We’ll all pay price when perfect storm strikes

Anybody who has followed Charlie McCreevy’s career knows that he loves a fight. But, judging from some of the heavyweights who are weighing in opposing his ‘hands off’ stance towards tighter official oversight of speculative hedge-funds and private equity deal-makers, the internal market commissioner is likely to emerge from this bout with a bloody nose if he does not put more emphasis on the need to curb the speculative excesses in these markets.

Last week (18 May) Jean-Claude Trichet, president of the European Central Bank (ECB), gave his backing to a ‘voluntary’ code of conduct to increase hedge-fund transparency. This was followed at the weekend (19 May) by publication of recommendations from the Basle-based Financial Stability Forum for what amounts to stiffer official oversight and tighter self-regulation of hedge-funds and the giant banks that mimic, finance and service them. The Bank of International Settlements now estimates that there are $400,000 billion (€295,000bn) outstanding in the exploding financial derivatives markets, ten times the value of the goods and services produced in the whole world each year.

In April, the Bank of England, in its half-yearly Financial Stability Review (FSR), raised the level of its concerns about financial market stability and the Banque de France devoted its FSR entirely to hedge funds. Why?

One worry is that, with the US economy slowing and possibly heading for a recession, the world economy could become increasingly unstable. But, says the Bank of England, financial markets are ignoring increasing risks and assets are being "priced for perfection" - a situation where the value of securities is dependent on everything turning out as expected, devoid of nasty shocks.

As global financial markets have become more and more closely integrated, central bankers and the regulators responsible for maintaining financial stability in their domestic backyards find themselves staring into a black hole. As one bank expert remarked privately last week, there are no processes in place to deal with the fall-out from the failure of a large globally-active financial institution. Who would lead a rescue, try to maintain confidence and co-ordinate reactions among the widening range of governments, banks, hedge-funds, pension funds and insurance companies likely to be affected? Could they do it swiftly enough to contain the damage given the speed and complexity of today’s global markets? Even the EU itself does not yet have the mechanisms in place to handle such an event involving a financial institution with headquarters in the EU.

Another worry is that the instruments that central banks use to cool growth and blow the froth off financial markets, increases in short-term interest rates, are working more unpredictably.

Short- and long-term interest rates have decoupled. As the American Federal Reserve Board has raised its short-term policy interest rate from 1% to 5.25% since 2004, ten-year bond rates have scarcely moved from around 4.5%. A similar phenomenon is evident in the eurozone.

Why this should be so is a perplexing question. Low inflation in goods prices is part of the explanation. So too are the vast pools of liquidity being stored up by the likes of China, Russia and OPEC countries through soaring private saving and official foreign exchange reserves.

Private sector speculators have easy access to cheap money. If you are prepared to take the currency risk, it is easy to borrow money at around 1% in Japan and shift it across borders and earn 5%, 10%, or more, investing in high-interest emerging market economies. The Bank of England says that, recently, not only has this "yen ‘carry trade’ increased in popularity". It points out that even private citizens in Eastern Europe are now borrowing cheap Swiss francs to finance house purchases. In fact, the easy availability of cheap money is such that officials are talking about the emergence of a "global financial market bubble". The Hanoi stock market is one of the most highly rated in the world. And in Communist China, peasants who know nothing about shares and risk are reportedly selling their homes to speculate on the soaring Shanghai stock market, forcing the government to step in to try to curb the rise.

With speculation rampant around the world, the effectiveness of central banks’ ability or willingness to shackle asset bubbles in doubt, and no reliable international banking safety-net in place, it is no wonder that last weekend’s FSF report should be calling for bank supervisors to toughen up their oversight of big banks and for the banks themselves to stop treating their untested risk assessment models like comfort blankets. They must, the FSF says, get a better handle on the indirect business risks they are running. At such a time McCreevy should join the choir calling for restraint. To do otherwise is to endorse recklessness.

• Stewart Fleming is a freelance journalist based in Brussels.

Anybody who has followed Charlie McCreevy’s career knows that he loves a fight. But, judging from some of the heavyweights who are weighing in opposing his ‘hands off’ stance towards tighter official oversight of speculative hedge-funds and private equity deal-makers, the internal market commissioner is likely to emerge from this bout with a bloody nose if he does not put more emphasis on the need to curb the speculative excesses in these markets.

• Primary Source