Trading the Risk: Financialisation, Loyalty and Emerging Market Government Policy Autonomy Iain Hardie University of Edinburgh.

Trading the Risk Financialisation Loyalty and

Emerging Market Government Policy Autonomy

Iain Hardie

University of Edinburgh

lsquoFor years now Lebanon has been able to sustain a

government debt-to-GDP ratio which is well beyond levels

deemed sustainablersquo (IMF 2006)

Debt-to-GDP RatiosSelected Countries (2005)

bull Japan 1760bull Lebanon 1746bull Greece 1075bull Italy 1064bull United States 699bull Brazil 673bull Turkey 580bull China 125bull Estonia 48

The Ability to Borrow Matters to Governments

bull Borrowing enhances Government capacity to spend without raising revenue

The Ability to Borrow Matters to Governments

bull Borrowing enhances Government capacity to spend without raising revenue

bull lsquoa crucial advantage enjoyed by the United States [during the Cold War] was the ability to finance increased arms spending by selling bonds to the publicrsquo (Ferguson 2001 406)

The Ability to Borrow Matters to Governments

bull Borrowing enhances Government capacity to spend without raising revenue

bull lsquoa crucial advantage enjoyed by the United States [during the Cold War] was the ability to finance increased arms spending by selling bonds to the publicrsquo (Ferguson 2001 406)

bull lsquoEventually the debt would have to be repaid For a politician however eventually is a long time certainly farther in the future than the next electionrsquo (Frieden 2006 381)

Who Governments Borrow From Matters

bull lsquoWhy does anyone want to buy [the bonds of] a government which is allocatinghellipall its revenues on interest paymentsItrsquos a Ponzi schemersquo (Fund manager London interviewed 18 October 2005)

bull Need to understand the sources of government financing Who Buys Bonds

Governments Want to Borrow Without Conditionality

bull Bond Borrowing Does Not Impose Direct Conditionality (as IMF)

Butbull lsquoIn the sovereign debt market national

governments borrow funds in order to compensate for revenue shortfalls or to fulfil other economic management objectiveshellipthose interest rates represent the governmentrsquos financing costs When market participants punish governments they do so by increasing the interest rates at which they will purchase government securitiesrsquo (Mosley 2003)

lsquoI used to think if there was reincarnation I wanted to come back as the President or the Pope or a 400 baseball hitter But now I want to come back as the bond market You can intimidate everyonersquo (James Carville Bill Clinton campaign strategist)

The Issues

bull How much can governments borrow sustainably

bull To what extent do governments in order to borrow have to follow the policy preferences of bond market investors

Case Study EMBI Yields

0

5

10

15

20

25

3030

04

1998

300

819

98

301

219

98

300

419

99

300

819

99

301

219

99

300

420

00

300

820

00

301

220

00

300

420

01

300

820

01

301

220

01

300

420

02

300

820

02

301

220

02

300

420

03

300

820

03

301

220

03

300

420

04

300

820

04

301

220

04

300

420

05

300

820

05

301

220

05

300

420

06

300

820

06

301

220

06

300

420

07

300

820

07

Date

Yie

ld (s

a) Lebanon

Turkey

Brazil

John Zysman (1983) Governments Markets and

Growthbull lsquothe structure of finance contributes to the statersquos

capacity to act in the economyrsquo

Butbull Contrast is between financing that is (1) capital-

market based (2) credit-based with government-administered prices and (3) credit-based dominated by financial institutions

bull (1) US and UK (2) France and Japan and (3) West Germany

bull Furthermore

bull Zysman assumes a static financial structure Need to analyse change

bull Need for study of lsquoever more elaborate financial marketsrsquo

So

bull Financial systems need disaggregating and their analysis needs updating

Differentiating Financial Market Actors

bull Consider Domestic and Foreign Investors Together

Differentiating Financial Market Actors

bull Consider Domestic and Foreign Investors Together

bull Consider Banks Individuals Pension Funds Mutual Funds Hedge Funds

Differentiating Financial Market Actors

bull Consider Domestic and Foreign Investors Together

bull Consider Banks Individuals Pension Funds Mutual Funds Hedge Funds

Key Variable is Loyalty Linked to the Ability to Exit (Hirschman 1970)

Financialisation

bull Ability to Exit is Linked to the Ability to Trade Risk Financialisation

bull Financialisation = The Ability to Trade Risk (Aglietta and Breton 2001)

Financialisation

bull Ability to Exit is Linked to the Ability to Trade Risk Financialisation

bull Financialisation = The Ability to Trade Risk (Aglietta and Breton 2001)

bull The Ability to Trade Risk is a function of the financialisation of a financial market actor and the financialisation of the market structure

Examples of Differential Investor Loyalty

Time Scale of Investmentbull lsquomy 30 year bonds will never come back within the

next 30 yearsrsquo (Assistant General Manager 50 per cent foreign-owned Turkish bank interviewed 8 December 2005)

Examples of Differential Investor Loyalty

Time Scale of Investmentbull lsquomy 30 year bonds will never come back within the

next 30 yearsrsquo (Assistant General Manager 50 per cent foreign-owned Turkish bank interviewed 8 December 2005)

bull lsquothis position that Irsquove kept is three weeks oldhellipthatrsquos a long timeNobody buys and keeps things for six months a year I mean things changersquo (Hedge fund manager London interviewed 23 June 2005)

Examples of Differential Investor Loyalty

Time Scale of Investmentbull lsquomy 30 year bonds will never come back within the

next 30 yearsrsquo (Assistant General Manager 50 per cent foreign-owned Turkish bank interviewed 8 December 2005)

bull lsquothis position that Irsquove kept is three weeks oldhellipthatrsquos a long timeNobody buys and keeps things for six months a year I mean things changersquo (Hedge fund manager London interviewed 23 June 2005)

bull lsquolocals arehellipreallyhelliplooking for what is going to happen tomorrow or next week 95 per cent of the locals think like thisrsquo (proprietary trader Brazilian bank interviewed 29 August 2006)

Examples of Differential Investor Loyalty

Disloyaltybull lsquoI canrsquot act like a hedge fund I canrsquothellip[sell short when Turkey

is hit by an earthquake] the hedge fund can do that and he wouldnrsquot care less if the news on the Turkish papers saying that they have shorted the market after the earthquakeI canrsquot do that Irsquom a real bank I gothellipclose to 5 million credit cards Im working with nearly every corporate in Turkey somehow on either a credit or a transaction basishellip[R]eputation means a lot to me I have much more good will in my corporate valuation than [a leading international hedge fund]rsquo (Deputy General Manager Turkish bank interviewed 5 December 2005)

Examples of Differential Investor Loyalty

Disloyaltybull lsquoI canrsquot act like a hedge fund I canrsquothellip[sell short when Turkey

is hit by an earthquake] the hedge fund can do that and he wouldnrsquot care less if the news on the Turkish papers saying that they have shorted the market after the earthquakeI canrsquot do that Irsquom a real bank I gothellipclose to 5 million credit cards Im working with nearly every corporate in Turkey somehow on either a credit or a transaction basishellip[R]eputation means a lot to me I have much more good will in my corporate valuation than [a leading international hedge fund]rsquo (Deputy General Manager Turkish bank interviewed 5 December 2005)

bull lsquoIf I would think that in order to make money I would have to go short I would go short andhellipin my mind still my first job is still as a prop trader rather than a bank partner and thatrsquos how it works So my compensation has little to do with the bank resultrsquo (proprietary trader Brazilian bank interviewed 29 August 2006)

Examples of Differential Investor Loyalty

Financing the Governmentbull lsquoat least I have to keephellipwhat I already have

with the governmentand if the governmentneeds some money I have to give itrsquo (Executive Advisor to Chairman Lebanese bank interviewed 8 September 2005)

bull lsquoIf you want to do something drastic you have to keep in mind that itrsquos going tohelliphave an impact on all the rest of your portfolio and assetsrsquo (Head of Treasury Turkish bank interviewed 7 December 2005)

Examples of Differential Investor Loyalty

Performance Measurementbull lsquoI believehellipin free markets but you want to also act as a central

bankerhellipyour business dictates that you want to make profit but not necessarily short term profit or fees profit in the long termrsquo (Head of Treasury Lebanese bank interviewed 9 September 2005)

Examples of Differential Investor Loyalty

Performance Measurementbull lsquoI believehellipin free markets but you want to also act as a central

bankerhellipyour business dictates that you want to make profit but not necessarily short term profit or fees profit in the long termrsquo (Head of Treasury Lebanese bank interviewed 9 September 2005)

bull lsquothe fact that it[Brazil]rsquos a big part of the index mean that a lot of people need to own it in big amountsrsquo (hedge fund manager London interviewed 23 June 2005)

Examples of Differential Investor Loyalty

Performance Measurementbull lsquoI believehellipin free markets but you want to also act as a central

bankerhellipyour business dictates that you want to make profit but not necessarily short term profit or fees profit in the long termrsquo (Head of Treasury Lebanese bank interviewed 9 September 2005)

bull lsquothe fact that it[Brazil]rsquos a big part of the index mean that a lot of people need to own it in big amountsrsquo (hedge fund manager London interviewed 23 June 2005)

bull lsquoIf your investor base doesnrsquot care about month to month PampLhellip then you donrsquot worry about your stop losses because if you have a right call itrsquos going to take 12 months to play outhellip you donrsquot really carehellip Now investors who we have they want a weekly update on the PampLrsquo (hedge fund manager New York interviewed 15 May 2006)

Examples of Differential Investor Loyalty

Financialisation of Market Structurebull lsquoUnfortunately when I want to sell Treasury papers

because of a certain political issue everybody is selling so there is no marketrsquo (Deputy General Manager Lebanese bank interviewed 2 September 2005)

bull lsquoyou cannot imagine a big bank unloading its securities portfolio into the market Thatrsquos not possiblersquo (Deputy General Manager Turkish bank interviewed 5 December 2005)

bull A local derivatives market lsquowouldhellipfundamentally change the way Irsquom running my portfoliorsquo (Deputy General Manager Turkish bank interviewed 5 December 2005)

The Autonomy Curve

Financialisation

Government Policy AutonomyDomestic Banks

Domestic Individuals

Domestic Pension Funds

Domestic Mutual Funds

Domestic Hedge Funds

International Hedge FundsTotal Return Investors

International Mutual FundsIndex Following Investors

Each different investor type is placed on the autonomy curvebased on their financialisation and influence on the financialisation of the government bond market

Movement Along the CurveThe Changing Ability to Trade Risk1 Financialisation of Market Structure

bull Regulation

bull New Financial Instruments Introduced

bull Primary Dealer System

bull Size of Market Individual Bonds

Movement Along the CurveThe Changing Ability to Trade Risk2 Financialisation of Market Actorsbull Regulationbull Performance Measurementbull Transaction Costs (Size of Investor)bull Nature of Investment (Long-TermShort-

Term Leverage Disloyalty)bull Investment Mandatesbull Ease of Full Exit

The Height of the Curve

bull Government Borrowing Requirement (but Relative to the Capacity of the Most Loyal Investors to Provide Financing)

bull Relative Strength of Push and Pull Factors

bull Absolute Strength of Push Factors

bull Credit Ratings

bull Technology

bull Size of Economy

Each Countryrsquos Overall Autonomy

Financialisation

Government Policy Autonomy

Lebanon

Brazil

Turkey

Conclusions

bull To borrow without following investor policy preferences governments must borrow from loyal investors

bull Investor loyalty is linked to the financialisation of government bond market structure and different market actors