What is ‘global’ about global finance?
‘Interest bearing capital always being the mother of every insane form...’
Marx, Capital (Volume 3)
FROM the earliest systematic attempts to study finance capital and its effects, there has been much debate regarding the convoluted relationship between finance capital and states. David Harvey succinctly articulates the issue: ‘While the state apparatus forms the core of the strategic control centre for the circulation of interest-bearing capital, the latter is simultaneously free to circulate in such a way as to discipline the separate nation states to its purpose. The state is both controlled and controlling in its relation to the circulation of capital.’
Finance capital can be thought of as both process and structure – as the flow of interest bearing capital and as the unity of banking capital and industrial, commercial capital. There is a long history of interest bearing capital circulating over distinct geo-political entities, from the credit arrangements of Marwari traders to the powerful international bankers of the 19th century, the Rothschilds, Barings and their ilk.
What is it that distinguishes contemporary international flows of capital from these prior arrangements? While it is almost taken for granted that global finance is a primary engine of the complex processes of globalization, what is it about ‘global’ finance that makes it ‘global’? I would like to examine this question through a set of vignettes sketching some crucial moments in the recent history of finance capital, which are connected to a fundamental notion: financial innovation.
Finance capital, in its self imagining, is abstract and fully realises itself only in a space that is devoid of politics, governed only by the inexorable abstract rules of supply and demand. The political institution of the nation state and its regulations are not flexible enough to meet the demands for such spaces; finance capital responds to the limits through innovation. Innovation is the mechanism through which financial institutions create new instruments that subvert current spheres of regulated activity and shift to (or create) new spaces that are not yet the focus of regulatory control. Innovation is a primary means through which finance capital attempts to evade politics and regulation.
Before any excursions into modern finance, one must mention the key event in its history: Bretton Woods. The Bretton Woods Agreement of 1944 was an attempt to build a international economic order through the regulatory power of money and credit. It created a system in which national currencies were linked to the dollar through fixed exchange rates and the dollar itself was linked directly to gold. It also created the two supra-national ‘public’ institutions of international finance: the International Monetary Fund (IMF) and the World Bank and solidified the post-war hegemony of the United States. The creation of ‘global’ finance is inextricably linked with this event.
Refugee credit: ‘National borders are no longer defensible against the invasion of knowledge, ideas or financial data... The Eurocurrency markets are a perfect example. No one designed them, no one authorised them, and no one controlled them. They were fathered by controls, raised by technology and today they are refugees, if you will, from national attempts to allocate credit and capital for reasons which have little or nothing to do with finance and economics...’ (Walter Wriston, Speech at International Monetary Conference 1979).
The Eurocurrency markets that Wriston (then Chairman of Citibank and a major player in Cold War economic intrigues) gloats about are among the major innovations that emerged in a bizarre dialogue between nation state and finance capital during the Cold War. For being such a central part of contemporary flows of finance capital, they have a rather ironic origin.
According to a predominant version, the first such currency, the Eurodollar, was born in 1949, out of the desire of the communist government of China to protect its dollar earnings from the long reach of the American state. The dollars were deposited in a Parisian bank, the Banque Commerciale pour l’Europe du Nord, which just happened to be owned by the Soviet Union and had the cable address ‘Eurobank’. The Soviets caught on quickly. They too began depositing their dollar earnings in banks outside America, using either the Paris bank or the Moscow Narodny Bank in London.
Since interest bearing capital must circulate sooner or later, these external dollar deposits were soon being traded by European banks. They came to be called Eurodollars from the cable address of the Paris bank. Now the term Eurocurrency (not to be confused with the new common European currency, the Euro) has come to mean any currency that is outside the purview of the national laws and diktats of the central banks of the nation state of its origin; for example, yen deposits outside of Japan are called Euro Yen (maybe soon we shall see the EuroEuro!).
The presence of other governments and multinational corporate entities who were reluctant to repatriate their dollars to United States led to the institutionalisation of a set of money and credit markets that were effectively beyond the authority of any national or international regulatory authority. Even though these markets were mostly based in London they remained outside the ambit of the British regulatory framework. These markets were secretive and remained hidden from even professional economists and financial writers for a number of years. Only in 1960 came the first published reference in The Times, to ‘the so-called Euro-dollar.’
One cannot emphasise enough the significance of these markets: there had been a few instances earlier of currencies being present outside the control of nations but that was just coins and paper money, this was abundant credit! Once credit creation goes beyond the boundaries of the nation state, the ability of nations to control financial institutions becomes more and more limited. The creation of the Euromarkets marks a major point in the struggle of finance capital against the Bretton Woods framework: for the first time there emerged a set of geographically deterritorialised economic institutions outside (and actively opposed to) the logic of national or international regulation.
One of the major consequences of the lack of regulation was that banks active in the Euromarkets were free to invent new financial instruments away from censorious central bank regimes. The primary innovation of most of these new instruments was that they revolved around banks directly lending to one another, something that was anathema to most national central banks.
So today, apart from the interest rates set for dollar deposits by the Federal Reserve of the United States, there are a differing set of rates for dollar deposits that are offered in the London inter-bank market, the LIBOR (London Inter-Bank Offered Rate) rates for dollars. This applies to a whole range of national currencies. The growth of the Euromarkets is probably the major reason for the revival of the fortunes of the City of London as the centre of the banking world and there have been numerous (less successful) attempts to replicate them in other locations, like Singapore.
As the Eurodollar markets expanded rapidly, the United States noticed and then became apprehensive about the increasing flow of dollars abroad. In an effort to strengthen the dollar and make foreign borrowing in America more expensive, an Interest Equalisation Tax was introduced in the States in 1963. It was too late in the game. All it did was to turn hungry borrowers to the Eurodollar market in Europe instead for cheaper loans.
While this growing flood of ‘refugee credit’ was the stuff of nightmares for conscientious central bankers, free marketers like Walter Wriston were triumphant in their unqualified enthusiasm. The Eurodollar markets grew even more in the late 1960s fuelled by global military expansion and rising trade and budget deficits in the States. Since the dollar was backed by gold, i.e. the U.S. Treasury would cash dollars for a fixed amount of gold, the gold reserves of the U.S. were under threat from this hoard of offshore dollars.
With rising inflation in the U.S., the dollar was rapidly losing value and cashing in dollars for gold became quite a bargain. So much so that the outflow of gold from the U.S. to London became so great during the week of the Tet offensive in Vietnam (March 1968) that the floor of the weighing room in the Bank of England collapsed under the strain.1 The French and British governments started cashing in dollars for gold; finally in August 1971 Nixon closed the gold window in the U.S. Treasury, unilaterally revoking the right of dollar holders to convert their notes to gold. This marked the beginning of the end of the Bretton Woods agreements on fixed exchange rates centred on the dollar being backed by gold; the conventions finally collapsed two years later and a brave new world of freely floating exchange rates began.
The formation and institutionalisation of the Euromarkets mark a new turn in the ongoing conversation between finance capital and the political institution of the nation state, a turn that begins to reveal what it means for finance capital to be ‘global’.
Crises and contagion: ‘...the major concern is to avoid another financial crises, of which there have been too many in the past five years. From Mexico in 1995, through the Asian crisis in 1997 and Brazil in 1999, and more recently in Argentina and Turkey, sudden reversals of short term capital flows have created financial crises. In many cases, these crises have proved devastating to the citizens of the countries affected. The existence of deep and liquid international capital markets offers opportunities for greater risk diversification by both borrowers and lenders. But it also increases the risk of contagion from one country to another affected by an outflow of short-term debt finance.’ (Mervyn King, Deputy Governor, Bank of England, Institute of Petroleum, 21 February 2001.)
‘A striking feature of private sector capital flows in recent years has been the pace at which they surged into countries with significant structural or macroeconomic vulnerabilities – almost up to the eve of a financial crisis – and their sudden abrupt reversal.’ (Bank for International Settlements, 69th Annual Report.)
For the past few years the trope of contagion has been ubiquitous in the discourse of central bankers, hedge fund managers, IMF and World Bank flunkeys, finance ministers, credit rating agencies and other unsavoury bit players in the wonderful world of finance. Though the transmission of market crises from one nation to the financial markets of other states has taken place with great regularity, the ‘Asian Crisis’ of 1997 caught the imagination of a whole generation of regulators and speculators, linking these events inextricably with the term ‘contagion’.
Without delving deeply into the details of the crisis (there is now a cottage industry devoted to publishing analyses of the crisis), I would like to examine two aspects of the story. The first relates the activities of two kinds of international finance capital: short-term debt capital emanating from major banks in the G10 countries and predatory, speculative, ‘fictitious’ finance capital emanating from currency, equity and interest rate trading desks (sometimes parts of the very same G10 banks).
The nine major East Asian nations (China, Hong Kong, Taiwan, the Philippines, Indonesia, Korea, Malaysia and Singapore) had a sustained period of growth till 1997; they were benefiting from rapid export growth and opening up their economies to foreign participants, warming the hearts of many a IMF economist. On top of this, they had fairly strong macroeconomic fundamentals: low inflation, low external debt. The five countries that were worst affected by the crisis were Korea, Thailand, Indonesia, Malaysia and the Philippines: these shall be the focus of the rest of this section.
Their growth attracted finance capital from the G10 in search of higher returns; most major banks from the G10 participated in a credit expansion that (along with the liberalisation of local financial markets) fuelled domestic asset price bubbles throughout East Asia. The G10 banks pursued a wide range of business and offered their clients a full array of ‘sophisticated’ products. They also participated in a whole variety of illiquid local markets. More crucially, they held significant short term debt claims on East Asian debtors that were denominated in European currencies or U.S. dollars. This exposed the debtors to huge risk in the event of the devaluation/depreciation of the local currency, increasing substantially the cost of their foreign currency debts.
In the past ‘emerging market crises’ the major G10 banks had exposure only to sovereign or public debt, i.e. the debtor was either a sovereign nation or a public institution within the nation. The Asian crisis was significantly different. The debtors, this time around, were mostly either local banks or private sector corporations. The G10 banks had bypassed the state, yet assumed that there were implicit state guarantees on these debts. Another crucial difference was that by dabbling in local capital markets the G10 banks had made themselves far more susceptible to local market fluctuations.
This was the stage in early 1997 when several huge Korean conglomerates declared bankruptcy. Massive speculative attacks were launched by currency traders on the Korean won, the Thai baht, the Indonesian and Malaysian rupiah over the next few months. The central banks struggled vainly to support their currencies. But soon, lacking both sufficient reserves and independence from the IMF to sustain fixed exchange rates for their currencies, Thailand, Indonesia and Korea floated their currencies. Under pressure from traders, the currencies underwent severe depreciation causing severe economic distress and political turmoil within these nations.
While the speculators were in a feeding frenzy, the G10 banks were having nightmares: most of their debtors could no longer make loan payments, primarily because the depreciation of the local currencies made the loan payments in foreign currencies simply impossible for them to meet. With their debtors defaulting on loans, the G10 banks were faced with major losses throughout East Asia, with no sovereign guarantees on the debt to ease the pain. It was a rather bizarre moment: one form of transnational finance capital profiting by wreaking havoc with state institutions that provided a stable environment for the operations of another related form of finance capital. The most visible consequence of these events was the fact that in late 1997 and 1998 the net capital outflow from the five worst affected economies was about $80 billion.2
In the final analysis, this rapid outflow of capital was contagious. The conditions necessary for this rapid outflow of capital is what distinguishes contemporary ‘crises’ from those of the late 1970s or early 1980s. The transition is marked by a shift in the focus of the primary object of risk for transnational finance capital: from the sovereign state to a private, individual, foreign counterparty linked through channels of trade and finance to a variety of international financial institutions, private and public.
The risks around which the old paradigm revolved were those of the willingness or ability of the sovereign state to honour its international debts and to provide foreign exchange to its viable, local credit-hungry debtors to meet international foreign currency denominated claims. Both the state and finance capital went to great lengths to avoid defaults, participating in an intricate dance in which neither party could afford to be hasty.
With changes in the regulatory frameworks of many nations that now allow local, private counterparties to access transnational finance capital with much freedom, the threat of default and the subsequent withdrawal of credit is far more common, since the relationship between a creditor and an individual debtor is far more volatile than between a creditor and the state. Credit expansion and credit flight are more rapid once the state is pushed to the sidelines.
It is no coincidence that the two most populous Asian countries, China and India, were less affected by the crisis: both had tight controls on cross-border capital movements and controls on foreign borrowings of local debtors. The national ‘borders’ that finance capital had to cross were not merely geographic, they consisted of the mundane yet crucial and intricate national and international laws that governed portfolio investments, commercial banking, trade finance, corporate taxation, special purpose vehicles, sovereign guarantees, bankruptcy etc., that provide the plumbing for the flows of capital. Finance becomes ‘global’ only through negotiating and transforming this infrastructure.
Quid pro quo (or what’s a nice nobel laureate like you doing in a place like this): ‘Strategic Relationships – LTCM intends to form strategic relationships with organizations with strong presences [sic] in targeted geographical locations throughout the world. These organizations will be selected by LTCM on the basis of the value to the Portfolio Company to be derived from such relationships and may assist LTCM with respect to the Investment of the Portfolio Company’s assets by, among other things, providing informed insights from a local perspective on macro-economic policies and financial issues that may affect regional markets and geographic areas. LTCM believes that as a result of these relationships the operation of the Portfolio Company should be considerably more efficient and flexible than they would be if it relied solely on its internally integrated infrastructure to support all of its operations.’ (Confidential Private Placement Memorandum. Long Term Capital, L.P., 1 October 1993. Merril Lynch & Co., Placement Agent.)
Long Term Capital Management (LTCM) was a hedge fund (i.e. a private investment fund specialising in formerly unorthodox, ‘sophisticated’ investment strategies using all kinds of ‘innovative’ instruments), that spectacularly went belly-up in September 1998 and very nearly took a large chunk of the financial sector of the OECD nations along with it.
Apart from the usual morals about greed, hubris, controls, risk and capitalism the episode is worth examining for what it may reveal about the globality of finance. LTCM had a star-studded cast of partners, including Robert Merton and Myron Scholes (joint winners of the 1997 Nobel Prize in Economics), led by John Meriwether, an immensely successful bond trader well known in the right financial circles. The firm specialised in highly leveraged, relative value arbitrage and convergence trades, taking advantage of small ‘mis-pricings’ between securities that are virtually identical or between securities whose values are highly correlated.
An extremely simple convergence trade would be to buy the 30 year United States Treasury bond that was issued last week and sell the 30 year United States Treasury bond that was issued last month if there was any significant price difference between them. Since, apart from maturing a month apart, the instruments are identical, any significant price differential between them would vanish over time, i.e. their prices would converge.
Leverage simply means multiplying the purchasing power of capital by sophisticated means of borrowing. Leverage was essential to the functioning of LTCM: the profit from each individual transaction was small if fairly predictable, so to make the game worthwhile the partners sought to maximise leverage and size. LTCM could function only by assiduously seeking the cheapest sources of credit, with the least restrictive terms.
In September 1998, LTCM’s total assets on balance sheet were about $125 billion, nearly all borrowed; compared to equity of about $5 billion, the figure reveals a breathtaking leverage ratio of 25 to 1. The offbalance sheet position, derivatives, swaps, options etc, was the almost meaningless figure of $1.25 trillion in notional principal.
The event that triggered the collapse was the de facto default on debt announced by the Russian government on 17 August 1998; the new capitalists in Russia causing more damage to the capitalist system than the 70 years of communist rule! The Russian default caused severe credit contraction and severe volatility across world financial markets. In various ways, LTCM managed to lose about 90% of its equity in about a month! No single creditor may have had a complete picture of LTCM’s operations but that does not satisfactorily explain why LTCM was able to obtain unusually good financing conditions, almost universally.
In the wake of LTCM’s collapse, the Financial Times (10/11 October 1998) published a leaked credit memorandum from a major bank detailing reasons for building a relationship with LTCM, an institution whose leverage exceeded normal limits. LTCM represented a good credit risk since ‘eight strategic investors’ including ‘generally government-owned banks in major markets’ owned 30.9% of LTCM’s capital. The memo infers that this gave LTCM ‘a window to see the structural changes occurring in those markets to which the strategic investors belong.’ In other words, LTCM had access to inside information.
The meaning of the ‘Strategic Relationships’ section of LTCM’s prospectus starts to become clearer when we realise that among the major known ‘strategic partners’ and investors were prominent government institutions including the Italian Central Bank, the Bank of Taiwan, the Government of Singapore Investment Corporation, the Hong Kong Land Authority and the Kuwait Pension Fund. Not to mention the private financial institutions that were ‘partners’.
It is suspected that a few other major central banks were also partners. The Bank of Italy invested $100 million in LTCM and gave loans amounting to $150 million. This throws an entirely different light on the fact that in 1994-1995 LTCM made 38% of its $1.6 billion earnings from the now well known Italian convergence trade. The convergence of the Italian bond market with the other European Monetary Union bond markets had to be accelerated, so that Italy could satisfy the terms of the Maastricht Agreement and finally adopt the Euro as its currency.
‘According to some observers... the Bank of Italy provided LTCM with market access and privileged information denied to Italian banks – which yield a massive profit. In return, LTCM – and a handful of others – would engineer the convergence of Italian debt...’3
The Italians were not alone; by the end of 1997, ‘Governments treated it (LTCM) as a valued partner, to be used whenever markets weren’t efficient enough to achieve macro-economic goals.’4
An intriguing idea: if central banks (standing for states) cannot effectively control macro-economic policies which are now heavily dependent on the ‘market’, then they have to turn to the ‘market’ itself for help (or at least to key players, like LTCM, big enough to move markets). There is, articulated in the LTCM strategy, a new dŽtente between states and finance capital. While the modern nation state has provided the conditions for the efficient reproduction of capital, capital constantly tries to innovate itself beyond the politics and regulations of the state.
Unable to find the one abstract, apolitical, unregulated space in which it imagines it would operate most efficiently, finance capital enters into global alliances with state and non-state institutions that provide unregulated access to opportunities of mutual benefit without actually challenging or subverting state authority – a new crony capitalism with the state as accomplice and stakeholder. Contra Walter Wriston, this version of finance capital does actively collaborate in ‘...national attempts to allocate credit and capital for reasons which have little or nothing to do with finance and economics...’
The structures of ‘global’ finance develop only in dialogue with the political institutions of the nation state. I have tried to illustrate three ways in which this dialogue has taken shape: subversion of state regulations, bypassing of state institutions, and collusion with state institutions. While this is far from a catalogue of the forms this dialogue takes, I hope that a sense of the issues involved has been conveyed.
1. Gary O’Callahan (1993). The Structure and Operation of the World Gold Market. Occasional Paper No. 105, Washington: IMF, September.
2. Eric van Wincoop and Kei-Mu Yi, Asian crisis post-mortem: where did the money go and did the United States benefit?
3. Nicholas Dunbar (2000). Inventing Money: The Story of Long Term Capital Management and the Legends Behind it.