At first glance, the title might seem to be bizarre. The point is that Bin Laden had helped bankers? bonuses ever since his Al Qaeda flew two planes into the WTC building on September 9, 2001. Let me explain.
In a recent speech, the perceptive Dr Raghuram Rajan of the IMF made the following comment as one of the three ingredients in his argument to explain why the markets were not out of kilter, although at first glance, they seemed so: ?The third, and perhaps the least understood, is global investment in physical assets that has yet to return to past levels despite the higher productivity and available savings.? He lists many reasons for this: countries are still working off past excessive investment; investments have changed from hard physical assets to investments in research and development that are expensed and not tracked; corporate goods are cheaper and hence less amounts are being spent on investment; investment in emerging markets are held back by economic uncertainty which, in turn, is a function of uncertainty?in policy, and due to heightened competitive pressures.
Dr Rajan dismisses some of the explanations. There could be two?one is that most countries have invested inadequately, given the erosion of their export- market share with China emerging as a major exporter. Also, as China?s savings are far in excess of its high investment spend, it has been unable to raise the overall level of investment spending globally.
The second explanation, and that?s what the title alludes to, is that global terrorism has made corporations very cautious as their money is mostly irrecoverable in the event of a collapse in demand caused by a major act of terrorism. Coming so close after the collapse of the technology bubble, September 11 dealt a heavy blow to risk appetite. And the subsequent US wars in Afghanistan and Iraq have not gone as per plans. So, the perception is that of higher risk. Though there?s been no terrorist attack on the scale of September 11 in the developed world, the risk perception is high enough to deter large-scale physical investment.
These savings have to be used elsewhere. Financial and real estate assets are easier (the former more so) to liquidate than investment in plant and equipment. So, these became the refuge for excess savings. That has led to share buy-backs, M&A transactions, investment in Emerging market bonds and US Treasuries. The result is lower cost of debt and equity capital and rising real estate and financial asset prices almost everywhere. In other words, the normal rise in risk aversion caused by acts of terrorism has paradoxically meant declining risk aversion indicators for financial assets. We can see high risk aversion for physical investment and low risk aversion for financial and speculative investment.
To an extent, Dr Rajan is correct in not holding central bankers fully responsible for this excess liquidity. A less proximate but more crucial cause is the ability and the willingness of banks to misprice risks. Globally, assets under hedge funds are $1.5 trillion. But, most derivative contracts they use are not exactly counted under ?Assets under Management? (AuM) as these contracts have only notional values. Thus, the AuM figures grossly understate the true size of investment positions that they carry.
According to Morgan Stanley?s Serhan Cevik (The curse of Alpha, Nov. 17, 2006), ?the International Swaps and Derivatives Asso-ciation?s data compilation shows that the outstanding volume of over-the-counter credit derivatives incre-ased from $3.5 trillion in 1990 to $63 trillion in 2000 and over $283 trillion this year. Thus, the total amount of exchange-traded and over-the-counter structured financial instruments ballooned from 27.3% of global GDP in 1990 to 772.8% this year.?
A hedge fund manager told me that when the Fund has a short position in USDINR (short US dollar against the Indian rupee) and a long position in USDPHP (long US dollar against the Philippine peso), their prime broker treats this as a combined net exposure of zero as the short position in US dollar is cancelled by the long position. Of course, it is possible the hedge fund is exposing itself to varied risks in both the rupee and the peso and might get its bets wrong on both counts. Obviously, risk controllers working for prime brokers of hedge funds don?t see it that way. The proclivity on their part to overlook risk has led to explosion in the volume of derivative trading described above. Thus, the combination of liquidity and mispricing of risk has inflated asset prices, re-ignited M&A activity and boosted trading and fee income for banks. Higher bonuses result.
To a large degree, banks created their own fortunes thus. But, Bin Laden triggered it. He made corporations reluctant to invest money into creating hard real assets, setting off the financial and speculative boom. Bankers therefore owe some, if not all, of their bonuses to him.
How would it end? The scourge of terrorism and the risk of further attacks persists. One could state that as long as this risk remains high, financial assets would be well bid, boosted by paper and notional money created by banks. Central banks can restore some sanity by raising the cost of funds and introducing an element of fear, which has been reduced in their bid to become transparent.
In the short term, fear of rate increase could come back into the market as it did in May-June this year but that would have a short-term impact. In the long term, this would only stop when hubris and the resultant overreach results in spectacular blow-ups like the Long-term Capital Management. There is no way of telling when and how. Meanwhile, rational investors would continue to stay on for the heady ride in asset prices.
?The writer is head of research, Asia-Pacific and Middle East, Bank of Julius Baer, Singapore. These are his personal views. He can be contacted at jeevatma@gmail.com
