For win-win finance

By Shin Jang-sup

The world economy is on a rollercoaster this year. Emerging market economies in particular were struck by great instabilities because global money was fleeing from emerging-market assets to U.S dollar assets as the U.S. Federal Reserve Board (Fed) started increasing its key interest rates. They were destabilized further by increasing views that China might fall into a crisis.

Korea could not stay aloof from this turmoil. It was unprecedented for the Korean economy to see its export machine shrinking every month from the beginning of the year. This was mainly because its major export markets were nearly frozen. Japan and China also experienced a similar decline in their exports.

The global financial market currently looks as if it is regaining stability as the Fed hurriedly announced last week that it would slow the pace of the interest rate hike. Oil prices also seem to have bottomed out. It is now time to reflect why the world economy had to go through such an unexpected rollercoaster.

As far as the real sector was concerned, it is difficult to say there was any big obstacle to the global economy in the beginning of this year. The U.S. was raising its interest rates because its economy was recovering. The fact that the largest economy in the world confirmed clear signs of recovery for the first time in seven years after the 2008 Global Financial Crisis should be good news for the world economy. It was also a well-recognized fact that the Chinese economic growth had slowed down. Around a 6% growth rate for the second largest economy in the world was not that bad. India, the second populous country in the world, also continued its economic expansion at the rate of 6 to 7% a year.

However, the global financial market movement was detached from the real sector. What we witnessed were sharp shifts of money flows and great volatilities in foreign exchanges, stock prices and oil prices. We would not have experienced such turmoil if investors simply tried to avoid financial risks of their assets held in emerging markets. It seems to me the rollercoaster stemmed mainly from significantly increased “big shorts” in the global financial market.

Before and during the turmoil, numerous hedge funds shorted emerging market assets and bragged about it blatantly. George Soros, who shorted the Malaysian ringgit and Hong Kong dollar during the Asian Financial Crisis in 1997, shorted the Chinese yuan and revealed it at none other than Davos Forum, where world opinion leaders flocked. Hayman Capital’s Kyle Bass, who became prominent for big shorts during the Global Financial Crisis, now poured 85% of his assets in shorting the yuan and publicly claimed that "the greatest investment opportunity right now" is to short the yuan. He even predicted that China was “going to go through a banking loss cycle like we went through during the Great Financial Crisis [in 2008]." There were many more hedge funds that were revealed to short the yuan, including Carlyle, Pershing Square, Druckenmiller, Tepper, Schreiber, Einhorn, and Scogging.

The current global financial market can be better understood as a “win-or-lose” arena where constant battles are unfolding between those who have short positions and those who have long positions. Foreign exchange investment was a “win-lose” game from the beginning because the rise of one currency’s value is automatically the fall of others’. Stock investment and real estate investment were previously considered as a “win-win” game because it was expected that their prices would rise as the economy becomes better. However, the reality of those markets has been completely changed. Markets for derivatives like forwards and options in which the divide between short and long is an integral feature, are now much bigger than spot markets. Real estate assets are also securitized and transformed into derivatives.

In businesses, we are often told, “crisis is opportunity”. This maxim normally means that, if one survives a crisis well, he/she will have good opportunities. In the current financial market, its meaning took a turn. Crisis is instant opportunity because those who have shorting positions earn money directly if the others who have long positions are in a crisis. If the others go bankrupt, this is even better. It is therefore natural that the market is flooded with “innovative” financial products by which investors can receive insurance money if their next-door-neighbors have caught fire. They then have every incentive to commit arson against their neighbors or add fuel to the fire.

This kind of shorting behavior is not unique to hedge funds. It is more a general behavior in the global financial market in which even the most reputable financial institutions are involved. For instance, Goldman Sachs paid a record $550 million of settlement fees to U.S. Securities Exchange Commission in 2010. This was because it was found that the bank sold $1 billion of the ABACUS Fund to its customers by advising them to long U.S. mortgage-backed derivatives when its internal trading position was changing to a big short on them. As a result, their customers lost most of the $1 billion they invested in the fund while Goldman Sachs pocketed $15 million in fees on top of their unconfirmed amount of gains from the potential shorting.

What should be done about this? The only way would be to devise policy measures to minimize room for “win-lose” finance while promoting “win-win” finance. However, governments around the world are not daring to do so. They are mostly hiding behind a pretext that those policy interventions would hurt “efficiency” of the financial market. For instance, the Korean Congress last year rejected a bill to prohibit the National Pension Service from lending their stocks to short-sellers. In making the decision, it was argued that the prohibition would reduce market “liquidity” which is essential for ensuring market “efficiency”.

However, the global financial market is the largest casino ever in history. Can the economy become more efficient by increasing liquidity in a casino? A critical problem in the current financial market nowadays is too much liquidity, not a lack of liquidity. And this liquidity is mostly circulating in “win-lose” finance and even obstructing the functioning of the real economy.

In managing the economy, it is a global vogue to clamor for “mutual growth” or “sustainable growth”. Why don’t policy-makers and academics dare to say this about finance?

Shin Jang-sup is an economics professor at National University of Singapore and former adviser to Korea's finance minister.