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Managing Market Mayhem |
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" Now
everyone is looking to East Asia –the hotbed of it all– and asking why?
Looking in retrospect for ways the crisis could have been averted." |
What started with the collapse of
Thailand’s stock market in 1997, ended in an unbelievable economic crisis for
the whole of East Asia? Many financial institutions crumbled under the crisis’
pressure and filed for bankruptcy. Billions of dollars worth of wealth
evaporated. Unemployment skyrocketed. Social and political crisis ensued,
epitomized in street riots and rampage. Today, Indonesia’s Suharto regime has
been ousted from power and Malaysia’s Mahathir Mohammad is facing profound
political pressure. South Korea witnessed a change in government –with a new
president coming in– at the very beginning of the crisis.
But the crisis exceeded the borders of
these nations –with Japan’s old and internal economic wounds opened and
aggravated. All this led to a loss of confidence in the markets, with the
now-cautious investors pulling stocks out of the Russian and South American
regions and discontinuing credit lines. Things quickly went from bad to worse
with every market collapse having a domino effect. The world economic growth
projected by the International Monetary Fund (IMF) was downwardly adjusted –twice–
a testimony to the crisis’ magnitude and impact on the world economy. In July
1998 the full force of the crisis hit the United States, causing problems for
the U.S. stock market –and the world as a consequence.
Now everyone is looking to East Asia
–the hotbed of it all– and asking why? Looking in retrospect for ways the
crisis could have been averted. What were the weaknesses of the economic
policies adopted? Do the conspiracy theories of the conniving stock exchanger
have any weight? Why do economic crises always start from the stock market?
And most importantly, how can we make sure this never happens again?
This article seeks to examine the stock
market –that is unstable by nature– and factors adding to its volatility,
trying to answer the above questions in the process.
The Cause of Crisis:
The first scent of crisis arose
from Thailand in 1996 when its currency –the baht– came under pressure from
the stock market. Many traders had realized that the baht –which was pegged to
the U.S. dollar– could no longer maintain its official exchange rate, despite
government efforts to deny the baht’s devaluation. Traders exploited the
difference between the exchange rates to buy shares in the real estate market
and consequently created a ‘stock bubble’. To make matters worse, the yen
weakened before the dollar and the baht –which like many other South East
Asian currencies was pegged to the dollar– strengthened before the yen, with
no clear economic justification. This served to decrease Thailand’s exports to
Japan –its major trading partner– thus exacerbating the already-bleak foreign
exchange figures, forcing foreign financers to pull out their investments. The
‘stock bubble’ burst and the market descended in a troubling stock tumult,
infecting the markets of South Korea, Indonesia, Malaysia and the Philippines
with a similar disease. All countries witnessed a drop in exports and a
weakening of their financial markets in 1996.
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" When
people started pulling out their assets and the flow of investment
reversed, the stock bubble burst sending the economy crashing down like
the house of cards it was." |
These factors spelled trouble for banks
and loan institutes as it shed light on their secreted and unsound practices
–such as invalid credits and loans granted to the politically corrupt and
connected, which stayed hidden from the public due to inadequate government
supervision. It quickly became clear that many of these loans were never
coming back. In a few days the bankrupted banks were auctioning the very
chairs they granted exorbitant loans in –loans that came from people’s
lifesavings and shattered investor confidence.
Panic-stricken investors were scrambling
to change their bahts to dollars magnifying the market mayhem. Finally, in
July 1997, the Thai government was compelled to abandon its official exchange
rate and acknowledge the full scale of the crisis. Lack of investor confidence
and political uncertainties caused a consistent downward spiral of the baht
for a considerable period of time followed by share devaluation, company
bankruptcies, factory closures, unemployment and the eventual fall to economic
recession. This same scenario was played out in Philippine, Indonesia,
Malaysia and finally South Korea –while the details were different the results
were much the same, as were the factors leading to the crisis, three of which
are mentioned below.
1. National Economic Policies:
For two decades these countries
witnessed an increase in physical money that surpassed production growth and
was not translated into inflation of the cost of living. This mysterious state
could have only had two explanations, either these economies had become
cash-centric or that they were experiencing "invisible inflation" that did not
directly effect consumer prices. Studies have indicated that the latter was in
fact the case. The inflation had remained undetected because foreign trade and
investment was keeping the prices of goods and services at bay. When people
started pulling out their assets and the flow of investment reversed, the
stock bubble burst sending the economy crashing down like the house of cards
it was.
A further factor that must be remembered
is that the economic boom enjoyed by the East Asian countries was bound to
come to an end sooner or later. The miracle economic growth experienced was
due to the generous injection of investments –coming from abroad– and
workforce –coming from throughout the region and the country’s unemployed.
While essential to economic startup, these elements must be supplemented by
efficiency and up-to-date technology to maintain their profitability. The lack
of these supplementing elements in these countries confined their activities
to product assimilation and duplication, and when they fulfilled the market
demand their boom died out.
2. The World Economy:
International occurrences –like the already
mentioned strengthening of the dollar– also had an impact on the East Asian
market crisis. Experts also attribute blame to the 30% devaluation of China’s
yuan in 1994, which served to decrease its export prices making competition
impossible for East Asian countries. But maybe most importantly was the
renovation and innovation of Western financial markets. With new methods of
financial management, investments and return on investments saw an impressive
increase. The new drive in the West to free up assets for investments in East
Asia, coupled by East Asia’s inability to utilize those investments led to
problems for both sides of the exchange.
3. Political Corruption:
The unsound political structures
of these countries on the one hand, and the more or less military and
totalitarian governments rather than democratic ones on the other, have
further impeded economic recovery by obstructing financial transparency.
Examples of corruption and bribery are in generous supply in these countries.
In South Korea the former president and other high-ranking officials are being
prosecuted for receiving astronomical bribes. In Indonesia the whole governing
system is put on trial for financial corruption. In Thailand it is not just
the government, but also the military that is in question. Philippine and
Malaysia are no different. The absence of democratic systems in these
countries where the exploitative ruling parties kept the corruption under
wraps –with no intention of reform– until it blew up as a profound economic
crisis.
Stock Markets and their Natural
Instability:
Stock markets are unstable by nature;
meaning sudden and harsh vacillation and fluctuations are commonplace. This
fact when combined with bad times is a recipe for disaster, to an extent that
capital and production evaporates overnight. The reason for this is discussed
below.
Principles of Offer and Demand in the
Stock Market: The stock
market’s volatility is very much dependant on the principles of offer and
demand, which put simply is when there is an expectation for growth more
stocks are demanded and fewer stocks are offered and vise versa. Another
factor adding to market fluctuations can be explained by the fact that every
trader cannot be aware of all the goings-on of a country and when a stock
begins to decline, after a period of stability or growth, traders will
immediately brand it as problematic and rush to sell it off, pushing its price
down further. The opposite is also true, when a stock increases after a period
of decline traders will rush to buy it believing it will continue to improve,
further escalating its value. Add to this the issues faced by the other stock
markets in the world, and you the endless potential for pandemonium.
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" In
1992 England’s central bank lost billions of dollars in the couple of
days it refused to lower its exchange rate while the Quantum Fund
pocketed billions." |
Currently there are thousands of
investment and saving funds in developed countries, holding dollars by the
countless billions. The managers of these funds conduct transactions of
hundreds of millions of dollars to make a few thousand bucks. These
transactions are decided upon by examining the flow of the market, meaning
when a slight increase in share value is detected the managers, throw the
weight of their huge capital into that market. Speed is essential for
successful trading, as the trader who acts quickest profits most from a rising
stock and loses least on a declining one. To maximize the speed of
transactions computers were utilized that would scan the market and
automatically issue buy or sell orders. These computers were themselves the
cause of the market crisis of the early 1990s. When these computers detected a
declining stock they automatically sold it, further devaluing it by tilting
the offer and demand scale. Subsequently the other computers detected the
now-exacerbated drop in the stock’s price and they too attempted to sell it
off. This chain-reaction continued until all that stock was dropped by all the
traders, causing major problems for the company and the market –all because of
a minor decline. In recent years, efforts have been made to make computers
more intelligent to prevent such occurrences.
Another reason for volatility is that
loss of stock and share value means loss of capital and assets. If your shares
decrease so will your purchasing power and this will have an adverse effect on
market flow and prices, as well as your credit standing. For example if your
shares are providing security of a loan payment at a bank, you may need to pay
back the loan because your shares no longer provide the adequate security.
One Stock Market Affecting the other:
Stock market instability can be
intensified by other stock markets. Share and stock are regularly held as
security with banks and loan institutes. When a stock value declines the bank
asks the stockowner to pay the price difference. This puts pressure on the
stockowner, which may be compelled to sell his stock to pay his debt. If this
becomes widespread, it will further push stock values down, hitting the stocks
still held at the banks hard. In this case, the banks themselves will
officially declare the stocks up for sale, which may bankrupt the stockowners.
The ruin of the stockowners can trigger a chain of bankruptcies and
insolvencies throughout banks, loan institutes and financial markets, leading
to an economic crisis.
Decisions made and actions taken in the
market can have unanticipated effects. For example, in October 1998 the yen
suddenly went up against the dollar, creating problems for both the Japanese
and American economies. Japan was struggling with financial hardship and was
caught off-guard by the dollar’s drop. The reason cited for the dollar’s drop
was that many Japanese businessmen were selling off their assets in America
and converting their payments into yen to maintain their business interests in
the struggling Japanese economy. When the market was flooded with dollars and
drained of yens traders rushed to get a piece of the action, boosting the
value of yen while devaluing the dollar.
The "Flocking Phenomenon" in Inept
Markets:
Every market has its problems, but efficiency and the
soundness of financial structures accompanied by supervision and control
ensures that problems will not turn into disasters. If a market has efficient
supervisory structures in place it can identify and confront problems –which
are inevitable in a naturally instable market– before they reach catastrophic
levels. However, in the inept markets of the countries under consideration
(Thailand, South Korea, Indonesia, Malaysia and Philippine) corrupt structures
exacerbate market problems. For example, if some players have inside
information and access to classified government documents the stage will be
set for what is known as the "flocking phenomenon". This means that all the
market’s traders keep an eye on the players with the privileged information
and 'flock' to the direction they are going, so if a problematic stock is
dropped by a player the rest of the flock will do the same, worsening the
stock’s already bad situation. Moreover, this turmoil can affect other
seemingly unconnected markets as seen in 1992-1993 European market crises that
spread throughout the world’s markets. The 1994-1995 South American market
crises, as well as the 1996 Asian crisis can also be cited as examples of one
market catching the disease of an unrelated counterpart.
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" Every
market has its problems, but efficiency and the soundness of financial
structures accompanied by supervision and control ensures that problems
will not turn into disasters." |
Games Played by the Big Stock
Exchangers:
The volume of money swapping hands through
investment funds is calculated at thousands of billions of dollars. The IMF
estimates that only a single group of America’s funds holds some 20 trillion
dollars. To make your eyes open wider, just add to this the amount of money
stored in all the other funds across developed countries. The managers of
these funds constantly scan the market to determine when to shop or drop
stocks. Huge portions of East Asian market investments were being financed
through these funds. There is, however, a group of funds that pursue
destructive policies in the stock market. These funds enter problematic and
shaky markets and throw their weight around until it collapses, benefiting
from their preparation in anticipation of the collapse. To cite a typical
example, in 1992 the Quantum Fund pursued this policy and derailed England
from the "Mechanism of Europe’s Common Currency". The way these funds work is,
for example, if they realize the English pound’s exchange rate with the dollar
is unsustainably high, then first, they amass huge dollar sums and buy pounds
with it. Next, they take their pounds to England’s central bank, which is
obliged to exchange the currency with dollars at the announced rate. If the
pounds that are up for sale exceed the bank’s dollar reserves, the bank will
come under tremendous pressure and must turn to international loan institutes
to attain its requirement. Meanwhile, the fund communicates its intentions to
the public through the mass media, triggering a stampede of people who want to
change their pounds to dollars before the price collapses. The bank will have
no choice but to succumb to the wishes of the fund and lower the pound’s
exchange rate. Now by reselling the dollars it has bought from the bank at a
higher price, the fund will cover all its costs and make a substantial profit.
When this scenario was played out in England in 1992, England’s central bank
lost billions of dollars in the couple of days it refused to lower its
exchange rate while the Quantum Fund pocketed billions.
Similar scenarios were also played out
in Malaysia and Hong Kong. In Malaysia it caused the collapse of its currency
–the ringgit. But in Hong Kong due to sound financial structures and China’s
financial backing (of $100 - $200 billion), it was the traders who suffered a
loss and eventually retreated. These scenarios have led to the creation of a
series of funds whose stated aim is to take advantage of the incorrect
economic policies and mistakes of governments, especially those of developing
countries. They have manifested themselves in the attacks on the currencies
that are pegged to the dollar and are traded at an official rate that is not
determined by economic parameters. The funds buy out the bank’s dollar
reserves and trigger the flocking phenomenon until the currency collapses to
the true –rather than official– exchange rate, making a lucrative profit in
the process.
Lessons to Be Learned from the East
Asian Experience:
In the
months following the East Asian market crisis many experts and analysts
commented on how the crisis came to be and how it could have been averted.
Below are some lessons to be learned from the East Asian experience.
Separation of Politics and Economics:
In most of the mentioned
countries there is no line separating political responsibility and economic
interests. This leads to a conflict of interests and responsibilities for
individuals who are at the same time the political leaders of a country and
the shareholders of a company. Because these politicians benefit from economic
endeavors they cannot conduct disinterested and impartial supervision over the
activities of major companies and banks, which means problems are not detected
until they reach a point of crisis. Moreover, politicians themselves take part
in the economic corruption and destructive trading and its subsequent
cover-up, encouraging crooked companies and channeling government resources in
their direction. The recent crisis has not had a harsh effect on countries
–like Singapore– that have a clear line separating their public\political and
private\economic interests. In Singapore politicians are paid a wage equal to
or higher than commercial and industrial CEOs and in return are expected not
to take part in economic activities.
Instilling Business Ethics in Monetary
Structures:
Many experts point out unethical banking as
a core cause of crisis. This problem is rooted in the nature of banking
systems and calls for the instillation of special supervisory techniques.
Unethical behavior is seen in all monetary structures and economists label
them as "asymmetrical information" or "conflict of interests". For example, in
banking systems depositors trust the bank managers to promote their interests,
while the managers aim to promote their own interests. This can be a very
obvious ground for conflict of interests. In the absence of supervisory
structures, bank managers can easily direct funds towards activities that will
benefit themselves, rather than the depositors, by investing in companies and
industries in which they themselves are the major shareholders or even
granting loans to dubious companies that channel them to their overseas
accounts. In these circumstances bank managers have no qualms about
squandering the wealth of the depositors. A way in which this situation can be
avoided is utilizing the "interest rate mechanism" which allows banks to
attract depositors by offering competitive interest rates. However, there can
be no preferential treatment, otherwise because banks can grant loans at lower
interest rates to some, who can then grant loans at market value and make a
profit from the difference.
These unethical behaviors indicate that
strict supervision is a must for all monetary structures. The supervision
banks need is provided by the central bank, thus it is a prerequisite that
there is a separation between the interests of the central bank and those of
the other banks. When that prerequisite is met, the central bank’s supervision
has several aspects, some of which follow. One, monitoring loans and credits
to ensure banks offer a suitable range of loans and are not restricted to
certain fields. Two, preventing the granting of dubious loans in secrecy or to
companies with shady legal identities. Three, securing loans made via bonds,
securities, collaterals, guarantees and insurance against nonpayment. And
finally, ensuring that loans and credits are not granted to colluding
companies or to the personal benefit of bank managers.
Promotion of Investment:
Astride with economic development and
the expansion of trade and commerce, stock markets must progress to meet the
demands of the economy. The first step of stock market expansion is attracting
foreign and domestic investment and establishing the infrastructures that
facilitate such investments. Next is the efficient and effective use of
investments to ensure profitability. Countless examples can be cited but a
typical one is throwing insurance reserves in the stock exchange until it is
needed. There is now even something called the "overnight loan", where banks,
institutes or individuals lend their excess funds at night and are repaid
–with interest– the next morning. The stock market must also expand in depth,
encompassing areas of risk management and conditional products. For example,
if a private company is to construct a power plant the investor will have
concerns such as: will the market’s demand for electricity be enough? If the
price of electricity is dropped, how will that effect my investment? What will
happen to our fuel supply in the future? The stock market must be capable of
answering these questions. |
