[Reader-list] What is ‘global’ about global finance?

[Jeebesh Bagchi]

What is ‘global’ about global finance?
SATYA PEMMARAJU
Seminar No 503, July 2001
http://www.india-seminar.com/2001/503/503%20satya%20pemmaraju.htm

‘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.



Footnotes:

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.

4. Ibid.