Presented at the Financial Seminar
São Paulo, Brazil
October 14, 1997

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The 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.

As 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.

Still, 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.

The Need for Efficient Capital Markets

There 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.

For 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.

So 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.

Financial 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:

The 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)

The Function of Derivatives

The 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 components.

Derivatives 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.

Thus, 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.

Second, 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.

Third, 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.

When 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.

The Unruly Road Toward Market Efficiency

Still, 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.

This 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.

The 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.

Serious 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.

Suddenly, 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.

While 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.

Asia's 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.

It 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."

The 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.

Of 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."

Similarities and Lessons

I 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 the law."

For 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.

Given 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.

Many 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.

At 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.

The Risks of Derivatives(2)

It 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)

These 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.

Rogue 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.

Make 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.

Thank you.


     (1) Testimony before the Subcommittee on Telecommunications and Finance of the Committee on Energy and Commerce, U.S. House of Representatives, 25 May 1994.

     (2) The 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.

     (3) Financial Derivatives: Actions Needed to Protect the Financial System, U.S. General Accounting Office, May 1994.

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