The Financial Crisis Ten years after

1. The Financial CrisisTen years after by Serge Berthier Asian Affairs ASEAN-ISIS Kuala Lumpur 2007

2. Can it happen again? • What reforms have been put in place? • Have governance issues been addressed? • What are the recent developments in Asian financial integration?

3. But wait a minute! • What was the process? • Was this process unique? • Are the actors still the same? • If yes, are they going to repeat the play? • If no, are we safe?

4. What was the process? • Financial liberalization, together with the currency pegs to the US dollar combined with a low interest rate environment in the Asean countries led to large capital inflows (US$69.8 billion in 1996), mainly in the forms of short-term bank loans. • Capital inflows combined with financial deregulation led to a credit boom which led to assets inflation and a perceived (rather than real) overinvestment in the manufacturing sector. • Capital inflows combined with the rising value of the US$ between June 1995 and June 1997 (+50%) and significant differentials in inflation rates created a real appreciation of several currencies. • 1 + 2 + 3 created the perfect environment for arbitrage and huge bets in a financial market with little regulations and little safeguards. • The herding behavior of international markets combined with the IMF”s financial repression in Indonesia created an unpredicted and unexpected contagion effect.

5. Was the process unique? • Capital inflows have been witnessed everywhere, from China to Russia, from Mexico to South America, etc… They have not stopped. • Assets inflation and overinvestment are still everywhere to be seen with the large private equity buy-outs financed by ever-rising instruments of debts (it is called financial innovation!) on the increase year after year. • The rising value of the US$ between June 1995 and June 1997 (+50%) has now turned into a rising devaluation against the Euro and the Yuan, Differentials in inflation rate and political perceptions are affecting the value of several currencies. • 1 + 2 + 3 creates the perfect environment for arbitrage in a financial market awash with a proliferation of hedge funds (20 times more than in 1990) betting on anything and anywhere for short-term gains.

6. Has the pattern of capital inflows changed? • Somechanges in the origin and direction due to the massive foreign reserves accumulated by the Gulf states (1,6 bn) and China (1,3 bn) such as the investment in Blakstone (China) or GE (Saudi Arabia), but the amounts remain insignificant. • During the early 1990s, there were 24 emerging market countries with a stock market. Today there are more than 41. • In 2006, private capital flows to emerging markets were an all-time 550bn. In 2007, private capital flows for emerging markets are on track to beat that record. • The result: “Due to high levels of liquidity and the chasing of yield, we are seeing a lack of differentiation in the pricing of various financial assets in global markets today” says William Rhodes, Chairman of Citibank.

7. Is the currency game the same? Definitely not. The emergence of the euro as the largest currency in the global economy since 2004 has many consequences. Commercial papers (bn) DEC 2005 DEC 2006 US$ 120.8 180.8 Euro 216.7 281.5 International bonds and notes (floating rate)(bn) DEC 2005 DEC 2006 US$ 1206.4 1077.3 Euro 2218.4 3184.4 International bonds and notes (Straight fixed rate) (bn) DEC 2005 DEC 2006 US$ 4036.9 4578.6 Euro 3978.9 5005.5 BIS Quarterly review March 2007

8. Yet the dollar is still the currency of preference for innovative financial instruments Equity related issues (bn) DEC 2005 DEC 2006 US$ 139.1 147.2 Euro 114 114.2 Other (innovative) instruments DEC 2005 DEC 2006 US$ 70.6 104.8 Euro 66.7 72.6 BIS Quarterly review March 2007

9. So 1 + 2 are still validWHAT ABOUT 3? • CURRENCY FLOWS still high. • Assets inflation still prevalent as exemplified by the Chrysler buy-out by Cerberus (7.3 bn + pensions). • What about the long-term value of the US dollar and who believes in it?

10. Not the US financial institutions

11. Have the governance issues been addressed? • They have not: • see World Bank • see G8 finance ministers’ meeting failure to address the hedge funds supervision issue • see the €290 CMS bond scandal where JPMorgan tricked the Greek State pension funds (FT June 1st, 2007) into buying an innovative bond at deeply unfavorable prices, while sharing reap profits with a hedge fund and a German financial institution (who all denied wrong doings but nevertheless are now running for cover). • see the remuneration of the leaders of the hedge fund industry to assess its governance

12. The hedge fund jackpotfor 25 people In 2004, the average earnings were US$251 million Total: US$6.275 bn In 2005: US$363 million Total: US$9.050 bn In 2006: US$570 million Total: US$14.250 bn 97 countries have a GDP above US$14bn,250 - 86 have a GDP of less than 14.250 Source: Alpha Magazine - Alpha uses two components to arrive at hedge fund managers’ earnings: the gains of their own capital in their funds and their share of their firm’s management and performance fees. Most funds charge a 5% management fee and a 44% performance fee)

13. What do you have to do to earn so much? • The most successful hedge fund in 2006 was Medallion (which is now closed to outside investors). It is part of Renaissance Technologies Corp which has been patronized by institutional investors. Medallion uses sophisticated computer programs to identify prices anomalies trading everything from equities and commodities to future and options. • Medallion is a frenetic trader, buying and selling everything from equities and commodities for short-term gains. • While Jean-Claude Trichet, European Central Bank governor says that he does not understand most of the activities of the hedge funds, the Bank for International Settlements (BIS) conclude that hedge funds are important for market dynamism “generally spurring to continuing financial innovation, and by absorbing risk, providing greater depth and liquidity to financial markets”.

14. Absorbing risk… • In late 1998, Long-Term Capital Management collapsed - forcing the Federal Reserve to arrange a bank-funded bail-out of US$3.5 bn involving 14 institutions to avert a possible financial crisis. • In 2006, Amaranth Advisors collapsed, when its tow main funds lost 65% of their investment. It closed with a loss of US$6.6bn from bets on natural gas. • There are about 9000 funds. Half of them have a life span of three years. And about one out of ten goes bust. • “Pension funds reusing hedge fund investment to diversify their own risks, but a situation where almost one-third of the capital for institutions on the cutting edge of financial risks comes from institutions whose first priority is safe investments certainly bears watching”. Rodrigo Rato, IMF Managing Director

15. Conclusion • Can multilateral currency swap deals protect the region from the financial buccaneers of New York and London? • Can the industry implement measures to guard against systemic risks and complacency? • Is the creation of new “products”, who have little transparency and defy both states and international banks a recipe for financial stability?