to different social and cultural constraints in different spots of the
world. It must strive at least to BE SEEN to be trying to minimize the
social costs of its often-botched plans. It must not behave as a
colonial power, which it often does. It must establish trust rather
than impose discipline. Otherwise, it stands no chance to laugh last.
Actually, it stands no chance even to survive.
(Article published January 4, 1999 in "The New Presence")
Return
Financial Crisis, Global Capital Flows and the International Financial
Architecture
The recent upheavals in the world financial markets were quelled by the
immediate intervention of both international financial institutions
such as the IMF and of domestic ones in the developed countries, such
as the Federal Reserve in the USA. The danger seems to have passed,
though recent tremors in South Korea, Brazil and Taiwan do not augur
well. We may face yet another crisis of the same or a larger magnitude
momentarily.
What are the lessons that we can derive from the last crisis to avoid
the next?
The first lesson, it would seem, is that short term and long-term
capital flows are two disparate phenomena with very little in common.
The former is speculative and technical in nature and has very little
to do with fundamental realities. The latter is investment oriented and
committed to the increasing of the welfare and wealth of its new
domicile. It is, therefore, wrong to talk about "global capital flows".
There are investments (including even long term portfolio investments
and venture capital) - and there is speculative, "hot" money. While
"hot money" is very useful as a lubricant on the wheels of liquid
capital markets in rich countries - it can be destructive in less
liquid, immature economies or in economies in transition.
The two phenomena should be accorded a different treatment. While
long-term capital flows should be completely liberalized, encouraged
and welcomed - the short term, "hot money" type should be controlled
and even discouraged. The introduction of fiscally oriented capital
controls (as Chile has implemented) is one possibility. The less
attractive Malaysian model springs to mind. It is less attractive
because it penalizes both the short term and the long-term financial
players. But it is clear that an important and integral part of the new
International Financial Architecture MUST be the control of speculative
money in pursuit of ever-higher yields. There is nothing inherently
wrong with high yields - but the capital markets provide yields
connected to economic depression and to price collapses through the
mechanism of short selling and through the usage of certain
derivatives. This aspect of things must be neutered or at least
countered.
The second lesson is the important role that central banks and other
financial authorities play in the precipitation of financial crises -
or in their prolongation. Financial bubbles and asset price inflation
are the result of euphoric and irrational exuberance - said the
Chairman of the Federal Reserve Bank of the United States, the
legendary Mr. Greenspan and who can dispute this? But the question that
was delicately sidestepped was: WHO is responsible for financial
bubbles? Expansive monetary policies, well-timed signals in the
interest rates markets, liquidity injections, currency interventions,
and international salvage operations - are all co-ordinated by central
banks and by other central or international institutions. Official
INACTION is as conducive to the inflation of financial bubbles as is
official ACTION. By refusing to restructure the banking system, to
introduce appropriate bankruptcy procedures, corporate transparency and
good corporate governance, by engaging in protectionism and
isolationism, by avoiding the implementation of anti competition
legislation - many countries have fostered the vacuum within which
financial crises breed.
The third lesson is that international financial institutions can be of
some help - when not driven by political or geopolitical considerations
and when not married to a dogma. Unfortunately, these are the rare
cases. Most IFIs - notably the IMF and, to a lesser extent, the World
Bank - are both politicised and doctrinaire. It is only lately and
following the recent mega-crisis in Asia, that IFIs began to "reinvent"
themselves, their doctrines and their recipes. This added conceptual
and theoretical flexibility led to better results. It is always better
to tailor a solution to the needs of the client. Perhaps this should be
the biggest evolutionary step:
That IFIs will cease to regard the countries and governments within
their remit as inefficient and corrupt beggars, in constant need of
financial infusions. Rather they should regard these countries as
CLIENTS, customers in need of service. After all, this, exactly, is the
essence of the free market - and it is from IFIs that such countries
should learn the ways of the free market.
In broad outline, there are two types of emerging solutions. One type
is market oriented - and the other, interventionist. The first type
calls for free markets, specially designed financial instruments (see
the example of the Brady bonds) and a global "laissez faire"
environment to solve the issue of financial crises. The second approach
regards the free markets as the SOURCE of the problem, rather than its
solution. It calls for domestic and where necessary international
intervention and assistance in resolving financial crises.
Both approaches have their merits and both should be applied in varying
combinations on a case by case basis.
Indeed, this is the greatest lesson of all:
There are NO magic bullets, final solutions, right ways and only
recipes. This is a trial and error process and in war one should not
limit one's arsenal. Let us employ all the weapons at our disposal to
achieve the best results for everyone involved.
(Article written on August 18, 1999)
Return
The Shadowy World of International Finance
Strange, penumbral, characters roam the boardrooms of banks in the
countries in transition. Some of them pop apparently from nowhere,
others are very well connected and equipped with the most excellent
introductions. They all peddle financial transaction,s which are too
good to be true and often are. In the unctuously perfumed propinquity
of their Mercedesed, Rolex waving entourage - the polydipsic natives
dissolve in their irresistible charm and the temptations of the cash:
mountainous returns on capital, effulgent profits, no collaterals,
track record, or business plan required. Total security is cloyingly
assured.
These Fausts roughly belong to four tribes:
The Shoppers
These are the shabby operators of the marginal shadows of the world of
finance. They broker financial deals with meretricious sweat only to be
rewarded their meagre, humiliated fees. Most of their deals do not
materialize. The principle is very simple:
They approach a bank, a financial institution, or a borrower and say:
"We are connected to banks or financial institutions in the West. We
can bring you money in the form of credits. But to do that - you must
first express interest in getting this money. You must furnish us with
a bank guarantee/promissory note/letter of intent that indicates that
you desire the credit and that you are willing to provide a liquid
financial instrument to back it up." Having obtained such instruments,
the shoppers begin to "shop around". They approach banks and financial
institutions (usually, in the West). This time, they reverse their
text: "We have an excellent client, a good borrower. Are you willing to
lend to it?" An informal process of tendering ensues. Sometimes it ends
in a transaction and the shopper collects a small commission (between
one quarter of a percentage point and two percentage points - depending
on the amount). Mostly it doesn't -and the Flying Dutchman resumes his
wanderings looking for more venal gulosity and less legal probity.
The Con-Men
These are crooks who set up elaborate schemes ("sting operations") to
extract money from unsuspecting people and financial institutions. They
establish "front" or "phantom" firms and offices throughout the world.
They tempt the gullible by offering them enormous, immediate, tax-free,
effort-free, profits. They let the victims profit in the first round or
two of the scam. Then, they sting: the victims invest money and it
evaporates together with the dishonest operators. The "offices" are
deserted, the fake identities, the forged bank references, the
falsified guarantees are all exposed (often with the help of an inside
informant).
Probably the most famous and enduring scam is the "Nigerian-type
Connection". Letters - allegedly composed by very influential and
highly placed officials - are sent out to unsuspecting businessmen. The
latter are asked to make their bank accounts available to the former,
who profess to need the third party bank accounts through which to
funnel the sweet fruits of corruption. The account owners are promised
huge financial rewards if they collaborate and if they bear some
minor-by-comparison upfront costs. The con-men pocket these "expenses"
and vanish. Sometimes, they even empty the accounts of their entire
balance as they evaporate.
The Launderers
A lot of cash goes undeclared to tax authorities in countries in
transition. The informal economy (the daughter of both criminal and
legitimate parents) comprises between 15% (Slovenia) and 50% (Russia,
Macedonia) of the official one. Some say these figures are a deliberate
and ferocious understatement. These are mind boggling amounts, which
circulate between financial centres and off shore havens in the world:
Cyprus, the Cayman Islands, Liechtenstein (Vaduz), Panama and dozens of
aspiring laundrettes.
The money thus smuggled is kept in low-yielding cash deposits. To
escape the cruel fate of inflationary corrosion, it has to be
reinvested. It is stealthily re-introduced to the very economy that it
so sought to evade, in the form of investment capital or other
financial assets (loans and credits). Its anxious owners are
preoccupied with legitimising their stillborn cash through the conduit
of tax-fearing enterprises, or with lending it to same. The emphasis is
on the word: "legitimate". The money surges in through mysterious and
anonymous foreign corporations, via off-shore banking centres, even
through respectable financial institutions (the Bank of New York we
mentioned?). It is easy to recognize a laundering operation. Its
hallmark is a pronounced lack of selectivity. The money is invested in
anything and everything, as long as it appears legitimate.
Diversification is not sought by these nouveau tycoons and they have no
core investment strategy. They spread their illicit funds among dozens
of disparate economic activities and show not the slightest interest in
the putative yields on their investments, the maturity of their assets,
the quality of their newly acquired businesses, their history, or real
value. Never the sedulous, they pay exorbitantly for all manner of
prestidigital endeavours. The future prospects and other normal
investment criteria are beyond them. All they are after is a mirage of
lapidarity.
The Investors
This is the most intriguing group. Normative, law abiding, businessmen,
who stumbled across methods to secure excessive yields on their capital
and are looking to borrow their way into increasing it. By cleverly
participating in bond tenders, by devising ingenious option strategies,
or by arbitraging - yields of up to 300% can be collected in the
immature markets of transition without the normally associated risks.
These sub-species can be found mainly in Russia and in the Balkans.
Its members often buy sovereign bonds and notes at discounts of up to
80% of their face value. Russian obligations could be had for less in
August 1998 and Macedonian ones during the Kosovo crisis. In cahoots
with the issuing country's central bank, they then convert the
obligations to local currency at par (=for 100% of their face value).
The difference makes, needless to add, for an immediate and hefty
profit, yet it is in (often worthless and vicissitudinal) local
currency. The latter is then hurriedly disposed of (at a discount) and
sold to multinationals with operations in the country of issue, which
are in need of local tender. This fast becomes an almost addictive
avocation.
Intoxicated by this pecuniary nectar, the fortunate, those privy to the
secret, try to raise more capital by hunting for financial instruments
they can convert to cash in Western banks. A bank guarantee, a
promissory note, a confirmed letter of credit, a note or a bond
guaranteed by the Central Bank - all will do as deposited collateral
against which a credit line is established and cash is drawn. The cash
is then invested in a new cycle of inebriation to yield fantastic
profits.
It is easy to identify these "investors". They eagerly seek financial
instruments from almost any local bank, no matter how suspect. They
offer to pay for these coveted documents (bank guarantees, bankers'
acceptances, letters of credit) either in cash or by lending to the
bank's clients and this within a month or more from the date of their
issuance. They agree to "cancel" the locally issued financial
instruments by offering a "counter-financial-instrument" (safe keeping
receipt, contra-guarantee, counter promissory note, etc.). This
"counter-instrument" is issued by the very Prime World or European Bank
in which the locally issued financial instruments are deposited as
collateral.
The Investors invariably confidently claim that the financial
instrument issued by the local bank will never be presented or used
(which is true) and that this is a risk free transaction (which is not
entirely so). If they are forced to lend to the bank's clients, they
often ignore the quality of the credit takers, the yields, the
maturities and other considerations, which normally tend to interest
lenders very much.
Whether a financial instrument cancelled by another is still valid,
presentable and should be honoured by its issuer is still debated. In
some cases it is clearly so. If something goes horribly (and rarely,
admittedly) wrong with these transactions - the local bank stands to
suffer, too.
It all boils down to a terrible hunger, the kind of thirst that can be
quelled only by the denominated liquidity of lucre. In the post nuclear
landscape of this part of the world, a fantasy is shared by both
predators and prey. Circling each other in marble temples, they switch
their roles in dizzying progression. Tycoons and politicians,
industrialists and bureaucrats all vie for the attention of Mammon. The
shifting coalitions of well-groomed man in back stabbed suits, an
hallucinatory carousel of avarice and guile. But every circus folds and
every luna park is destined to shut down. The dying music, the frozen
accounts of the deceived, the bankrupt banks, the Jurassic Park of
skeletal industrial beasts - a muted testimony to a wild age of mutual
assured destruction and self deceit. The future of Eastern and South
Europe. The present of Russia, Albania and Yugoslavia.
Return
The Typology of Financial Scandals
Tulipmania - this is the name coined for the first pyramid investment
scheme in history.
In 1634, tulip bulbs were traded in a special exchange in Amsterdam.
People used these bulbs as means of exchange and value store. They
traded them and speculated in them. The rare black tulip bulbs were as
valuable as a big mansion house. The craze lasted four years and it
seemed that it would last forever. But this was not to be.
The bubble burst in 1637. In a matter of a few days, the price of tulip
bulbs was slashed by 96%!
This specific pyramid investment scheme was somewhat different from the
ones, which were to follow it in human financial history elsewhere in
the world. It had no "organizing committee", no identifiable group of
movers and shakers, which controlled and directed it. Also, no explicit
promises were ever made concerning the profits, which the investors
could expect from participating in the scheme - or even that profits
were forthcoming to them.
Since then, pyramid schemes have evolved into intricate psychological
ploys.
Modern ones have a few characteristics in common:
First, they involve ever growing numbers of people. They mushroom
exponentially into proportions that usually threaten the national
economy and the very fabric of society. All of them have grave
political and social implications.
Hundreds of thousands of investors (in a population of less than 3.5
million souls) were deeply enmeshed in the 1983 banking crisis in
Israel.
This was a classic pyramid scheme: the banks offered their own shares
for sale, promising investors that the price of the shares will only go
up (sometimes by 2% daily). The banks used depositors' money, their
capital, their profits and money that they borrowed abroad to keep this
impossible and unhealthy promise. Everyone knew what was going on and
everyone was involved.
The Ministers of Finance, the Governors of the Central Bank assisted
the banks in these criminal pursuits. This specific pyramid scheme -
arguably, the longest in history - lasted 7 years.
On one day in October 1983, ALL the banks in Israel collapsed. The
government faced such civil unrest that it was forced to compensate
shareholders through an elaborate share buyback plan, which lasted 9
years. The total indirect damage is hard to evaluate, but the direct
damage amounted to 6 billion USD.
This specific incident highlights another important attribute of
pyramid schemes: investors are promised impossibly high yields, either
by way of profits or by way of interest paid. Such yields cannot be
derived from the proper investment of the funds - so, the organizers
resort to dirty tricks.
They use new money, invested by new investors - to pay off the old
investors.
The religion of Islam forbids lenders to charge interest on the credits
that they provide. This prohibition is problematic in modern day life
and could bring modern finance to a complete halt.
It was against this backdrop, that a few entrepreneurs and religious
figures in Egypt and in Pakistan established what they called: "Islamic
banks". These banks refrained from either paying interest to depositors
- or from charging their clients interest on the loans that they doled
out. Instead, they have made their depositors partners in fictitious
profits - and have charged their clients for fictitious losses. All
would have been well had the Islamic banks stuck to healthier business
practices.
But they offer impossibly high "profits" and ended the way every
pyramid ends: they collapsed and dragged economies and political
establishments with them.
The latest example of the price paid by whole nations due to failed
pyramid schemes is, of course, Albania 1997. One third of the
population was heavily involved in a series of heavily leveraged
investment plans, which collapsed almost simultaneously. Inept
political and financial crisis management led Albania to the verge of
disintegration into civil war.
But why must pyramid schemes fail? Why can't they continue forever,
riding on the back of new money and keeping every investor happy, new
and old?
The reason is that the number of new investors - and, therefore, the
amount of new money available to the pyramid's organizers - is limited.
There are just so many risk takers. The day of judgement is heralded by
an ominous mismatch between overblown obligations and the trickling
down of new money. When there is no more money available to pay off the
old investors, panic ensues. Everyone wants to draw money at the same
time. This, evidently, is never possible - some of the money is usually
invested in real estate or was provided as a loan. Even the most stable
and healthiest financial institutions never put aside more than 10% of
the money deposited with them.
Thus, pyramids are doomed to collapse.
But, then, most of the investors in pyramids know that pyramids are
scams, not schemes. They stand warned by the collapse of other pyramid
schemes, sometimes in the same place and at the same time. Still, they
are attracted again and again as butterflies are to the fire and with
the same results.
The reason is as old as human psychology: greed, avarice. The
organizers promise the investors two things: (1) that they could draw
their money anytime that they want to and (2) that in the meantime,
they will be able to continue to receive high returns on their money.
People know that this is highly improbable and that the likelihood that
they will lose all or part of their money grows with time. But they
convince themselves that the high profits or interest payments that
they will be able to collect before the pyramid collapses - will more
than amply compensate them for the loss of their money. Some of them
hope to succeed in drawing the money before the imminent collapse,
based on "warning signs". In other words, the investors believe that
they can outwit the organizers of the pyramid. The investors
collaborate with the organizers on the psychological level: cheated and
deceiver engage in a delicate ballet leading to their mutual downfall.
This is undeniably the most dangerous of all types of financial
scandals. It insidiously pervades the very fabric of human
interactions. It distorts economic decisions and it ends in misery on a
national scale. It is the scourge of societies in transition.
The second type of financial scandals is normally connected to the
laundering of capital generated in the "black economy", namely: the
income not reported to the tax authorities. Such money passes through
banking channels, changes ownership a few times, so that its track is
covered and the identities of the owners of the money are concealed.
Money generated by drug dealings, illicit arm trade and the less exotic
form of tax evasion is thus "laundered".
The financial institutions, which participate in laundering operations,
maintain double accounting books. One book is for the purposes of the
official authorities. Those agencies and authorities that deal with
taxation, bank supervision, deposit insurance and financial liquidity
are given access to this set of "engineered" books. The true record is
kept hidden in another set of books. These accounts reflect the real
situation of the financial institution: who deposited how much, when
and under which conditions - and who borrowed what, when and under
which conditions.
This double standard blurs the true situation of the institution to the
point of no return. Even the owners of the institution begin to lose
track of its activities and misapprehend its real standing.
Is it stable? Is it liquid? Is the asset portfolio diversified enough?
No one knows. The fog enshrouds even those who created it in the first
place. No proper financial control and audit is possible under such
circumstances.
Less scrupulous members of the management and the staff of such
financial bodies usually take advantage of the situation. Embezzlements
are very widespread, abuse of authority, misuse or misplacement of
funds. Where no light shines, a lot of creepy creatures tend to develop.