Euros, Dollars, Sukuks and Yuans: Uncertainty Reigns in Global Financial MarketsPublished: July 27, 2005 in Knowledge@Wharton
At the start of the Wharton Global Alumni Forum's panel on regional financial markets, moderator Richard J. Herring noted that discussing this topic from a regional perspective -- vis-a-vis Europe, Africa and the Middle East -- may appear to be "an anomaly since financial markets are probably more thoroughly globalized than any other sector of the economy. But recent events are having a particularly strong impact on regional financial markets."
Herring was joined on his panel by several other speakers, including Robert E. Diamond, chairman of Barclays Global Investors, Peter Garber, chief strategist of Deutsche Bank Global Market Research, Richard Moore, head of global rates and currencies in the global fixed income division of Citigroup, and Abdulrazzak Mohammed Elkhraijy, head of Islamic banking at the National Commercial Bank of Saudi Arabia.
In his remarks on the European, African and Middle Eastern markets, Herring noted that a huge disequilibrium in the world's economy comes from outside these regions in the form of fiscal and current account deficits in the U.S. The sheer size of the U.S. current account deficit -- a record $195.1 billion in the last quarter -- means it is now "consuming about 75% of the world's international savings." Moreover, "it is associated, not with an investment boom as it had been in the late 1990s, but with a large and growing U.S. government deficit."
According to Herring, professor of finance at Wharton, director of the Lauder Institute of Management and International Studies and co-director of The Wharton Financial Institutions Center, "until recently, the dollar had fallen against most major currencies," including the euro, yen, pound, Swiss franc, Canadian dollar, Australian dollar and Swedish krone. "But it has actually appreciated a bit against others -- including the currencies of Mexico, China, Taiwan, Korea, Russia, India, Saudi Arabia and Israel, among others -- which account for about half of U.S. trade." Even in Europe, Herring said, "the reluctance of the Asian economies to appreciate their currencies has brought more pressure on the euro to appreciate." The appreciation of the euro is believed, he said, "to have contributed to a loss of competitiveness in Europe."
Is this is a sustainable situation? "Many people would argue it is not," said Herring. Key to the discussion is "whether the Asian central banks and others will continue to want to hold the dollar as a reserve currency." Has the euro provided an attractive alternative to the dollar? "Since exchange market intervention by central banks in support of the dollar has been so substantial, it's a key question to figuring out what is next," Herring said.
One of the great successes of the many single market initiatives within the European Union, he noted, has been the development of the fixed income and derivatives markets in Europe, which stemmed from the introduction of the euro. "By now the government debt market in the euro-area is quite comparable in size to the U.S. and the private debt market is growing rapidly as well," although it is not as big as the U.S. market. One of the biggest disappointments, however, "is the equity markets in the euro areas which continue to be small relative to U.S. dollar markets. The euro area markets are technically very efficient, at times using more advanced technology than their counterparts in the U.S., but the cost" of cross-border securities transactions within the European Union is four to five times higher than from state to state within the U.S."
The most recent data available, Herring added, "shows that the euro so far has not displaced the use of U.S. dollars in transactions between third and fourth countries. In fact the euro has a share that is equal to the deutsche mark share before the introduction of the euro. Ironically, the pound sterling, which everyone thought would be the loser from the formation of the euro areas, is actually gaining share."
Herring also discussed the exchange market consequences of the recent 'no' votes in France and the Netherlands to the European Union constitution. "This caused a very sharp drop in the dollar value of the euro, which offset a good deal of the earlier appreciation." The 'no' votes "had no direct implications for the euro, but they do undermine confidence in the euro's future. You could see this reflected in credit spreads for the major governments issuing debt in the euro area ... Until the negative votes on the constitution, there was an implicit assumption that no government would be permitted to default on its euro-denominated debt, even though there was no explicit guarantee. But once the constitution was rejected, people began to worry about what this might mean for the credibility of these implicit guarantees."
As for the shift of wealth to the Middle East caused by recent high oil prices -- and its impact on financial markets -- Herring used IMF figures showing that the shift will involve between $140 billion and $150 billion a year. "Since 9/11, a number of investors in the Middle East have had a strong preference for holding assets outside the U.S. including euro-denominated assets. Moreover, there is a notable preference for Shariah-compliant (Islamic-law compliant) assets or services."
One example of this are sukuks, an innovative Shariah-compliant debt instrument that can be traded in secondary markets. One of the interesting questions about sukuks, Herring noted, is whether they will be of interest beyond the Middle East. "Some initial evidence indicates that people outside the Islamic world are finding them an interesting way to raise money and an attractive diversification tool."
Given the increasing wealth in the Middle East along with the growth of Islamic banking, some are also concerned about how Islamic banking will coexist -- and compete -- with Western banking practices. Abdulrazzak Mohammed Elkhraijy noted that his bank has introduced Shariah-compliant banking services alongside its traditional services in response to consumer demand. A number of Western banks also have an Islamic banking window that will do Shariah-compliant transactions. Elkhraijy noted that "Demand has reached critical mass so it is now commercially attractive to banks to provide these financial services." Although local boards of Islamic scholars determine whether particular services or products are Shariah-compliant, Elkhraigy stated that "Studies show that 90% of the time local boards agree about how products and services can be made Shariah-compliant."
Herring turned briefly to the issue of China and India's increasing presence in international markets and how this will affect global financial markets. "Questions about the sustainability of the dollar have a lot to do with what the private sectors in India and China will do with their new wealth," he said. "Until now, they have had very little opportunity to diversify internationally, but China sooner, and India relatively soon, will be freeing up their capital accounts and there will be a pent-up demand for diversification. If they simply hold a market neutral position, they may want as much of 50% as their assets to be in dollars, which would be a source of demand that would sustain the dollar."
If China revalues the yuan, Herring added, "Europeans believe it would take some of the pressure off the euro and also make Europe more competitive. I'm not so sure that it will. The solution to Europe's competitiveness problems lies in Brussels, not Beijing."
The Key Issue Is Risk
Barclays Global Investors' Richard Diamond focused his remarks on the changing role of investment banking, driven "not by regulations but by new demands from our corporate clients." The key issue is risk: "The market can be brutal. If corporations don't recognize and manage the risks associated with the market, they will be penalized by decreasing share prices and downgraded credit ratings. We saw this with Enron" which was downgraded, he said, because it couldn't fund its obligations. The company lost its access to the capital markets because of perceived risks. That's what sent it into bankruptcy."
Going back 10 years, Diamond said, "only one currency -- the dollar -- existed for serious funding." Because of the Glass-Steagal Act, "there was also a complete separation of investment banking from commercial banking. There was only one capital market for transactions and an oligopoly of firms that could provide them.... A short list of 'bulge-bracket' investment banks could provide advice about mergers and acquisitions and underwrite new issues, while commercial banks" were available for short-term loans and other services.
Today the model works differently. "With the erosion of the Glass-Steagal Act, now one financial institution can partake in all the capital raising a client may need," Diamond said. The second big difference is the introduction of the euro. There is now "a second big liquid sophisticated capital market, an alternative to the U.S. dollar market. This breaks the oligopoly of U.S. bulge bracket firms and the U.S. capital markets."
Twenty years ago, when you did a transaction, it often took a week or two weeks, Diamond noted. "Today it takes about a nanosecond. In addition, the demands coming from clients are incredibly sophisticated. They produce products and have staff in multiple locations. It's a far more complex world."
So where does this lead us, Diamond asked. He suggested that companies look to investment banks to offer "more integrated packages, pulling together all aspects of managing risk." For example, each person working with a company needs to understand the interaction between such variables as raw material prices, fuel prices, and so forth. "It has to be about a solution, something that will satisfy needs, not pump products." At the same time, given the reality of the global marketplace, investment banks in fact are "providing more complex products. We are seeing incredible growth in credit and interest rate derivatives. This helps us put together more sophisticated products for our clients and helps them raise capital more efficiently."
Deutsche Bank's Peter Garber noted recent discussion in the media on whether some countries may drop out of the euro. "There has been strong political pressure to do something about the exchange rates," he said. "Unemployment is the driving force. Europe is seen as incapable of generating sufficient demand and the appreciating euro is seen as contributing to the economic malaise." At Deutsche Bank, "we think the euro would have to go to 1.40 or 1.50 before there would be a crisis. Although we have recently seen some talk in Italy of withdrawing from the euro, the advantage to reintroducing the lira is likely to be elusive. With its massive government debt, Italy would immediately be confronted with substantially higher interest rates that would cause even larger fiscal deficits and overwhelm any gain in competitiveness from a depreciation."
Talk about the break-up of the euro, which until recently "had been taboo," he added, "is due to a temporary loss of morale among the euro classes."
Hedge Funds and Credit Derivatives
Citigroup's Richard Moore focused his comments on the growth of hedge funds and the widespread use of credit derivatives on the financial markets, especially in Europe.
According to Moore, rapid growth in the hedge fund sector over the past decade, particularly since 2000, "is closely related to disappointing performance and outlook from traditional investment approaches. Demographic changes and economic slowing in Organization for Economic Cooperation and Development (OECD) markets underlined the shortfalls of traditional investment products. As a result, many investors have migrated to hedge funds."
While it is estimated that hedge funds now top $1 trillion, there are legitimate dangers associated with them. "The European Central Bank, for example, has warned against 'hedge fund crowding undermining the stability of Euro Zone markets,' where a simultaneous rush for the exit can overwhelm available liquidity."
Yet it would be "a mistake to conclude that hedge funds are intrinsically bad," Moore said, noting that they "provide liquidity, promote transparency, reduce market inefficiencies and offer alternative return profiles at a time when alternative investment vehicles are needed."
Derivatives have at times faced similar criticism, Moore noted, pointing out that Warren Buffett famously called them "weapons of mass destruction." Alan Greenspan, however, has praised their benefits. "A decade or two ago, loan and bond credit primarily underpinned economic activity," Moore said. "Despite regional variations, most credit risk was assumed by the banking sector. In periods of economic distress or credit deterioration, banking bore the brunt of difficulties. This was hugely dangerous for some banks: Continental Illinois collapsed in 1980 and Spanish Bank Banesto had to be rescued in 1993 as a direct result" of concentrated credit risks.
Credit derivatives, he said, "have transformed this situation, allowing diversification, management and movement of credit risk throughout the financial sector. The growth of credit default swaps, collateralized debt obligations and synthetic collateralized debt obligations, (CDOs), permits investors to select risk and return profiles. Similarly, banks can retain or sell loan risk, depending on their credit perspective."
The strong performance of the banking sector throughout the most recent credit cycle "is a result of this diversification," he noted. "Derivatives allow a freer flow of risk capital across different asset classes and between different types of institutions." But derivatives do involve a degree of risk from, for example, the stress of rapid growth and the emergence of products that haven't been adequately tested. "Similarly, widening credit spreads increase potential for unanticipated losses. The recent jitters in CDO markets underline these inherent problems, demonstrating that even the most sophisticated models can be faulted."