in the Thai
banking sector. This was a formula for serious trouble. "We became
too rich too quickly" said Thai Finance Minister Thanong Bidaya,
in a display of abject honesty.
course, we don't need to feel sorry for George Soros. He was
fully capable of defending himself and did. The outspoken financier
was eminently correct when he said that the Malaysian Prime Minister's
suggestion to ban currency trading is so inappropriate that it
does not deserve serious consideration. "He is using me," declared
Soros, "as a scapegoat to cover up his own failure." A failure
that was exacerbated when Prime Minister Mahathir ordered restrictions
on short sales and moved to prop up stock prices for Malaysians,
but not for foreign investors. That led investors to flee, and
Mr. Mahathir was soon forced to make a sharp reverse turn. But
the damage to his country's financial credibility was done and
will last for a long time. As Soros told the government officials
who gathered in Hong Kong, "Interfering with the convertibility
of capital at a moment like this is a recipe for disaster. Dr.
Mahathir is a menace to his own country."
cannot help but agree, but there are lessons to be learned. The
current crisis in Asia, just as those experienced in this part
of the world, and those yet waiting to happen in Russia and beyond,
are clear warnings that the road to efficient and free markets
is difficult and beset with dangers. A county's underlying economic
and political structure must have in place sound fiscal policies,
sound regulation of banks and finance companies and a tighter
hand over lending and spending by government-led agencies. As
Jeffrey Garten, Dean of Yale's School of Management recently
lamented, "Free markets are emerging without the required political
preconditions—without adequate regulatory structures, minimal
safety nets, or fair and impartial institutions for enforcing
instance, many emerging markets investors fear the next casualty
for currencies and stock markets after Asia may take place in
Latin America. High on their list of candidates is Brazil, which,
by some economic measures, bears a passing resemblance to Thailand.
How vulnerable is the real, launched just 3 years ago? It is
not just the crucial economic question for Brazil, which is enjoying
its first sustained period of economic stability for decades,
but for the region as a whole. Because Brazil accounts for around
half of the GDP of Latin America, an economic crisis would have
profound ramifications for the rest of the continent.
the potential for markets to become nervous about Brazil, the
government has recently made some pre-emptive economic strategy
moves. The appointments in August of Gustavo Franco as head of
the central Bank and Andre Lara Resnede as special advisor to
President Cardoso were designed to emphasize that there will
be continuity in economic policy—both men were part of the team
of economists that planned the new real. Good moves, but most
analysts agree that the risks in Brazil will start to rise in
the second half of next year as the election approaches.
Latin American experts say the risk of currency contagion in
Latin America—and Brazil in particular—is probably exaggerated,
and that concerns about parallels between Thailand and Brazil
aren't warranted. Economic reforms, high growth, low inflation,
and corporate restructurings have helped boost investor confidence
in the main Latin American markets, and turned them into stellar
performers earlier this year. Brazil's market is up over 60%
while Mexico is up more than 45% so far this year in local currencies.
While the baht's devaluation in July simply highlighted the fact
that many of the southeast Asian currencies looked overvalued,
Brazil's currency, the real, did not come under attack. If it
had, the central bank has over $60 billion in reserves with which
to defend it.
any rate, for now Latin America seems to have shrugged off the
Asian crisis. The reason is obvious. Political stability, steady
economic growth, and fiscal reforms have all shored up investor
confidence in Latin America. This may be a reason why lending
rates are down. A growing number of banks are competing to provide
capital to about a hundred top tier Latin companies. Bankers
insist that the price cuts are a case of relative value. They
say they are careful to lend only to high credit companies, many
of which have proved their resilience during the 1995 Latin American
financial crisis sparked by the devaluation of the Mexican peso.
Analysts say rates are likely to keep falling. Even with Latin
lending rates at record lows, they are still above levels in
the developed world and most other emerging markets. This is
likely to encourage continued capital flows from global firms,
providing a steady flow of new money. In sum, Latin America offers
attractive opportunities or money would not be flowing this way.
Risks of Derivatives(2)
would be wrong to conclude this presentation without a word of
caution. Derivatives represent sophisticated instruments of finance
that require education and comprehension. And there are four
inherent risks. There is (1) Credit Risk. The exposure
to the possibility of loss resulting from a counter party's failure
to meet its financial obligation; (2) Market Risk. Adverse
movements in the price of a financial asset or commodity; (3) Legal
Risk. An action by a court or by a regulatory body that
could invalidate a financial contract; and (4) Operations
Risk. Inadequate controls, deficient procedures, human error,
system failure, or fraud.(3)
risks should be clearly understood before establishing positions
in derivatives markets. In truth, these same or similar risks
exist with or without the use of derivatives. Most of the horror
stories involving the loss of money through derivatives have
one of two causes: They were either the result of a speculation
that went bad, or the result of inadequate management controls.
In neither case is it the fault of derivatives.
traders are all too common in business, and management must know
to protect itself from their criminal actions. Clearly, before
a company deals in derivatives, its management must have a sound
understanding of the derivatives market, know whether the prospective
position is speculative or a hedge, ensure there are adequate
risk controls to prevent fraud or unauthorized trading, and ensure
that a system of checks and balances are in place to measure
the market exposure involved. Those are serious requirements
but not a serious deterrent in today's marketplace.
no mistake about it! In our global market environment—driven
by constant and changing market risks, instantaneous information
flows, and sophisticated technology—derivatives are an essential
instrument of finance. And for emerging economies, they are indispensable
tools in the development of free and efficient capital markets.
Whether we like it or not, nations that attempt to go against
free-market principles or deter the use of derivatives, end up
punishing not speculators but their own people.
before the Subcommittee on Telecommunications and Finance of
the Committee on Energy and Commerce, U.S. House of Representatives,
25 May 1994.
Importance of Derivative Securities Markets to Modern Finance,
A Catalyst Institute Research Project, June 1995. Philippe
Jorion, University of California at Irvine, and Marcos da Silva,
University of So Paulo.
Derivatives: Actions Needed to Protect the Financial System,
U.S. General Accounting Office, May 1994.
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